February 2014 Letter to the Secretary
Dear Mr. Secretary:
Since the Committee last met in November, the economy has continued to expand at a solid pace, with real GDP increasing at a 3.2% annual rate in the fourth quarter. Consumer spending was quite strong last quarter, which helped to offset some of the drag from residential investment – a sector which appeared to be suffering from the back-up in mortgage rates that occurred in the middle part of last year. Businesses built up inventories at a rapid pace in the second half of last year, and a slowing in the pace of stock building could moderately hold back overall economic activity early this year. Even so, growth in final sales is expected to remain solid, thanks to healthy household balance sheets, generally accommodative financial conditions, and an easing in the degree of fiscal restraint. Employment growth slowed in December, but overall labor market conditions remain favorable and the unemployment rate has continued to decline. Even with this decline, Fed officials view the unemployment rate as too high and inflation – which remains quiescent – as too low. Thus the decision to slow the pace of asset purchases has not been seen as a step toward a quick normalization in interest rate policy.
Real consumer spending advanced at a 3.3% rate last quarter, the fastest rate in three years. Households received some temporary support in the form of falling energy prices. Rising wealth may have also boosted consumption, as the saving rate fell from 4.9% in the third quarter to 4.3% last quarter. Looking forward, the expiration of extended unemployment benefits may temporarily reduce the growth of disposable income, but in the medium run household income and balance sheet fundamentals should be supportive of further gains in real consumption outlays. Real business fixed investment outlays rose at a 3.8% pace last quarter, and capital equipment spending increased at a 6.9% rate. While the pace of capital equipment spending last quarter was faster than the pace registered in the first three quarters of the year, recent softer data on orders and shipments of capital goods caution against expecting a rapid near-term acceleration in business investment outlays. Even so, corporate sector fundamentals still appear healthy, and the ebbing of fiscal policy uncertainty could contribute to a pick-up in capital expenditures.
Housing weakened in the fourth quarter, as real residential investment contracted at a 9.8% annual pace. Homebuilding activity has still been feeling the impact of the rise in mortgage rates that occurred in the spring and summer of last year. Some sentiment measures suggest that the housing recovery should resume soon, but so far the hard data has been mixed. Real government expenditures contracted at a 4.9% pace last quarter, led by a 12.6% rate of decline for federal government spending. This was partly due to the effect of the government shutdown early in the fourth quarter, and first quarter federal government spending should benefit from a bounce-back effect. Since the Committee last met, federal fiscal policy has been more orderly, as budget authority has been extended for the remainder of the fiscal year, and political commentary generally expects a more benign resolution to the upcoming debt ceiling issue.
Net exports were a significant support to the economy last quarter, adding 1.3%-points to overall economic growth. Some of that was due to what appear to be unsustainable gains in net exports of energy and agricultural products. Concerns about emerging market weakness may cloud some the outlook for export demand, but growth still appears healthy in most major developed market trading partners such as Japan and Europe.
Labor market indicators have been mixed, but generally still point to favorable developments. Job growth averaged 192,000 per month in the first 11 months of the year, but decelerated sharply to 74,000 in December. Some of the weakness was attributed to weather, and most other survey measures of the labor market do not point to any significant deceleration in hiring. The unemployment rate fell to a cycle-low 6.7% in December. This decline was accompanied by yet another fall in the labor force participation rate, to a 36-year low of 62.8%, and the extent to which this decline reflects cyclical versus structural factors remains hotly-debated.
Some survey measures point to an anticipation of a rise in wages, but the hard data generally indicate most measures of wage inflation are low and steady, and average hourly earnings increased at only a 1.7% annual rate in the fourth quarter. Overall consumer price inflation has been similarly subdued, as the personal consumption expenditure (PCE) price index increased at only a 0.7% annual rate last quarter, and is up only 0.9% over the past year. Weak commodity prices, particularly for energy products, have helped to hold down growth in this price index, but even the ex-food and energy core PCE price index only advanced at a subdued 1.1% annual rate last quarter, and is up only 1.1% over the past year. With little indication of an imminent acceleration in wage or commodity inflation, the outlook for consumer price inflation in the near-term appears to be broadly similar to the recent past.
Since the Committee last met, the Federal Reserve has embarked on a process of gradually reducing the monthly pace of asset purchases, and in two steps has cut the purchase rate from $85 billion per month before the December FOMC meeting, to an announced pace of $65 billion per month after the January FOMC meeting. Market participants generally expect further reductions in the monthly pace of purchases of $10 billion per meeting, consistent with Fed communications, and for purchases to be completed in the fourth quarter of this year. The Fed continues to signal that overnight interest rates will remain accommodative for quite some time, and market pricing is generally aligned with the FOMC’s expectations for the path of short term interest rates.
Against this economic backdrop, the Committee’s first charge was to examine whether adjustments to the debt issuance schedule were warranted. The committee continued to recommend a gradual lengthening of the weighted-average maturity of the debt. For the January to March 2014 quarter, given the expected financing needs, the Committee recommended keeping current coupon issuance levels unchanged from the prior quarter. Given the success of the January 2014 inaugural auction of 2-year maturity Floating Rate Notes (FRN), which the Committee views as a substitute for Treasury bill issuance, the Committee recommended that Treasury continue with its plan for quarterly issuance in the $10 to 15 billion range with two reopenings per quarter.
Given medium term expectations for stronger economic growth, improved tax receipts and excess funding if the Treasury were to leave coupon issuance unchanged at current levels, the Committee recommended that the Treasury consider a gradual reduction in coupon issuance over upcoming quarters. The Committee believes this coupon reduction should be focused on 2 and 3 year maturity notes, potentially beginning in the April to June 2014 quarter. In addition, the Committee recommended a reduction in Treasury bill issuance to offset the FRN issuance. The Committee reiterated its recommendation from last quarter that the Treasury expand the FRN offerings to longer maturities as the market develops. The Committee continued to recommend that the debt calendar be adjusted gradually and incrementally to maintain future financing flexibility. The Committee also discussed the importance of a timely increase in the debt ceiling limit in order to avoid disruptions in financial markets. The Committee’s financing recommendations are attached.
The Committee’s second charge was to provide an overview of the primary dealer (PD) system and its evolution. In addition, given changes in the financial services industry, market structure, regulation and technology, the Committee was asked to make suggestions for modification to the PD model that might result in lower funding costs for Treasury or enhance secondary market liquidity. The presentation (attached) reviewed the current structure of the PD system, reviewed the selection criteria for PDs, highlighted the dual responsibilities of PDs to the Federal Reserve and the Treasury and provided a comparison to issuance methodologies used by other sovereign debt management offices. The Committee agreed that the current PD model works well for routine debt issuance in normal market conditions. Concerns were raised regarding both the decreasing number of PDs and the increasing percentage of direct purchases via the Treasury Automated Auction Processing System (TAAPs), which diminish the role of primary dealers in the primary market. Suggestions for changes to the system were discussed including a more explicit role for Treasury in the selection and evaluation of PDs (which is currently in the Federal Reserve’s jurisdiction), increased monitoring and transparency of direct bidders, allowance for the option of “greenshoe” post-auction purchases by dealers within agreed upon and well disclosed parameters, and the potential use of syndicates in the future if the Treasury were to issue non-standard securities, such as longer dated maturities.
Continuing with a topic that was discussed in the November meeting, members of the committee provided an update on discussions with academic experts regarding longer term research projects on topics of interest to the Treasury and the Committee. These discussions are in process with the goal of an engagement before the May 2014 meeting. A topic under consideration is the optimal sovereign debt issuance strategy and a comparison to current practices, including practical suggestions for Treasury to consider.
Dana M. Emery
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