Fed Watch: Green Shoots Notwithstanding, Odds Favor More Easing

The Fed took an interesting risk by holding policy steady on Wednesday. With green shoots all the rage, policymakers are ready to step to the sidelines as they monitor the progress of their many programs. And clearly, they must have known that the 3% level on 10-year Treasuries was dependent on the expectation that policymakers would expand the pace of outright purchases of those assets, but are betting that economic conditions will remain sufficiently weak to prevent a crippling increase in rates.

Still, given that policymakers continue to see the economy in decline, albeit at a slower rate, the odds favor additional easing in the months ahead, especially considering expectations of a widening output gap. Recall that labor markets, and the threat of deflation, kept the Fed easing well past the end of the recession in 2001.

Short of an outbreak of inflation, or an unexpected and unlikely surge of growth, there is little reason to think that the Fed is ready to bring policy to a sustained pause. And an imminent rise in inflation remains an outside risk for the Fed; the focus remains consistently on disinflation or, worse yet, outright deflation. A key paragraph is:

In light of increasing economic slack here and abroad, the Committee expects that inflation will remain subdued. Moreover, the Committee sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer term.

Policymakers are counting on a rising output gap (both here and abroad) and lags in the price setting process to keep inflation at bay. Indeed, this must be the case, as some of the current numbers are really not all that comforting. I am not inclined to place too much focus on headline inflation - oil prices appear to have found a bottom around $50 a barrel, and sustained hints of a firming of global economic activity would promise to send prices higher, thus offsetting the strong disinflationary impact of falling energy prices since the middle of 2008. In contrast to low year-over-year headline numbers, the personal income and outlays report for March revealed that core PCE prices gained by 0.2% in each of the past three months, pushing the annualized three month trend back above 2% (click on chart to enlarge):

And note that near-term inflation expectations have climbed back up into a normal range (click to enlarge):

From this perspective, policymakers have done a good job anchoring inflation expectations against the possibility of deflation. Is this enough, however, to unsettle FOMC members? Despite these inflationary hints, it is simply unlikely that the Fed would ignore the disinflationary implications of the output gap. One way to ignore the gap is to argue that the US will revert to an emerging market inflation dynamic. I think such an argument requires a steady depreciation of the Dollar to hold - which could happen, but a Dollar crisis looks, for the moment, unlikely given relative global weakness. One could also argue that estimates of potential output are optimistic and don't reflect the importance of structural change in the economy. This is the issue that Nick Rowe at the Worthwhile Canadian Initiative attempts to tackle:

Even in the short run a good banking and financial system will be important in re-allocating capital between growing and declining sectors, if there are shifts in relative demand. If people want fewer cars and more restaurant meals, but banks cannot shift loans from car manufacturers to restaurants, the Short Run Aggregate Supply curve may shift left, because the restaurants won't be able to expand to meet demand, and car manufacturers' prices or wages may be sticky downwards.

If you see the financial crisis as causing the recession by shifting the SRAS curve left, then monetary and fiscal policies, which shift the AD curve right, are not the appropriate cure. Even if you see leftward shifts of the SRAS curve as only part of the story, you will see limits on what monetary and fiscal policy can achieve. When expansionary monetary and fiscal policies start to cause excessive inflation, before output and employment have returned fully to normal, you will know that purely AD policies have reached the limit of what can be expected from them.

Nick is slapped down by Brad DeLong:

But if bad banks have shifted the AS curve inward, then right now we should have stagflation: depression and inflation, as output falls and prices rise. We don't. The argument that fiscal and monetary policies won't reduce unemployment to normal levels because we have a supply side problem is completely incoherent in an AS-AD framework.

Brad is correct that in a traditional AS-AD framework, bad banks are demand shocks, not supply shocks. There is still something about Nick's argument that is important - the financial system redirected capital investment into housing and consumption related activities. Presumably, potential output includes the ability to build and sell as many houses as the US economy produced at the height of the housing bubble. But what good is that output if we don’t want to build and sell that many houses in the future? How do we redirect capital away from those sectors? And how long does it take? Arguably, the narrowing of the US trade deficit is pushing that adjustment forward, as the US economy can't focus entirely on producing nontradable goods. Recall Brad DeLong from 2005:

There is an alternative scenario, one in which foreigners'--including foreign central banks'--desired holdings of dollar-denominated assets shortly hit the wall, and the asset price shifts that result from desired holdings' hitting the wall reduce, or do not increase, confidence in the dollar.

In this alternative scenario, the U.S. has to move about ten million workers out of currently-favored sectors--construction, home-equity-credit financed consumer expenditures, and so on--into export and import-competing manufactures. How much structural unemployment does such a sectoral shift require, and how long does the structural unemployment last? Other countries have to shift up to forty million workers out of export manufactures into other industries, and to generate demand for the products of those industries (without destabilizing their own monetary systems and asset prices, as Japan appears to have done at the end of the 1980s). The U.S. Federal Reserve would have to cope with whatever inflationary pressures are generated by rising import prices. Foreign central banks would have to cope with whatever stresses on their own asset prices are created by enormous losses of value in the stocks and bonds of their exporting companies.

If structural unemployment is rising - not because banks are currently bad, but engaged in bad behavior in the past - attempts to reduce unemployment back to pre-recession levels will yield higher inflation. This problem is minimized if labor resources can be quickly redirected into other sectors, a process that Nick above is implying is hampered by the existence now of bad banks. But, as Brad suggested in 2005, getting to inflation in the current environment seems to require a Dollar collapse - a story that for now is difficult to tell.

All of which is interesting, but even if you believe that structural unemployment is rising, I don't think anyone believes it is near the 8.5% rate for March (not to mention the underemployment rate of 15.6%). Nor does anyone expect that recent green shoots are sufficient to keep unemployment from rising further. Moreover, note that the Employment Costs Index released today reveals the continued slide in employee compensation costs - consistent with the FOMC's concerns about economic slack. Indeed, the ECI highlights the risks of the Fed's move to hold steady policy: Declining wage growth, coupled with higher interest rates, would play havoc with household efforts to reduce balance sheets and intensify the need to boost saving rates. Hence why the risks still favor additional policy easing - especially if programs such as TALF and PPIP are less successful than imagined.

In short, the shoots are much too green and the output gap much too wide to stimulate much discussion on Constitution Avenue that the end of easing has conclusively been reached. A pause to assess, yes. But Fed officials will be looking for clear and convincing evidence that economic activity is both self sustaining (not likely to fade after the initial burst of federal stimulus moves through the pipeline) and sufficient to substantially reduce the output gap before they sound the all clear signal. An end to the rapid pace of job loss is very different from a return to steady job growth. Again, recall the sustained pattern of easing in the wake of the 2001 recession - we need to go a long way up from -6% GDP growth before the job engine is started. To be sure, there should be some lingering concern that the Fed will act quickly (or at least the markets will act quickly), if there is a perceived need to withdraw monetary accomodation. But the data are well short of what would be necessary to justify such a shift in policy in the near future.

Comments

[MGA_1:]

Bernanke is a money printer, he's basically gone on record as such and his record would certainly seem to support that conclusion. Who's going to fund the upcoming $2 trillion federal deficits? The american public? They're broke. The Chinese? They're getting rid of their t bills and buying gold. The fed has already committed to purchasing $300 billion on long t bills and I can't imagine they won't do the same to support the upcoming deficit.

May 01 10:36 AM

[Econ 101:]

Shine a light on the cockroaches, watch them scatter

Support HR 1207, an Audit of the Federal Reserve:
www.govtrack.us/congre...

Find your congress person:
www.house.gov/house/Me...

Why is BHO looking like Bush Lite??
www.oftwominds.com/blo...

May 01 11:55 AM

[LKofScotland:]

Bush lite? Looking like "Bush heavy" to me. Cram downs? Government take-overs? I love it. Finally a government that is honest with its citizens and says "we wish to control the worthless means of prodcution by spending insanely valuable taxpayer money." And gentle Ben? He appears to be going from Big Lovin' Ben to Big Gay Ben. With all his media activities an appearance on American Idol can't be far behind. There's music in that man--you just have to get the crowd to bring it out to hear the magic.

May 01 03:07 PM

[aarc:]

We may soon have a green shoot with the stock market.

Dow Jones and SnP are potentially forming a running triangle. Running triangle got formed when the market went in defiance against the most expected direction. Most traders and investors have been expecting last April that the markets are either going to make another sell-off after the "bear rally" of March. Or at least a minor pullback expected by the perma-bulls and the new converts. So many traders and investors who had been left behind by the unexpectedly strong rally were hoping for at least a reasonable pullback.

Neither happened, instead the market simply keep going minor highs and minor lows on the daily basis similar to that of DJ and SnP of 2005 to mid-2006 on the monthly chart. Traders got repeatedly whipsawed in the process not knowing what was happening.

Look at the SnP monthly chart pattern of Jan 2005 to July 2006. Then compare it to SnP daily chart of late Mar 2009 to the present. They are basically similar if not identical. What is missing is the expected green shoot rally.

Can you remember what happened in 2005 to mid-2006? Almost everybody was expecting a pullback after the massive rally from Oct 2002. But that did not happen. Then repeatedy during the sell-offs were the expectations of garden variety recessions that did not happen either. But in late 2005, some analysts were questioning why the markets kept on failing to sustain any sell-off despite almost a year of extremely bad news counter-butting the stream of good news. The markets were not able to initiate a sustained rally until after the middle of 2006. That was the biggest running triangle I had ever seen. And the spike rally was spectacular. Many traders have never seen such ferocious rally in their decades of market participation.

We are dealing with a tiny potential running triangle this time around on the daily chart - but the events surrounding the formation of the triangle have many similarities in this compressed time of 1+ month against 1-1/2 years.

The triangle pattern is being telegraphed by the anemic volume since late March. But a spike rally (or sell-off) will be needed to confirm the presence of the triangle. No spike rally or sell-off = no triangle. Higher probability of a spike rally than that of the spike sell-off. Also, with a running triangle, the potential spike rally can be 3 times bigger than a potential spike sell-off. So it is a lot more profitable to bet on a spike rally than a spike selloff off a potential running triangle.

Quick and dirty target = 982 for SnP. Fingers crossed since a spike rally has a very wide range potential target of from 956 to 1029 or more. Extremely hard to determine the potential termination price of a spike rally.

Spike rally, green shoot , that is what everybody wants these days. We should have at least made a pullback already with the horrible GDP and the swine flu being broadcasted every hour of the hour in CNN. But CNBC is obsessed with the green shoot. Don't under-estimate the capability of CNBC to brainwash the traders and investors.

May 01 04:10 PM

[marketman54:]

Less bad, declining at a slower rate, not as bad as we expected....

Lets look at reality:
1. Unemployment is going up and will continue till the end of the year with the help of the auto industry.
2. The banks have a huge tsunami brewing - More unemployement means more mortgage defaults, more credit card payment defaults, more auto loan defaults. Commercial real estate defaults are rolling down the street. The banks still have their existing toxic assets and whatever credit swap defaults that they own. Don't forget the hanky panky accounting they are allowed to use to cover up whatever ails them currently!
3. GE Capitol is in the same shape as the banks.
4. Fannie Mae and Freddy Mac are still hiding behind the curtain.
5. Hey, remember AIG, they will be back.
6. The entire insurance industry is about go bust!
7. Retail sales are less bad and will continue to get more bad.
8. Our consumer society has quit consuming thereby making manufacturing less bad and will continue to get more bad.
9. Name the industry, they are taking a pounding. Less bad of course.
10. Our government is printing money faster than we can get the paper to print it on. INFLATION, you bet. Faster and bigger than Jimmy Carter can make it happen.
11. USA DEBT: who is gonna buy it? who is gonna pay for it?

Folks, we are in deep, deep doo doo. The dow will drop to 5500 by August. There is no way they can stop this thing from happening.

May 01 09:36 PM

[aarc:]

This is reality markets, man and woman!

We need FDIC now more than ever.

We're not going down the tube anymore with these small bank take-overs. Green shoots are starting to sprout around. And FDIC lost money in the process of taking over small banks instead of making a couple or two billions when they declared Wamu and Wachovia bankcrupt? FDIC was able to make $2B with WB takeover and more than $1B on Wamu if I can remember it right.

That is how the job is done, folks. Bring the American economy down to it's knees and make tons of money in the process.

Now, FDIC is losing $1.4 Billion dollars on this latest Friday take-overs? See the latest issue on MarketWatch.

Not good, we need more Wamu and WB, the bigger the better.

We can't go down to depression level if FDIC is becoming such an impotent entity hitting only the small banks.

OK, Wamu and Wachovia were sleeping at that time. They did not know they were bankcrupt already before the sneak attacks. Now, the big banks are fully awake and must have installed a lot of defence mechanisms against FDIC take-overs.

The small banks are done no matter what. They can't have any defences against FDIC without Fed and Treasury bail-outs. Those bail-outs are the scrouge of the earth, they must be declared illegal or something. How can we possibly destroy our financial industries if those big banks can survive and revive the economy later on? How about the non-financial companies such as GM and GE? The big banks might help them when they get into really big trouble and the government fully tapped out.

No way, we also have to destroy our manufacturing and technology centers if we really want to achieve our main objective of taking our economy down to at least a depression level. The more industries we can destroy, the longer the depression can last. We did that before with such an excellent outcome in 1929 to 1932 and beyond into the 40's. More than 10 years of depression, was'nt it?

And World War II was our trophy - a fitting reward for a job well done. No bail-outs and green shoots were allowed to pester the mission from start to finish. Pres. Hoover was our Hero, he did not allow any bail-outs for the banks back then.
It was a very successful mission with half the banks going down and the other businesses they supported then. That was the catalyst for mass jobs layoffs into 25% unemployment rate.
We need somebody like Hoover now, we are not making any progress these days.

We have to protect our taxpayers no matter what. It is only a matter of time and we will be able to achieve 25% unemployment rate as more of our industries start hitting the dust. How about 33% same as Germany of 1939? That would be a wet-dream come true. We want a bigger trophy this time around.

No bail-outs to anybody no matter what. That is the “guaranteed” way for them to go bankcrupt while we deprive them of our cash by refusing to spend anything except for our daily necessities. Bancrupcy is our WMD for insuring instant mass jobs lay-offs. Lets use it as often as we can.

But those Fed and Treasury bail-outs are now starting to produce green shoots! Sooner or later, companies will be starting to hire more workers and the economy will be able to recover. They are making 5% on those bailout funds these days. If the economy recovers, they are going to make a lot more money. TARP is being converted into common stocks with Citigroup into $3.25/share. What if Citigroup recovers and the stock goes to $30. An unacceptable nightmare if Citigroup recovers back to $60. Imagine Geithner beaming ear to ear with his $3.25 going for $60 or more? Not acceptable at all. They used our taxpayers’ money for that. And then what, spend the money on pork barrels?

Not good. We need more than 700,000 jobs lay-offs a month to hasten our progress towards 33% unemployment rate. Make it 1 million layoffs, the more the merrier.

What now?

Why not simply attack the big banks such as Citigroup, BAC, JPM and Well Fargo head to head? No holds bare. Specially BAC, they carry the name America. Hit BAC as hard as possible, show the whole world what America is made of. Citigroup carries the name City. We already have “deserted” shopping malls. How sweet, it is not a mirage, folks. Soon we will have whole Cities “deserted”. Detroit is our test bed. What a fitting outcome for the cradle of American industrialization.

Take GM down, they have GMAC, don't they? Perhaps FDIC can do something really nasty about that. And GE, they have their own financial arm, don't they? How sweet if we can take GE down as fast as possible. No electricity = No cities.

Declare ALL of them bankcrupt no matter what. Use our financial WMD (bankcrupcy) to it's fullest extent. This will surely bring us to our Gold-plated Depression if not the Great Depression Part II. GLD is the ticker symbol for gold, guys and gals.

Kill all those pesky green shoots in one big bazooka. How can we pay for our original sins of profligate living for the last 3 decades if the economy can recover with green shoots sprouting all over the place?

Wake Up, FDIC!

Wake up everybody, green shoots are now at the borders, we have to stop them, use our WMD – Prontos Amigos! Take it from our Mexican friends.


Dow Jones 5,500? Not good enough! Lower if you will.

Dow Jones 1,000. That is how collective Seppuku can be done. Those not willing to join will suffer anyway, directly or indirectly.

Panic is the magic word. We've done it from Oct 2007 to March 2009. We can do it again and again.

May 02 04:45 AM

[Zekeko:]

in order for any green shoots to actually occur, they must grow out of a pile of shit in the first place. And by the looks of it, there's plenty of shit to sort through in this market

May 02 01:53 PM

[Madcow2:]

in times of inflation, prepare for deflation. in times of deflation, prepare for inflation. its all just a matter of timing.

presently, there's no end in sight to deflation. what was created over a period of 50+ years isn't going to be reversed in a year or two. despite the FEDs "will", there's just no way to stop prices from falling. my guess is that we get back down to 1980 - 1981. And then the cycle will begin again.

so long as government can adjust by shrinking 75% in its size and scope and taxes can be dramatically reduced across the board, everything is going to be okay.

May 02 09:49 PM

[Sober Realist:]

"...so long as government can adjust by shrinking 75% in its size and scope and taxes can be dramatically reduced across the board, everything is going to be okay."
----That's the problem. Government is not shrinking. Today's government consumes 45% of the economy by its spending, plus another 13% of the economy via its un-funded regulatory mandates - - leaving less than half of the economy to the free-market private sector.

"45% of our economy today is dependent on government spending & control."

Slow, gradual government expansion over time is not recognized by the masses which gradually become dependant upon it. This leads to serfdom to the state. America is more a socialistic nation, and less a free-market economy, then ever before in its history, because our total economy has become significantly more government-dominated and dependent. Our founding fathers are rolling in their graves and weeping for the children of this once great land.

We are being extin­guished and stupefied as a people, reduced to a flock of timid, subservient sheep of which the government is the shepherd.

mwhodges.home.att.net/...

May 03 11:08 AM

[Market Sniper:]

Greenshoots? LOL..fed by the manure of public (taxpayer) spending through a backdoor bailout scheme! Wake up people! You are being raped and pillaged. There are CONSEQUENCES for what is going on. Where is the outrage?

May 03 04:17 PM

[Minlita:]

I think people are relieved that the new Administration is competent. That gives them a kind of long run confidence that the decline will eventually hit bottom.
I don't think they are confident in a recovery

May 03 06:44 PM

[Whippet:]

The greenest grass in my yard is where my dog does his business. But the grass is dead in big spots in the same area. If we keep talking only about the green shoots and leave the crap in place, the soil will no longer sustain life.

To wish for government downsizing is to ask the tapeworms feeding on your body to "please go away, I'm at the proper weight now." The American people got fat, wanted the miracle cure, and will die in squalor if nothing is done. We can't reason with parasites, folks. Unfortunately, the majority of voters in this country will gladly trade their liberties and the liberties of their children, won with the blood of their fathers, and trade them for handouts. We are the nation of Esau, trading our birthright for a bowl of lentil stew.

<<so long as government can adjust by shrinking 75% in its size and scope and taxes can be dramatically reduced across the board, everything is going to be okay. >>

May 04 02:20 PM