August 5, 2014
Letter to the Secretary
Dear Mr. Secretary:
Since the Committee last met in April, economic growth has rebounded following the surprisingly sharp decline in activity earlier in the year. Real GDP snapped back to a 4.0% annualized pace of expansion in the second quarter, after contracting at a 2.1% rate in the first quarter. Growth in the second quarter benefited from the fading of several unusual one-time drags that restrained activity in the first quarter. While growth was also recently supported by a notable acceleration in inventory accumulation, real final sales expanded at a 2.3% annual rate in the second quarter, somewhat stronger than the 1.8% average annualized pace experienced over the course of the expansion thus far. Labor markets have continued to improve and job growth has averaged 230,000 per month in the first seven months of the year. Geopolitical developments remain a source of worry, but most observers expect only limited impact on the US economy. Early July data and surveys indicate that growth momentum remained solid heading into the third quarter, and private and official sector forecasters continue to expect above-trend growth in the second half of the year.
Real consumer spending advanced at a 2.5% annual rate last quarter, supported by a weather-related bounce-back in spending on autos and other durable goods. After an unusual dip in the first quarter, healthcare spending resumed positive growth in the second quarter, albeit at a relatively subdued 0.7% rate. The aggregate household balance sheet appears healthy, and labor income has shown some signs of accelerating in 2014, which should support more sustainable gains in consumption outlays.
The housing market has shown signs of recovering from the slowdown in activity that followed last year’s increase in mortgage rates. Existing home sales increased each month in the second quarter and are up 9.8% from their March lows. Nonetheless, the recovery has been uneven, as the latest new home sales, pending home sales, and housing starts reports all registered declines. Most measures of home price appreciation have exhibited moderating price gains in recent months. House prices had been rising at a double-digit pace, so some cooling is to be expected.
Business investment spending advanced at a 5.5% annual pace last quarter, following a more-modest 1.6% rate in the first quarter. Real outlays for capital equipment increased 7.0% in the second quarter; spending on tech equipment rebounded at a 21.4% rate, following declines in the prior two quarters. The most recent orders and shipments data for capital goods were mildly disappointing, but most business surveys indicate continued modest growth in capital outlays.
Real government spending increased at a 1.6% annual rate last quarter. Although federal government spending contracted slightly, state and local outlays increased at a 3.1% pace, the fastest in five years. Employment in the government sector has likewise begun to improve, as total government employment has increased by 68,000 since the beginning of the year. The continued waning of fiscal austerity remains an important reason for optimism about broader economic growth prospects.
Real exports have been volatile in the first half, contracting at a 9.2% pace in the first quarter and expanding at a 9.5% rate in the second. The export growth last quarter was more than offset by a strong 11.7% rate of growth of real imports. Overall, net foreign trade subtracted 0.6% from GDP growth last quarter. Recent economic readings from the eurozone and Japan have been somewhat disappointing, while Chinese growth looks to have firmed some lately.
Labor market indicators remain favorable. Job growth has averaged 245,000 per month over the past three months, and the unemployment rate has declined to 6.2%, down from 6.7% at the time of the last meeting. Broader measures of labor resource slack have also shown improvement in recent months. The U-6 measure of labor market underutilization – which includes marginally attached workers and those working part time for economic reasons – has fallen 0.9% since the end of last year. Levels of wage inflation remain low, with only faint hints of an acceleration. The Employment Cost Index increased 0.7% last quarter – firm by the standards of recent years – but that came on the heels of a very soft 0.3% increase the prior quarter. Average hourly earnings have increased 2.0% in the year ending in July, little changed from the pace seen over the past four years.
When the Committee last met in April, the most recent reading of the deflator for personal consumption expenditures (PCE) had increased only 0.9% over the prior twelve months. In the twelve months ending in June, the PCE deflator had accelerated to 1.6%. Much of that acceleration was due to rising food and energy prices. However, the core PCE index has also firmed, rising to 1.5% on a twelve-month basis, up from 1.1% at the time of the last meeting. As the economy makes progress toward full employment, a return to 2% inflation is a reasonable expectation, though the rapid pick-up in core inflation in the second quarter likely reflected some one-time factors which may fade in coming months.
The Fed has continued to dial back the pace of asset purchases by $10 billion a month at each meeting so far this year, and is on pace to complete the current purchase program at the October meeting. The most recent FOMC statement indicates a sense of reduced downside inflation risk, but also a shift from focusing on unemployment toward incorporating broader measures of labor market underutilization. Markets generally anticipate a first tightening sometime in the middle quarters of next year, and the market’s anticipated path of policy tightening is somewhat shallower than the one expected in the central tendency of the FOMC’s interest rate forecasts.
This economic backdrop as well as Treasury’s presentation to TBAC on fiscal outlook, financing projections and auction demand informed the ensuing discussions. Before addressing the formal charge questions, the Committee and Treasury staff continued a discussion that began at the April 30, 2014 TBAC meeting. At that meeting, the Committee asked the Treasury to provide a framework to determine the prudent level of structural cash that the Treasury should maintain to minimize operational or technical default risk in the event of a market shutdown, where normal access to funding is disrupted or delayed. The Treasury staff reviewed the attached presentation entitled “Considerations for Developing the Optimal Treasury Cash Balance,” which described Treasury’s historical approach to cash balances, risks to that approach, a framework for determining the magnitude of the market shortfall were the Treasury to lose market access for a period of time, and a methodology for quantifying the appropriate level of structural cash to minimize shortfall risk. After significant discussion, the Committee recommended that the Treasury increase structural cash to address peak potential shortfalls in funding and believes that this would result in a positive net economic benefit to Treasury. More specifically, after reviewing past theoretical shortfalls over various time periods of market or operational disruption, the Committee recommended that the Treasury should increase cash to address peak potential shortfalls over a 10 day period, approximately $500 billon in the current environment. The Committee asked that the Treasury provide a more detailed presentation at a future TBAC meeting in order to further the steps toward potential implementation.
Following that discussion, the Committee’s first charge was to examine whether adjustments to the debt issuance schedule were warranted in light of current funding needs. To inform the discussion, the Committee reviewed the attached debt financing outlook slides. In keeping with the Committee’s recommendation from the April 2014 meeting, the Treasury initiated a series of 2-year and 3-year Treasury auction size reductions beginning with the May 2014 refunding. The 2-year was reduced by $1 billion per month from $32 billion in April 2014 to $29 billion in July 2014. The 3-year Treasury auction size was reduced by $1 billion per month from $30 billion in April 2014 to $27 billion in July 2014. While the Treasury forecasts overfunding through 2015, even if it continues to reduce 2 and 3-year auction sizes, the Committee recommended that the Treasury maintain the auction sizes at the July 2014 levels in order to build structural cash. Also discussed was the fact that Treasury faces an extended funding shortfall beginning in FY 2016. Full consideration was given to the March 2015 debt ceiling requirement to reduce Treasury cash to $33 billion, but the Committee believes that this obligation can be addressed through adjustments to Treasury bill issuance. These recommendations are consistent with the Treasury’s prior commitment to continue extending the Weighted Average Maturity of the outstanding marketable debt.
The Committee’s second charge was to provide the Treasury with its views on the factors that contributed to the recent decline in asset price volatility and forward looking measures of market uncertainty across a range of fixed income, equity and foreign exchange markets, both in the US and globally. One member presented the attached slides to address this charge, stating that the primary contributor to lower volatility over the past two years has been Fed and ECB policy. In QE1, the Fed significantly clipped downside risks in terms of economic and market outcomes. As rates approached the zero bound, volatility was lower by construction and contributed to maturity extensions, lower term premia and declining volatility across other asset classes through a lower and more certain discount rate. In addition, a more stable economic growth environment has contributed to lower dispersion of GDP growth forecasts, and enhanced forward guidance by the Fed regarding monetary policy has led to greater investor perception of certainty regarding outcomes and an increased willingness to assume risk across a wide variety of asset classes. In addition, given autocorrelation, low volatility can perpetuate: low realized volatility, normal for this phase of the economic cycle, leads to lower implied volatility in a self-reinforcing loop. The member also pointed to various market measures, including option pricing across asset classes, to show that expectations for increased volatility are generally low. The presenting member highlighted the potential for excessive risk taking in periods of low volatility as market participants can become complacent about future risks. The member pointed to evidence of possible increased risk taking which included recent growth in hedge fund assets and an expansion of return expectations relative to market interest rates by public pension funds, driving return-seeking allocations to alternative strategies with imbedded leverage and increased credit risk. A flattening of volatility term structures, currently steep versus history for certain assets classes, could suggest excessive complacency and bears watching. Concerns were also raised regarding changes in market structure resulting from increased regulation which has reduced the liquidity available to market participants. This dynamic could become exacerbated in periods of increased volatility and market disruption, especially within the less liquid markets such as credit, emerging markets and leveraged loans.
The Committee ended by discussing possible future meeting topics including the pros and cons of making coupon and principal payments in the strips market fungible and issuing Treasury debt securities with maturities greater than 30 years. In addition, several members suggested that the Committee revisit the funding strategy for the growing government student loan volumes.
Dana M. Emery