Paulo's Econ Watch

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US Inflation chart pack - are we there yet? (Sep/2015)

Posted on October 15th, 2015

Fed's criteria for raising rates:

"The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term."

So Fed needs to be reasonably confident inflation will move back to 2%. Are we there yet?

No. Recent Fed comments suggest the Fed is increasingly worried about downside risks to inflation (due to oil prices, strong dollar, slowdown in some recent economic data).

Consumer inflation is not there yet, but inflation momentum (3-month annualized inflation) is hovering around 2.0% in the last three months to September.

The chart below shows that CPI excluding energy is growing at 1.9% for 2 years -- with no sign of an impact of the stronger US dollar on overall price level. It is very hard to infer an slowdown in price increases from the chart below.


The reason for the steady pace of overall inflation (ex energy) is that services prices are increasing at a healthy 2.7% yoy (and 2.5% in the last 2 years). This is not far behind where core services were before the recession.

Housing prices (rental and OER) represents 33% of CPI and is increasing at 3.2% yoy.

See the detailed chart pack below.
Core inflation momentum moved from 1.5% in Jan to 2.4% in June and down to 2.0% in September. (2% in the last three prints - July, August, September).
Trimmed-mean CPI -- mentioned in the minutes -- moved from 1.2% to 2.1% and then to 1.9% in the same comparison.


The chart below looks at the average of the three measures of core inflation over a longer time span. Despite all the talks of deflation / lowflation, annual core inflation has barely moved since late 2011.



Core CPI at 1.9% and CPI ex energy at 1.8%.

It's all about energy...

...and goods. Services inflation running at a healthy 2.7%

Oil prices are spilling over to core. Core inflation excluding airfares is a bit higher. Looking at this chart it is hard to understand the Fed's fears of inflation remaining low...

Gasoline prices down again

Sticky-Price CPI growth remains stable -- a sign of anchored expectations

The Atlanta Fed produces a breakdown between 'sticky' vs 'flexible' prices and they argue 'sticky' prices (which is a weighted basket of items that change prices relatively slowly) "appear to incorporate expectations about future inflation to a greater degree than flexible prices".

The chart below shows that 'sticky' prices remain...well, sticky at around the 2% level annually. Moreover, sticky prices inflation is down but is running very close to 2%. This is in clear contrast to the 2009 to 2011 period which clearly showed concerns about future inflation.



Market-based inflation compensation is falling...this moves with oil prices and FOMC decided to downplay this by move late 2014.



FOMC minutes: all we need is confidence...but we only get uncertainty

Posted on October 8th, 2015

Minutes confirmed my preliminary assessment after the statement and press conference: "The Fed has not materially changed the outlook, neither the balance of risks, but has acknowledged an increase in uncertainty. And if one is not willing to show this uncertainty in the forecasts, you show it by lowering the 'dots' when your forecast suggest otherwise, and sound dovish".

Main takeaways from September minutes:
  • Decision to be on hold explained:
    • All but one member agreed developments over the intermeeting period had not materially changed the outlook.
    • But, "in part because of risks to the outlook for economic activity and inflation" they decided it was prudent to wait for additional information to bolster their confidence on inflation returning to target.
  • Wait a minute: didn't they write that the balance of risks had remained unchanged?
  • But the minutes make it clear: The balance of risks has not changed. But the risk of risks has! (in other words, uncertainty) - This was the missing information in the statement and press conference...(see Frank Knight for the difference between risk and uncertainty).
  • Members agree that unemployment rate is at a level "quite close to" NAIRU.
  • Not quite there yet:
    • many members think labor market conditions met or would soon meet one of the Committee's criteria for liftoff.
    • but some members indicated confidence on returning inflation to target had not increased (because global economic and financial developments)
  • Most members need to see growth to "continue to expand at moderate rate" and labor market conditions to "improve further" for them to increase their confidence on inflation returning to target.
  • So when to move?
    • Many members expect conditions to be met later this year.
    • But several members were concerned about downside risks to growth and inflation.
    • A couple of members expressed unease with decline in market-based measures of inflation compensation. (Yellen seems to be one of them, based on her remarks in the Q&A)
  • Yellen seems to be on the very dovish side of the debate. And she's the boss.
  • Some of the comments that the September decision had been a 'close call' were not evident in the minutes. At least among voters (Williams included), all but Lacker easily agreed to wait for more information.
  • Meeting-by-meeting and data dependency continues to hold...

US September Payroll -- weakness in manufacturing spilling over to services?

Posted on October 2nd, 2015

Main takeaways:
  • Very weak report, across the board; median expectations for private employment growth averaged 204k in the last three months and the actual number was 138k (lowest since mid-2012, right before QE3... if only Bernanke was there... :-)
  • Job creation in goods sector had already been weak since earlier this year, but job creation in the services sector slowed materially in the last couple of months.
  • Is this the spillover from the industrial sector (oil, exports, etc.) into the services sector or just a temporary halt in new hiring due to global uncertainty?
  • Low unemployment claims suggest layoffs are not increasing and a combination of measures of labor market activity (see below) suggest it might be the later.
  • The contradictory message in this report is that, while job creation has slowed, measures of labor slack kept shrinking.
  • Particularly worrying it the decline in labor force participation (LFPR), which seems to be back to the trend observed from 2010 to 2013 (LFPR stabilized in 2014, a year in which labor market improved materially).
  • If LFPR remains flat a mere 145k/month payroll for the next 15 months is needed to reach the 2016 median unemployment forecast; if employment growth slows from the current 2.2% to 1.5%yoy and LFPR remains constant (against structural trend), then unemployment rate would reach 4.5% by the end of 2016. Allowing the LFPR to continue its down trend since 2010, 145k/month would lead unemployment rate to 3.8% by the end of 2016.
  • As for the timing of liftoff...who knows... the Fed keeps hinting at December but, fears of a more serious growth slowdown in the US has now been added to the China risk and tightening of financial conditions. Since I believe the payroll slowdown is temporary and that global risks are likely to recede in the coming months, I think December is still the most likely date for moving out of the ZLB.

Establishment report:
Private payroll increased 118k in August, well below the bloomberg consensus again. Net revisions were negative 69k.

The table below shows the expected range for private payroll (excluding outliers), the monthly surprise and revisions to the last 3 months. The actual print is in "red" (an "x" when inside the expected range and a box when outside).

There were 4 large negative surprises in the last 18 months: Aug/14, Mar/14, Aug/15, and Sep/15.

Market has clearly missed the pace of job creation in the last 3 months!

One can see that the average of the median expectations for the last 12 months was 219k/month, very close to the actual releases of 218k/month in the same period (after revisions, private payroll averaged 217k/month in the last 12 months).

In the last 6 months the median expectations averaged 214k/months and the actual release averaged 194k (179k/month after revisions).

In the last 3 months the median expectations averaged 204k/m and the actual release averaged 156k/month (138k/month after revisions).


Measurement error in August?
After August disappointment, a strong emphasis was given to the fact that, since 2009, August payroll had always been revised higher (see chart) -- but the opposite happened this time.

The trend in private payroll (proxied by the 12-month moving average) moved down to 217k/month from 232k/month (unrevised) in August. The chart below shows the current vintage (orange line) as well as the real time path observed in each of the last few months.

The chart below shows that annual growth rate in private payroll is growing at 2.2% yoy -- off the highs but is still a healthy pace of growth.


September annualized growth (1.2%) is close to the recent lows -- which in the recent past proved to be transitory. The current yoy growth (2.2%) continues very close to the growth observed in private payroll in the last 3 years, which is above the peak observed in March/2006 during the previous expansion period and is closer to the growth rate observed in the late 1990´s.

Labor input:
The volume of total hours worked in the economy contracted in September resulting in an annualized contraction of 0.4% in the last 3 months (blue line in the chart below). This is well below the main trend (since Oct/09) which remains at 2.3%. There were several episodes of a similar sharp slowdown in total hours worked since the crisis: Oct/10 to Jan/11, Jan/12 to Jul/12, Feb/13 to Jul/13, Nov13 to Feb/14, Dec/14 to Apr/15, and the last one starting in June.


Contraction in mining and weak manufacturing are behind the stagnation in hours worked in the goods sector.
Hours worked in the services sectors slowed down a bit.


Wages:
Wages (average hourly earnings) were flat in September.
Wages for all employees rose by 2.2% yoy and for production worker rose 1.9% yoy - stable compared to August. Overall, as the chart below shows, average hourly earnings have consistently grown at about 2% p.a in the last three years.


Household income:
Total payroll income for production workers contracted sharply in September (-3.6% ar). For all employees, payroll income dropped 2.9% annualized in the month. Payroll income in the goods sector was negative in a quarter for the first time since 2010.


Below the breakdown in goods and services sector.


Household report:
The labor force participation rate moved 'sharply' down in June to 62.4%, breaking what had appeared to be a stable level. It is interesting to highlight that the most LFPR managed to do was to stabilize in 2014 -- a year in which job creation and labor market conditions improved quite substantially. Will LFPR resume its structural downtrend now that the economy appears to be weakening? This is a crucial question as it could put the Fed in a position where they see labor slack shrinking further at the same time that the economic growth slows.

The broader measure of unemployment (U-6), which includes marginally attached, discouraged workers, and employed part time for economic reasons is falling faster than the headline unemployment -- more on that in the spider charts below.

The median forecast for unemployment rate in the Fed's SEP (Summary of Economic Projections) is 4.8% for 2016, 2017 and 2018. Assuming a flat LFPR, a forecast of 4.8% unemployment rate by the end of 2016 is compatible with average employment growth of 145k/month, even lower than the 167k/month of total payroll observed in the last 3 months (which was way on the weak side -- if a recession does not happen).


As a reference, even a slowdown in employment growth from 2.2% currently to 1.5% yoy (the floor observed since mid-2011 was 1.8% yoy) would be equivalent to monthly employment gains of 178k and this would lead to a 4.5% unemployment rate by the end of 2016. Bottom line: LFPR needs to rebound (or job creation to settle at a very low level) for a 4.8% unemployment forecast to be attainable.

See detailed charts below:




The chart below shows unemployment rate (and short-term unemployment) and the recent tightening cycles (yellow). The short-term unemployment rate is at the lows.

Long term unemployment rate is improving faster. Moreover, the 'shadow' labor (i.e., the gap between U-6 and the headline unemployment rate) is improving faster in the recent months. This is a clear sign that the labor market continues improving.



Spider charts:
The two spider charts use 13 measures of labor market activity. The first chart shows how far away the labor market is from conditions that prevailed when employment was at its postrecession low and how close to conditions that prevailed when employment was at its prerecession peak. The second chart converts the upward trending indicators in the first chart to rates. (Source: Atlanta Fed -- details here)

The charts below compare the 13 measures of labor market in July/2015 and Sept/2015. It shows that, despite the sharp slowdown in net job creation in the last two months (payroll), the overall market conditions improved in the period. Note also that Yellen's preferred measures of labor market utilization (e.g., part time for economic reasons, marginally attached) continued to improve in the last couple of months.

Levels chart:

Rates chart:










September employment by category - chart pack

Posted on October 2nd, 2015

The charts below show employment by category. The blue line is total employment in the category, the orange bar is monthly change and the red line is the linear regression in the last two years.

Total payroll increased 142k in September, after a 136k growth in August (which was revised down from 173k). The trend for the last 6 months slowed from 280k/month by the end of last year to 200k in the 6 months to September.

Private payroll increased 118k in September, after 100k growth in August (revised down from 140k).
The trend for the last 6 months slowed from 270k/month by the end of last year to 180k in the 6 months to September.

Most of the slowdown in the pace of job creation was initially concentrated in the goods producing sector (mining and manufacturing), but it seems that this slowdown is now spreading into the services sector. Overall, the 6-month pace of job creation in the goods sector slowed from 50k (at the end of last year) to close to zero, while in the services sector it slowed from 220k to 180k in the same comparison.

Employment categories
Total nonfarm
Total private
Goods-producing
Mining and logging
Construction
Manufacturing
Private service-providing
Trade, transportation, and utilities
Wholesale trade
Retail trade
Transportation and warehousing
Utilities
Information
Financial activities
Professional and business services
Temporary help services
Education and health services
Educational services
Health care and social assistance
Leisure and hospitality
Other services
Government


Total nonfarm (trend from 242.8 to 243.9 to 242.7/m)

Total private (trend from 238.2 to 238.2 to 235.6/m)

Goods-producing (trend from 39.7 to 37.5 to 34.8/m)

Mining and logging (trend from 0 to -0.5 to -1.1/m)

Constructions (trend from 23.9 to 23.2 to 22.4/m)


Manufacturing (trend from 15.8 to 15 to 14.1/m)

Private service-providing (trend from 198.6 to 200.8 to 200.8/m)


Wholesale trade (trend from 8.3 to 8.2 to 7.9/m)


Retail trade (trend from 24.2 to 24.1 to 24.0/m)


Transportation and warehousing (trend from 13.0 to 12.7 to 12.4/m)


Utilities (trend from 0.6 to 0.6 to 0.7/m)


Information (trend from 3.9 to 3.9 to 3.9/m)


Financial activities (trend from 10.7 to 11.4 to 11.6/m)


Professional and business services (trend from 52.9 to 53.5 to 53.7/m)


Temporary help services (trend from 12.3 to 12.2 to 11.9/m)


Educational services (trend from 4.5 to 4.6 to 4.2/m)

Health care and social assistance (trend from 36.1 to 37.8 to 39.1/m)

Leisure and hospitality (trend from 37.4 to 37.2 to 37.1/m)

Other services (trend from 6.9 to 6.6 to 6.2/m)

Government (trend from 4.5 to 5.7 to 7.0/m)

Global industrial trends

Posted on October 1st, 2015

Main takeaways:
  • Global PMI continues trending down.
  • But there is a clear divergence between emerging and developed countries...
  • ...that suggests convergence of growth between the regions is likely to continue...
  • ...resulting in a slowdown in global industrial production growth compared to pre-crisis growth pace.

Global PMI continues trending down...

... with a clear divergence between developed and emerging markets happening in the last 6-7 months.

This suggests industrial production in developed economies should continue to grow at around 1%...

...while industrial production growth in EM economies should slowdown further in the coming months.

And within emerging countries, the slowdown in industrial activity is driven by Asia (China)

The EM and DM PMIs suggest a convergence of growth between the regions is likely to continue...


... and as a result global industrial production growth is likely to slowdown. The chart below shows that world industrial production is usually cyclical -- except in the unusual expansion period between Dec/2001 and Feb/2008 and in the last 4 years up to mid-2014.
The previous slowdown / contraction periods (Dec/94 to Dec/95, Oct/97 to Oct/98, Aug/2000 to Dec/01, Feb/08 to Mar/09) were all period of crisis (Mexico, Asia, Nasdaq, and the GFR) and lasted about one year.



US Personal Income and Outlays (Aug/15 chart pack)

Posted on September 28th, 2015

Main takeaways:
  • No sign of a slowdown on either income or spending in August - despite the tightening of financial conditions and drop in consumer confidence. However, it might be too early to gauge the full effect of financial conditions on economic activity.
  • Household consumption was up 0.4% in June and income rose 0.3%.
  • Nominal (real) disposable income trend growth in the last 12 months growing at 3.3% (3.0%) and consumption trend growth at 3.4% (3.0%).
  • Core nominal (real) consumption (ex food and energy) growing at 4.4% (3.3%) in the last 12 months.

Personal spending rose 0.4 in August and household income rose 0.3% in the month.

The charts below shows that consumption has catch up and seem to be back to its previous trend before the slowdown in the first quarter. Savings rate remained moved down a bit to 4.7% (from 4.8%) in the month (the average rate observed since 2013 is 5%).


Disposable income seems to be in a steady trend, while household consumption rebounded from the lows early in the year and is back to its previous trend growth.

Chart 1a) Income and expenditures, nominal, since 2007

The growth trend in the last 12 months for disposable income went up to 3.3% in August from 3.2% in July and 3.1% in June, while the growth trend for consumption moved up to 3.4% from 2.8% and 2.6%, respectively.

Cart 1b) Income and expenditures, nominal, last 2 years

Chart 2a) Income and expenditures, volume, since 2007

When looking at volumes (constant prices) the trend growth in real disposable income slowed to 3.% in the last two years (from 3.2%), while real consumption rose 3% (from 2.8%).

Chart 2b) Income and expenditures, volume, last 2 years

The chart below shows slightly different measures of income. The green line shows private sector wages have clearly slowed down in recent months (from above average growth) and are now more aligned with the broader concept of disposable income.

Chart 3a) Different measures / concepts of household income, since 2007

Chart 3b) Different measures / concepts of household income, last 2 years

The chart below shows that almost all the recent stagnation in consumption was due to 'energy' consumption.

Chart 4a) Household consumption, core vs total, nominal, since 2007

Chart 4b) Household consumption, core vs total, nominal, last 2 years

Chart 4c) Household consumption, core vs total, volumes, since 2007


Chart 4d) Household consumption, core vs total, volumes, last 2 years

Breaking household consumption into goods and services show that the recent soft patch was entirely due to goods consumption -- but take a look in the chart of volumes: it shows goods consumption growing even faster than its recent growth trend.

Chart 5a) Goods and services consumption, nominal, since 2007

Chart 5b) Goods and services consumption, volume, since 2007

Digging further into goods consumption it is evident that most of the hit happened in nondurable (which includes gasoline), but when adjusting for prices nondurable goods seem to be back to the previous growth trend.

Chart 6a) Goods consumption (durables and nondurables), nominal, since 2007

Chart 6b) Goods consumption (durables and nondurables), volume, since 2007

Chart below focus only on nondurable goods (volume) to better spot the trends.

Chart 6c) Goods consumption (nondurables), volume, since 2007







US 2Q15 GDP (third release): revised up to 3.9% (from 3.7%); real GDI revised up a tenth to 0.7% in the quarter

Posted on September 25th, 2015

Main takeaways:
  • GDP keeps running above potential.
  • But GDI has been running very weak in the last two quarters. It may only be a 'catch-down' since GDI was running above GDP, but it bears watching.
  • Inventories are close to the highs -- this could trigger a short-term GDP slowdown.
  • Investments (ex. oil) are picking up.
  • The value of goods and services purchased by US residents, "private" GDP, private domestic demand, are all growing at or slightly above 3%.

Second quarter GDP was revised up by 0.2pp, above market consensus of no change.
Note that the contribution from inventories went down by 0.2pp.




Chart pack
GDP is running roughly 1pp above potential...

The average of GDP and GDI is running a bit below GDP. GDI has slowed in the last two quarters -- the statistical discrepancy is shrinking, since GDI is higher than GDP, but it is worth watching how GDI evolves in the coming quarters.


GDP excluding inventories is growing at 2.5%...


The value of goods and services purchased by US residents (regardless of where goods and services were produced) excluding inventories is growing at a healthy 3% since mid-2014...

... a similar growth pace is obtained if one looks only at "private GDP" (i.e., GDP excluding government consumption and investment)...

...and private domestic demand is growing at 3.5%.

Looking only at business value added, the growth pictures is similar to the whole GDP. It was very strong in 2Q (5.1%) and growing at around 3% since mid-2014.


GDP breakdown: Consumption
Consumption rebounded in 2Q and is growing a bit above 3%.

Excluding energy and food, consumption growth is even higher.



GDP breakdown: Investment
Overall investment growth rebounded in the last few quarters but the annual pace of growth is slowing...

...but recall that there is a collapse in investment in the oil sector.

Excluding oil sector, overall investment picture is improving, with annual growth rates at 6.9%. Note that this is not far away from the pace of investment growth before the great recession.

Nonresidential investment in structures excluding the oil sector is "booming"...


...and investment in intellectual property (R&D) is also booming...

...but traditional equipment investment is lagging well behind.

Housing investment has recovered from the taper tantrum and is growing at a pace comparable to before the great recession.







US FOMC: The headwinds keep blowing...

Posted on September 18th, 2015

Main takeaways:
  • The 25bp cut in the median 'dot' is not compatible with the change in forecasts.
  • This is happening since Sept/14. Blame it on the 'headwinds'.
  • Interestingly, the headwinds have consistently failed to affect Fed's forecasts. They only make their way to the underlying path of equilibrium real rates.


Despite FOMC's dovish statement and remarks, the forecasts for 2016 and 2017 have not changed materially:


Nevertheless, the 'dots' moved down by 25bp across the board. Is it compatible with the forecast revisions?

In order to check this, I have used Yellen's preferred Taylor rule -- the one she mentioned in her speech on Normalizing Monetary Policy.

The chart below plugs Fed forecasts into Yellen's Taylor rule for December 2015. It shows the implied path for interest rates assuming zero real rates (the solid light gray line) and assuming real rates at the long run value forecast by the Fed.

The lines with markers show the median and the trimmed average 'dots'. One can see that the Fed's median forecasts for interest rates at the end of 2015 have been consistent with negative real rates since mid-2013. The average in the period from Jun/13 to Jun/15 was -35bp and the most recent median dot is compatible with real rates at -65bp.


When looking at 2016 forecasts, the picture changes materially. The updated forecasts suggest nothing has materially changed in the Taylor rule range, however the median dot for December 2016 has consistently moved down since September/14. The most recent median dot is compatible with equilibrium real interest rates at -35bp.


The trend for 2017 is similar to 2016: the implied equilibrium real rate moved down by 100bp in the last year (but is currently compatible with equilibrium real rates at +50bp).


The bottom line is: no, the change in the 'dots' is not compatible with the change in forecasts (assuming the reaction function has not changed).

Therefore, the pattern of the last four FOMC dot-plots can only be compatible with the famous 'headwinds' (low oil and commodities, strong dollar, slower global growth) which, interestingly, have consistently failed to affect the forecasts. They only make their way to the underlying path of equilibrium real rates!

The chart below shows the implied Yellen Taylor rule assuming 1.5% real rate (red) and zero real rate (green). The blue dots are the median dot in the Fed's forecast and the chart shows also the fed fund futures the day before the meeting and as of September 18. Markets are skeptical the Fed will be able to follow its own plan (and markets have been right, so far).





US FOMC: Hinted at December liftoff, but within a very dovish framework

Posted on September 17th, 2015

Main takeaways:
  • FOMC hinted the most likely meeting for liftoff is December.
  • Yellen message was: FOMC has not "fundamentally altered its outlook", the risks remain balanced, but uncertainty increased; thus...
  • ...FOMC wants more evidence to bolster its confidence inflation will return to 2%.
  • However, the message was conveyed in a very dovish framework that sounded like a departure from the previous reaction function.
The FOMC surprised with a clear "dovish hold". The question is, why?

The quick answer comes straight into the statement:

"Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term."

A more explicit link from global developments to domestic developments is provided in Yellen's prepared remarks at the press conference:

"My colleagues and I continue to expect that the effects of these factors on inflation will be transitory. However, the recent additional decline in oil prices and the further appreciation of the dollar mean that it will take a bit more time for these effects to fully dissipate."

In another passage of her prepared remarks, Yellen explained what has made FOMC to change stance: equity prices, stronger dollar and spreads.

Developments since our July meeting, including the drop in equity prices [-5%], the further appreciation of the dollar [2%], and a widening in risk spreads [20bp], have tightened overall financial conditions to some extent. These developments may restrain US economic activity somewhat and are likely to put further downward pressure on inflation in the near term."
Note: the numbers in [ ] were not mentioned by Yellen.

So should we just focus on financial conditions? Not so fast... the Fed claims it does not target financial conditions... during Q&A Yellen stated:

"The Fed should not be responding to the ups and downs of the markets and it is certainly not our policy to do so. But when there are significant financial developments, it's incumbent on us to ask ourselves what is causing them ... And so they have concerned us in part because they take us to the global outlook and how that will affect us."

Ok. Now I got it. The FOMC has changed its global outlook and therefore its US outlook. No...read a bit further:

"...these recent developments...have not fundamentally altered our outlook. The economy has been performing well, and we expect it to continue to do so."

And then she mentions that "to be clear":

"...our decision will not hinge on any particular data release or on day-to-day movements in financial markets. Instead, the decision will depend on a wide range of economic and financial indicators and our assessment of their cumulative implications for actual and expected progress toward our objectives."

Then she added:

"The recovery from the Great Recession has advanced sufficiently far, and domestic spending appears sufficiently robust, that an argument can be made for a rise in interest rates at this time. We discussed this possibility at our meeting."

Ok. Now it is clear !! The US economy is so close to a rise in interest rates that the Committee has decided to send a very dovish message...go figure.

To be fair, Yellen mentioned that the "Committee judged appropriate to wait for more evidence...to bolster its confidence that inflation will rise to 2 percent".

It seems, thus, that despite the dovish message, the FOMC just wants to wait a bit more to make sure the recent bout of volatility will indeed only have temporary effects on the economy.

That might be the case...but it wasn't the message that came across from the statement, from Yellen's prepared remarks and from the Q&A.
The emphasis on (previously disregarded) market-based inflation compensation, explicit concerns about Chinese growth, the impact of commodity prices on emerging market economies, the capital flight from EM, and even concerns about Canada "which is an important trading partner", all departed from the message conveyed in a similar bout of uncertainty earlier this year and sounded very dovish.

Indeed, from late 2014 to earlier this year, the Fed watched a sell-off in EM currencies, a decline in oil and other commodity prices, a strengthening of the US dollar, a sharp drop in market-based measures of inflation compensation, a sharp slowdown in global trade, West Coast port slowdown, a contraction in first quarter GDP growth,..., and the message conveyed back then was more upbeat.

One thing that stood out was Yellen's remarks on inflation compensation:

"...the Committee has taken note of the recent declines in market-based measures of inflation compensation and will continue to monitor inflation developments carefully."

This was a complete departure from the line of thought of late 2014 and earlier this year!
Back then the FOMC decided to focus on survey-based measures of inflation expectations and disregarded market-based measures of inflation compensation. In February Semiannual Monetary Policy Report to Congress Yellen mentioned that inflation compensation "mainly reflects factors other than a reduction of longer-term inflation expectations". Fed staff even prepared a box in the Monetary Policy Report explaining the "challenges in interpreting measures of longer-term inflation expectations" from financial instruments.

To be fair, when speaking by herself (and not on behalf of the Committee), Yellen often seemed more concerned about inflation compensation than the full FOMC.

Allow me a digression to show how inflation extracted from the TIPS for the 5 year period from 2020 to 2025 is correlated with today's oil prices!!
(And, by the way, market-based measures of inflation compensation today are not far away from where they were back in February 2015 when Yellen spoke to the Congress.)

Returning to the main point, it is clear that the FOMC is worried about inflation and that something has changed.
One can clearly see that in their forecasts!!


Don't you think a tenth down change in median forecast and in the central tendency range for inflation reflect a material change? Well, you've got company. It is very hard to argue that a tenth move is not well within any forecast error margin...

But, what about the move in headline PCE down from 0.7% to 0.4%? Well, that's really a large shift, but note that the core PCE rose from 1.3% to 1.4%. Moreover, would the FOMC make today's monetary policy based on the forecast for the next 3 months? Even Yellen believes monetary policy has lags..."But there are lags in the impact of monetary policy on the economy" she answered in the Q&A.

So, if the FOMC has not materially changed the forecasts, has the dovish message resulted from a change in the balance of risks? The statement reads:

"The Committee continues to see the risks to the outlook for economic activity and labor market as nearly balanced but is monitoring developments abroad."

It seems the risks remain balanced but worth monitoring; so has uncertainty increased?
Yellen mentioned in the prepared remarks that "the outlook abroad appears to have become more uncertain of late, and heightened concerns about growth in China and other emerging market economies have led to notable volatility in financial markets".

So it seems that an increase in uncertainty was behind the change to a more dovish stance. But what is odd is that this uncertainty is not reflected in the forecasts. Look at GDP, unemployment and inflation forecast in the table above: forecast ranges have not changed materially from June -- this does not reflect an increase in uncertainty (or the Fed was not brave enough to change forecasts and acknowledge the worsening of the outlook and increased uncertainty).

So, the Fed has not materially changed the outlook, neither the balance of risks, but has acknowledged an increase in uncertainty. And if one is not willing to show this uncertainty in the forecasts, you show it by lowering the 'dots' when your forecasts suggest otherwise, and sounding dovish.

Would the markets really get surprised with a liftoff?

Posted on September 16th, 2015

  • No.
  • Fed fund futures imply less of 30% change of the first hike on Sept. 17.
  • Surveys (e.g., Bloomberg, FT) suggest the odds are closer to 50/50.
  • More interestingly, the term structure of the yield curve already has one hike fully priced!!

One of the key arguments against an increase in fed funds on September 17th is the fact that the Fed has not provided a 'heads-up' and therefore the market is not prepared for it. It would be too disruptive to move away from the ZLB without the markets being prepared for it, the argument goes.

So, would markets really get surprised in the event of a liftoff?

The immediate answer is yes -- just look at the fed fund futures and you'll see that the probability of leaving the zero bound is as low as 30%. The Fed only moved in the last 20 years when the implied probability is north of 70%, Larry Summers recently said.

But looking at economist surveys, one gets a different picture. A Bloomberg survey shows that 51 out of 113 economists / strategists expect the Fed to move 25bp on Sept. 17th and 3 expect a move half this size. A similar survey by the FT shows 47% of 30 economists expect a move.

One may quickly dismiss surveys and argue that market prices provide a more accurate picture.

So, let's take a closer look at market prices other than Fed funds futures.
The term structure of the yield curve provides valuable information. From 1985 to 2007, 99% of the variance of the term structure of the yield curve can be explained by two factors (the first 2 PCA).

The chart below shows that using the common information provided in the 6m, 1y, 2y, 3y, 5y, 7y, 10y, 20y, and 30y constant maturity treasuries one can closely replicate the actual Fed funds rate. Note that the PCA calculated does not include the FF.


So it is clear that the term structure contains information on the fed funds rate. Note also how the blue line (FF compatible with the term structure) often (but not always) anticipates the move in the actual fed funds.

What if we use the model coefficients estimated up to 2007 (to avoid including the period of the crisis) to forecast where the fed funds rate should have settled, based only on the actual path of the yield curve term structure? (again, not using the actual fed funds).

The chart below shows that the estimated fed funds would have been negative for most of the ZLB period. Except for the last few months!

Zooming into the ZLB period, one can see that the term structure of the yield curve is compatible with a fed funds rate which has increased since Jan/2014 and matched the actual fed funds by November 2014.
The most recent data shows that the term structure is compatible with fed funds at about 35bp, exactly where the market expects the FF to trade after the first hike!


Bottom line: the term structure of the yield curve already embeds one hike.

Paulo Gustavo Grahl, CFA

Random comments on macro data. Views are my own. Except when they aren't.