Federal Reserve Bank of St. Louis President James Bullard participated in an event we co-hosted with the European Chamber of Commerce at the New York Stock Exchange earlier this morning. A video link is available for those interested on Bloomberg (and we would be happy to forward it to those who would like). The press also covered the event, but we wanted to note what we felt were the key takeaways, including some critical points that we believe have not been picked up, especially on the guidance and potential implications of persistently low inflation:
Upbeat on the recovery, labor market improvement
The views we are highlighting are best taken against the backstory of Bullard’s generally upbeat take on the outlook. Echoing the thrust of Fed Chair Janet Yellen’s testimony yesterday and which is likely to be the tone of the Minutes when they are released February 19, the Fed is still looking for a 3% plus growth this year. That means it is likely to look past the recent soft numbers, weather-driven or otherwise, and on the flipside, to also look past any burst of pent-up demand that may soon follow.
The second half of last year saw the stronger growth the Fed had been projecting, which allowed for the long awaited start to the downward adjustments in the flow of bond purchases. Despite the recent soft but noisy data, weather related or otherwise, last year is setting up for a gathering momentum to growth this year that is also being boosted by Congress getting out of the way this year with less fiscal drag.
Bullard also echoed Yellen in concluding that most of the decline in the labor participation rate reflects a long term demographic trend and therefore far more structural than cyclical in nature. On the margin, job seekers may have given up and opted for early retirement, but in general, the 6.6% headline unemployment rate does in fact provide a pretty accurate picture of the labor market conditions, which have unmistakably improved, substantially so, since the launch of the open ended QE regime in September 2012.
And if growth does indeed pick up to a 3 handle from the subpar 2% plus pace of the last few years, there is likely to be an even faster improvement in the labor markets. Maybe that will lift the participation rate as discouraged workers are drawn into the workforce, but either way, the pace of job creation means the Fed will need to adjust its thinking on the Numerical Thresholds, and its guidance going forward on rates.
Thresholds – “Rest in Peace”
We wrote last month (see SGH 1/22/14, “Fed: Towards a Post-Threshold Framework”) that with the far faster than expected decline in the headline unemployment rate to within a whisker of the 6.5% threshold, the Fed would be scrambling to update its guidance and what to do with the Numerical Thresholds. At that time, we wrote that the “lean” within the system seemed to be towards dropping the thresholds altogether for a more qualitative guidance that fleshes out the “well past” phrasing inserted into the December statement to reaffirm the Fed had no intention to raise rates any time soon.
Bullard echoed Fed Chair Janet Yellen in her first Humphrey Hawkins testimony yesterday who said the Fed would be looking at the thresholds once one or both of the thresholds is crossed, but he took it a bit further.
The numerical thresholds instituted in December 2012 served their purpose in guiding expectations the Fed would not be raising rates while unemployment was so high. But now that the headline unemployment rate has dropped to nearly the 6.5% threshold, it would be better, Bullard said, to move on to a “next phase” of the guidance in a more traditional guidance, or something we took to mean as a return to pre-August 2011 statement when there were neither calendar-specific or numerical thresholds to guide expectations.
It would maximize the Fed’s flexibility and discretion as it draws close to the longer run employment levels (and markets would just have to learn to live with the new communications regime). At a 6.6%, the headline unemployment rate is now only 0.8 above the average level of the last 50 years, Bullard pointed out. And Bullard was happy to note, with a smile, that the St. Louis Fed held the distinction of having had the most accurate unemployment forecast last year in the system.
We do think the FOMC will not have the luxury of delaying a revision to the guidance beyond the March meeting, even if the unemployment rate turns back up a notch by the time of the meeting. We did not think simply knocking the threshold down to 6% or to a range below the current 6.5% makes much sense and believe it has little resonance within the Committee, as it clearly does not with Bullard. Qualitative guidance is much more likely, but what exactly that will entail is unclear and there is certainly no consensus taking shape yet within the FOMC beyond perhaps citing the wider array of labor market indicators than just the headline rate or, we suspect, a stronger lean on the inflation measures, or perhaps wage growth (we prefer not to call it wage “inflation”).
The thought we were left with is that the shift to a more qualitative guidance in the context of stronger growth may mean yields start to find their more “natural” levels however well the Fed still manages to anchor short rates. Maybe that would be a good thing, but the economy better be able to handle it, or the Fed could end up undercutting the recovery just when it is still shy of the elusive escape velocity of a self-sustaining growth and the unconventional policy measures of the last five years all for naught.
The inherent risks in adopting a “qualitative guidance” to guide short rates can be gleaned from market pricing in the wake of Bank of England Governor Mark Carney’s ill-fated foray into forward guidance. Barely after the ink dried on the Old Lady’s own version of unemployment thresholds to guide rates, Carney earlier today dumped the thresholds to embrace a new qualitative guidance, which immediately saw short rates soar well forward of the timeframe suggested by the guidance.
Those Problematic “Dots”
The Fed yearns for a return to a policy guidance phrased in qualitative descriptive language rather than numerical thresholds or a calendar-specific steer. But doing so may lead markets to place an outsized emphasis on the first rate hike and year end fed funds projections of the quarterly Summary of Economic Projections. That, however, we noted, would be problematic, and President Bullard went into candid detail over the dilemma the FOMC is grappling with in how to improve on the dots as a guidance tool.
For one, its presentation in a calendar-based chart can be misleading in that it on the face of it undercuts the Fed’s ongoing messaging of a state-contingent rather than calendar-specific guidance. The dots are in fact based on forecasts, but that tends to get lost in the translation. Or perhaps the FOMC could break down the annual columns into quarters as its current structure is not granular enough. More importantly, however, for all the work the Fed has put into the SEPS and the dots guidance, they are still based on 13 different staff forecasts and 19 different interpretations of where the appropriate rate path should be in order to achieve those forecasts.
But from the outside, there is no way of knowing what assumptions are behind where the rate dots were penciled in: is the dot at whatever level it is on the chart because that FOMC member and his or her staff think trend growth is low or falling, or inflation pressure are positively dormant, or if rates are not going up very quickly, is that because they fear growth is stalling (it is difficult to overlay the dots to the central tendency forecast or the wider ranges around the CTF).
And of course, the seven Board dots are based on the same staff forecasts, so unless one of the Governors has a wildly differing view on the implied rates to achieve that forecast, those seven dots will be by definition bunched up together. And how do the voting member dots differ from the non-voting dots? And which of those darned 19 dots is the Chair’s?
As we recall, when Chair Yellen was heading the communications subcommittee a few years ago, they were working towards a unified central tendency forecast and a more in-depth Bank of England style quarterly Monetary Policy Report complete with fan charts and the like. That stalled, apparently at least in part, due to the resistance of the Districts seeking to preserve their independent voice. For now, the dots are about as good as they are probably going to get, at least for a while.
But the shift to a less firm qualitative guidance and the market’s likely reliance on the SEP rate projections that are awkward to use as the front end of the guidance – the statement and the votes behind it remains the primary forum for policy guidance, period – nevertheless underlines the need for the Fed to more fully explain the reasons behind its faith in why rates should stay so low for longer amid stronger growth.
Lower for Longer, yes, not so sure about Slower for Longer
But Fed officials have not yet fully explained their confidence in and the reasons behind the “lower for longer” rates, and implicit in the 2016 dots added to the SEPs in September last year, a very gradual, “slower for longer” upward trajectory once the tightening is underway. Why exactly, for instance, can the fed funds rate by the end of 2016 be less than half the assumed longer run or neutral fed funds rate when both employment and inflation are back to or beyond trend levels?
One story to tell, Bullard said, is that real interest rates globally are very low, so it is not just a US narrative, and the appropriate policy rate is just not at the same higher level as before the crisis and the distortions it has caused in the transmission channels and altered behavior and expectations, or stalled investment and consumption in the real economy. That is certainly one of the reasons many Fed officials cite for a neutral fed feds rate that is for now drifting a bit below the more commonly assumed 4%. Type it into the models and what comes out in order to hit the desired growth and employment gains is a policy rate well below traditional Taylor Rule assumptions. For the reason, take your pick, former Chairman Ben Bernanke put it to vaguely defined “headwinds,” so that will have to do for now.
But even if the argument to keep rates lower for a bit longer than under any previous Taylor Rule assumption is a valid one, and it does seem to be widely accepted both within the FOMC and the markets, that rates can also be increased at only a very gradual pace is not. Most models – not to mention the instincts of most market players – would point to a fairly rapid increase in rates once the hikes are underway after holding them steady for so long. It would seem, judging by Bullard’s remarks and those recently made by the unambiguously hawkish and orthodox – and voting member — Charles Plosser of the Philadelphia Fed, there is fairly strong undercurrent of skepticism about the Fed’s ability to undertake such a rate trajectory, or its merits.
By definition, under an optimal control framework, the trade-off and benefits to keeping rates lower for longer in return for possibly “temporarily” higher inflation later also alters as the forecasts change. The assumptions that rates should or will be guided as low as they have or a trajectory remain as gradual as it was when escape velocity was still so distant and unemployment was still so obviously too high may likewise be misplaced.
Could rates kept low for too long cause falling inflation expectations?
This last point is the most important one in its implications. It doesn’t seem to have been quite grasped by, or grabbed, much press attention, but it really leapt out at us as it goes to the core of what will be a central policy debate by late spring or summer if inflation does not begin to pick up.
In the Fed’s current projections, as the economy gathers strength this year, the low inflation that persisted through last year should be giving way and rising towards its 2% medium term target level. Indeed, the Fed’s lower for longer rates guidance is premised on an outcome in which inflation should begin to steadily as the tail-end to the optimal trade-off of faster near term gains towards trend employment for a little more inflation down the road.
But that was supposed to be getting underway last year but it didn’t, so how much leeway does that give the Fed this year in continuing its aggressive guidance on low rates and a gradual upward trajectory once the rate tightening is underway? That is the question.
There are two issues the FOMC will be grappling with on this score if the inflation rate fails to rise this year. The first is the question Bullard asked today and others within the Fed system have as well: what if the low inflation is caused by rates kept so low for too long that they are pushing inflation expectations downward? Promising to stay at zero can be a double edged sword, because if kept so low for too long, and markets start to expect negative inflation and end up with the Japanese situation which is very hard to break out of once there.
For now, those inflation expectations do seem to be well anchored. For many if not most in the market or especially those among the Fed critics, they are looking upward; but for many Fed officials, they are looking more to the south for any evidence those expectations are falling in a sustained way.
The first instinct and assumption in the markets may be the lack of inflation gives the Fed the leeway to double down on its low rates guidance. But on the other hand, it may also trigger a reassessment of the entire paradigm behind the open ended regime and an optimal control framework of rates kept lower for longer until it begins to generate higher growth, employment, and inflation. That would also open the door to questions over the merits of a rate path that is more gradual in its upward trajectory once the tightening is underway. Even if keeping rates lower for longer works, by most accounts, there will be little room or too much risk in not moving rates back up towards neutral in a fairly rapid clip.
And again, if there is a no show of inflation later this year, any subsequent reassessment of the optimal control framework would also play back into the current debate over the thresholds and how to take the Fed’s now primary policy tool of forward guidance to its next phase.
Oh yes, about the taper
We almost forgot to mention the taper, which is saying something. But as Chair Yellen and just about every member of the Committee has said since the turn of the year, it is a pretty high bar for the Fed to move off, in either direction, on the measured pace of the tapering down in the flow of its monthly bond purchases. The path is not preset, and the FOMC could always opt to pause or accelerate the taper’s pace if the economy veers too far north or south of the central tendency forecast.
But short of that, why mess with something now that they have finally moved the focus off QE? More to the point, the FOMC can ill afford to tamper with the taper for fear of its powerful signaling effect on rates policy when they are still trying to sort out the next phase of its forward policy guidance. So maybe journalists will finally stop asking about it after every data point surprise.