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The Fed Is Data-Dependent, Depending on What Data It Chooses


How can the market calibrate the Fed's forward guidance when the guidance keeps changing?

Well, last week was an interesting one for monetary policy. We entered thinking the Fed was going to taper QE at its upcoming meeting in an attempt to wind down the controversial program, and that the controversial Larry Summers was going to be appointed to replace Chairman Bernanke when the latter's term expires in January. Of course what we got was Summers pulling his candidacy on Sunday night and the Fed pulling its tapering threat on Wednesday.

You would have thought these pivotal events would have elicited massive readjustments in market discounts. However the story of the week is not that Summers pulled out or that the Fed didn't taper. It's that the markets didn't seem to care all that much.

When I read through the press conference transcript, this comment from Bernanke epitomized the forward guidance flaw (emphasis mine):
The criterion for ending the asset purchases program is a substantial improvement in the outlook for the labor market. Last time, I gave a 7% as an indicative number to give you some sense of, you know, where that might be. But as my first answer suggested, the unemployment rate is not necessarily a great measure in all circumstances of the -- of the state of the labor market overall. For example, just last month, the decline in unemployment rate came about more than entirely because declining participation, not because of increased jobs. So, what we will be looking at is the overall labor market situation, including the unemployment rate, but including other factors as well. But in particular, there is not any magic number that we are shooting for. We're looking for overall improvement in the labor market.

No magic number? Other factors? The Fed says it is data-dependent but it keeps moving the goal posts around on what data it is depending on. How can the market calibrate the Fed's forward guidance when the guidance keeps changing?

Minyanville's Michael Sedacca pointed out this tidbit to me the following day (emphasis mine; full transcript here):
... the general framework in which we're operating is still the same. We have a three-part baseline projection which involves increasing growth that's picking up overtime as fiscal drag is reduced, continuing gains in the labor market, and inflation moving back towards objective.

In my opinion, what we have here in Fed policy is confirmation of a de facto nominal GDP target, i.e. growth and inflation. Nominal GDP is running at around 3.0% year-over-year, which is the slowest growth rate of the recovery. This is a reflection of a soft job market and low inflation that is product of weak aggregate demand. In order for the Fed to achieve its dual mandate of maximum employment in the context of price stability, it needs NGDP growth closer to 4.0% or higher.

I said it when it launched QE in December 2012. I said it when it switched to FG (forward guidance) in July. And I'm saying it now after it pulled the taper rug on account of suspect job gains and too-low inflation.

After the December 2012 FOMC meeting I commented in Bernanke Capitulates; Launches De Facto Nominal GDP Target:

As I forecasted back in July at Wednesday's FOMC announcement, Bernanke capitulated and opted to attach what are being called "thresholds" to the Fed's uber-easy and accommodative monetary policy by raising the inflation target to 2.5% in order to bring the unemployment rate down to 6.5%.

Make no mistake about it, this is a de facto nominal GDP target.

Then in July in US Monetary Policy at a Crossroads, I reiterated this view that the Fed had a stealth nominal GDP target:
Bernanke didn't want to explicitly launch a nominal GDP target because he instead wants to stick to the Fed's employment mandate, but in his mind he probably thought it was implicitly the same. However it's not working out that way. Payrolls are not generating an increase in aggregate demand.

This remains the Fed's biggest problem. Jobs are not translating into aggregate demand which can sustain more jobs in what is typically the virtuous cycle that fosters economic growth. This conundrum can be illustrated in the following chart of PCE and average hourly earnings. Consumption growth relative to wage growth has been declining since 2011. During the credit bubble consumers spent more than they made, financed with debt. Today as consumers deleverage, consumption growth is becoming more aligned with wage growth which remains anemic and adjusted for inflation is virtually flat.

PCE Vs. Average Hourly Earnings

I think the key takeaway from this FOMC decision is that when tapering was first floated in February, it was an admission by the Fed that it was not prepared to defend the inflation target, which was the driver of negative real interest rates. When the Fed officially backed off in May, real rates rose as inflation expectations fell, which pushed nominal yields higher.

The decision not to taper is a re-engagement of its defense of the inflation target. In fact since the weak August employment report, falling real rates and the steeper curve was reflecting this inflation target commitment ex ante. It seems the market already had a sense that the Fed wasn't going to taper. The question for participants going forward is whether this extension of QE will re-raise inflation expectations in order to lower real rates.
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