Thursday, December 18, 2014

Madam Chairman, Are You Serious?

The Editors at Bloomberg View aren't happy, putting out an op-ed, Can Janet Yellen Be Serious?:
Sometimes you have to wonder if the Federal Reserve's governors are just laughing at the analysts who pore over every statement to find crucial hidden meanings in their blandest phrases. If they aren't laughing, they should be.

For days before the publication of this afternoon's Federal Open Market Committee statement, discussion had centered on the phrase "considerable time." What did the FOMC mean when it previously said that it would hold short-term interest rates close to zero for a "considerable time"? Would that pivotal phrase be removed from the December statement? If it were, what would its absence mean?

In something of a conceptual if not linguistic breakthrough, the Fed both dropped the phrase and retained it. The new language says that the Fed "can be patient in beginning to normalize the stance of monetary policy." On the other hand, it pointed out that this new formula is "consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October."

Splendid. Analysts can now spend the holiday season debating whether the Fed will merely be patient or will be patient for a considerable time, or some combination thereof; how long a "considerable time" is, exactly (at least that's a comfortingly familiar question); what it means, monetarily if not spiritually, to be "patient"; and indeed, whether the change in language signifies anything at all.

Does anyone else think this is all a bit -- what's the right word -- excessive? Here's a more plausible theory: The change in language signifies nothing. That does raise the question of why the Fed changed it anyway.

Chairman Janet Yellen actually addressed this point when she spoke to the media after the statement had been released. Fed policy hadn't changed, she affirmed. But the language had. Why? Because the FOMC wanted to remove the link between the Fed's words and the end of its policy of quantitative easing -- which happened in October. This makes sense.

But then she said, most unwisely, that "patient" should be taken to mean that the Fed didn't expect to announce higher interest rates at the next two meetings. Analysts can now obsess over what that means. Will the two be changed to one or three in subsequent statements, modified in some other way, or simply dropped? Adding a wrinkle to that completely pointless discussion, Yellen said that interest-rate decisions don't need to be confined to meetings followed by pre-scheduled news conferences. One wonders what she meant by that.

Here's the point, and it's really quite simple: The Fed doesn't know when it will start to raise interest rates, nor should it have to know, nor should it indulge analysts' misconceived determination to find out. Interest-rate changes are not, and should not be, on a schedule. They depend entirely on what happens in the economy, and the Fed -- like every last one of those analysts -- doesn't know what will happen. What it can and should do is draw attention to the economic indicators it is following -- in particular, indications of inflation pressure in the labor market. The rest just sows confusion.

For some reason, the Fed refuses to learn this lesson. Over time, supposedly in pursuit of clarity, Fed statements have grown ever longer and more complicated. The new statement follows the familiar pattern of seeking to clarify by means of introducing fresh complications and debating points.

The whole purpose of a phrase like "considerable time" is that it's meaningless. Embrace that, Janet. In future, for the sake of clarity, keep it short and respond to all questions with, "We'll get back to you when we know."
Ouch, this criticism is quite harsh! In my personal opinion, Chairman Yellen is doing an outstanding job communicating Fed policy in one of the most difficult and eerily uncertain economic periods in post-war history.

The December FOMC statement was a bit long but it provides clear guidance as to the Committee's concerns and there were quite a few dissenters (added emphasis is mine):
Information received since the Federal Open Market Committee met in October suggests that economic activity is expanding at a moderate pace. Labor market conditions improved further, with solid job gains and a lower unemployment rate. On balance, a range of labor market indicators suggests that underutilization of labor resources continues to diminish. Household spending is rising moderately and business fixed investment is advancing, while the recovery in the housing sector remains slow. Inflation has continued to run below the Committee's longer-run objective, partly reflecting declines in energy prices. Market-based measures of inflation compensation have declined somewhat further; survey-based measures of longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators moving toward levels the Committee judges consistent with its dual mandate. The Committee sees the risks to the outlook for economic activity and the labor market as nearly balanced. The Committee expects inflation to rise gradually toward 2 percent as the labor market improves further and the transitory effects of lower energy prices and other factors dissipate. The Committee continues to monitor inflation developments closely.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy.
The Committee sees this guidance as consistent with its previous statement that it likely will be appropriate to maintain the 0 to 1/4 percent target range for the federal funds rate for a considerable time following the end of its asset purchase program in October, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored. However, if incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Stanley Fischer; Loretta J. Mester; Jerome H. Powell; and Daniel K. Tarullo.

Voting against the action were Richard W. Fisher, who believed that, while the Committee should be patient in beginning to normalize monetary policy, improvement in the U.S. economic performance since October has moved forward, further than the majority of the Committee envisions, the date when it will likely be appropriate to increase the federal funds rate; Narayana Kocherlakota, who believed that the Committee's decision, in the context of ongoing low inflation and falling market-based measures of longer-term inflation expectations, created undue downside risk to the credibility of the 2 percent inflation target; and Charles I. Plosser, who believed that the statement should not stress the importance of the passage of time as a key element of its forward guidance and, given the improvement in economic conditions, should not emphasize the consistency of the current forward guidance with previous statements.
You'll notice I highlighted all the inflation passages in the FOMC statement. Why? Because in my mind, even though they will never publicly admit it, some members of the FOMC are petrified of deflation coming to America, increasing the likelihood of a loss of credibility at the Fed and creating more panic at other central banks that are already panicking.

Interestingly, during the press conference (see below), Chairman Yellen said she's not worried about falling oil prices and dismissed the drop in "inflation compensation" saying it mostly reflects "safe haven liquidity flows" into U.S. bonds.

Huh? That was the part that confounded me. While many economists openly question the use of inflation expectations in projecting actual inflation, the drop in these expectations is pronounced and could signal a price shock that the world has hereto never experienced before.

Obviously, I didn't expect the Fed Chairman to come out and publicly worry about the huge drop in inflation expectations as measured by the five-year breakeven inflation expectations (click on chart below), but to dismiss the plunge in oil as purely "transitory" and good for America is to ignore pronounced economic weakness abroad.

And as Sober Look has rightly noted, the Fed's policy trajectory is tied to the global recovery and it is increasingly concerned about importing disinflation. Moreover, in a fascinating comment, Sober Look notes the Fed launched a reverse repo program "experiment" and has been aggressively testing the various monetary tools that will give it additional flexibility during the rate normalization process:
For those who still track the Fed’s total balance sheet, don’t – the balance sheet doesn't tell you much about the monetary stance when you have these new forms of “sterilization”. Of course all this is viewed as temporary and the reserves may yet return to their peak levels next year. And judging from current disinflationary pressures (see chart), the actual liftoff - when these tools are going to be implemented on a more permanent basis - may be as long as a year away. For now however these monetary experiments have been sufficiently large to raise short-term interest rates.
Very interesting indeed. And what message did the Fed send to the stock and bond market? Pretty much that it won't raise rates till it meets its inflation target which is why I still see a huge melt-up in the stock market (ex energy and commodities) and agree with those who see a melt-up in the bond market too.

For now, all stocks are viewing patience as a virtue and melting up, especially beaten down oil drillers and service shares (click on image):

But as I warned you before, these countertrend short covering/ relief rallies in energy and commodity shares are nothing more than that and investors should use them to exit or underweight positions, not add to their existing positions. Smart money will use these violent rallies to short these stocks.

Below, take the time to listen to the press conference with Chairman Yellen keeping in mind my comments above. I also embedded an excellent CNBC interview with Larry Summers who discusses the Fed's balancing act and why he thinks oil is out of sync with other commodities (Really? Copper prices have plunged too, which doesn't bode well for the global recovery).

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