At first blush, the Federal Reserve looked to have pulled off an almost seamless hand-off of accommodation from quantitative easing to forward guidance at the last FOMC meeting. The announcement of the long-awaited taper was met with a subdued bond market reaction, while stocks soared. Since then, however, bond yields have climbed, breaching the three percent mark at the end of last week. Mortgage rates have been pulled along for the ride, and if they continue higher, the sustainability of the housing recovery will again be questioned. As discussed earlier by Matt Boesler at Business Insider, this very much looks like a challenge to the Federal Reserve's forward guidance. Or is it? It is not really a "challenge" if it simply reflects expectations of what a data-dependent policymaker would do in the face of a stronger than expected economy. I think a little of both is happening.
Policymakers will be alert to signs that recent gains in rates look to be driven by expectations that the Fed will hike rates sooner than suggested by the Fed's own forward guidance. Relying on the separation principle so well defined by Gavyn Davies, the Fed would be less concerned with rate increases driven by a higher term premium. Using the two year Treasury rate as a proxy for the forward path of short rates, however, it looks clear that market participants are fundamentally reassessing Fed policy:
Note too that recent movements are not in response to higher expected inflation, and thus represent rising real rates:
What is somewhat remarkable about higher short-term rates is that at their December meeting, the Fed lowered the expected path of interest rates. The average of rate expectations for year end 2015 was 106bp, down from 125bp in September. In effect, the Fed and the market are moving in different directions.
What could account for the difference? Of most concern to the Fed is that market participants simply do not believe the Federal Reserve is committed to a sustained low rate path. But what has changed to make markets doubt the Fed? To answer this, consider that the low rate story was driven by a combination of faith in the optimal control framework championed by incoming Federal Reserve Chair Janet Yellen and the belief that the decline in the unemployment rate was overstating the improvement in the labor market. I tend to think that Federal Reserve Chairman Ben Bernanke threw cold water on both ideas in his final press conference.
In the press conference, Robin Harding jumps on the Fed's tapering decision in light of the optimal control framework:
ROBIN HARDING. Robin Harding from the Financial Times. Mr. Chairman, your inflation forecasts never get back to 2 percent in the time horizon that you cover here, out to 2016. Given that, why should we believe the Fed has a symmetric inflation target? And, in particular, why should we believe you're following an optimal policy-optimal control policy, as you've said in the past-given that that would imply inflation going a bit above target at some point? Thank you.
CHAIRMAN BERNANKE. Well, again, these are individual estimates, there are big standard errors implicitly around them and so on. We do think that inflation will gradually move back to 2 percent, and we allow for the possibility, as you know, in our guidance that it could go as high as 2½ percent. Even though inflation has been quite low in 2013, let me give you the case for why inflation might rise...
After explaining why the Fed expects inflation to move higher, Bernanke adds:
CHAIRMAN BERNANKE. Well, even under optimal control, it would take a while for inflation-inflation is quite-can be quite inertial. It can take quite a time to move. And the responsiveness of inflation to increasing economic activity is quite low. So-and particularly given an environment where we have falling oil prices and other factors that are contributing downward forces on inflation, it's difficult to get inflation to move quickly to target. But we are, again, committed to doing what's necessary to get inflation back to target over the next couple of years.
In other words, don't believe all those nice little charts Yellen has been touting that show inflation smoothly rising above two percent. We are not trying to recreate those charts, so don't expect us to maintain accommodation even if inflation is below two percent. And, by the way, we aren't really trying to drive inflation above two percent, we are just making clear that we will not panic if inflation is up to 50bp above target. Moreover, a symmetric target also means that we will not panic if inflation is 50bp below target, and it is easy to see how we get to that minimum level.
I don't really believe they will not panic if inflation crosses two percent. I think that, given the size of the balance sheet, they will panic. In my mind, the decision to taper only reinforces my belief that the Fed is more comfortable with inflation below two percent than above it. The target is not symmetric.
Regarding unemployment, read carefully:
MURREY JACOBSON. Hi. Murrey Jacobson with the NewsHour. On the question of longer-term unemployment and the drop in labor force participation, how much do you see that as the result of structural changes going on in the economy at this point? And to what extent do you think government can help alleviate that in this environment?
CHAIRMAN BERNANKE. I think a lot of the declines in the participation rate are, in fact, demographic or structural, reflecting sociological trends. Many of the changes that we're seeing now, we were also seeing to some degree even before the crisis, and we have a number of staffers here at the Fed who have studied participation rates and the like. So I think a lot of the unemployment decline that we've seen, contrary to sometimes what you hear, I think a lot of it really does come from jobs as opposed to declining participation.
That being said, there certainly is a portion of the decline in participation, which is related to people dropping out of the labor force because they are discouraged, because their skills have become obsolete, because they've lost attachment to the labor force, and so on. The Fed can address that, to some extent, if-you know, if we're able to get the economy closer to full employment, then some people who are discouraged or who have been unemployed for a long time might find that they have opportunities to rejoin the labor market.
But I think, fundamentally, that training our workforce to fit the needs of 21st-century industry in the world that we have today is the job of both the private educational sector and the government educational sector...
With each passing month, the Fed is moving closer and closer to the belief that the decline in unemployment is not to be dismissed as simply a cyclical decline in labor force participation that will soon be reversed. Indeed, I suspect this is why the Fed is not likely to lower the unemployment threshold anytime soon. And if the Fed is now taking the unemployment rate decline at face value, consider the implications for policy given the path of unemployment:
It doesn't take much to believe that policymakers will find themselves hiking interest rates sooner than anticipated as they increasingly believe that a rise of labor force participation is not coming - and it doesn't sound like Bernanke expects to see much of a rise. Do others? Does Yellen?
In short, it is easy to see why financial market participants would be rethinking the path of short-term rates given that the Fed is dismissing the low inflation numbers and embracing the structural explanations for declining labor force participation. Furthermore, there was some expectation that the Fed would change the unemployment thresholds as an "action" to cement the forward guidance and to counter the "action" of reducing the pace of asset purchases. The Fed disappointed on that front. The old adage "actions speak louder than words" comes to mind. It comes back to the problem the Fed faced this summer - how essential is the tool of quantitative easing in controlling the path of short-term interest rates? Can the Fed effectively promise an interest rate path that is not consistent with past behavior without the "action" tool of asset purchases to put muscle into their words?
If the Fed believes that market participants are fundamentally misreading their intentions, they will want to push back against the current rise in short term rates. They will try to do so verbally at first; I believe they will be very resistant to reversing the taper or lower the unemployment threshold. Those are tools that I anticipate the Fed will use only if they believe they have completely lost control of the expectations for short rates.
Another possibility, however, is that the Fed validates the rise in rates by pointing to signs of stronger growth. After all, the Fed's forecast is data dependent - it is not truly a challenge to the Fed's forward guidance if economic conditions change such that a different path of short term rates is appropriate. Almost certainly, you should expect the hawks to embrace this explanation. More interesting, and with the possibility of creating significantly more volatility in bond markets, is the situation in which doves also embrace the "stronger growth" explanation for higher short-term yields. This, I suspect, would lead market participants to further reject the current forward guidance.
As a final possibility, consider that the recent market movements may simply reflect trading in thin holiday markets, in which case the current "markets challenging the Fed" theme would be expected to disappear quickly in the new year.
Bottom Line: The Fed's stated expected rate path looks overly dovish relative to policymakers' growing belief that the declining unemployment rate should be taken at face value and their dismissal of low inflation when making the decision to taper. Consequently, short rates are moving higher, taking long rates with them. The interpretation of these moves is complicated by stronger economic data, suggesting not that the Fed is being challenged, but that a data dependent Fed will find its current expectations inconsistent with the actual path of the economy. I tend to think some of both factors are at play - that any lingering doubts about the Fed's commitment are only aggravated by better data. How doves react to rising rates is critical. They will cement the shifting expectations if they embrace the rise as an expected response to stronger data.
Inflation, Wages, and Policy
As something of a addendum, I wanted to follow up on the take-down of the inflation story by Ethan Harris of BAML as reported by Sam Ro at Business Insider. Harris' argument is that there is plenty of slack in the labor market, so there is no reason to worry that wage growth-fueled inflation is just around the corner. Fair enough; I have always said that the ultimate test of the theory that labor markets were tight would be higher wages. The part I wanted to follow up on was this quote:
Moreover, even if wages do inch higher, we are a long way from the normal 3 or 4% rate that could start to create serious pricing pressure.
I think this overlooks an important point - the Federal Reserve has historically tightened policy at or before wage growth turns upward and the policy peak occurs when wage growth is hovering in the 4-4.5 percent range:
In other words, we don't need to see wage growth high enough to create price pressures to trigger tighter monetary policy. Typically, the Fed is tightening policy ahead of higher wage growth. This, I think, is one reason to question the Fed's stated policy path and also explains why the Fed would be hesitant to embrace a lower unemployment threshold. The fact that wages are rising while unemployment remains high is probably something of a puzzle to them, and lends credence to the stories that the labor market is currently affected by severe structural issues even though they see the same measures of labor market slack that Harris identifies.
So it is not that the Fed is currently behind the curve, but that the upturn in wage growth will make them worry that they will need to act to prevent them from falling behind the curve. It is also another reason why they want to extract themselves from QE as soon as possible; they want to be prepared to act quickly should they find they took an overly dovish view of the labor market. I think there is a lot of uncertainty regarding unemployment / wage / inflation dynamics at the moment, and that uncertainty is not making the Fed happy given the size of the balance sheet.
Also consider also Federal Reserve Chairman Ben Bernanke's justification for expecting inflation to trend toward the Fed's 2 percent target. From his press conference (emphasis added):
First, there are some special factors, such as health-care costs and some other things, that have been unusually low and might be reversed. Secondly, if you look at the fundamentals for inflation, including inflation expectations, whether measured by financial markets or surveys; if you look at growth, which we now anticipate will be picking up both in the U.S. and internationally; if you look at wages, which have been growing at 2 percent and a little bit higher according to many indicators-all of these things suggest that inflation will gradually pick up.
In short, although as Harris states we would not expect significant price pressures until wage growth accelerates further, wage growth is already at a rate that biases the Federal Reserve toward tighter policy (or, at a minimum, less accommodative policy). Even the current meager wage growth rate is used as justification to ignore the inflation trend and initiate a plan to end asset purchases. What then might be the possibilities for policy from even slightly higher wage growth?