After watching highlights of Federal Reserve Chair Janet Yellen’s testimony this week, I realized the Federal Reserve has been slow to relate their change in outlook. In my most recent commentary about the January Federal Reserve meeting minutes, I noted the comment regarding not targeting specific economic indicators. I pointed out this was in reference to the former chair targeting a specific unemployment rate before the Fed would begin raising interest rates. By not mentioning specific parts of the economy, the Fed left open the idea there is a large number of indicators they are watching before committing to a normalization in policy.
During the testimony, Chair Yellen mentioned the Fed was still waiting for inflation to reach the target of 2% and would hold off on raising rates until that target rate was reached. Okay, so it is time to put together another graph showing a few measures of inflation. The CPI for January was just released this week and it was quite alarming, if you are a Federal Reserve committee member. The graph I put together is on the companion site.
The top line on the chart is one of the measures I prefer. It looks at inflation over the past ten years. I prefer this measure because inflation has a tendency to affect consumer’s attitudes for far longer than the extent of it. Yet, this measure has been declining and now sits at 2.05% per year. It is not possible to use this measure against the Fed’s target since they don’t use it and they are more interested in future inflation than past inflation. Also, the momentum of this measure will continue to pull it lower as we move through 2015 since the calculation will be removing 2005.
The next line to discuss is the red line, the one-year inflation rate. When the Bureau of Labor Statistics releases the CPI numbers monthly, this is the headline number they report. Stunningly, the United States crossed over into deflation as the year over year reading was reported at -0.09%. Notice also the momentum of this measure is sharply downward. Unless we see some inflation in the sub-areas, this measure will continue to move lower at least through the middle of summer. There are parts of the press which incorrectly use this reading to compare to the Fed’s target. Again, the Fed doesn’t target historical inflation.
That brings us to the third line, the blue line, which is the five-year forward breakeven inflation rate. There are market instruments that you can invest in which pay interest. These things are real securities. The difference between the prices of these securities results in an implicit guess on where inflation will be in five years. Here are the notes from the St. Louis Fed’s database:
The breakeven inflation rate represents a measure of expected inflation derived from 5-Year Treasury Constant Maturity Securities and 5-Year Treasury Inflation-Indexed Constant Maturity Securities . The latest value implies what market participants expect inflation to be in the next 5 years, on average.
That blue line has also been moving down and currently reads 1.3%. If the market thinks that inflation will be 1.3% per year on average over the next five years, the Fed has the cover to not change rates through at least the middle of the year as indicated in the latest meeting minutes.
And so, it is time to change my expectations. While I would prefer the Fed raise rates in March, I know they won’t. I think they and the Federal government are perpetrating a War on Savers, but it does not matter what I want. The only thing that matters is what the market thinks and the influences upon the market. The Fed has can postpone any rate hike past their current target of June. In fact, I think they can postpone a rate hike into 2016. But wait there’s more — they may not need to raise rates even then. Here’s why:
It starts with the value of the dollar. One of my indicators to watch for 2015 was the value of the dollar. It had just touched a key technical level at the end of 2014 and has moved sharply higher in 2015. When the dollar increases relative to other currencies, the affect is a decrease in the price of imports. By decreasing the price of imports, the inflation rate here drops (largely because we operate with a trade deficit as a result of the reserve currency status of the dollar). Now if the Fed were to raise interest rates, investors from foreign countries would move their funds here to take advantage of the higher interest rates. By doing that, the value of the dollar would continue to rise, causing imports to become even cheaper, and inflation to drop even further.
The problem becomes — raising interest rates will accelerate the deflationary trend in the US. If you read the phrase “importing deflation”, this is what it means. The conclusion I reach is the Fed cannot raise interest rates as long as Japan and Europe, our main trading partners, are aggressively easing their economies through their own quantitative easing programs. Japan may never end theirs and Europe’s isn’t expected to end before September 2016. Thus, no rate increase here until at least then.
The War on Savers continues.
You know, if I were to start a series on the failings of the Congress to fund the government, I might have a very lengthy series of posts for this year. Let’s start with the obvious: the House just failed to pass a bill to fund the Department of Homeland Security for three weeks. This bill is just to get out a few weeks to continue discussions on a full funding measure. Stunningly, it didn’t pass.
The DHS includes functions such as TSA and Secret Service. While functions such as these will likely be declared essential, there remains the possibility of 250,000 people getting furloughed. The remainder may or may not get paid immediately, which means they will work for free until funding is restored.
The reason I bring this up is because the three-week funding measure was looming to drop one crisis upon another. Congress really messed up trying to pass a full-year funding bill with an amendment over-turning the change in immigration law. By allowing so much time to pass, Congressional leaders were unable to gather enough votes to pass a short-term funding bill.
The key point is there is another contentious issue coming on March 15th. It was during February 2014 that Congress postponed debate on the debt ceiling for fifteen months. That period ends on March 15th. We are not too many days away from that becoming major headlines again.
But what there’s more!
Congress needs to re-write Medicare compensation rules to medical practitioners by March 30th. I know nothing about the current rules and won’t likely be following the associated news flow, but wow! March is going to be a crowded month of Congressional news.
Given how poorly Congress performed on funding one of the smaller, yet critically important, departments of the government, I don’t expect them to get together and pass something the President will sign regarding the debt ceiling or Medicare.
Of course, I could be wrong. The last time Congress was unable to pass a bill regarding the debt ceiling, the government temporarily shut down. I would expect the Republican leaders of the House and Senate will want to avoid that scenario a second time. Polls still indicate the Republican Party is held as responsible for that action and with the party controlling both halves of Congress, they likely would face blame again.
Still, if you watch the actions of the Republican Party, it seems like we are watching the slow scism of the party into a conservative / moderate wing and a tea party / conservative wing. The Senate seems reasonably united behind a conservative / moderate leader, but the House has a conservative leader being undermined by a tea party led side that would rather see his authority taken away. With the House seemingly operating under three parties, it is highly unlikely there will ever be a consensus on any of the three issues I have listed here, yet alone other measures to keep the government functioning.
March is going to be an interesting month (and I thought the drama in Greece was interesting in February).
The minutes of the January 2015 Federal Reserve board meeting were released this past week. There were plenty of market action review items to open the minutes. Most of which were around the robustness of market intervention policies when normalization of rates commences. In the section titled, “Staff Review of the Financial Situation”, there is this comment:
…reflecting in part the deterioration in market sentiment, the expected path for the federal funds rate implied by market quotes shifted down. Results from the Desk’s January Survey of Primary Dealers indicated that dealers continued to put the highest probability on scenarios in which the FOMC chooses to commence policy firming around the middle of the year, although the average probability assigned to a commencement after June increased somewhat.
As I have noted in the past, I am strongly in favor of rate normalization beginning in March. But as I have been instructed, you work with the market you have not the market you want. In this case, market sentiment is moving after the middle of the year for a rate change. No one at the Fed has signaled a change in probable policy from the middle of the year. This will bear watching.
Later on, we get to the section titled, “Participants’ Views on Current Conditions and the Economic Outlook” and find this part of the first paragraph:
Although growth likely slowed from the rapid rate recorded for the third quarter of 2014, a variety of indicators suggested that real GDP continued to grow faster than potential GDP late in the year and during January.
This seems to one of the first signs of when the economy is performing better than expected and rate normalization may commence.
Further down, we find an unusual comment about inflation:
It was pointed out that the recent intensification of downward pressure on inflation reflected price movements that were concentrated in a narrow range of items in households’ consumption basket, a pattern borne out by trimmed mean measures of inflation.
The trimmed mean inflation measures were pioneered by the Dallas branch of the Federal Reserve. They are generally considered better indicators of overall inflation than core PCE since volatility is retained and only those two measures at the extreme ends are kicked out. While core PCE removes Food and Energy subcomponents, the trimmed mean until recently has removed Energy and Communications subcomponents.
After this are two lengthy paragraphs devoted to the discussion around the timing of rate normalization including the risks of commencing later than the market perceives is necessary and earlier than the market wants. It is fairly clear there was a significant amount of time devoted to this subject. It was also noted that one participant wanted to ease further until the targeted inflation rate of two percent was reached. In terms of passing along a set of indicators for when rate normalization would begin, most of the participants’ noted that would be difficult. Interesting that it wasn’t difficult in the past, yet we went through those measures and rates have not changed. Maybe that is why it is difficult now. Then these comments on inflation measures are mentioned:
Many participants indicated that such economic conditions would help bolster their confidence in the likelihood of inflation moving toward the Committee’s 2 percent objective after the transitory effects of lower energy prices and other factors dissipate. Some participants noted that their confidence in inflation returning to 2 percent would also be bolstered by stable or rising levels of core PCE inflation, or of alternative series, such as trimmed mean or median measures of inflation. A number of participants emphasized that they would need to see either an increase in market-based measures of inflation compensation or evidence that continued low readings on these measures did not constitute grounds for concern. Several participants indicated that signs of improvements in labor compensation would be an important signal, while a few others deemphasized the value of labor compensation data for judging incipient inflation pressures in light of the loose short-run empirical connection between wage and price inflation.
From my perspective, the Fed’s mandate is to control inflation, not wages. In addition, that last sentence should be noted since there are many studies showing the weak link between wage growth and inflation. Targeting wage growth would send the wrong signal regarding what is important in the economy. With wages little changed in the past ten years and debt as a percent of income continuing to rise, it seems that wage growth would have a tendency to go more towards debt reduction rather than consumer purchases. That reduction in debt would be a deflationary indicator. It is thus more important to target price inflation instead.
An interesting meeting from my perspective. There seems to be more interest in allowing the market to dictate when rates should normalize and that seems to be moving later in the year. While no explanation was given for what is moving the market, I have mentioned the impact of divergence in global policy in the past. There are some economists who will argue for a later move to rate normalization because of the relative tightening the Fed is doing (no action while others are easing is the equivalent of becoming tighter on a relative basis). There also seems to be some voices within the committee that are watching the wrong indicators. I still hold the belief the Fed should be a national bank rather than the world bank and they should do what is best for the domestic economy. In fact, that would be just what the Bank of Japan and the European Central Bank are doing.
On January 3rd, I created a blog post with four watch list items for 2015. One month into the year, I decided to create an update.
The first indicator was the spread between the 2-year and 10-year treasury. We started the year at 150 basis points and we are now at 126 basis points. I expected the spread to reach 100 and we are well on our way.
The second indicator was the trade-weighted value of the US dollar. At the end of the year, it was at 85.1 and now is 88.9. This is the highest level it has been in the past ten years. I expect this to continue to move higher, though I doubt it even breaks 100 by the end of the year.
The third indicator is the Euro-Yen currency cross. I think there is a building currency war between the two. At the end of the year, the cross was 145.0. The ECB did announce a QE program and Japan did not immediately announce a counter. The cross ended the month at 132.9. My expectation was the cross to remain fairly stable. It hasn’t so far, but the EBC’s program will commence in February if the legal challenges do not occur.
The final indicator is the value of Bitcoin. The value at the end of the year was $319.7. I expected this to move higher as the effects of slowing economies in China, Europe, and Japan take effect. Instead, the value has decreased to $227.9. While unexpected, I will continue to keep this as an active watch list item.
I have a few other watch list items sitting by the side, but I haven’t seen a need to move any of these current ones off the list. I am beginning to read more commentary that the US Federal Reserve may hold off on raising rates. I think they should move rates in March, but I am emotionally biased against the current financial repression (hey, at least I recognize that). For February, I don’t expect any change from the Fed, I do expect the ECB to make its first market purchase, and Japan to remain on course.
The value of the dollar is having an impact on emerging countries across the planet. Combine that with the fall in the price of commodities and we are repeating the events that led to the Asian crisis in 1997.
One of those other items I am watching relates to the price of oil. There are several economies that are suffering due to fewer dollars from selling oil. I don’t know if any will announce major changes or create another market altering event, but it can’t be too many more months.
There was increased volatility in the US stock market during the second half of January. Earnings season hasn’t started out great (Apple aside) and I wonder if investors are starting to recognize some of the potential issues are more than just worry.
The Bureau of Labor Statistics (BLS) released the December 2014 CPI this past week. I expect to report on weightings changes with next month’s release, but for today, I want to write about the concept of a Personal Price Index. I have written a few times about how people experience inflation depending upon their age. I have been critical of the Federal Reserve targeting Core inflation when the elderly typically have higher than average medical, energy, and food expenses. By removing those items from Core inflation, Social Security benefits get indexed at a lower rate than inflation experienced by the people who receive it.
|Component||2013 Weight||2014 Weight||Importance|
|Food & Beverage||18.9%||15.3%||14.9%|
|Education & Communication||8.3||10.7||7.1|
For myself, I started with expenses in 2013 and 2014. I sub-totaled my expenses based on the naming convention of the BLS and compared it to the Importance factor in the latest release. You can see the results in Table 1. Right away, you can see I spend significantly less than average on Housing and significantly more on Other. I used Other for cash withdrawals as well as other miscellaneous items since I did not itemize how I spent cash.
|Component||2014 CPI||Weight Impact||CPI Impact||Expected CPI|
|Food & Beverage||3.27%||-29.7%||-0.97%||0.62%|
|Education & Communication||0.40||15.6||0.06||0.03|
Constructing Table 2 where I calculate my Personal Price Index will take some explanation. The concept of constructing the index is based on the choices I have made regarding purchases and how those choices shift as I age. The calculation starts with the 2013 weightings of my expenses and that becomes step 1. Step 2 takes those expenditures by component and inflates them using the 2014 CPI by component. The result is Expected Expenditures for 2014. For step 3, we need to find out the impact of the changes in expenditures. To do this, I took my actual expenses by component for 2014 and subtracted the result of step 2 and finally dividing by the result of step 2. In table 2, you can see the result in the column labeled Weight Impact.
Let’s spend some time on this column and grab the first row, Food & Beverage. By reducing my expenditure weighting from 18.9% to 15.3%, the impact from the change in weighting is -29.7%. Similarly, the Education & Communication line is impacted by 15.6% due to the increase in relative expenditures from 2013 to 2014.
The next column is titled CPI impact and the calculation is step 4. By multiplying the 2014 CPI for each component by the Weight Impact column, we get the impact on the Personal Price Index by component. Staying with the two example lines, the Food & Beverage component has a -0.97% impact to my Personal Price Index because my decrease in expenditures offset the large increase in the 2014 CPI. For Education & Communication, the large increase in weighting was offset by the small increase in 2014 CPI resulting in a 0.06% impact to me.
The opposite side shows up in the Transportation component where I had a substantial decrease in weighting from 2013 to 2014 which results in a -20.7% weight impact. Due to the -6.17% CPI in 2014, the impact to my personal price index becomes 1.28%. By decreasing my expenditures in Transportation, in effect I did not get to enjoy the decrease in prices.
Let me take a side note to explain why this calculation is odd and almost misleading. If I purchased 1000 gallons of gasoline in both 2013 and 2014, my expenditures in 2014 would have decreased in dollar terms compared to 2013 because prices went down. Notice the quantity of goods I purchased remained constant, but the value of those goods decreased. The purpose of the personal price index is to show how my choices affected my budget. By not increasing the quantity of goods that were decreasing in cost, the impact would be to increase my price index relative to the average consumer’s price index.
By adding the values of the CPI Impact column together, we arrive at my Personal Price Index for 2014 of 1.65%. The CPI reported by the BLS was 0.80% for 2014. While my price index was higher, it is not significantly out of line.
One last item to calculate: if we take the 2013 expenditure weighting and multiply it by the 2014 CPI, we get the final column titled Expected CPI. Summing the components together creates the expected personal price index of -0.07% for 2014. In other words, if my expenditure weights in 2014 matched my expenditure weights of 2013, I would have experienced a personal price index of -0.07% in 2014. The swing in the impact from the Transportation component is greatly felt through this result. Because of the choices I made in 2014, I felt the effects of inflation more than I should have.
A quick note about the U.S. 10-year yield: in the past 16 trading days, the yield has moved from 2.26% to 1.82%, a 42 basis point move. If you look at the chart, it sure seems like 1.63% is the point where the downward move meets resistance. At it’s current pace, it could achieve that within 10 trading days.
With the Swiss Central Bank changing policy to allow the Swiss Franc to move independent of the Euro, I expect to see an announcement within a couple of days regarding a large easing program by the European Central Bank. If that is correct, the Euro should fall relative to the dollar and there will be increased trading activity into U.S. Treasuries. If you need a potential story for the continued decrease in the ten-year yield, that seems like a reasonable path.
As I expected, the Federal Reserve did release their December balance sheet this week. I have updated the Easing Program graph with the latest numbers. Since I watch the weekly releases, I did notice in increase in the size of excess reserves. The amount increased from $2.519 trillion in November to $2.606 trillion in December. In December 2013, the amount was $2.485 trillion. This level supports my desire to see targeted interest rates increase in March. While the Federal Funds rate did increase to 0.12% in December, I would prefer to see it at 0.25% in March.
As I have stated previously, I would prefer to see the level of excess reserves maintained until targeted interest rates have normalized. The length of the financial repression that has taken place is excessively long and needs to end.
When I watched the evening news last night, a mention was made of the drop in the unemployment rate but a drop in average earnings as well. Given it was the evening news, no analysis was done so we shall do some of that here. As I mentioned in the recent post on the minutes of the December Federal Reserve meeting, there is concern that a continued drop in the unemployment rate could lead to a large rise in wage inflation. The result from yesterday’s announcement from the Bureau of Labor Statistics seems to contradict that concern. Looking inside the numbers will show us why this isn’t a contradiction.
The Federal Reserve has been criticized for focusing on the unemployment number as one of its targets on when to normalize targeted interest rates. I have agreed with that criticism. It shouldn’t be the unemployment number that is followed. Instead I think the participation rate should be followed. For December that number fell from 62.8% to 62.5%. This matches the low seen in January 2014 which was the lowest rate in eleven years. As an indicator, average earnings should be decreasing in that situation.
If you want to consider the unemployment rate, I find it more useful to use the maximum participation rate as a factor. This has the benefit of including the unemployed who are discouraged and not looking for work. That unemployment rate increased from 11.4% to 11.8%. Since the unemployment rate only includes those who are looking for work, it misses all of those in the labor force who have stopped looking. That number increased in December.
The participation rate for men 16 years of age and over slightly decreased from 68.9% to 68.8%. The participation rate for women 16 years of age and over decreased from 57.1% to 56.5%.
The participation rate for people between 16 years and 24 years of age decreased from 54.5% to 53.5%. For men, that rate changed from 55.2% to 55.0%. For women, it significantly changed from 53.7% to 52.1%.
For men 65 years of age and over, the participation rate increased from 22.8% to 23.0%. For women 65 years of age and over, the rate stayed constant at 15.1%.
The conclusions are simple:
- women dropped off payrolls disproportionately more than men
- the young also dropped off payrolls disproportionately more than older people
- young women saw a remarkable decrease in their participation rate
While the government may be celebrating the number of consecutive months with greater than 200,000 new jobs, the number of unemployed visible and invisible continue to rise.
I know I just created a horrible title for a blog post, but I needed to put a date in the title since it looks like this could be a year that I post frequently about the ten-year yield. I have been following the ten-year yield in the US for a few years now and this year I made it part (well, it is part of a formula) of my indicator watch list. I wanted to mention it specifically after this week. The yield moved from 2.12% to 1.97%. That is a meaningful move because it is the lowest yield we have recently seen. On a technical basis, it also means we should continue to see lower yields until we test the 1.63% yield from May 2013. On the graph I have made, I have changed the color to red indicating this is a transition period that began on December 24, 2014 with a yield of 2.26%. We have seen lower yields almost every day since that date. With the recent decrease in yields across Europe, the terrorist attacks in France, and increase speculation about Greece not meeting ECB goals and exiting the Euro, it shouldn’t surprise us to see the move into treasuries. The move from the current rate of 1.97% to the low of 1.63% is a long road and it seems there will need to be more than technical analysis to continue the downward trend.
When I left school, I would read the minutes of the Federal Reserve meetings as a reference to historical events. In those days, the minutes were released multiple years after the actual meeting. Those documents were a succinct way for me to recall what the economy was like and the focus of economists at that time. I stopped reading the minutes in the middle of the 1990s because I became highly focused on investments. As you might recall, investing was unhinged from the economy.
After ten years away from the minutes, I became fascinated again around 2007 as the market dropped significantly and the economy followed. Even though events were changing rapidly, the minutes were an interesting way to see how the thought processes were unfolding within the meetings.
Recently, the Fed has been making the minutes available on an accelerated basis. In fact, the minutes of the December meeting were released on January 8th. This is part of the agenda of the Fed to make signals more transparent to the securities markets. The minutes from the November meeting included some odd language that had not been discussed in previous meetings. Those comments were also in the December minutes. In what follows, I will reprint some of the minutes and add some comments. My point of reference for the comments arises from my consideration of what I am following during 2015.
The meetings have two teams that show up in the minutes: the staff and the participants. The staff includes analysts and other non-voting members of the Federal Reserve. The participants are the voting members. Here is the first comment from the staff:
Reflecting divergent economic and monetary policy prospects in the United States and abroad, the dollar appreciated substantially against most currencies over the intermeeting period. The dollar moved up significantly against the yen as the Bank of Japan expanded its asset purchase program as well as against the currencies of oil exporters as oil prices declined.
The part to notice the mention of the rise in the dollar. Maintaining the value of the dollar is the purview of the Treasury Department. It has been tradition for the Federal Reserve to not mention the dollar in its minutes. That changed in the November meeting and again, the dollar is mentioned in the December minutes. In addition, I was caught off-guard by the reference to “divergent” policy prospects. It is certainly true prospects for monetary policy are diverging, but the Fed has not mentioned it using this direct language. I applaud this inclusion.
The second highlighted comment comes from the participants’ economic view:
In their discussion of the foreign economic outlook, participants noted that the implications of the drop in crude oil prices would differ across regions, especially if the price declines affected inflation expectations and financial markets; a few participants said the effect on overseas employment and output as a whole was likely to be positive.
While I can certainly agree about the impact being different across regions, I would strongly disagree with the few who think it will be positive. The change in price has been too far too fast and there are likely to be severe impacts that will spread across our globalized economies. We are already seeing significant strains in Venezuela and Russia. Domestically, Helmerich & Payne announced they were stopping 50 wells and the CDS spreads on junk rated energy bonds tripled over the past week. Market dislocations are just now beginning and they were conceivable back in the middle of December.
The Federal Reserve should keep to its mandate regarding the economy of the United States. When they look at world economies, I get nervous because of the potential for them to think of themselves as a global central bank. Eventually, we will need one, but it will likely need to be independent of any government and global trade will need to be much higher than at present (in other words, national economies will need to be even more inter-connected).
Here are the list of risks to the economic outlook:
- …if declines in oil prices and the persistence of weak economic growth abroad had a substantial negative effect on global financial markets
- …the solid record of payroll employment gains in 2014 suggested that the real economy may end up showing more momentum than anticipated
- …the boost to domestic spending coming from lower energy prices could turn out to be quite large
- …a risk that [inflation] could run below their 2 percent objective
- …the recent substantial fall in energy prices could lead to a reduction in longer-term inflation expectations
- …if the unemployment rate continued to decline quickly, wage and price inflation could rise more than generally anticipated
I agree with all of those risks. Other risks that probably cannot be mentioned in such hallowed halls include a substantial rise in the dollar, Venezuela default, a rise in Japan government debt yield, and slowing economic activity in China.
The final quoted section comes from the Committee Policy Action section:
The Committee decided to maintain its 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.
I have been following the level of excess reserves at the Fed for some time and have a graph. While the quote doesn’t mention maintaining the full-level, I think that is what is implied. I am fully in favor of that. Especially, if it means normalizing targeted interest rates sooner. I’ll wrap up this post by mentioning I expect the December Federal Reserve balance sheet will be released tomorrow. I’ll update that graph and post a short comment about the change with that post. They clearly have not been maintaining the full level of QE4, but the weekly numbers have been rising late into December.