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Analyzing The Economic Conditions Needed For Persistently "Exceptionally" Low Rates

Tyler Durden's picture





 

One of the key departures by the FOMC yesterday in comparison to prior rate statements, was providing a glimpse into what the specific economic conditions are that warrant continued "exceptionally" low rates. Among these the Fed outlined "low rates of resource utilization, subdued inflation trends, and stable inflation expectations"- so long as there is no perceived change to any of these, expect rates to persist in the 0-25 bps zone. Goldman provides some valuable insight on how to interpret these three key considerations by the Fed.

it is useful to consider what specific indicators FOMC members may have in mind as they consider whether “low rates of resource utilization, subdued inflation trends, and stable inflation expectations” remain in force.  Current values of these indicators are shown in the table below, with the most important indicators (in our view) in bold text.
 
1. Low rates of resource utilization.  The broadest measure of resource utilization is the output gap – the difference between actual and potential GDP.  The Congressional Budget Office, the definitive source for estimates of potential GDP, currently estimates the gap at 6.3% as of the end of the third quarter, the largest since the early 1980s.  (The gap shrank marginally in Q3, since the economy grew above trend last quarter.)
 
However, the output gap is a nebulous, difficult-to-measure concept and many analysts view it with skepticism.  An alternative is to review more “‘micro” measures of resource utilization, a few of which are included in the table below.  (A more extensive table is provided as Exhibit 5 of “Deflating Inflation Fears,” GS Global Economics Paper No. 190, September 29.)  Of these, we view the unemployment rate as most important.  It is a widely accepted surrogate for the GDP gap, it carries significant socioeconomic implications, and it is one of four indicators for which Fed officials provide public forecasts on a regular basis (the others are real GDP, core PCE inflation, and headline PCE inflation).  At 9.8% as of September, the unemployment rate is nearly three standard deviations above its average level of the past half-century. 
 
2. Subdued inflation trends.  The use of the word “trends” in the statement hints at core inflation as a more prominent metric than headline, though a few FOMC members might take issue with that interpretation.  Historically, current core inflation has tended to be a better predictor than current headline inflation of future headline inflation.  In the short term, this is a distinction without a difference, as headline metrics show deflation over the past year and core inflation is on the soft side of desired levels.  However, the distinction is likely to matter much more in 2010: headline inflation will rise well into positive territory in coming months as year-over-year comparisons become “easier”, while (after perhaps a slight increase in the remainder of 2009) we expect core inflation to decline further in 2010.  The Fed forecasts price indexes for personal consumption expenditures (PCE) rather than the consumer price index, so we see the core PCE inflation metric as the most important.
 
3. Stable inflation expectations.  A significant increase in inflation expectations could push the Fed to tighten even if actual growth or inflation remained on the weak side.  In fact, a big move in inflation expectations in either direction would probably trump other indicators in terms of the influence on Fed policy.  A case in point is the sharp decline in market-based inflation expectations in late 2008, which coincided with much more aggressive Fed rhetoric (including the statement that the FOMC would use “all available tools” to restore growth) and actions (the initiation of asset purchases in late November and expansion in March).  
 
In our view, the most important indicators of inflation expectations are longer-term measures of breakeven inflation (the difference between the yields on nominal and inflation-protected Treasury securities; inflation swaps provide a slightly ‘purer’ alternative metric with fewer liquidity issues) and household expectations of inflation.  In the case of breakeven inflation, the five-year, five-year forward measure is commonly used.  In the case of household expectations, the longstanding University of Michigan measure of median 5-10 year inflation expectations is probably foremost.  
 
After these two measures, the next is probably the long-term inflation expectations captured in the Philadephia Fed’s Survey of Professional Forecasters.  We view forecasters’ expectations as slightly less important, as they generally lag a bit and the channels through which they affect actual inflation are less direct. In any case, longer-term market-based expectations are slightly above their average of the past few years while survey-based inflation expectations are slightly below.  In short, inflation expectations are low and fairly stable at the moment.
 
Some Fed officials may also view the value of the US dollar or commodity prices (particularly gold) as containing information about inflation expectations, or about future inflation. It is more difficult to calibrate exactly how “out of whack” these variables are, and we very much doubt that they alone would prompt a change in Fed policy. However, large moves might be a contributing factor to a change in rhetoric if they accompanied modest changes in market- or survey-based measures of inflation expectations.

As for which of these three will show weakness first and provide at least some ammo for the Fed Hawks, here is how Goldman sees the sequence of priorities:

We see utilization as least likely to be an issue in 2010 – spare capacity is so large that it will take a long time to whittle away even with strong growth.  In fact, where the unemployment rate is concerned, a simple rule of thumb known as Okun’s Law suggests that it could take many years to return to “normal” unemployment rates.  (The rule is that two percentage points of above-trend growth, i.e. growth in the high 4% range, would reduce the unemployment rate by one percentage point per year.)

Core inflation is also highly persistent and we view the predominant forces as downward.  Headline inflation, on the other hand, should perk up somewhat given commodity prices and easing year-ago comparisons.  It is the most likely (although not very likely) to move above comfortable ranges in the next year, although as noted above, it is probably viewed by most FOMC members as secondary to core inflation.    

Inflation expectations are the hardest variable to predict, and the process by which long-term expectations are formed is not especially well understood.  Therefore, they have to be seen as a risk factor.  However, insofar as some portion of expectations is “adaptive” (reacting to past inflation rather than predicting future inflation), lower inflation now would seem to point towards downside, rather than upside, risk to inflation expectations.

One thing is certain: the Fed will dither for years without doing much, even as another full blown liquidity bubble grows ever larger in its face. And by the time it wakes up and begins tightening, the market will likely again be in the parabolic phase last witnessed during the silly tech days of early 2000.

 


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Thu, 11/05/2009 - 10:55 | Link to Comment Cognitive Dissonance
Cognitive Dissonance's picture

Does anyone else get the feeling this has nothing to do with improving the "economy" and everything to do with improving corporate profits? I read something last night that applies where ever I look.

False hopes bind us to impossible situations.

As long as we can convince ourselves through false hope that the intolorable conditions we're experiencing will lessen or change, we won't expend the energy needed to throw out the old and bring in new systems, procedures and processes, be it governmental or social order.

Thu, 11/05/2009 - 14:35 | Link to Comment Unscarred
Unscarred's picture

Does anyone else get the feeling this has nothing to do with improving the "economy" and everything to do with improving corporate profits?

CD, that is a GREAT perspective.  The stated objectives of the Fed are: 1) low inflation, and 2) full employment.  If firms will not hire until they have incentive to do so (in this assumption, loss of potential profits in a profitable marketplace by not increasing production capacity), would the Fed consider an attempt to manipulate corporate earnings such as to improve the labor markets?

It's a compelling thought...

Thu, 11/05/2009 - 15:20 | Link to Comment Cognitive Dissonance
Cognitive Dissonance's picture

"would the Fed consider an attempt to manipulate corporate earnings such as to improve the labor markets?"

Absolutely they would, just as various administrations in the past have used false flag attacks and other engineered "events" to change public opinion about any number of things (entering or escalating wars, changing the social compact, clamping down on dissidents etc.) that just so happen to get the economy moving again.

One only needs to do some in depth reading about deep politics to see that many things which appear innocent on the surface have numerous unseen layers.

Thu, 11/05/2009 - 16:17 | Link to Comment Unscarred
Unscarred's picture

I suppose the question itself was rhetorical...

We should all presume, then, that the eventual movement towards greater Federal Reserve oversight by Congress will be nothing more than a window dressing, as well.

Thu, 11/05/2009 - 10:58 | Link to Comment Anonymous
Thu, 11/05/2009 - 10:58 | Link to Comment Anonymous
Thu, 11/05/2009 - 12:17 | Link to Comment Cognitive Dissonance
Cognitive Dissonance's picture

The collapse trade, conversely, is a total mystery to brokers who know how to sell a stock to a client but have no real ability or incentive to sell selling.

Not only that but the average retail customer doesn't understand the concept of shorting a stock to make money. In fact, many think it is unpatriotic and anti American to sell stocks short. That it hurts the country to sell short.

The average person thinks that when a stock goes down in price, the company is directly hurt and has less money to use or the "lost" stock value comes directly from the company. If the stock price drops by $2, many think the $2 comes from the company or at least its balance sheet. Remember that the average person thinks money/currency is "real".

They don't understand that once the stock is issued, it trades in the secondary market and while the fortunes of the company do eventually effect the stock price, it's not a direct connection in either direction. At least not in the way they think.

That may sound crazy to readers of ZH but the average person is woefully ignorant about the basics of money, capitalism and capital markets.

Thu, 11/05/2009 - 11:10 | Link to Comment Anonymous
Thu, 11/05/2009 - 11:14 | Link to Comment Anonymous
Thu, 11/05/2009 - 11:14 | Link to Comment Assetman
Assetman's picture

The thing I find surprising is that there is still a whole bunch of "expanded balance sheet stuff" as part of out lovely QE 1.0 that needs to be unwound, as well as some of the loan programs, like TALF.

I just cannot imagine the U.S. will gravitate away from ZIRP at least until the Fed's balance sheet gets back to normalization.  And despite what we may have heard recently, even that will take longer than most expect.

Thu, 11/05/2009 - 11:24 | Link to Comment SWRichmond
SWRichmond's picture

Gold likes persistently exceptionally low rates.

BTW, gold is money: http://www.bobdance.com/bob-dance-gold-rush.htm

Thu, 11/05/2009 - 11:25 | Link to Comment Sqworl
Sqworl's picture

Its all about the take taxpayer money at Zero and lend to them at 33.1%...

Thu, 11/05/2009 - 11:47 | Link to Comment Anonymous
Thu, 11/05/2009 - 11:28 | Link to Comment Steak
Steak's picture

So it is said that if you know your enemies and know yourself, you can win a hundred battles without a single loss.
If you only know yourself, but not your opponent, you may win or may lose.
If you know neither yourself nor your enemy, you will always endanger yourself.

The author of that quote rhymes with guess who...reading goldman deciphering fedspeak falls into the category of knowing your enemy, which is why i read this post despite my animus for both said parties.

Thu, 11/05/2009 - 11:32 | Link to Comment Screwball
Screwball's picture

This is all just depressing.  We are so screwed.

CNBC just reported (I didn't catch it all) some new government plan to allow homeowners to pay rent to the bank until they can refiance, or somthing along those lines.  This would be for current homeowners only, and not to flippers.  My details might be off a little as I only caught a little of it.

At the end of the day, I have to believe it is good for the banks.  Imagine that!

Thu, 11/05/2009 - 11:38 | Link to Comment Anonymous
Thu, 11/05/2009 - 11:48 | Link to Comment Anonymous
Thu, 11/05/2009 - 11:49 | Link to Comment RockyR
RockyR's picture

well, at least bubbles are fun.  this time around, i'm buying luxury cars and livin large.  can't beat em?  join em.

Thu, 11/05/2009 - 11:52 | Link to Comment Anonymous
Thu, 11/05/2009 - 11:55 | Link to Comment Sqworl
Sqworl's picture

Goldman Sachs job opening...only government employees apply:

http://www.charmin.com/en_US/enjoy-the-go/index.php

Thu, 11/05/2009 - 11:56 | Link to Comment Anonymous
Thu, 11/05/2009 - 12:00 | Link to Comment RockyR
RockyR's picture

i walked into a ford dealership for the first time in 10 years last night (had 20 minutes to kill before a meeting).  all I saw were $40k FORDS!  now, if that's not inflation I don't know what is...

 

Thu, 11/05/2009 - 12:09 | Link to Comment Sqworl
Sqworl's picture

40K to be Found On Road Dead????

Thu, 11/05/2009 - 12:16 | Link to Comment Anonymous
Thu, 11/05/2009 - 13:31 | Link to Comment Cognitive Dissonance
Cognitive Dissonance's picture

From where I sit, you got off cheap. In my state, moving violations are $400 and up. Some states charge even more.

States learned the pros many years ago. Charge what the market will bare, not what the item is worth. Since they hold the gun, the "market" will bare a lot.

Thu, 11/05/2009 - 14:39 | Link to Comment Anonymous
Thu, 11/05/2009 - 15:27 | Link to Comment Cognitive Dissonance
Cognitive Dissonance's picture

Fair enough. How do you propose one deal with a situation where the state has fined you and will jail you if you do not comply? Don't get me wrong, I agree with your premise. Read some of my many posts.

But unless and until enough people draw the line and say "no more" you will simply suffer in jail for your rebellion against totalitarianism. 

Thu, 11/05/2009 - 12:29 | Link to Comment mtguy
mtguy's picture

While bracing for inflation, given the Fed actions, we do have to ask the question of when? Yes, oil is at roughly $80, whereas it ws at $35 earlier in the year, but remember, it was $147 last year. Inflation or deflation? Depends on your time-frame. Given capcity utilization and the rising unemployment,(and thus little if any upward pressure on wages) it is hard to see that inflation is biting our heals currently. Add to that the fact that velocity of money is ziltch, b/c our beloved banks aren't lending and I think inflation is a ways off, (my humble opinion).

If I put on my tin foil hat I might also add that this socialistic/(marxist?) administration wants the economy to tank, it favors deflation continuing. Remember, they (S/M's) want us to be dependent on big gov't.

Thu, 11/05/2009 - 12:47 | Link to Comment Anonymous
Thu, 11/05/2009 - 13:27 | Link to Comment mtguy
mtguy's picture

See, the "greenies" are right -get out of that car and ride your bike! lol

Thu, 11/05/2009 - 14:23 | Link to Comment Unscarred
Unscarred's picture

"...low rates of resource utilization, subdued inflation trends, and stable inflation expectations..."

I think that part of this "Fed-Speak" translates to how bad they believe the CRE crash is going to be.  Keeping rates at zero offers the steepest yield curve posible for banks to help build additional loss reserves to survive the soon-to-be-released Depression 2.0.

Thu, 11/05/2009 - 16:35 | Link to Comment Cognitive Dissonance
Cognitive Dissonance's picture

I've learned that the only reference I should use when parsing Fed speak is the Rosetta Stone. Still effective after all these years. :>)

http://en.wikipedia.org/wiki/Rosetta_Stone

Fri, 11/06/2009 - 00:07 | Link to Comment Unscarred
Unscarred's picture

Do you mind forwarding me a copy of that, CD?  I seem to have outgrown my starter's guide:

http://www.investopedia.com/articles/economics/08/translating-fed-speak.asp

Do NOT follow this link or you will be banned from the site!