The Fed’s Inflation Problem

As 2014 draws to a close the Fed is presented with a problem. Based on recent speeches, a substantial part of the committee seems eager to raise rates. At the same time. some of the Fed’s preferred metrics suggest this may be premature and the market is trapped in between. Market participants are on the lookout for clarity in next week’s press conference from Chair Janet Yellen. The expectation among Fed watchers is that at next week Yellen will solidify expectations that rates will begin to rise in June 2015.

Why do I think the Fed is getting ready to raise rates? We discussed the shifting composition of the voters on the committee a few weeks ago and came to the conclusion that the shift involved roughly equal numbers of hawks and doves coming and going. When we look at the statements from the permanent members such as Vice Chair Stanley Fischer (see this WSJ interview) and NY Fed President Dudley, I see a more hawkish tone.

Why this shift? Below I graph the Fed’s performance against its dual mandates of stable prices and full employment.   The chart shows unemployment and inflation along with the Fed’s inflation target (in blue) and the unemployment rate consistent with stable prices (in pink). The economy has improved without inflation over the last five years.   Today, the Fed is in the happy spot where there is slack in both inflation and unemployment.


With inflation below target today, are inflation expectations what are causing the hawkish tilt?  Not really. The chart below shows three measures of inflation expectations – two derived from various market prices and one from a survey of professional economists asking for the average inflation rate expected over the next five years. Any way we look at it, inflation expectations for the intermediate term are low and, if anything, falling. It is not clear to me what, other than a simple distaste for rates remaining at the zero lower bound is moving the Fed to raise rates


What does the market think about the Fed’s likelihood of raising rates? We can plot the fed funds futures against the Fed’s forecast of where rates will be at year end as revealed in their quarterly reports. This chart shows that as of yearend 2015 the FOMC expects short term rates to be around 1.375% (up from about 0.125%) and the fed fund futures market expects the same rate to average around 0.55% that month.

Forecasts of the fed funds rate

We see similar skepticism in the low level of yields in US treasures. One interpretation of US ten year bonds yielding 2.16% is that the Fed’s expectations of rates (the blue dots) are either will not materialize or will need to be quickly reversed. That is, if the bond market believe that short term rates were going to 3.75% by 2017 and staying there, the ten year bond would yield a lot closer to 3.75%. In fact the Fed’s survey of major market participants reveals a 20-30% possibility that the Fed will be led to quickly undo its rate rise. It would not be the only central bank to reverse course since the crisis.

How might the Fed square the circle? If inflation expectations remain low it is hard to see the forecast of rates represented by the blue dots coming to pass. On the surface, this is very odd. The fed gets to set the level of short term interest rates, its forecasts of fed funds should be as accurate as my forecasts of my daughter’s allowance: completely with the control of the forecaster.   Perhaps the forecast should be seen a way as allowing hawkish members to blow off steam. If so, it would be better to discontinue them.

I am currently expecting 1) the Fed will raise short term interest rates beginning in June 2) they will only raise rates slightly over the course of the year and fed funds will end the year below 1%. It will remain to be seen if the Fed will walk back the higher expectations found in their quarterly forecasts. My guess is that hints of more aggressive moves will cause some substantial moves in the fixed income markets.

(Other views of the upcoming meeting you should consider: Tim Duy, Gavyn Davies, Paul Krugman)

FOMC September preview – Beware of a change in forward guidance

When the FOMC meets next week the big question is whether the forward guidance on the future path of interest rates will be confirmed or changed. To refresh your memory, the Fed has been taking two unusual actions over the last few years.   First it has engaged in quantitative easing by buying treasury and MBS bonds in the market. Second it has tried to assure the market that it was not going to raise rates any time soon. As QE winds down next month, minds are turning to the forward guidance.

Forward Guidance

Our guess is that either at this meeting or the one in December, the next two occasions with a press conference from the Chair, will be when forward guidance is adjusted. As of last June’s meeting, the members of the FOMC anticipated Fed Funds rates, currently around 0.1% to rise to around 1% by the end of 2015.   Usually, the Fed likes to move gradually so one plausible path which is consistent with the Fed’s published material, would be to raise rates by 0.15% in the middle of next year, and by 0.25% each of the next three meetings.

This scenario is inconsistent with continuing the FOMC statement which last read “it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends.” What is a considerable period? Chair Yellen said about six months at her last press conference. If we put all the pieces together, they add up to the removing that language from its statement sometime soon. However, last year’s taper tantrum showed that the fixed income market can overreact to Fed intentions.

In sum, the Fed has a communications problem: to let the market know that even considerable periods of time must end while minimizing bond market gyrations. Best to stay alert for market disruption around and after the press conference, next Wednesday, September 17.

Will the fed be aggressive in raising rates?

The Fed still has the substantial policy dilemma we have covered in the past (here and here, for example). We will update here our Dual mandate Report Card showing that the Fed is still in the happy situation where there is no conflict between encouraging the labor market to improve and maintaining price stability.


There is a great deal of discussion, however, about exactly how much slack is in the labor market.   Specifically, how many of the millions of Americans who dropped out of the labor force since the financial crisis can be enticed back in? Aging population means that many workers have retired and are not seeking new jobs. Chair Yellen’s speech in Jackson Hole was not quite as dovish as I had anticipated giving more credence to the idea that a good part of the reduction in the percentage of the population working or looking for a job permanent. See this report by Stephanie Aaronson and her colleagues at the Federal Reserve for one careful study which estimates that only 1/4 to 1 percentage points of the 3 percentage point drop in the labor participation rate will be recovered.

I will agree with Cardiff Garcia (here, for example) that given the low levels of current inflation, the stability of inflation expectations, long-term under shooting of the Fed’s inflation target and a weak global growth environment, the safest thing for the fed to do would be to allow rates to remain low until they can find hard evidence of higher inflation.

 Smart reads to dig into before Wednesday:

    • Tim Duy previews the FOMC
    • SF Fed on the difference between Fed forecasts and the fed fund futures market
    • Gavyn Davies on the stability of the US recovery


– John Eckstein

[Updated September 16]
See also Gavyn Davies take. I agree that changing the “considerable” language in December makes the most sense and that is what I would vote for. I do wonder, however, if Chair Yellen will attempt to prepare the ground for next quarter’s change in this quarter’s press conference.

World PMI update for August – Weakness in Europe

With the flash update for selected Markit PMIs for August, here is our monthly heatmap of worldwide manufacturing PMIs.


A few observations:

  • The Markit PMI for the US jumped to its highest level since 2011. While this is an encouraging sign, the link between the Markit measure and the more familiar ISM measure is not as strong as you would imagine, and we see this as confirming the strength we saw in July’s ISM release.
  • We were beginning to get concerned about Europe last month and that concern continues this month. France’s PMI is at a 15 month low and all of the big four Eurozone countries show month on month declines, though only France is below the 50 line showing that most companies are experiencing declining business conditions.
  • China continues to oscillate around the expansion / contraction line but the strength in the rest of Asia makes us hopeful. In particular, on this measure at least Japan seems to be emerging from its post VAT increase slowdown.
  • Fed Watch – Jackson Hole

    The Kansas City Fed is hosting its annual Jackson Hole conference this weekend (motto: “interrupting Wall Street vacations since 1978”) . Several times in the last few years we have gotten a good preview of the Fed’s concerns for the year ahead by listening to the Chair’s speech. The last two rounds of Quantitative Easing, for example, were foreshadowed by Chair Bernanke’s talks.

    The detailed agenda has not been announced yet (watch this space) but it may again be worth taking a day off the beach as the theme of the conference is “Re-Evaluating Labor Market Dynamics” and Janet Yellen’s speech is titled simply “Labor Markets.”

    This is timely as one of the most important economic questions of the day is how much slack is truly remaining in the labor market. My forecast, along with many other Fed watchers, is that Yellen will make a point of emphasizing the slack remaining in the labor market.

    While the unemployment rate is approaching more normal levels digging deeper we do find evidence of slack beyond the unemployment rate. The number of involuntary part time workers, which I noted in this post, is very high, perhaps three million above typical levels. In addition, the lake wage gains above the level of inflation indicates that despite record corporate profits, employers are not finding it necessary to compete on price. The labor participation rate is more complicated. A large number of people have dropped out of the labor force since the recession though a mixture of the median American getting older and through the difficulty the long-term unemployed have in getting a new job. These contending forces are examined in an interesting report by the Council of Economic Advisors find that about half of the reduction in the labor force is due to aging and about half due to other factors we might hope to be reversed.

    Against these indicators of slack what do we see when we look for tightness? I noted the improvement in the unemployment rate above and referring again to my post from July, the quit rate and the job opening rate are both looking as good as they have since the recession and about as good as they did during the last recovery.

    Where does that leave the Fed? We can look at the Fed Dual Mandate Report Card below. The X axis show the unemployment rate (with the Fed’s estimate of long run unemployment in pink) and the Y axis shows five-year-ahead expected inflation (with the Fed’s 2% target plus an error band in blue). The details are explained in my post Janet Yellen’s Report Card.



    My interpretation of this chart is that the Fed is in the happy situation when its two mandated goals (price stability and full employment) are not in conflict so there should not be a reason to raise rates any time soon.

    In thinking about what the Fed will do in the future we need to bear in mind that by law they are mandated to try and manage both inflation and employment. My sense is that Yellen and most of the FOMC see today’s balance of risks tilted toward problems of employment and will let inflation expectations drift somewhat above their target. This may be a change in tolerances from what many of us are used to from the Fed policy in the 1990-2007 period, as economist Tim Duy writes: “Yellen can point out that since the disinflation of the early 90’s, the Fed has not faced an inflation problem, but instead has struggled with three recessions. This on the surface suggests that monetary policy has erred in being too tight on average.” I hope Chair Yellen will give us some clarification and some arguments to shape the discussion.