Tim Duy's Fed Watch

FOMC Recap

In broad terms, the FOMC meeting concluded as I had expected. To the extent there were any surprises, they were on the hawkish side. Or, I would say, hawkish mostly if you believed the events of the last few weeks justified a radical revision of the Fed's anticipated policy path. I didn't, but was too busy those same past few weeks to scream into the wind.

As I anticipated, the Fed dismissed the decline in market-based inflation expectations. They clearly believe  financial markets over-reacted to the decline in oil prices, and that that decline would ultimately prove to be a one-time price shock rather than the beginning of a sustained disinflationary process.

This is why we watch core-inflation.

And note that the Fed sent a pretty big signal along the way. In contrast to conventional wisdom, they do not hold market-based measures of inflation expectations as the Holy Grail. Especially with unemployment below 6%, pay more attention to survey-based measures. And recognize they will discount even those if they feel they are unduly affected by energy prices in either direction.

Somewhat more hawkish than I anticipated, they did not explicitly hold out the hope of future asset purchases. The statement shifts directly to the issue of rate hikes. On that point, they did as I had expected, emphasize the data-dependent nature of future 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.

In my opinion, this suggests that they want to retain the baseline expectation of a mid-2015 rate hike with the option for an earlier hike. I don't think they see recent data or market action as by itself justifying the shift to the latter part of 2015. If anything, remember that recent data is pointing to accelerating growth and a rapid decline in unemployment.

And that rapid decline in unemployment is important, as I have trouble imagining a scenario in which the Fed is content to watch unemployment fall below 5.5% without at least beginning the rate hike cycle. Remember that they think that even as they increase rates, they believe that policy will continue to be accommodative. In other words, they do not fear raising rates as necessarily a tightening of policy. They will view it as a necessary adjustment in financial accommodation in response to a decline in labor market slack.  Hence the line:

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 anticipated at least one dissent. In all honesty, this would have been a more impressive call if I had also indicated the direction of the dissent. I expected a hawk to reject the retention of the considerable time language. No such luck - quite the opposite, with noted-dove Minneapolis Federal Reserve President Narayana Kocherlakota protesting both the considerable time language (wanting a more firm commitment to ZIRP) and the decision to end QE. The hawks, in contrast, were generally comfortable with the direction of the discussion. Expect Dallas Federal Reserve President Richard Fisher to say as much soon.

The acceptance of the hawks with the general tone of the meeting is also important. Clearly hawkish in contrast with the shift in market expectations. Time will tell.

Bottom Line:  Despite the market turbulence of recent weeks, the general outlook of monetary policymakers remain generally unchanged.  In general, they continue to see the direction of activity pointing to a mid-year rate hike.  The actual date is of course data dependent, but they have not seen sufficient data in either direction to change that baseline outlook. 

FOMC Meeting

I have been buried the past few weeks.  So blogging has been, and will be, at least for a little longer, light. That said, I have trouble letting an FOMC meeting pass without at least few words before and after - even if there already exist broad agreement on the outcome.

The general expectation is that the Fed ends its bond buying program at the conclusion of the meeting tomorrow. That alone promises to knock down the FOMC statement to a more manageable size. While St. Louis Federal Reserve President James Bullard offered up the possibility of retaining the program for another meeting, there is little indication that other FOMC members are similarly inclined. They have long wanted to get out of asset purchase business, and see no shift in activity sufficient to delay that objective. Moreover, as Boston Federal Reserve President Eric Rosengren has noted, the remaining $15 billion is effectively a rounding error. If the Fed really wants to do something, they need to go bigger. But that is not on the table.

Regarding the statement, here is what I anticipate:

1. The general description of the economy will remain essentially unchanged, expanding at a "moderate pace." This would be consistent with expectations that the economy is currently on track to post 3%+ growth in the third quarter.

2. That said, they will mention they remain watchful of foreign growth.

3. They will acknowledge the further decline in unemployment rates yet retain the view that labor market indicators still suggest underutilization of resources. I would not be surprised by specific mention of low wage growth as evidence of underutilization.

4. I expect the Fed will acknowledge the decline in market-based measures of inflation expectations, but ultimately dismiss those measures for now in favor of stable of survey based measures. In general, I think they will take the approach of Rosengren in this Washington Post interview:

"Inflation breakevens," Rosengren explained, "are based on the pricing of Treasury securities and Treasury Inflation-Protected Securities (TIPS). So if you think about what the implication of significant financial market turbulence is, particularly about Europe, it's for foreign investors to buy Treasury securities. They disproportionately buy regular Treasury securities, so the flight to safety is going to start changing the relative prices of Treasury securities" and make it look like markets expect less inflation. But "if you look at inflation expectations based more on surveys, there's been a little bit of softening, but certainly nothing consistent with the kind of movements we've seen in the [Treasury] breakevens. So I wouldn't overreact to one or two weeks of sharp movements, because I think there are plenty of other reasons to explain" them.

5. I expect the risks to growth and employment will remain balanced, and the risk of persistently low inflation will continue to be "somewhat diminished."

6. They will announce the end of the asset purchase program, but emphasize continued reinvestment of principle and that the sizable asset holdings will continue to provide support for the recovery.

7. They will note that despite the end of asset purchases, such purchases remain in the monetary toolbox and could be revived if conditions warranted.

8. The "considerable time" language will remain. I don't anticipate any tweaks to the interest rate guidance, but I would expect if there are any such tweaks, they would be to emphasize the data-dependent nature of future policy decisions.

9. I expect at least one dissent.

Bottom Line:  I am anticipating a pretty straightforward result from this FOMC meeting. 

The Methodical Fed

Just a few months ago the specter of inflation dominated Wall Street. Now the tables have turned and low inflation is again the worry du jour as a deflationary wave propagates from the rest of the world - think Europe, China, oil prices. How quickly sentiment changes.

And given how quickly sentiment changes, I am loath to make any predictions on the implications for Fed policy. The very earliest one could even imagine a possible rate hike would be March of next year, still five months away. But since that month is the preference of Fed hawks, better to think that the earliest is the June meeting, still eight months away.

Eight months is a long time.  We could pass through two more of these sentiment cycles between now and then.  Or maybe the story breaks decisively one direction or the other.  Given the uncertainty of economy activity, it is clearly dangerous to become too wedded to a particular date for liftoff.  At best we can describe probabilities.

But what I think is often missing is a recognition that through all of the ups and downs of last year, the Fed has sent a very consistent signal: The ongoing improvement in the US economy justifies the steady removal of monetary accommodation. To be sure, we can quibble over the timing of the first move, but consider the path since last May:

1. In May of 2013, then-Federal Reserve Chair Ben Bernanke opens the door for tapering of asset purchases.
2. The actual tapering begins in December of that year, two meetings later than expected. I think it is heroic to believe those 12 weeks were materially important. By that point, the underlying expectation was well established.
3. Although they claimed that the pace of tapering was data dependent, they proceeded on a very methodical path of $10 billion cuts at each meeting. They proceeded on this path despite persistent below target inflation.
4. They clearly established that this month's meeting is very, very likely to be the end of the asset purchase program. Again, they stated this expectation despite low inflation.  
5. Despite the current turmoil, I still expect the asset purchase program to end. I think hawks and doves alike want out of that program. They want to return to interest rate-based policy.
6. Even as inflation bounces along below target, they formulated and announced the path of policy normalization. That normalization includes the expectation that the expansion of the balance sheet was temporary and thus will be reversed.  
7. Even as inflation has bounced along below trend, they have repeatedly warned via the Summary of Economic Projections that rate hikes are just around the corner, and that market participants should plan accordingly. 
8. And while New York Federal Reserve President William Dudley foreshadowed the minutes and a week of Fedspeak that was generally interpreted dovishly, the key takeaway was although the US economy was not expected to accelerate further, the current path was sufficient to believe in the "consensus view is that lift-off will take place around the middle of next year.  That seems like a reasonable view to me"  even "if it were to cause a bump or two in financial markets." Those remarks were seconded by San Francisco Federal Reserve President John Williams. So the moderates and hawks both continue to send signal rates hikes by the middle of next year, leaving the voices of doves Minneapolis Federal Reserve President Narayana Kocherlakota and Chicago Federal Reserve President Charles Evans sounding very lonely. Fed Chair Janet Yellen has been somewhat absent from the current debate, although we suppose she sympathizes more with the dovish position.

Given the consistent, methodological approach to policy normalization witnessed over the past year, is it wonder that inflation signals all look soft? For example:

 

Fed signaling resulted in consistent, downward pressure on inflation expectations. Hence what they view as a dovish policy stance, I view as a hawkish policy stance. And most remarkable to me is that they never realized what I always thought was obvious - that they were setting the stage for a return trip to the zero bound in the next recession. Matthew C Klein at the Financial Times points us to this from the Fed minutes:

For example, respondents to the recent Survey of Primary Dealers placed considerable odds on the federal funds rate returning to the zero lower bound during the two years following the initial increase in that rate. The probability that investors attach to such low interest rate scenarios could pull the expected path of the federal funds rate computed from market quotes below most Committee participants’ assessments of appropriate policy.

The most hawkish projection for the long-term Federal Funds rate is 4.25%.  During the downside, cutting cycles are generally in excess of 500bp. The math here is not that complicated. I struggle to find the scenario by which policy does not revert to the zero lower bound. That would imply that the Fed allows conditions to evolve such that the appropriate Fed Funds rate is well in excess of 6%. But given the Fed thinks that the equilibrium real rate has fallen, this implies a willingness to support higher inflation expectations, which is something I just don't see at this point.  

And I don't think it is just me. I don't think Wall Street sees the path out. Hence the high probability assigned to a return to the zero bound. Hence also the flattening of the yield curve since tapering began:

I think the Fed should very much change its messaging if policymakers want to lift us from the zero bound for more than a couple of years. I think they should drop the calendar-based guidance they are all now giving. I think they should drop the SEP dot plot, because that clearly sends a hawkish message. I think they should drop reference to the labor market outcomes in terms of quantities in favor of price signals (wages, a direction they seem to be moving). I think they should define their policy strategy to make clear they intend to lift the economy off the zero bound permanently, but that I believe requires them to abandon their 2% inflation fetish (and note that on this I believe their behavior is clearly more consistent with a 2% ceiling then a symmetrical target). They also need to adandon their claim that the balance sheet will be reversed.  The size of the balance sheet should not be a policy objective, only the economic outcomes yielded by the size of the balance sheet.

That said, I am also beginning to expect that a return to the zero bound is almost guaranteed. I fear the time has passed for the appropriate mix of fiscal and monetary policy that leaps the economy to a higher equilibrium. But that is a topic for another post.

Bottom Line:  Fed policy might sound dovish this week, but take note the the underlying tone has been methodically hawkish for a long, long time. And markets have responded accordingly, including anticipating a return to the zero bound when the next recession hits. Nor should this be unexpected. Monetary policymakers have yet to set clear objectives that includes a high probability that the zero bound is left behind for good. 

The Labor Market Conditions Index: Use With Care

I was curious to see how the press would report on the Federal Reserve Board's new Labor Market Conditions Index.  My prior was that the reporting should be confusing at best.  My favorite so far is from Reuters, via the WSJ:

Fed Chairwoman Janet Yellen has cited the new index as a broader gauge of employment conditions than the unemployment rate, which has fallen faster than expected in recent months. The index’s slowdown over the summer could bolster the argument that the Fed should be patient in watching the economy improve before raising rates.

But its pickup last month could strengthen the case that the labor market is tightening fast and officials should consider raising rates sooner than widely expected. Many investors anticipate the Fed will make its first move in the middle of next year, a perception some top officials have encouraged.

Translation:  We don't know what it means.

Now, this is not exactly the fault of the press. The Fed appears to want you to believe the LMCI is important, but they really don't give you reason to believe it should be important. They don't even release the LMCI - the charts on Business Week and US News and World Report are titled erroneously.  The Fed releases the monthly change of the LMCI, as noted by Business Insider. But wait, no that's not right either. They actually release the six-month moving average of the LCMI, which means we really don't know the monthly change.¹ What the Fed releases might actually be more impacted by what left the average six months ago than the reading from the most recent month. And you should recognize the danger of the six-month moving average - the longer the smoothing process, the more likely to miss turning points in the data.  Unless of course the Fed released the raw data to follow as well.  Which they don't. [Update:  Commenter Ernie Tedeschi reads through the confusion and believes that the reported number is simply the monthly change.  It would be helpful to have the raw data in levels to clarify this point further.]

The LCMI becomes even more confusing because it has been impressed upon the financial markets that it must have a dovish interpretation. From Business Insider:

The index was first "made famous" by Fed Chair Janet Yellen in her speech at Jackson Hole, when she said, "This broadly based metric supports the conclusion that the labor market has improved significantly over the past year, but it also suggests that the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions."

Recall that at Jackson Hole, Yellen spoke about the labor market puzzle of a steadily declining unemployment rate and strong payroll gains against the backdrop of declining labor force participation and flat wages.

Consider this in light of this from the Fed:

The first part of the associated commentary:

Table 2 reports the cumulative and average monthly change in the LMCI during each of the NBER-defined contractions and expansions since 1980. Over that time period, the LMCI has fallen about an average of 20 points per month during a recession and risen about 4 points per month during an expansion. In terms of the average monthly changes, then, the labor market improvement seen in the current expansion has been roughly in line with its typical pace...

If you look closely, the average monthly change during this expansion is faster than every recovery since the 1980-81 expansion. How does this fit with the conventional wisdom that we are experiencing a slow labor market recovery?  Indeed, look at the chart:

According to this measure, the pace of improvement in this recovery exceeds than much of the 1990's.  Think about that.

Moreover, consider the next sentence of the commentary:

...That said, the cumulative increase in the index since July 2009 (290 index points) is still smaller in magnitude than the extraordinarily large decline during the Great Recession (over 350 points from January 2008 to June 2009).

OK - so the Fed thinks the cumulative change is important. They think it is relevant that the LCMI has not retraced all of its losses. Let's take this idea further. Rather than using the recession dating, consider the even larger move from peak to trough. Between May 2007 to June 2009, the cumulative decrease in the LCMI was 398.4. Since then, the cumulative increase is 300.7, so the LCMI has retraced 75% of its losses.

Now consider the unemployment rate. The unemployment rate increased 5.6 percentage points from a low of 4.4% to a high of 10%. SInce then it has retraced 4.1 percentage points of that gain to last month's 5.9% rate.  4.1 is 73% of 5.6.  In other words, the unemployment rate has retraced 73% of it losses.

The LCMI has retraced 75% of its losses. The unemployment rate has retraced 73% of it losses. So the LCMI shows the exact same amount of improvement in labor market conditions peak to trough as implied by the retracement of the unemployment rate.

You see the problem. The LMCI (or the data made available to the public) suggests the same amount of improvement in labor market conditions as implied by the unemployment rate. The LMCI suggests a faster pace of improvement than that seen in the previous three recoveries. So how exactly does Yellen reach the conclusion that "the decline in the unemployment rate over this period somewhat overstates the improvement in overall labor market conditions"? I am not seeing it on the basis of the data provided. Indeed, where exactly is the research showing the LCMI has some policy relevance?  

Then again, this could be exactly why Yellen uses the modifier "somewhat" in the above quote. Perhaps she has no conviction that the LMCI provides information not already in the unemployment rate.  If that's the case, then expect the LMCI to die on the vine, eventually relegated to be computed by whoever still has the p-star model on their list of assignments.

Bottom Line:  Use the Fed's new labor market index with caution.  Extreme caution.  They are not releasing the raw data. They don't appear to have research explaining its policy relevance. Yellen's halfhearted claim that it provides information above and beyond the unemployment rate is questionable with a simple look at the cumulative change of the index compared to that of unemployment. And her halfhearted claims are even more telling given that she was the impetus for the research. If it was policy relevant, you would think she would be a little more enthusiastic (think optimal control). Moreover, the faster pace of recovery of the index compared to previous recessions - as clearly indicated by the Fed - seems completely at odds with the story it is supposed to support. Simply put, the press and financial market participants should be pushing the Fed much harder to explain exactly why this measure is important.

 

1. The LCMI data provided by the Fed is described as the "average monthly change." I am not sure why they don't explicitly provide the span of the averaging, but the website describes it as "Chart 1 plots the average monthly change in the LMCI since 1977. Except for the final bar, which covers the first quarter of 2014, each of the bars represents the average over a six-month period."

Is There a Wage Growth Puzzle?

Is there a wage growth puzzle?  Justin Wolfers says there is, and uses this picture:

 

to claim:

This puzzle isn’t entirely new, as the usual link between unemployment and the rate of wage growth has totally broken down over recent years.

​The recent data have made a sharp departure from the usual textbook analysis in which a tighter labor market leads to faster wage growth, and subsequent cost pressures feed through to higher inflation.

But has the link between wage growth and unemployment "totally broken down"? Eyeball econometrics alone suggests reason to be cautious with this claim as the only deviation from the typical unemployment/wage growth relationship is the "swirlogram" of fairly high wage growth relative to unemployment through the end of 2011 or so. But is this a breakdown or a typical pattern of a fairly severe recession? While, it might seem unusual if you begin the sample at 1985 as Wolfers did, so let's see what the 1980-85 episode looks like:

Same swirlogram. Compare the two recessions:

Fairly similar patterns, although in the 80-85 episode there was more room to push down the inflation expectations component of wage growth. It would appear that in the face of severe contractions, wage adjustment is slow. Now consider the 1985-1990 period:

Notice that wage growth is stagnant until unemployment moves below 6% - past experience thus suggests that we should not expect significant wage growth until we move well below 6% (you could argue the response actually began at 6.5%). Thus, it is premature to believe that there has been a breakdown in this relationship. So far, the response of wages is exactly what you should have expected in light of the 1980's dynamics. Which leads to two points:

1. I am no fan of Dallas Federal Reserve President Richard Fisher.  That said, he did not pick 6.1% out of a hat when he said that was the point at which wage growth has tended to accelerate in the past.  That number fell out of his staff's research for a reason and surprises me not one bit.
2. There is a reason the Fed picked 6.5% unemployment for the Evan's rule.  There was absolutely no chance that that would be a meaningful number as far as labor market healing is concerned.  

Consider now the sample since 1990:

 Note four points:

1. Notice the minor "swirlogram" associated with the early-90's recession. Again, not a breakdown.
2. After 1992, wage growth tends to move sideways until unemployment sinks below 6%.
3. Since 2012, the relationship is as traditional theory would suggest, a point that is actually evident on Wolfer's chart as well. The R-squared on the regression line is 0.75. Although notice that again, as wage growth moves into that 2.5% range, it appears to once again move mostly sideways.  No mystery - nothing we haven't seen before.
4. Clearly, there is some noise in the relationship. You should be able to extract away from the noise and recognize that there is no sudden acceleration in wage growth. 

Now let's take another step and consider the relationship between unemployment and real wages (note that the series ends in 2014:8 - we don't have the September PCE price data yet):

 

The period of the Great Disinflation was generally associated with negative real wage growth. The period of the mid-90s to the Great Recession was generally associated with positive real wage growth. The swirlogram of the Great Recession is again evident, but notice that as unemployment approached the bottom end of the black regression line (R-squared = 0.65), real wage growth actually accelerated before returning to trend. I now have additional sympathy for firms that have complained in the past two years that they could not push wage growth through to higher prices. It does appear that real wage growth was faster than might be expected given the pace of economic activity and, by extension, the level of unemployment.

Oh - and real wage growth has reverted to the pre-Great Recession trend - pretty much exactly where you would expect it to be given the level of unemployment. Honestly, this one surprised me.

Which suggests that labor market healing has progressed much further than many progressives would like to admit. Many conservatives as well.

Which also means a lot of people are not going to like this chart.

And before you complain that the all-employee average wage data holds some great secret that is not in the production and nonsupervisory wage series (I have trouble taking seriously any sweeping generalizations of the business cycle dynamics of a series we only have through one business cycle), here is that version:

 

Same swirlogram. Pretty much the same idea with wage growth heading right back to where you would expect prior to the great recession.    

Bottom Line:  Be cautious in assuming that this time is different. The unemployment and wage growth dynamics to date are actually very similar to what we have seen in the past. Low wage growth to date is not the "smoking gun" of proof of the importance of underemployment measures. There very well may have been much more labor market healing that many are willing to accept, even many FOMC members. The implications for monetary policy are straightforward - it suggests the risk leans toward tighter than anticipated policy. 

Fisher on Wages

Dallas Federal Reserve President Richard Fisher said Friday the US economy was threatend by higher wages.  Via Reuters:

Fisher said on Friday he worries that further declines in unemployment nationally could lead to broader wage inflation. To head that off, and also to address what he called rising excesses in financial markets, Fisher said he prefers to raise rates by springtime, sooner than many investors currently anticipate.

After a snarky tweet, I wondered if he was not misquoted or misinterpreted.  But he definitely warns that wage growth is set to accelerate in his Fox News interview (begin at the 3:50 mark).  The crux of his argument is that wage growth accelerates when unemployment hits 6.1% and he uses strong wage growth in Texas as an example.  He seems genuinely concerned that wage growth is negative outcome - that wage growth in Texas is a precursor to a terrible outcome for the US economy as a whole.

His entire tone is odd, and I feel compelled to clean up his argument, at least as much as is possible.  

Fisher says that he presented evidence at the last FOMC meeting that 6.1% was the tipping point for wage acceleration.  I can't disagree - I said as much this past March.  The updated chart:

Another version:

It is reasonable to expect that wage growth will accelerate as unemployment moves below 6%.  I believe this is something of a test of the hypothesis that alternative measures of under-utilization more accurately convey information about the degree of slack.  If that hypothesis is correct, then wage growth should not accelerate.

That said, why should Fisher fear wage growth?  I don't see how one can expect real wages to rise in the absence of nominal wage growth in excess of inflation.  And once you accept the possibility of real wage growth, you recognize the link between wage growth and inflation could be very weak.  And so it is: 

Note the period of disinflation that pulls inflation down to it's range since the mid-90s across a wide-variety of wage growth rates. The past 20 years give no reason to believe that 4% wage inflation cannot happily coexist with 2% price inflation.  

So if wage inflation does not necessarily translate into price inflation, why worry at all? Why is Fisher even worried about wages?  The key is really just this quote:

This is like duck hunting, you shot ahead of the mallard rather than try to get it from behind, otherwise you can't hit it.

It is all about the timing. I think his argument might be more effective is he said this:  

• The reason low unemployment does not cause inflation - or, essentially, why the Phillips curve is now flat - is that policymakers remove financial accommodation ahead of actual inflation.  This is implicit in the Summary of Economic Projections.  The reason inflation stabilizes near target is because unemployment settles near its natural rate, guided there by higher interest rates.
• To judge the appropriate timing and magnitude of financial market accommodation, the Federal Reserve traditionally used the unemployment rate as a key indicator of slack in the economy.  Accommodation would be reduced as the unemployment rate moved close to its natural rate, and conditions tightened has unemployment moved below the natural rate.
• The Texas experience suggests that these traditional measures remain relevant - this should be his key point.  Low unemployment rates stoke wage inflation as firms compete for workers, just as it has in the past.
• Rather than act disgusted by higher wage growth, he should say that the Fed needs to ensure that such growth translates into real wage growth, and the Fed accomplishes this by adjusting accommodation to maintain its price inflation target. The Fed wants to hold unemployment in a zone consistent with both real wage growth and low and stable inflation. This requires nominal wage growth in excess of 2%.
• It follows then that given the unemployment rate is already near 6%, it is not reasonable for the Fed to suggest that the first rate hike is a "considerable period" off in the future.  The Fed traditionally moves ahead of inflation, and higher wage growth, which will soon be at hand, will be evidence that the first rate hike needs to be pulled forward.  

Stated like this, I suspect a large portion of the FOMC would be sympathetic. For example, recall San Francisco Federal Reserve President John Williams from this past March:

“At that point if we don’t start to adjust monetary policy there’d be a risk of overshooting,” he said. “You don’t wait until you’re at full employment before you start to raise interest rates from zero.”

That said, most members lack Fisher's certainty that wages gains are set to accelerate and indicate that labor market slack has dwindled to the point that it is appropriate to remove financial accommodation. There remains the concern that the unemployment rate is not the best measure of labor market slack. They would prefer to wait until they have firm evidence of the absence of labor market slack and risk a small overshoot of inflation.

Moreover, as we now know, showing their anti-inflationary resolve did not do the Fed any favors in 2006 and 2007.  As a whole, the Fed is acutely aware of this result.  It has not gone unnoticed that the while the economy has suffered from repeated recessions since the great Moderation began, it has not suffered from a bout of inflation.  It is reasonable to thus conclude that on average, the Fed has been too tight, not too loose. Hence again why the FOMC is willing to be patient in the normalization process.

Bottom Line: Fisher suggests that wage inflation by itself is a concern and needs to be brought to a halt.  This is of course incorrect. Fisher sees an inflation threat in any and all data. Indeed, there could really be no other reason to be concerned about wage inflation. I suspect that Fisher has pivoted to concerns about wage inflation because his much feared price inflation has never emerged.  That said, there is an element of truth here as well. Unemployment is nearing a range that is typically associated with faster wage growth. The Fed will respond to reduced slack in labor markets with less accommodation, and they will see accelerating wage growth as a signal that slack has largely been eliminated.  But they are in no rush to do so any faster than necessary.  Hence the slow taper and the subsequent delay in hiking rates.  The balance of risks may be in the direction of tighter than expected policy, but the Fed needs to see more convincing data before they actually move in that direction.  

Hawkish Undertone

 The Fed continuous to moves toward policy normalization.  

Slowly. Very slowly.  

They believe they are making every effort to avoid a premature withdrawal of accommodation. Every step is sequenced. And that sequencing did not allow for the removal of the considerable period language just yet.   

That said, Federal Reserve Chair Janet Yellen noted in the associated press conference that, considerable period or not, the statement does not represent a promise to maintain a particular policy path. Moreover, the ambiguous definition of "considerable time" gives the Fed sufficient flexibility without breaking a promise in any event. Assuming asset prices end in October as the Fed expects, even a rate hike as early as March could still be considered a "considerable period."  So too arguably would be a hike as early as January. It seems then that the considerable period language could survive longer than I anticipated. 

Of course, if the statement is not a promise and "considerable period" has no fixed meaning, then the path of policy is strictly data dependent. And that is the idea now emphasized repeatedly by Yellen and Co. If the economy performs better than expected, rates hikes will come sooner and faster currently anticipated. If worse, the withdrawal of monetary accommodation will be delayed.  

This is where the dot-plot comes into play. If we combine the midpoint of the economic estimates with the median of the rate expectations, you see the central tendency of the FOMC is to still expect a considerable period of time until rate normalization:

 

Normalization is coming. But slowly. Very slowly. They have yet to see sufficient evidence to believe that policy will need to be considerably more aggressive than expected.

But where must the FOMC believe the balance of risks lies? Given the progress toward goals already achieved, and the wide spread between traditional metrics of appropriate policy and expected actual policy, it is reasonable to believe the FOMC is cautious that the risks are balanced toward tighter than expected policy. Indeed, the slow but steady increases in federal funds rate projections suggests that the data are indeed moving in such a direction. Hence, the Fed wants to disabuse market participants of the notion that the statement represents a promise. It is an only a policy expectation dependent on a particular set of assumptions. When those assumptions change, so too will the expectation.

Simply put, the Fed believes the statement accurately conveys their expectations given the current state of knowledge. It must then be somewhat disconcerting to the FOMC that while the possibility of a tighter than anticipating policy path is very real, financial market participants appear to believe the risks are weighted in the opposite direction. That, at least, is the message delivered by the San Francisco Federal Reserve in a well-publicized research note. The note also suggested much less uncertainty about the rate outlook than that of the FOMC. See also the Financial Times:

The FOMC’s median rate for the fed funds rate by the end of 2015 was raised to 1.375 per cent from 1.125 per cent, with the key overnight borrowing rate seen reaching 2.875 per cent, rather than 2.50 per cent by the end of 2016.

In contrast, the bond market expects a funds rate of 0.76 per cent by the end of 2015 and 1.82 per cent a year later.

When asked about these divergent expectations, Yellen suggested that other research found more aligned expectations. And even if the expectations did differ, they can be explained by different forecasts:

They are taking into account the possibility that there can be different economic outcomes, including--even if they're not very likely--ones in which outcomes will be characterized by low inflation or low growth and the appropriate path of rates will be low. So, differences in probabilities of different outcomes can explain part of that.

I would suggest another explanation. Financial market participants are attempting to find Yellen's dots as an indicator of the median policy expectation (note that Jon Hilsenrath of the Wall Street Journal asked her to reveal her dots during the press conference). The focus has fallen on the lower sets of dots in recognition of her reputation as a policy doves and, I think, the view that she repeatedly made an explicit policy promise with her optimal control framework. Specifically:

 

No policy liftoff until 2016 - a rate path that is more consistent with the lower or lowest set of dots in the Fed's SEP than the median policy expectation. The assumption is that Yellen's dots are bigger in practice than the other dots, hence an emphasis on expecting a more prolonged period of low rates than the median FOMC participant. 

It would be helpful if Yellen revisited her optimal control theory now that unemployment is hovering near 6%. But it is reasonable to believe that she is less certain of her previously suggested path of monetary policy now that the Fed is closer to meeting its stated goals.  Hence the ambiguity in her message beginning with Jackson Hole. She is telling us that the time of commitment to low interest rates is drawing to an end. The data now take precedence. As long as the data cut in the direction of what are believed to be Yellen's dots, then those dots will yield a fairly accurate forecast.  But if the data cut in a more positive direction, then more hawkish dots will have been the better forecast. 

And, importantly, the Federal Reserve wants market participants to figure this out on there own.  Policymakers believe they have sent sufficient signals regarding their likely reaction function. Now they want to see participants adjust pricing according to that reaction function, not on the basis of some promise that was never really a promise in the first place.  Or, in Yellen's own words:

What can I say is that it is important for market participants to understand what our likely response or reaction function is to the data and our job is to try to communicate as clearly as we can the way in which our policy stance will depend on the data, and I promise to try to do that.

Bottom Line:  The outcome of last week's meeting had little impact on my policy outlook. I continue to expect a rate hike in the middle of next year, with my distribution of risks weighted toward second over third quarter outcomes. And note that the second quarter would include a June meeting - still nine months away. I anticipate a generally positive pace of activity that will push the unemployment rate well below 6% by that time. As the unemployment rate moves below 6%, the FOMC will simply worry that accommodation is straying too far past traditional metrics to be consistent with stable inflation. They would not want this to come as a surprise, hence the emphasis on the ambiguity of the forecast. An ultra-low rate future is not guaranteed. The Fed is emphasizing the uncertainty of the forecast to ensure that market participants recognize another future is possible - and even perhaps more likely - than the lowest set of dots, as suggested by the upward drift in median rate projections. If that upward drift is prescient, don't say the Fed didn't warn you. Follow the data, just as the Fed is telling you.

Forward Guidance Heading for a Change

The lackluster August employment report clearly defied expectations (including my own) for a strong number to round out the generally positive pattern of recent data.  That said, one number does not make a trend, and the monthly change in nonfarm payrolls is notoriously volatile.  The underlying pattern of improvement remains in tact, and thus the employment report did not alleviate the need to adjust the Fed's forward guidance, allow there is a less pressing need to do so at the next meeting.  In any event, the days of the "considerable time" language are numbered.

Nonfarm payrolls gained just 142k in August while the unemployment rate ticked back down to 6.1%.  In general, the employment report is consistent with steady progress in the context of data that Fed Chair Janet Yellen has identified in the past: 

Arguably the only trend that is markedly different is the more rapid decline in long-term unemployment, a positive cyclical indicator.  Labor force participation remains subdued, although the Fed increasing views that as a structural issue.  Average wage growth remained flat while wages for production workers accelerated slightly to 2.53% over the past year.  A postive development to be sure, but too early to declare a sustained trend.

The notable absence of any bad news in the labor report leaves the door open to changing the forward guidance at the next FOMC meeting.  As Robin Harding at the Financial Times notes, many Fed officials, including both doves and hawks, have taken issue with the current language, particularly the seemingly calendar dependent "considerable time" phrase.  Officials would like to move toward guidance that is more clearly data dependent.

Is a shift in the language likely at the next meeting?  Harding is mixed:

Their remarks could mean a move at the September FOMC meeting in 10 days, although there is little consensus yet on new wording, so a shift might have to wait until next month.

The trick is to change the language without suggesting the timing of the first rate hike is necessarily moving forward.  The benefit of the next meeting is that it includes updated projections and a press conference.  Stable policy expectations in those projections would create a nice opportunity to change the language.  Moreover, Yellen would be able to to further explain any changes at that time.  This also helps set the stage for the end of asset purchases in October.  A shift in the guidance next week has a lot to offer.

A change in the language would also throw some additional light on Yellen's comments at Jackson Hole.  Her typically unabashed defense of labor market slack was missing from her speech, replaced by a much more even-handed evaluation of the data.  Was she simply setting the stage for an academic conference, or was she signalling a shift in her convictions?  A change in the language at the next meeting would suggest the latter.

Bottom Line: The US economy is moving to a point in the cycle in which monetary policymakers have less certainty about the path of rates.  Perhaps they need to be pulled forward, perhaps pushed back.  Policymakers will need to be increasingly pragmatic, to use Yellen's term, when assessing the data.  The "considerable time" language is inconsistent with such a pragmatic approach.  It is hard to see that such language survives more than another FOMC statement.  Seems to be data and policy objections are not the impediments preventing a change in the guidance, but instead the roadblock is the ability to reach agreement on new language in the next ten days.

August Employment Report Tomorrow

Tomorrow morning we will be obsessing over the details of the August employment report with an eye toward the implications for monetary policy.  Time for a quick review of some key indicators.  First, initial unemployment claims continue to track at pre-recession levels:

 The employment components of both ISM reports where solid:

 

The ADP report, however, was arguably lackluster with a gain of just 204k private sector jobs:

 

The consensus forecast is for nonfarm payroll growth of 230k with a range of 195k to 279k.  I am in general agreement with that forecast:

 

I am somewhat concerned that I should be downgrading the importance of the ADP number and upgrading the strong claims and ISM data, leading me to conclude that the balance of risks lies to the upside of this forecast.  

Of course, the headline nonfarm payrolls report is not necessarily the most important.  Per usual, we will be scouring the data for indications that underemployment is lessening and slack being driven out of the labor market. And although Fed Chair Yellen has diverted our attention to those numbers, we should also keep a close eye on the unemployment rate, still the best single indicator of the state of the labor market.  Consensus is a slight drop in the rate to 6.1%.  I would hazard that a sub-6% rate is not out of the question as we have seen our share of 0.3 percentage point declines or greater in recent years.  

A 5 handle on the unemployment rate would increase tensions in the FOMC between those who believe we are straying dangerously far from traditional indicators of appropriate monetary policy:

 

and those who are willing to risk falling behind the curve by waiting until at least sustained target inflation is reached:

Either way, I suspect any meaningful decline in unemployment will add fire to the communications debate at the Federal Reserve.  Newly minted Cleveland Federal Reserve President Loretta Mester said today:

In addition to taking another step to taper asset purchases, in July, the FOMC maintained its forward guidance on interest rates.  This guidance indicated that given our assessment of realized and expected progress toward our dual-mandate objectives, it will likely be appropriate to maintain the current 0-to-¼ percentage point range for the federal funds rate for a considerable period after the asset purchase program ends.  With the end of the program nearing, I believe it is again time for the Committee to reformulate its forward guidance.

 Bottom Line:  Any further good news in labor markets will make it increasingly difficult for the Fed to maintain its "considerable period" guidance.  

Solid Start to September

The ISM manufacturing report came in ahead of expectations with the strongest number since 2011:

Moreover, strength was evident throughout the internal components:

Note too that the report is consistent with other manufacturing numbers:

 If this is a taste of the data to expect this fall, it is tough to see how the Fed will be able to maintain their "considerable period" language much longer.