Tracking the Fed’s Integrity

Preamble

By now every financial market participant and pundit with a pulse expects the FOMC to raise interest rates at its meeting on March 15th, 2017. The FOMC is finally executing on a plan for gradually normalizing interest rates that was outlined and initiated in December 2015, then promptly abandoned. Whether the FOMC was suffering from a collective form of economic attention deficit disorder, paralyzed into inaction by the potential impact of political events in Europe and the US, or simply nodding off at the rate switch, the dithering badly eroded their credibility. The conveniently hawkish reversal post-election has now cast doubt on their integrity. 

Here we provide a backwards prospective of FOMC decisions, from Dec 2015 through Dec 2016, as reasoned in the FOMC press conference transcripts. The progression from "we're finally ready to do this, baby steps!" to the FOMCs attempt at a Jedi mind-trick, "monetary policy magically tightens because we lowered our pretend target" is worth the review. Unfortunately, it calls into question the monetary policy objectivity of this FOMC, which continues to emphasize political or financial market gyrations ahead of its mandate. 

Why We Focus on FOMC Meetings with Press Conferences

There are eight regularly scheduled FOMC meetings per year (FOMC meeting calendars, statements and minutes ) spaced approximately six weeks apart. In March 2011, then-Chair Ben Bernanke announced that he would begin holding quarterly press conferences after FOMC meetings, in order to “further enhance the clarity and timeliness of the Federal Reserve’s monetary policy communication.” In theory, the press conferences - which occur every other meeting - should impact neither the timing or pace of FOMC decisions to raise or lower rates. In reality, financial market participants and Fed watchers quickly presumed any substantive shift in the stance of monetary policy would only occur at “live” meetings, when the Chair has the opportunity to elaborate on (or perhaps justify) the FOMC’s decision during the press conference. Although FOMC members have murmured from time to time that meetings without press conferences scheduled should still be considered “live”, in fact no significant change or communication regarding monetary policy or the FOMC’s economic outlook has since occurred at a meeting which is not followed by a press conference.

The FOMC also releases an updated version of its Summary of Economic Projections (SEP) at each regularly scheduled meeting which is followed by a press conference. The SEP contains summary data of FOMC members economic forecasts, including:

·        Changes in real economic growth (GDP);

·        The unemployment rate;

·        Inflation, as measured by personal consumption expenditures (PCE) and core PCE; and

·        Projections for the appropriate path of monetary policy - the level of the fed funds target rate –consistent with their economic outlook. 

Objectives of Monetary Policy

Excerpts from a Federal Reserve Board FAQ titled, What are the Federal Reserve's Objectives in Conducting Monetary Policy? (edited for brevity):

The Congress established the statutory objectives for monetary policy--maximum employment, stable prices, and moderate long-term interest rates--in the Federal Reserve Act.

The FOMC judges that inflation at the rate of 2 percent (as measured by the annual change in the price index for personal consumption expenditures, or PCE) is most consistent over the longer run with the Federal Reserve's statutory mandate.

The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the job market. These factors may change over time and may not be directly measurable. In the FOMC's December 2016 Summary of Economic Projections, Committee participants’ estimates of the longer-run normal rate of unemployment ranged from 4.5 to 5.0 percent and had a median value of 4.8 percent.

Two objectives of monetary policy: The Fed has long interpreted its statutory objectives for monetary policy as a dual mandate for (1) maximum employment and (2) low inflation ( = stable prices + moderate long-term interest rates).  

Not an objective of monetary policy: Everything else. That includes stoking or impeding US economic growth, global economic growth, fiscal policy, tax policy, the integrity or stability of the financial markets (which arguably falls under the Fed’s regulatory objectives and mandate, but not its monetary policy objectives), fretting about the Brexit vote, the Greek debt crisis, performance of the equity markets, or the volatility of the foreign exchange markets. Just to name a few.

FOMC Meeting of December 16, 2015 – liftoff.

The FOMC finally begins what is billed as a gradual tightening of monetary policy, and raises interest rates from the “zero lower bound.” The FOMC increases the target fed funds rate from a range of 0% to 0.25%, to a range of 0.25% to 0.50%, and the IOR rate in tandem from 0.25% to 0.50%. The median forecast of FOMC members, as released in the Dec 16 2015 SEP , projects the appropriate path of monetary policy would lift the upper bound of the fed funds target range by 100 bps, to 1.50% by year-end 2016 and 2.50% by year-end 2017, assuming their economic forecasts are achieved.

Throughout this piece the indented text are excerpts from Chair Yellen’s remarks from various FOMC press conference transcripts (edited for brevity, formatting and subheadings added for clarity, emphasis mine):

Overview

This action marks the end of an extraordinary seven-year period during which the federal funds rate was held near zero to support the recovery of the economy from the worst financial crisis and recession since the Great Depression. It reflects the Committee’s confidence that the economy will continue to strengthen.

Room for further improvement in the labor market remains, and inflation continues to run below our longer-run objective.

The process of normalizing interest rates is likely to proceed gradually, although future policy actions will obviously depend on how the economy evolves relative to our objectives of maximum employment and 2 percent inflation.

Unemployment and GDP

The unemployment rate, at 5 percent in November, is down 0.6 percentage point from the end of last year and is close to the median of FOMC participants’ estimates of its longer-run normal level.

The improvement in employment conditions this year has occurred amid continued expansion in economic activity. U.S. real gross domestic product is estimated to have increased at an average pace of 2¼ percent over the first three quarters of the year.

Inflation

Overall consumer price inflation— as measured by the price index for personal consumption expenditures—was only ¼ percent over the 12 months ending in October.

However, much of the shortfall from our 2 percent objective reflected the sharp declines in energy prices since the middle of last year, and the effects of these declines should dissipate over time.

The appreciation of the dollar has also weighed on inflation by holding down import prices. As these transitory influences fade and as the labor market strengthens further, the Committee expects inflation to rise to 2 percent over the medium term.

Rationale for Raising Interest Rates

With inflation currently still low, why is the Committee raising the federal funds rate target?

Much of the recent softness in inflation is due to transitory factors that we expect to abate over time, and diminishing slack in labor and product markets should put upward pressure on inflation as well.

In addition, we recognize that it takes time for monetary policy actions to affect future economic outcomes. Were the FOMC to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly at some point to keep the economy from overheating and inflation from significantly overshooting our objective. Such an abrupt tightening could increase the risk of pushing the economy into recession.

Fed Funds Forecast

The median projection for the federal funds rate rises gradually to nearly 1½ percent in late 2016 and 2½ percent in late 2017.

As the factors restraining economic growth continue to fade over time, the median rate rises to 3¼ percent by the end of 2018, close to its longer-run normal level.

The Committee currently expects that, with gradual adjustments in the stance of monetary policy, economic activity will continue to expand at a moderate pace and labor market indicators will continue to strengthen. Although developments abroad still pose risks to U.S. economic growth, these risks appear to have lessened since last summer. Overall, the Committee sees the risks to the outlook for both economic activity and the labor market as balanced.

So on December 16^th, 2015, the FOMC itself projected they would raise the target rate 4 times in 2016, or approximately at every other meeting (presumably at the “live” meetings). Instead they raised interest rates once - a year later at the December 2016 meeting. What the hell happened?

FOMC Meeting of March 16, 2016 – the FOMC immediately gets cold feet, and pauses the rate hikes.

Excerpts from Chair Yellen’s remarks at the press conference (edited for brevity, formatting and subheadings added for clarity):

            Overview

Today the Federal Open Market Committee decided to maintain the target range for the federal funds rate at ¼ to ½ percent. Our decision to keep this accommodative policy stance reflects both our assessment of the economic outlook and the risks associated with that outlook. The Committee’s baseline expectations for economic activity, the labor market, and inflation have not changed much since December: With appropriate monetary policy, we continue to expect moderate economic growth, further labor market improvement, and a return of inflation to our 2 percent objective in two to three years. However, global economic and financial developments continue to pose risks. Against this backdrop, the Committee judged it prudent to maintain the current policy stance at today’s meeting.

Unemployment

The labor market continues to strengthen. Over the most recent three months, job gains averaged nearly 230,000 per month, similar to the pace experienced over the past year.

The unemployment rate was 4.9 percent in the first two months of the year, about in line with the median of FOMC participants’ estimates of its longer-run normal level.

A broader measure of unemployment that includes individuals who want and are available to work but have not actively searched recently and people who are working part time but would rather work full time has continued to improve.

Of note, the labor force participation rate has turned up noticeably since the fall, with more people working or actively looking for work as the prospects for finding jobs have improved.

But there is still room for improvement: Involuntary part-time employment remains somewhat elevated, and wage growth has yet to show a sustained pickup.

Inflation

Overall consumer price inflation—as measured by the price index for personal consumption expenditures—stepped up to 1¼ percent over the 12 months ending in January, as the sharp decline in energy prices around the end of 2014 dropped out of the year-over-year figures.

Core inflation, which excludes energy and food prices, has also picked up, although it remains to be seen if this firming will be sustained. In particular, the earlier declines in energy prices and appreciation of the dollar could well continue to weigh on overall consumer prices.

But once these transitory influences fade and as the labor market strengthens further, the Committee expects inflation to rise to 2 percent over the next two to three years.

Economic Outlook

The median growth projection edges down from 2.2 percent this year to 2 percent in 2018, in line with its estimated longer-run rate.

The median projection for the unemployment rate falls from 4.7 at the end of this year to 4.5 percent at the end of 2018, somewhat below the median assessment of the longer-run normal unemployment rate.

The median inflation projection rises from 1.2 percent this year to 1.9 percent next year and 2 percent in 2018.

Rationale for Not Raising Interest Rates

Since the turn of the year, concerns about global economic prospects have led to increased financial market volatility and somewhat tighter financial conditions in the United States, although financial conditions have improved notably more recently.

Economic growth abroad appears to be running at a somewhat softer pace than previously expected.

These unanticipated developments, however, have not resulted in material changes to the Committee’s baseline outlook (because):

·       Market expectations for the path of policy interest rates have moved down, and

·       The accompanying decline in longer-term interest rates should help cushion any possible adverse effects on domestic economic activity.

Indeed, while stock prices have fallen slightly since the December meeting and spreads of investment-grade corporate bond yields over those on comparable-maturity Treasury securities have risen, mortgage rates and corporate borrowing costs have moved lower.

The Committee will continue to monitor these developments closely and will adjust the stance of monetary policy as needed to foster our goals of maximum employment and 2 percent inflation.

Fed Funds Forecast

Compared with the projections made in December (editor: only 3 months ago) the median path is about ½ percentage point lower this year and next; the median longer-run normal federal funds rate has been revised down as well.

Most Committee participants now expect that achieving economic outcomes similar to those anticipated in December will likely require a somewhat lower path for policy interest rates than foreseen at that time.

Followed by two paragraphs of why the FOMC member’s projections for the fed funds rate are individual forecasts, but not “plans” for future policy, because the future is uncertain and unexpected things happen and don’t ever hold us to a decision or an outlook. God forbid anyone need to make investment decisions or recommend a trading strategy based upon future interest rates.

First question out of the gate (from my hero, Steve Liesman):

Madam Chair, as you know, inflation has gone up the last two months. We had another strong jobs report, the tracking forecasts for GDP have returned to 2 percent, and yet the Fed stands pat while it’s in a process of what it said it launched in December was a “process of normalization.” So I have two questions about this:

1.     Does the Fed have a credibility problem, in the sense that it says it will do one thing under certain conditions but doesn’t end up doing it?

2.     And then, frankly, if the current conditions are not sufficient for the Fed to raise rates, well, what would those conditions ever look like?

I will spare you Chair Yellen’s answer, but it boils down to the following:

·        The “median forecast” for the appropriate path of monetary policy is meaningless, because the FOMC is ruled by the doves, and I am their queen.

·        Global growth outside the United States is slowing and there has been some widening of credit spreads (the spread between US Treasuries and investment grade or high yield bonds). Despite the fact that these events have at best tertiary impact on our mandate, we are still collating.

·        So when we said we were going to gradually raise rates, we meant at the pace of a tortoise, because we prefer to make no decision at all than to make a decision which might, you know, have consequences.

FOMC Meeting of June 15^th, 2016 - wherein the FOMC enters the Twilight Zone.

I can’t with this meeting. Here’s the synopsis:

·        The economic data was mixed. It vexes us.

·        GDP growth in late 2015 / early 2016 was “lackluster,” though they expected it to improve.

·        Job market gains averaged 200k per month - though April and May were weaker at 80k per month - and the unemployment rate fell to 4.7% in May.

·        Yellen (roughly paraphrased): “yabbut, that’s because more people dropped out of the labor force (they’re called boomer retirees, Janet), and besides, there are still too many people working part-time who want full-time jobs.” Editor’s note: Not Your Problem.

·        The year-end median forecast for the unemployment rate – which has been revised lower to 4.6% - is now below the FOMC’s assessment of the longer-run normal unemployment rate.

·        Average hourly earnings increased 2.5% over the prior 12 months, a “welcome indication that wage growth may finally be picking up.” Grammar and thought police: Wage growth, in fact, picked up. For a whole year. Remember, it’s historical data.

·        Inflation rose to 1% for the 12 months ending in April. Core inflation (ex food and energy) was running closer to 1.5% over the same period. Both moving higher towards the stated target.

            Rationale for Still Not Raising Interest Rates

This decision (not to raise interest rates) reflects the Committee’s careful approach in setting monetary policy, particularly in light of the mixed readings on the labor market and economic growth that I have discussed, as well as continuing below-target inflation.

Although the financial market stresses that emanated from abroad at the start of this year have eased, vulnerabilities in the global economy remain.

In the current environment of sluggish global growth, low inflation, and already very accommodative monetary policy in many advanced economies, investor perceptions of, and appetite for, risk can change abruptly.

We continue to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate. We expect the rate to remain below levels that are anticipated to prevail in the longer run because headwinds weighing on the economy mean that the interest rate needed to keep the economy operating near its potential is low by historical standards. These headwinds—which include developments abroad, subdued household formation, and meager productivity growth—could persist for some time.

Editor’s note: The “vulnerabilities in the global economy” and “developments abroad” that Yellen is alluding to is a feared reaction to the UK’s Brexit vote, which is mere days out from this meeting (it took place on June 23^rd, 2016). She is asked about it during the Q&A, but we don’t rehash it since:

a)     It has so far not turned out to be some huge global disaster; and

b)     Even the most bearish economists did not expect it to – nor has it had - a big impact on the US economy.

On a closing note, the FOMC reports that its (completely meaningless and laughably wrong) median forecast / projection for the fed funds rate for year-end 2017 is now 1.50%, rising to 2.50% for year-end 2018.

FOMC Meeting of September 21, 2016 – the one where the FOMC actually said “instead of raising rates we lowered our forecast.”

In a nutshell:

o   Economic growth had substantially improved. The drivers were higher household spending, based on solid increases in household incomes, consumer sentiment and wealth.

o   Job gains rebounded to average ~180k per month over the preceding 4 months, and the unemployment rate was stable at 4.9%.

o   Inflation was just below 1%, with the shortfall again attributed to the transitory factors of low energy and import prices. Core inflation was 1.5%.

  

In fact, the economy was doing so well, that the focus of the Yellen’s remarks revolved around a laborious attempt to justify not raising rates.

The “Neutral Fed Funds Rate” Gets a Promotion

The recent pickup in economic growth and continued progress in the labor market have strengthened the case for an increase in the federal funds rate. Moreover, the Committee judges the risks to the outlook to be roughly balanced. So why didn’t we raise the federal funds rate at today’s meeting? Our decision does not reflect a lack of confidence in the economy.

(blah blah nothing to see here blah)

We continue to expect that the evolution of the economy will warrant only gradual increases in the federal funds rate over time to achieve and maintain our objectives. That’s based on our view that the neutral nominal federal funds rate—that is, the interest rate that is neither expansionary nor contractionary and keeps the economy operating on an even keel—is currently quite low by historical standards. With the federal funds rate modestly below the neutral rate, the current stance of monetary policy should be viewed as modestly accommodative, which is appropriate to foster further progress toward our objectives. But since monetary policy is only modestly accommodative, there appears little risk of falling behind the curve in the near future, and gradual increases in the federal funds rate will likely be sufficient to get to a neutral policy stance over the next few years.

So this economic construct – this fictitious rate that the FOMC made up – moves around based on their projections for some future state of the economy. Now instead of raising interest rates congruent with: their monetary policy objectives, and the plan outlined nine months prior (and almost immediately abandoned), the FOMC claims that the target fed funds rate at a whopping 0.50% is now only “modestly accommodative” because it’s long term neutral level is lower than previously guesstimated. Three months prior in June the FOMC characterized the same fed funds rate as "very accommodative". 

Can someone design an index out of this rate? I know some former Libor traders who would love to make a market in it.

First ball, fast ball hitter Steve Liesman:

Madam Chair, critics of the Federal Reserve have said that you look for any excuse not to hike, that the goalposts constantly move. And it looks, indeed, like there are new goalposts now when you say looking for “further evidence” and—and you suggest that it’s evidence that labor—labor market slack is “being taken up.” Could you explain what “for the time being” means, in terms of a time frame, and what that further evidence you would look for in order to hike interest rates? And also, this notion that the goalposts seem to move, and that you’ve indeed introduced a new goalpost with this statement.

I think you had to be there to truly appreciate the obfuscation in her answer. If you’re interested, it is in the transcript (starting on page 5 of 24).

Tuesday, November 8, 2016 - Donald Trump wins the presidential election and Republicans take a majority of seats in both chambers of Congress.

Over time: Legislation dating back to 2008 to “audit the Fed” is revived. Pressure on Yellen to resign as Fed Chair increases. Yellen states publicly and candidly that she intends to complete her term as Chair, which ends in January of 2018. Fed Governor Daniel Tarullo – architect of an enormous amount of banking and financial markets regulation phased in following the financial crisis – announces his resignation, effective April 2017. Trump and the Republicans begin planning legislation to scale back parts of Dodd-Frank, to repeal or reconstruct pieces of Obamacare, to implement fiscal stimulus, to revamp and simplify tax policy. The equity markets tear higher.

FOMC Meeting of December 14^th, 2016 – the FOMC raises the target fed funds rate and nudges their economic projections higher.

The economic growth picture and employment data was roughly in-line with where it had been in September, though the unemployment rate hit a post-crisis low of 4.6% in November, the lowest level since 2007. Inflation ticked higher to 1.5%, as expected due to the rebound in energy prices. Core inflation rose to 1.75%.

The more meaningful change was the shift in tone in Yellen’s prepared remarks for the press conference. Gone were several of the dovish explanations for why the FOMC was effectively discounting good data by emphasizing lingering areas of weakness.

Some excerpts:

Today the Federal Open Market Committee decided to raise the target range for the federal funds rate by ¼ percentage point, bringing it to ½ to ¾ percent. In doing so, my colleagues and I are recognizing the considerable progress the economy has made toward our dual objectives of maximum employment and price stability. Over the past year, 2¼ million net new jobs have been created, unemployment has fallen further, and inflation has moved closer to our longer-run goal of 2 percent. We expect the economy will continue to perform well, with the job market strengthening further and inflation rising to 2 percent over the next couple of years.

Job gains averaged nearly 180,000 per month over the past three months, maintaining the solid pace that we’ve seen since the beginning of the year. Over the past seven years, since the depths of the Great Recession, more than 15 million jobs have been added to the U.S. economy. The unemployment rate fell to 4.6 percent in November, the lowest level since 2007, prior to the recession. Broader measures of labor market slack have also moved lower, and participation in the labor force has been little changed, on net, for about two years now, a further sign of improved conditions in the labor market given the underlying downward trend in participation stemming largely from the aging of the U.S. population.

Recall the transcript for the June 2016 meeting, where the drop in the unemployment rate in April to 4.7% was written off by the FOMC because it was driven by a drop in labor force participation, in favor of focusing on a measure of labor market slack – the number of part-time workers who want full-time jobs. These two metrics, which were worrisome enough in June and September to contribute to the FOMC deciding not to raise rates, are suddenly improving if understood in the context of a long-term trend. No kidding.

The more disturbing theme is that the FOMC press conference remarks seem to have taken on the tone of a campaign speech. It could be a campaign for Yellen to keep her job, for the Federal Reserve to avoid additional scrutiny of their regulatory and policy decisions, or a long overdue recognition that eight years post-crisis the economy has recovered and it may continue to improve if the FOMC gets its fanny off the yield curve.

FOMC Meeting of Tuesday, March 15^th, 2017 – if you don’t believe the Fed is going to raise rates and come out sounding like a bunch of hawks, you clearly haven’t been paying attention.

If you’re still reading, I applaud you. I am genuinely, deeply grateful.