Can You Hear Me Now?
Cumberland Advisors June 20, 2013
The Fed has decided to keep its asset purchase program in place and also its accommodative low target for the Federal Funds rate. The statement issued after yesterday’s meeting was accompanied by the FOMC’s revised economic projections. For those of us who have been engaged in the economic forecasting business for a while, the projections are filled with contradictions that make one wonder about the underlying structure of the individual forecasts that are being masked by their aggregation. Here are some basic observations that suggest that at least on the surface there are logical inconsistencies that could possibly be easily removed if the forecast procedure and release of those forecasts were revised.
First let’s look at the GDP forecasts. The Committee lowered the central tendency for growth from March from 2.3-2.8% to 2.3-2.6%. The central tendency is derived by dropping the three highest and the three lowest forecasts. From March to June the full range of forecasts, including those dropped from the central tendency data, went from 2.0-3.0% to 2.0-2.6%. In other words, the Committee marked down its growth forecasts, and all of those markdowns reflected changes in the views of the most optimistic FOMC participants. This is at best tepid growth, and it is puzzling why some in the press would view this as a more optimistic outlook.
We estimate that, if the economy grew new the upper end of the Committee’s forecast range of 2.5%, somewhere between 113K and 158K jobs would be created per month. Based upon the historical average rate of job creation, it would normally take our economy until well into the second quarter of 2015 for the unemployment rate to fall to 6.5%, the so-called trigger to initiate discussion of a possible movement away from the Fed’s accommodative strategy.
So what do the FOMC’s unemployment forecasts look like? The central tendency for the unemployment rate is 7.2-7.3%, a remarkably tight consensus as to where unemployment will be at the end of 2013. The forecast range is only slightly wider at 6.9-7.5%. This is an improvement from the Committee’s March forecast, and it comes with a somewhat less optimistic central tendency for growth than the Committee had in March. How can one explain this better job outlook, given slower expected growth, especially with the emphasis on fiscal drag from sequestration that Chairman Bernanke gave in his press conference?
The forecasts for 2014 are equally interesting. The central tendency for GDP in 2014 was revised up significantly from that in March, and with it the central tendency for the unemployment rate was also lowered to 6.5-6.8%. What is there in the data that suggests such a dramatic improvement? The question is whether by the end of 2013 the improvement in the forecast growth rate would be sufficient to generate enough jobs to justify that kind of improvement in the unemployment rate. Here more detail on the expected trajectory for growth in the latter half of 2013 going into 2014 might help explain the optimistic 2014 employment picture. Our estimates suggest that if the economy were to grow at 3% from this point forward, and if it consequently created on average the number of jobs that growth rate has historically generated, it would still take until somewhere between the third quarter of 2014 and the middle of 2015 before the unemployment rate hit 6.5%. Again, this evidence-based analysis seems inconsistent with the Committee’s forecasts and calls for more explanation for the forecasts’ deviation from historical performance.
In short, given the modest growth forecasts, it appears that the FOMC’s projected improvement in the employment situation is very optimistic. All this makes the message delivered by Chairman Bernanke yesterday understandably confusing, since he talked about tapering off the asset purchase program in 2013.
What did the Chairman do and not do? The Chairman was brutally honest and forthcoming with a message that markets didn’t want to hear, as demonstrated by the subsequent market reactions. He spooked markets by suggesting that the tapering off of the Fed’s asset purchase program could begin as early as this fall and might even be triggered by an unemployment rate that reached 7%. Notice that he didn’t tie this trigger to the FOMC’s forecasts, though perhaps he should have. Note too that the 7% number was outside the bounds of the Committee’s 7.3-7.4% central tendency for 2013 and will thus require robust growth in the second half of the year, which is inconsistent with the Committee’s own assessment, or at least the evidence it provided in its forecasts. Understandably then, markets are confused.
What about the Chairman’s other messages? They were clear, both with regard to the fact that the decision to begin tapering off the asset purchase program will depend upon incoming data, and also with respect to the Committee’s assessment of conditions in labor markets and the inflation situation. While Bernanke’s remarks were perhaps an accurate description of the Committee’s views, these weren’t the specifics that markets wanted to hear. Huge positions rest on getting the expected policy situation right, and the markets’ initial reactions suggest that policy moves are expected sooner rather than later. This is not the message that the Chairman likely intended to communicate, but that’s what happened.
Additionally, the Chairman was clear that the Committee viewed its chief policy instrument to be the size of the Fed’s portfolio rather than its incremental asset purchases. Bernanke stated that, by taking assets off the market, prices were bid up and rates were lowered. There was no similar reference to the effects that the incremental purchases might or might not have. Indeed, he seemed to be puzzled as to why markets would place so much emphasis on a slight decrease in asset purchases and why that would prove to be such a negative event.
Finally, the chairman was clear that not only was the Committee focused on unemployment, but also that conditions in labor markets more generally, along with inflation (and inflation expectations), would be important conditioning factors affecting any policy decisions. Yet again, all this apparently generally fell upon deaf ears as the market responded negatively. When questioned about the recent rise in longer-term bond rates and how that squared with his statement that inflation expectations were well-anchored, he replied that it could reflect a more optimistic view for growth. Clearly, this is not the typical interpretation of market participants who emphasize uncertainty and policy risks, rather than growth prospects or increased inflation risks, as the reasons that rates have moved up.
So what are the lessons from the day’s events? Clearly, while the Fed may view communication as an important policy tool, its use is not yet refined; nor does the Committee appear to recognize that there are multiple constituents for information who may require different messages. Yesterday’s events and the problems that the press had in interpreting the Fed-speak bring to mind the now familiar refrain, “Can you hear me now?”
The answer seems to be “No.” Investors and market participants have a short time horizon and need a degree of specificity that the general public doesn’t require. There is a need to better link the Fed’s communications to its forecasts, which were absent to a surprising extent. The Committee should give careful consideration to revising its forecast process. In particular, markets are interested in the near-term path of policy and are less interested in Committee’s views about the economy’s progress over a series of yearly horizons. Quarterly as opposed to yearly forecasts would be especially helpful, especially when the Chairman is trying to explain why the Committee believes that it could begin tapering off its asset purchase program in 2013.
Finally, the Committee’s next meeting will be even more closely watched than yesterday’s announcement. But there will not be a press conference. Nor will revised forecasts be available to justify a modification in FOMC policy in July, should one be forthcoming. New forecasts won’t be provided until the September meeting. That meeting won’t be held until after the FRB Kansas City Jackson Hole conference, which Chairman Bernanke will miss this year. In the past, that Conference has been used to signal a potential policy change. Equally important should his absence portend a possible departure, what might that mean for a policy decision on asset purchases at the FOMC’s September meeting?
So where does all this leave us for the rest of the year? Despite market reactions, it is unlikely that economic growth or the unemployment situation would justify a policy change in 2013, especially given the recent declines in the break-even inflation rates. Deflation, not inflation, is likely to be the short-term trump card concern that would dissuade the dovish FOMC from modifying even its asset purchase program this year. Markets won’t like this, and so we expect elevated volatility and risk premia combined with turbulence in debt markets. These are conditions that will give savvy investors real opportunities for informed purchases.
Bob Eisenbeis is Cumberland’s Vice Chairman & Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com. He may be reached at Bob.Eisenbeis [at] cumber [dot] com.