The Fed wants to tighten but can’t; the ECB wants to loosen but can’t. Currency stalemate

A James Alexander post

What is more important the short, medium or long term? The recent gyrations of the EUR/USD exchange rate have grabbed a lot of attention since the start of the year.

In theory the strong easing bias of the ECB versus the confusing position of the Fed should mean the EUR weakens versus the USD. Or should it? That currency story based on the stance of the respective central banks is surely “in the price” already.

The new information that could shift the EUR/USD is more debate about what more the ECB thinks it can do within its mandate of inflation ceiling mandate of  “close to, but below 2%”. The Fed has been tightening for many months, first passively and then actively. The debate is now, what will it do next?

Actually, we now have more uncertainty about the relative stance of monetary policy in the two biggest (freely-floating) currency blocs than for a long while.

Over the last four months it looks as if there has been a major strengthening of the EUR vs the USD judged by the short term currency chart. The sharpest movement within this time frame was the dramatic reaction to William Dudley’s dovish speech on February 2nd in the midst of the market’s first quarter swoon. It was the first major recognition by the Fed that perhaps things had changed since the December rate hike.

We commented on it at the time as a remarkable ride to the rescue by the market’s chief representative on the FOMC. The NY Federal Reserve was thus doing its time-honoured job of forcefully presenting the actual state of things to the often out-of-touch board staff and regional governors. It absolutely goosed the FX markets, and with other follow-ups over the next two weeks turned around what was fast becoming a nasty situation in the markets.

On February 11-12, a couple of things happened. There was Jamie Dimon’s massive confidence-boosting purchase of his bank, JP Morgan’s, shares; there was the apparently panic-driven calls from Yellen to the heads of the Bank of England and the ECB. And just 5 days later, the icing on the cake when the swing voter on the FOMC, Bullard, swung.

JA USD-Euro1

The subsequent strengthening of the USD versus the EUR, as the wider markets also recovered, has now been offset by a weakening again. Draghi has done his best to show the ECB is still very much in easing mode, via increasing the size, scope and duration of its QE programme. Rates have gone even more negative. But still the markets want more and were disappointed by some comments during the March press conference that maybe rates could not go more negative.

Draghi’s problem remains that the ECB’s mandated inflation ceiling adds such a heavy tightening bias onto the easing bias of the practical measures. The German lobby on the ECB is also known to be powerful, so the dynamic of the ECB Council is very different to that of the FOMC where the Chair is far more powerful and there are little or no regional or political influences. Sometimes Market Monetarists wish there were more political influences on the Fed, especially when they go all obsessive about microscopic inflation or on “normalization” wanderings and simply ignore the overriding goal to support prosperity.

The medium term

A lot of the last four months in the life of the USD, especially versus the EUR, has been mere noise. The currency move from late 2014 and during the first half of 2015 when the Fed began to seriously contemplate tightening is still the standout feature. The EUR weakened substantially during this period and it has not reversed. The Fed was determined to tighten and the ECB to loosen. By mid-2015 these new biases were very much in the price of the EUR/USD.

Nothing much has changed since mid-2015, although both central banks have had to work hard at keeping markets convinced that they mean business: the Fed by actually tightening and raising rates, the ECB by increasing QE and moving to negative rates.

JA USD-Euro2

The Fed’s tightening bias, seen by various regional governors immediately starting up the tightening talk anytime the markets stabilise, means the USD will likely strengthen again. The strength won’t last as US NGDP growth is too weak to take the tightening. Some Market Monetarists like Scott Sumner and David Beckworth might charitably call this sort of thing an improved Fed reaction function. It looks more like ignorance flavoured with panic to me. Whatever. The result will most likely be sideways drift.

And on the other side, the ECB looks boxed in by its complete inability to focus on nominal growth over inflation. It´s often repeated fixation on the ceiling is just horribly counterproductive. Until it sees the problem, or until some sort of economic slowdown hits Germany, things seem unlikely to improve very much. The result will be drift in the Euro Area too.

The crappiest of ideas

That´s the ‘dot plot’, conceived by the “Transparency Committee” headed by Janet Yellen while a Governor at the Board.

Interestingly it came ‘on line’ for the first time in January 2012 at the same time inflation hit the target. Since then inflation has mostly trended down. It has done so even while oil prices remained high. Naturally, when oil prices tumbled in mid-2014, headline inflation followed suit.

Dot Plot_1

However, by the time the first dot plot was released in January 2012, the Fed was no longer expecting to chart an exit from stimulus soon. The economy had taken a turn for the worse; in fact, additional bond-buying was on the horizon.

Then-Fed Chairman Ben Bernanke consequently downplayed the dots, a tradition that Janet Yellen continued when she assumed leadership of the Fed at the beginning of last year. At times, the chart—with its 17 disparate projections of the future path of policy—can conflict with the unified message the committee is trying to send.

In her first press conference as Fed chair in March 2014, Yellen told reporters “one should not look to the dot plot, so to speak, as the primary way in which the committee wants to or is speaking about policies to the public at large.”

Over the last several quarters, however, the dots have come back down, suiting Yellen’s message that the pace of tightening to follow what would be the Fed’s first rate increase in nearly a decade will be gradual.

So Yellen has turned back to the dots as “Exhibit A” for investors. During her press conference in June of this year, she pointed to it repeatedly when asked about the central bank’s likely course.

Other signs of utter confusion

Dudley in August:

“From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago,” Dudley told a news conference Wednesday at the New York Fed.

I really do hope that we can raise interest rates this year, because that would be a sign that the U.S. economic outlook is good and that we’re actually on track to achieve our dual mandate objective,” Dudley said.

Dudley today:

Federal Reserve Bank of New York President William C. Dudley said the central bank will “probably” raise interest rates later this year despite uncertainties over global growth.

Unemployment in the U.S. has fallen to its lowest level in more than seven years, making it harder for the Fed to justify interest rates near zero. Inflation, however, has remained well below the Fed’s target. It was 0.3 percent in the 12 months through August, as measured by the Fed’s preferred gauge of price movements.

Dudley said inflation probably would move back toward the target over time, and that 2 percent was “the right target.”

With the biggest confusion being the view that monetary policy has been accommodative:

“We’ve had so many years of accommodative policy, I think the market is losing faith in the Fed,” said Priya Misra, the head of global interest-rate strategy in New York at TD Securities, one of the 22 primary dealers that trade with the central bank. “You’re not really seeing the impact of policy end up in inflation.”

Which completely misses the logic that “you’re not really seeing the impact of policy end up in inflation” exactly because monetary policy has been anything BUT accommodative!

Looking back, during the Greenspan years monetary policy worked fine. Greenspan was the “anti-transparency”:

 “I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant”.

Nowadays we feel like it´s more like a take on George Santayana´s:

Having lost sight of our objectives, we redoubled our efforts.”

Forget interest rates as providing the stance of monetary policy, and look instead at NGDP growth and inflation (remembering that the rising dollar and falling commodity and oil prices are consequences or symptoms of monetary tightening).

A mindset cast in bronze

Back in April 1997, while still a ‘freshman’ Fed Board member, Laurence Meyer gave a milestone speech at the Forecasters Club of New York. For the first time, I think, a board member provided a detailed account of his decision process framework.

One month earlier, the FOMC had changed (raised) interest rates for the first time since having reduced it in February 1996.

Meyer writes:

I am going to offer some interpretations of the outlook as a context for the recent policy action by the Federal Reserve and explain how I view this action as part of a prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an ideal forum for me to offer this commentary because, in my view, the recent policy action must be understood not in terms of where the economy has been recently, but rather in terms of the change in the forecast, a change in expectations about where the economy likely would be in six or twelve months in the absence of a policy change.


Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be difficult to implement in practice. Still, this relationship was about the most stable tool in the macroeconomists’ tool kit for most of the past 20 years; those who were willing to depend on it were likely to be very successful forecasters of inflation, and the record speaks for itself on this score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year low in inflation was a surprise to those using this framework. The challenge is to understand why we have been so fortunate…

So, what was going on and what did come about? The charts illustrate.

Inflation had been stable while unemployment was trending down. Almost immediately following the speech, the fall in unemployment increased and inflation ‘shot down’!


The more convincing story behind this fact was the productivity increase that was taking place (helped out by the steep drop in oil prices following the Asia crisis, although this did not have much effect on core prices). Anyway, such positive supply shocks reduce inflation and increase growth (reduce unemployment).

In short, contrary to Meyers (and most in the FOMC) view, there was no ‘dangerous’ increase in resource utilization.

The rate increase was of the “one and done” kind. Much later, following the Russia/LTCM event in August 1998, rates were reduced.


The next chart indicates that NGDP was evolving close to trend, growing close to 5.5%. When Russia/LTCM happened, the growth in AD was increased. This turned out to be excessive. We know that because it ignited a cycle to nominal spending that first went too high and later was brought down too low, only being stabilized again towards the end of Greenspan´s tenure in early 2006!


The “too much nominal growth” leg is seen in the next chart, which indicates that money growth more than offset the fall in velocity, especially following Russia/LTCM.


Jumping to the present, apparently nothing has changed because now we read:

Federal Reserve officials might raise interest rates soon because they have a theory: Falling unemployment pushes up prices and wages, requiring tighter credit to keep inflation in check.

David Altig, research director at the Atlanta Fed is quoted:

We haven’t lost faith in the framework described by Mr. Phillips and his successors, that a tight labor market generates higher inflation, said David Altig, research director at the Atlanta Fed. But the numbers that you would plug into that framework and the exact levels at which the pressures begin to emerge, we’re not so clear on those.

In economics, it´s interesting to observe how some things, especially those that require “estimation”, become “gospel” and, despite their suspicious origins, never go away, being endlessly “reestimated”.

When Modigliani and Papademos (yes, the same one who later became head of the Central Bank of Greece and then its Prime Minister)  “invented” NAIRU (NIRU at the time) in a BPEA paper in 1975, their clear aim was to downplay “monetarism” and argue for monetary expansion expansion based on the fact that NAIRU/NIRU was above its “non accelerating rate”:

At this point the analysis confronts a widely held concern, encouraged by at least some monetarists, that such a rapid rate of growth and sudden acceleration of the money supply , would unfavorably influence prices and inevitably set off a new round of inflation.

Our analysis indicates that such concerns are unfounded; it implies that inflation systematically accelerates only when unemployment falls below NIRU, and the M1 growth that we expect will be needed as component of a policy package aimed at approaching NIRU from above over the next two years.

We all know how that turned out!

Today, New York Fed chief Dudley apparently moved markets by saying:

From my perspective, at this moment, the decision to begin the normalization process at the September FOMC meeting seems less compelling to me than it was a few weeks ago,” he said.

But he also said:

Responding to a question about whether a Fed move will come in a subsequent 2015 FOMC meeting, Dudley said he “really” hopes to raise rates this year, but “let’s see how the data unfold before we make any statements about exactly when that might occur.”

And I say: I really hope a large rock will fall on my head this year!

The unemployment controversy

Five years ago, Kocherlakota dismissed the power of monetary policy to bolster employment:

Kocherlakota in August 2010

What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

Three years later (September 2013) his view changed completely:

First, I will show you data that depict the painfully slow pace of recovery in the U.S. labor market. Second, I will show you data that demonstrate that there is considerable monetary policy capacity with which to address this problem.

Now, New York Fed William Dudley parrots Kocherlakota in 2010:

The New York Fed president was in western New York for a routine district visit, his third to Rochester in the past five years. In remarks kicking off his one-day tour, Mr. Dudley highlighted structural imbalances in the labor market, saying they can’t be resolved with monetary policy alone.

He said there is a growing mismatch between employers’ needs and job seekers’ skills or locations, and that monetary policy couldn’t substitute for the workplace development programs that are needed to fix them.

 “Monetary policy can help labor markets recover by providing incentives for firms to invest and grow,” Mr. Dudley said. “However, monetary policy cannot by itself solve skill mismatches that may exist in the economy. These frictions must be addressed in other ways.”

The point that Kocherlakota grasped two years ago is that monetary policy, by “capping aggregate spendinghas not been providing incentives for firms to invest and grow.