An exciting start to 2015 in Europe

January is off to a brisk start for traders and central bankers in Europe. I see no quick turnaround to Europe’s economic malaise.

The ECB is widely expected to announce a well telegraphed QE announcement this week. The hints going around are slightly higher than I expected, at around 600B Euros. If the ECB is being quite clever they may take a page from public companies and be leaking slightly lower numbers so as to “beat expectations.”

My expectation is that QE alone will not be successful in moving Eurozone inflation back toward its upper bound of near 2%, though any bounce in oil would help, or in stimulating noticeably faster growth in the Eurozone. My argument is the three toos: 2015 is too late because rates are already too low and in any event EUR 600B is too little. I am assuming that QE works through the portfolio channel, and that by taking government bonds out of circulation, cash will have to be deployed in more risky, and hopefully investment stimulating instruments. But rates are already so low in most of Europe that it is hard to see what a slight decrease in rates will do. For example, the Spanish 10 year bond is yielding 1.5% according to Bloomberg, will 1.4% or 1.3% make much of a difference? Though it is possible that after all the hints from Frankfurt, at this point the market is pricing in QE and if they did not do it yields would increase significantly.

What might make a difference would be a large coordinated expansion from countries with fiscal room but this is unlikely to transpire.

What will happen in Greece is different question. An election may usher in a new government which wants debt write-offs. I think the consensus of economists is that Greece will indeed need debt write-offs, though they may need to be hidden in maturity extensions and interest payment deferrals. As the bulk of Greek debt is held by the official sector, this is possible if well enough disguised. I do not see Greece leaving the Euro. They will not leave by choice and being expelled would put tremendous pressure on at least Portugal and perhaps even Italy. If Cyprus can stay in the monetary union why not Greece?

Finally, the Swiss National Bank lifted a three year old cap on the exchange rate of Swiss Francs to Euros. As recently as last month this looked like a rock solid policy and the market was caught completely off guard. One lesson we can draw from this is: there is no such thing as an absolute promise from a central bank. Policies are fixed for a particular purpose and in a particular political context. In this case the SNB has not even convincingly explained why they suddenly ripped off the Band-Aid. A minor point is that the SNB moved deposit rates down to -0.75. If they manage to make this stick, markets paying up for safety in the form of negative interest rates may become more widespread.

Overall, direct implications on the US are negative, though modest. We have seen further dollar strength which will tend to slightly reduce exports and hence growth. The more direct effect is the continued high price in risk-free assets, by which I mean US government bonds. I mentioned a few weeks ago, NY Fed President Bill Dudley has said that when the Fed does raise rates it is going to want to see a genuine tightening in fiscal conditions. US 10 year bonds at 1.85% is unlikely to qualify implying more than just token rate rises when the moment comes.

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)

New directions for the Fed in 2015

The big decision for the Fed next year will be if they should start raising interest rates. Remember that the fed is charged to try to maintain price stability and full employment. This 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.


The argument for raising rates is that it is necessary to control inflation.  This this post from The Economist for example.  I disagree for a few reasons:

  • As the chart below shows, over the last 20 years actual inflation has spent a good deal of time below a band around 2% inflation except and only brief episodes above, suggesting that the Fed is too hawkish on average.


  • There is mounting evidence (for example this note published by the Fed) that the recessions, the possible outcome for raising rates prematurely, can involve permanent reductions in the level of output. Simply put, if you have a million people working for a year they make a certain amount of stuff. If there is a recession and they are out of work, they don’t make up all of the lost output once the economy recovers. To take this risk the threat to price stability must be substantial.
  • Finally, inflation expectations (based on surveys or derived from market prices) remain stable.

Of course, what I think doesn’t matter, only the opinions of the voting members of the FOMC count. Every year a shifting cast of regional presidents serve as voting members on the FOMC. This year sees 4 new presidents along with the chair of the NY Fed who is always a voting member in deference to that bank’s constant connection with the markets. We have two members I would characterize as patient about raising rates and two who seem eager

  • Richmond Fed’s Jeffrey Lacker says that “the unemployment rate is an accurate gauge of labor underutilization. ” Suggesting that rates can rise soon.       Interestingly, he not only expects to raise rates, he wants the Fed to sell securities held under quantitative easing, not just cease to purchase. “I believe the Fed’s efforts to normalize monetary policy must include the sale of mortgage-backed securities in order to reduce the Fed’s role in credit allocation. ” Lacker speech
  • Similarly, the San Francisco Fed’s Williams says “Rate hike likely by mid-2015” Williams speech
  • On the other hand Chicago’s Charles Evans sees risks to tightening: “I am concerned about the possibility that inflation will not return to our 2 percent PCE target within a reasonable period of time.” And he emphasizes caution: “As I think about the process of normalizing policy, I conclude that today’s risk-management calculus says we should err on the side of patience in removing highly accommodative policy.” Evans speech
  • At the Federal Reserve bank of Atlanta Dennis Lockhart believes the United States will approach conditions consistent with full employment by late 2016 or early 2017 and in his view undershoot of the inflation target is currently a bigger risk than overshoot. Lockhart speech
  • The New York Fed president William Dudley seems to be willing but not eager to raise rates next year: “The consensus view is that lift-off will take place around the middle of next year.  That seems like a reasonable view to me.   But, again, it is just a forecast.  What we do will depend on the flow of economic news and how that affects the economic outlook” Dudley speech

Incidentally, NY Fed President Dudley says

In assessing inflation expectations, I currently put more weight on survey-based measures of inflation expectations as opposed to market-based measures.  Survey-based measures have been generally stable, consistent with inflation expectations remaining well-anchored.  However, market-based measures, such as those based on breakeven inflation derived from the difference between yields on nominal versus Treasury Inflation-Protected Securities (TIPS), have registered declines over the past few months, even on a 5-years forward basis.  Research done by my staff suggests that much of this decline in market-based measures of inflation compensation reflects a fall in the inflation risk premium—that is, what investors are willing to pay to protect themselves against inflation risk.  Adjusting for the fall in the inflation risk premium, inflation expectations appear to have declined much less than implied by TIPS inflation breakeven measures.

If he is using this as a reason to raise rates, I cannot agree. First of all, surely a decline in inflation risk premiums means that the market is less concerned about sudden jumps in inflation. That is, the market is telling you that the market is not worried about inflation. I am not sure why a policymaker would want to discount that. Second, it is not clear that Survey based inflation expectations are indeed stable. See this chart of expectations for next year from the Consensus Economics survey.


Whatever is ahead, our next landmark is the final FOMC meeting of 2014 which will feature new forecasts from the committee members and a Janet Yellen press conference on December 17. Hopefully we will get more insight into the Fed’s plans then. In the meantime it is worth noting that for Fed Funds to get to what the median member expects of about 1% by the end of 2015 and they proceed in bite-sized 0.25% steps, they will need to start raising rates in their fifth meeting of the year in July. Given the Fed’s reluctance to surprise the markets, I would expect clear warnings at the March press conference at the latest.

Interestingly, the Fed Fund futures seem to expect less easing overall with year-end 2015 rates in the market at 0.5% which implies starting later or not raising rates at every meeting after they start.

FOMC preview

I am expecting little news from the FOMC this week. The committee should take the final tranche of QE off, which might have been an unfavorable surprise amid the financial market volatility two weeks ago, but which is likely to go unnoticed this week.

Some of the regional presidents have been advocating their views towards on the one hand a slower move to higher interest rates (President Evans of the Chicago Fed, see his speech here) or on the other hand, a faster move (President Plosser of the Philadelphia Fed, see his speech here). My personal view is closer to the raise-rates-later view of President Evans. whatever the decision turns out to be, I do not expect any committee level move with this meeting, but we might get some additional information from Chair Yellen’s press conference and the updated “dot plot”, December 17th.

-John Eckstein, Chief Investment Officer

FOMC Quick Reaction

[Before press conference]

There is the danger of inconstancy in the Fed’s communications. On the one hand, the language in the FOMC statement about the “considerable period” is still there, which Chair Yellen described as six months. On the other, the FOMC median expectation for fed funds at the end of 2015, which after all the FOMC controls, is for 1.375%. That rate today is about 0.10%. So that means five 0.25% increases of out eight meetings, which all adds up to the Fed’s projections are implying rates to begin to rise in June of next year. Is that a “considerable” amount of time away?

We hope we get some clarification from the press conference.

[After press conference]

With the animating spirit of Alan Greenspan obfuscating her answers, Chair Yellen allowed the ambiguity noted above to stand. My best guess is that the tension between the “considerable time” formulation and the FOMC consensus opinion on where rates should go will be resolved by how inflation (and the expectations for further inflation) move and how quickly. That is to say, the FOMC is not sure exactly when it will raise rates and wants to maintain freedom of maneuver. Our best guess is that the modest pace of economic growth and residual slack in the economy will allow rates to stay low.

There were some technical details about unwinding QE and normalizing monetary policy. The major change to what we knew before being that rates will rise before the Fed allows a passive reduction in its balance sheet by ceasing to reinvest principal and interest as it is paid.

There was a good question in the press conference about the divergence between fed fund futures and the famous Dot Plot(page 3 of the FOMC Projection Tables report). That is Fund Futures are now implying a funds rate of 0.75% at the end of 2015, while the dot plot says 1.375% One source of divergence is that the Fed is polling its members about the appropriate rate, not the rate which will obtain.


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.

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.