How should we assess whether the current stance of monetary policy remains accommodative of the baseline scenario, and what will help policymakers calibrate hypothetical responses to tail risks? It's natural to turn to policy rules of thumb like the Taylor rule to make those judgments. Indeed, the current policy debate is once again full of prescriptions based on such policy rules. We're skeptical that these models give adequate guidance on how to calibrate policy options, but given their popularity, it's important to assess the validity of their message.
Taylor rules of thumb. Taylor rule calculations are popular because they approximately describe the historical connection between key drivers of policy and policy rates. The formula relates the federal funds rate to a resource gap like the output gap, as well as the gap between actual and targeted inflation. Such rules suggest that as slack in the economy narrows and inflation rises toward the Fed's target, policy should move back towards equilibrium, as defined below. Those key policy drivers are echoed in the FOMC's current assessment that "low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period."
Taylor's original formulation involved equal weights for the inflation and output gaps, and assumed that the real ‘equilibrium' (or natural) funds rate was 2%. Algebraically,
r = 2 + π + 0.5 (π - π*) + 0.5 (y - y*)
where r is the nominal federal funds rate, π is the inflation rate, π* is the Fed's implicit inflation target, and y - y* is a measure of slack in the economy, typically measured by actual less potential real GDP or by the unemployment rate less a rate associated with ‘full' employment.
Translating conventional rules is difficult. In the current setting, the obvious problem with such rules is that they suggest the nominal policy rate should be negative. That's why the Fed engaged in quantitative and ‘credit' easing - to push inflation and inflation expectations back towards the 1.5-2% zone that avoids deflation, and to lower mortgage and Treasury yields to boost credit-sensitive spending. Credit easing was a response to the credit crunch that tightened financial conditions over the past three years. And the Fed's current language is aimed at communicating its commitment to an extremely accommodative policy stance until the inflation outlook and inflation expectations move up and the prospects for slack move lower. The qualitative message in the Taylor rule supports that policy stance.
However, some analysts suggest extracting a more precise implication from the negative rate prescription. Specifically, some argue that the Taylor rule can be used to define the "extended period" in the Fed's directive to mean no increase in rates until 2012. Some believe that policymakers should translate the rule's indication for rates into how much to change financial conditions via purchases of securities or other adjustments to the Fed's balance sheet. The first argument presumes that the Taylor rule offers relatively precise guidance for policy duration, while the second presumes that a translation from rates to Large-Scale Asset Purchases (LSAPs) is possible. We are skeptical on both counts.
Uncertain calibration. In our view, at least three areas of uncertainty - about measures of slack, the effect of credit conditions on rules, and the weight to assign to each factor - translate into a high degree of uncertainty around the quantitative prescriptions from such rules.
Slack is clearly dwindling, but degree is uncertain. The output gap is the difference, in percentage points, between the levels of potential and actual GDP. As such, it measures economic slack, which tends to depress price change. The output gap - calculated by the Congressional Budget Office at 5%+ in 1Q - has receded from its recent peak, but remains the largest in the post-war period. But its true size is uncertain. Recently soaring productivity - at a 3.9% annual rate over the past two years - could mean that potential growth is higher, that the gap is wider, and thus that disinflation risks are higher than anyone thought. In contrast, the bust in capital spending and the financial crisis have probably both reduced the economy's potential growth rate. Indeed, corporate capital spending discipline and restructuring of several industries have promoted a sharp 150bp decline in industrial capacity since early 2009. That has reduced slack and helped push up operating rates, and we expect that trend to continue.
A shrinking credit crunch implies less need for emergency policies. There is broad agreement that the credit crunch that began in 2007 was a key cause of the recession and a main reason for its depth and duration. The Fed's Senior Loan Officer Survey offers a variety of metrics to gauge the extent of the credit crunch. Our read of those measures is that lenders are still cautious, but that an easing in lending standards has begun for large companies and for consumers. For example, in April, 14% of respondents reported willingness to make consumer installment loans - a four-year high. To the extent that the Fed aimed its emergency policy setting at offsetting the credit crunch, the need for such offsets is dwindling.
Econometric pitfalls. In an effort to improve on the original Taylor rule, many analysts - both inside and outside the Fed - have attempted to estimate parameters for it that would more accurately describe policy reactions. After all, assigning equal weights to the inflation and output gaps seems arbitrary. But any statistical estimates are subject to a few classic econometric pitfalls: Different sample periods produce different results, as monetary policy regimes change; and the Taylor rule omits variables other than slack and inflation that may have influenced monetary policy. In addition, the estimation techniques do not account for the fact that nominal interest rates cannot go negative (at least they haven't yet!); and the rule is set up as a simple linear equation.
Some econometric estimates of a simple rule developed at the San Francisco Fed illustrate these pitfalls. Simplifying the Taylor rule, Glenn Rudebusch estimated the following equation:
r = 2.1 + 1.3 π - 2.0 (U* - U)
where U and U* are the unemployment rate and the non-accelerating inflation unemployment rate, or NAIRU, as estimated by CBO.
Re-estimating this equation shows how the results depend on the sample period. Our results for the period 1988-2009 are quite similar to his, but when the sample period is extended back to 1980, the coefficient on the unemployment gap falls by two-thirds - from 1.8 to 0.6 - and the coefficient on inflation rises from 1.3 to 1.8 - both indicating a very different policy prescription for the Fed. Of course, inflation is lower and less volatile in the shorter sample period, and the Fed's tolerance for high unemployment was arguably higher when inflation was high.
Some policy rules may put too much weight on slack. But there is a broader point: Given the uncertainty about measurements of slack in the economy, we believe that policymakers should put less weight on this variable, not more, as the econometric results suggest. Many argue that this argument is hollow, given the substantial amount of slack in housing, goods and services, and labor markets. But if the slack-inflation relationship has become looser, as seems likely, then downside risks to inflation are perhaps less dire, and the recommended policy stance to avoid deflation may be inappropriate.
Policy rules ideally vary with the future outlook. As Fed Chairman Bernanke noted earlier this year, "the most significant concern regarding the use of the standard Taylor rule as a policy benchmark is its implication that monetary policy should depend on currently observed values of inflation and output. However, because monetary policy works with a lag, effective monetary policy must take into account the forecast values of the goal variables, rather than the current values" (italics added).
We couldn't agree more. Because we believe that the inflation outlook is changing, and that underlying inflation in 2011 will rise back towards or even to 2%, we expect the Fed to begin tightening monetary policy in the early spring and to raise interest rates significantly over the course of the year. Updating the Taylor rule using Bernanke's suggestion - replacing the current value of inflation with a forecast of inflation over the current and subsequent three quarters - yields a recommended funds rate even more aggressive than our own forecast.
Risk management important. The bottom line is that policy rules may be useful qualitatively for informing policy, but close quantitative adherence to them may lead to policy mistakes. In the current uncertain climate, it is only prudent that officials consider ‘tail' risks on both sides of their central outlook when judging policy. It may be disconcerting to think that their options to combat the downside are limited to the renewal or extended use of existing tools. But those tools seem to have worked well so far - so well that we believe the chances that additional tweaks will be needed are virtually nil.
Our view remains constructive. Market views about US monetary policy have shifted dramatically in the past two months. Risks of sovereign debt contagion, of further declines in inflation and inflation expectations, and of continued or even increasing slack have trimmed expectations of tightening from 75bp to 25bp over the next year. Compared with the market, we think that risks lie to the upside: We see little contagion risk, a bottoming in inflation, solid growth, and as much as 150bp of tightening by mid-2011.
Treasuries ended the week little changed after holding in fairly narrow ranges through the week (trading ranges averaged only 13bp for the benchmark issues) with low volatility and light volume on an intraday basis. While not ending up doing a whole lot, rates markets did have a notable underlying bid all week that kept them well supported during what was a solid run for risk markets, diverging from a period of what had been becoming an extremely tight day-to-day and intraday correlation between stocks and Treasury yields. For equity and credit investors, reduced pessimism about the fallout from Europe's fiscal turmoil - which in the minds of investors perhaps is even getting downgraded from the ‘crisis' stage at this point, two months after the situation started to rapidly deteriorate in mid-April - allowed markets to rally even during the first part of the week when some key stress indicators were actually worsening. In particular, the spread between Spain and Germany's 2-year government bonds jumped 40bp to a series of new highs, peaking at 279bp Wednesday, but European stocks and the euro still managed to post good gains during this period. And then the euro and European stocks flattened out Thursday and Friday when pessimism about Spain's finances eased considerably following well-received long-end auctions Thursday, which Spain's finance ministry followed Friday with a statement saying that it planned to issue debt along the curve in 3Q. Spanish officials also moved to push back against the attacks on their fiscal situation and highlight the comparative strength of their banks by announcing that they would publish national bank stress-test results, driving the broader EMU-wide move to publish stress-test outcomes despite prior objections by some countries. This news and an associated surge in Spanish bank stocks on top of the successful auctions Thursday helped Spain's 2-year spread over Germany tighten 40bp Friday to 235bp, a small net improvement on the week. But European stocks and the euro were flat Friday after the early week gains. So, either market participants were unusually prescient, or maybe most people in Europe were just watching soccer all week. In any case, these developments helped drive activity in US stocks to a significant extent. For rates markets, with the economic calendar fairly light and as we move towards this week's FOMC meeting, it seemed to be largely a situation in recent days of investors deploying money out the curve in an environment where the Fed is expected to be on hold for the foreseeable future even if the European situation is settling down somewhat and systemic spillover impacts to this point look minimal. There's little expectation of the Fed doing anything new at this week's meeting, but the mention in the press the past week that they would probably talk about contingency plans in case Europe ends up being much more negative for the US than seems in any way likely at this point did stress that the shift back towards exit strategy mode is far away. So with perhaps some stabilization in the European situation, low inflation, the Fed on hold at zero rates for some time - it's back to the old carry and roll-down apparently. This has been a bigger boost to mortgages recently than Treasuries, as this benign environment has contributed to muted interest volatility, including a significant decline over the past week, helping the MBS market extend its excellent performance of recent months that has left MBS yields and mortgage rates near all-time lows.
For the week, benchmark Treasury yields ended up more or less unchanged - the 2-year yield dipped 1bp to 0.72%, 3-year was flat at 1.21%, 5-year 1bp to 2.02%, 7-year rose 3bp to 2.69%, 10-year rose 1bp to 3.23% and 30-year rose 2bp to 4.16%. Based purely on Treasury financing considerations, the four-week bill size probably should have been cut significantly this week, with the heavy net coupon issuance on June 15 plus the 40%Y surge in the big June 15 corporate tax payment. The debt managers apparently didn't want to add to a worsening squeeze in the bill sector, and their decision to the keep the four-week elevated at US$31 billion helped stabilize things (though it remains to be seen if quarter-end pressures build again in the next couple weeks), with the four-week bill yield up 1bp on the week to 0.04% and three-month 3bp to 0.10%.
In addition to the broad downward pressure on interest rates, a key positive spillover to offset the negative hit to exports and market impacts from the European situation has been the downward pressure on gasoline prices that is providing a big boost to consumer purchasing power. This showed up in significant declines in headline inflation measures over the past week at both the CPI and PPI levels. Core inflation at the consumer and producer levels was a bit elevated this month, however, and while the PPI upside was more one-off in nature as it was concentrated in volatile tobacco and light trucks components, the turn in CPI we think may be marking the trough in core consumer price inflation as shelter costs start turning the corner in line with trends in rental markets. Helped by this underlying upside, TIPS outperformed modestly on the week despite the weakness in headline CPI. The 5-year TIPS yield fell 3bp to 0.31%, 10-year 4bp to 1.20% and 30-year 3bp to 1.74%. To two decimals, the core CPI rose 0.12% in May, a high since October. Over the past couple of months, the key shelter category (which accounts for more than 40% of the core) has started to show signs of having reached a bottom, as owners' equivalent rent and rent appear to be stabilizing. This is a key aspect of our call for a near-term bottom in core CPI. We have seen widespread evidence in apartment REIT company reports, survey data, and anecdotal information of a modest tightening in rental market conditions across much of the country starting to lead to a turn higher in rents - after moderating shelter costs were responsible for almost all of the deceleration in core CPI seen over the past several years. Indeed, the core CPI ex shelter was running at +2.1%Y in May, right about where it was in early 2008.
The muted Treasury market performance the past week was reflected in falling volatility, which helped mortgages extend a strong recent run. Unlike equity market volatility, interest rate market volatility hasn't seen any significant upside during the past couple months of market stress, so it is reaching quite contained levels with the latest moves down. Late Friday, 3-month X 10-year normalized swaption volatility was at 108bp, down 6bp on the week. The low for the year for this measure was near 90bp in March and the high 120bp in early May - while the high last year, around this point in the year, was over 200bp. Investors looking for perceived low-risk carry trades in an expected low volatility, Fed-on-hold environment drove a significant MBS outperformance versus flat Treasuries on the week, with Fannie 4% MBS outpacing Treasuries by about a half point to move back above par and send current coupon yield down to near 3.95% from 4% at the end of the prior week. Average 30-year conventional mortgage rates have returned to prior record lows near 4.7% first hit in December the past couple of weeks and will stay there with MBS yields at these levels. Meanwhile, there wasn't any further movement of any note in Libor or Libor/OIS spreads in the latest week, but we have now had almost a full month of stability at levels that are not worrisome. Even without further outright improvement, spreads continued to come back down as the scare wears off, with the benchmark 2-year swap spread down another 5bp on the week and 12bp the past two weeks to 34bp.
Risk markets had a good week, but stocks stalled out early in the week while credit kept ramping higher. For the week, the investment grade CDX index tightened 15bp to 110bp, with our desk observing that a lot of negative sentiment about the cash credit market was hedged in the CDS market through May - the right trade until recently for both CDS and cash - but sentiment has shifted abruptly now and investors see much less need to hedge their long cash positions in the CDS market, helping to explain the strong tightening move the IG CDX index saw during the week as positions were squared up. Stocks did well, but less so, and almost all of the upside came early in the week when Europe was surging. The S&P 500 gained 2.4% on the week. There was somewhat of a pro-growth tilt to the rally, with industrials and tech leading, but not by much as sector performance was kind of bunched up on the week.
Other than the inflation figures, it was a light week for economic news. Housing starts pulled back sharply in May, as expected after the expiration of the homebuyers' tax credit. Inventories of unsold new homes were already at a more than 40-year low at the end of April, so even with a big payback in new home sales in May, the drop in starts should help keep inventories extremely lean. Upside to homebuilding activity is limited over the medium term as homebuilders will likely continue to struggle to compete with a continued flow of sales of distressed existing homes, but downside to homebuilding activity is probably also very limited with inventories as lean as they are. On the positive side, industrial activity continues surging, rising another 1.2% overall in May, with the key manufacturing gauge up 0.9%. Manufacturing continues to experience a V-shaped recovery and lead the upturn with help from booming exports, and early regional surveys suggest that the momentum extended into June. Looking ahead to the initial round of key economic data for June, we expect positive results to continue. While jobless claims showed some upside this week, we are not focusing too much on them at this point (see US Economics: Why Are Jobless Claims So High? by David Greenlaw on June 1, 2010 for a discussion) and other labor market indicators remain broadly positive. The May employment report showed broad strength aside from the ex census payroll number, and the softness there we think was largely a payback from job growth pulled ahead to April by the unusually favorable weather. Our preliminary estimate for ex census June jobs is +150,000, and we're looking for a -75,000 overall non-farm payrolls number, assuming a 225,000 decline in temporary census jobs. Meanwhile, the first two regional manufacturing surveys were surprisingly upbeat, so our initial expectation (which we will update as more regional reports are released) is for the ISM to remain highly elevated again in June. On an ISM-comparable weighted average basis, the Philly Fed manufacturing survey rose to 53.3 from 51.6 and the Empire State to 55.8 from 54.3. The ISM held up surprisingly well with only a fractional decline in May despite broad pullbacks across the regional surveys, so we still look for some further moderation this month, but after the upside in Philly and Empire, our initial estimate is only for another small dip in June to a still very high 59.0 from 59.7.
It will be a couple more weeks before we get to the employment and ISM releases for June in the first couple days of July. In the meantime, the coming week's economic calendar has a number of housing releases, including what should be a very large, but widely expected, pullback in new home sales in May after the expiration of the homebuyers' tax credit. There will be another run of heavy supply totaling US$108 billion in gross coupons, US$40 billion 2s Tuesday (US$2 billion smaller than last month), US$38 billion 5s Wednesday (US$2 billion smaller) and US$30 billion 7s Thursday (US$1 billion smaller). The FOMC meets on Tuesday and Wednesday but will probably release an uneventful statement again on Wednesday. We expect the Fed to reiterate the same message from last time (and many times before that) and not give any suggestion that it isn't firmly on hold until the uncertainty created by the European fiscal consolidation clears. There could certainly be some discussion at the meeting about what the FOMC might do down the road if the spillover from European strains ends up being much worse than currently seems likely, but the increasing momentum in the domestic economy and lack of signs of any broad systemic spillovers from the European situation make it quite unlikely in our view that the Fed will need to implement any steps along these lines, so it's likely to be a moot point. Notable economic data released due out this week include existing home sales Tuesday, new home sales Wednesday, durable goods Thursday and revised GDP Friday:
* We look for existing home sales to jump another 5% in May to a 6.05 million unit annual rate on top of the roughly 7% gains seen in both March and April. Obviously, the recent upside was largely attributable to the then pending expiration of the homebuyer tax credit. To qualify for the tax credit, contracts had to have been signed by April 30 and closing must occur by June 30. Since the existing home sales figures are based on closings, we may see some further upside in next month's report followed by a sizeable drop-off beginning in July.
* Even though the homebuilder sentiment survey showed surprising improvement in May, we look for about a 20% decline in new home sales to 400,000 units annualized. The anticipated drop-off reflects the impact of the expiration of the homebuyer tax credit and is consistent with the recent pullback in mortgage application volumes. To qualify for the tax credit, contracts had to have been signed by April 30, and the new home sales data are based on contract signings.
* We forecast a 0.5% dip in May durable goods orders. Company data point to some slippage in the volatile aircraft category this month. Thus, we expect to see a dip in the headline orders figure. However, the ISM orders index held steady at a high level in May, so we should see more strength in the underlying data. Moreover, the bizarre seasonal pattern that has emerged over the course of the past couple of years is expected to continue. It appears that the key core component - non-defense capital goods ex aircraft - tends to show a significant drop-off in the first month of the quarter followed by gains over the succeeding two months. In particular, the machinery sector appears to be following such a pattern. Thus, we look for nearly a 1% rise in core orders for the month of May following on the heels of a 2.6% decline in April.
* We expect 1Q GDP growth to be unrevised at +3.0%. The only significant adjustments are likely to be in inventories and foreign trade. Newly available inventory figures show somewhat higher stockpiles of retail goods (worth about 0.2pp on GDP). Meanwhile, although exports are likely to be revised higher, imports should be adjusted up by even more - implying a wider trade gap than originally reported.
1) A renminbi exit from the USD peg would lower the risk premium of the equity market stemming from fear of a Sino-US trade war.
2) It helps contain ‘imported' inflation pressures and therefore reduces the probability of an aggressive monetary tightening through stringent credit controls and/or consecutive interest rate hikes.
3) A modest initial revaluation to be followed by gradual appreciation would fuel expectations of further appreciation over time.
Impact on our economic and policy calls:
• We maintain our forecasts for the USD/CNY spot rate to reach 6.60 by end-2010 and 6.20 by end-2011.
• We now change our interest call from "no more than one rate hike in 2H10" to "no rate hikes through 2010".
• We attach a high probability that the target of new bank lending of Rmb7.5 trillion for 2010 could be revised upward by 4Q10.
• In view of this desirable policy change, we maintain our call for a Goldilocks scenario in 2010, featuring 11% GDP growth and 3.2% average CPI inflation, while noting that the balance of risks on both fronts is tilted slightly to the downside.
The pre-crisis technical arrangement for the renminbi trading band is unchanged: It is important to understand how the existing (or pre-crisis, pre-new peg) trading band works technically. At the beginning of each trading day, the USD/CNY central parity of the current trading day is determined based on the weighted average of the price quotes provided by the market markers. The central parity rate is announced 15 minutes before trading begins each morning. The trading band applies to intra-day moves only in that the USD/CNY rate is now constrained within ±0.5% of the renminbi-USD central parity of that trading date. However, the central parity rate may, in theory, vary by any magnitude from the closing rate of the previous trading day. In another words, the inter-day changes are not constrained by the band (see China Economics: Band Widening ≠ Faster Renminbi Appreciation, May 21, 2007).
Although the central parity of renminbi-USD exchange is, in principle, determined based on the weighted average of the quotes from market makers, it is still heavily managed by the PBoC, which has considerable discretion over determining the weights when the weighted average is calculated. Thus, the pace of renminbi appreciation ultimately hinges on how comfortable the Chinese authorities are with allowing faster appreciation of the central parity rate instead of the intra-day volatility around the central parity rate.
PBoC's press statement: Below is the text posted by the PBoC in announcing the policy change under the title "Further Reform the RMB Exchange Rate Regime and Enhance the RMB Exchange Rate Flexibility."
"In view of the recent economic situation and financial market developments at home and abroad, and the balance of payments (BOP) situation in China, the People's Bank of China has decided to proceed further with reform of the RMB exchange rate regime and to enhance the RMB exchange rate flexibility.
Starting from July 21, 2005, China has moved into a managed floating exchange rate regime based on market supply and demand with reference to a basket of currencies. Since then, the reform of the RMB exchange rate regime has been making steady progress, producing the anticipated results and playing a positive role.
When the current round of international financial crisis was at its worst, the exchange rate of a number of sovereign currencies to the USD depreciated by varying margins. The stability of the RMB exchange rate has played an important role in mitigating the crisis' impact, contributing significantly to the Asian and global recovery, and demonstrating China's efforts in promoting global rebalancing.
The global economy is gradually recovering. The recovery and upturn of the Chinese economy has become more solid with the enhanced economic stability. It is desirable to proceed further with reform of the RMB exchange rate regime and increase the RMB exchange rate flexibility.
In further proceeding with reform of the RMB exchange rate regime, continued emphasis would be placed to reflecting market supply and demand with reference to a basket of currencies. The exchange rate floating bands will remain the same as previously announced in the inter-bank foreign exchange market.
China's external trade is steadily becoming more balanced. The ratio of current account surplus to GDP, after a notable reduction in 2009, has been declining since the beginning of 2010. With the BOP account moving closer to equilibrium, the basis for large-scale appreciation of the RMB exchange rate does not exist. The People's Bank of China will further enable the market to play a fundamental role in resource allocation, promote a more balanced BOP account, maintain the RMB exchange rate basically stable at an adaptive and equilibrium level, and achieve the macroeconomic and financial stability in China."
IMF statement: Mr. Dominique Strauss-Kahn, Managing Director of the International Monetary Fund (IMF), issued the following statement today on China's exchange rate regime:
"The People's Bank of China's announcement to increase exchange rate flexibility and return to the managed floating exchange rate regime in place prior to the global financial crisis is a very welcomed development. A stronger renminbi is in line with findings of the G-20 Mutual Assessment Process, to be presented in Toronto next week, and will help increase Chinese household income and provide the incentives necessary to reorient investment toward industries that serve the Chinese consumer."
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