Economics 470/570 - Monetary Theory and Policy

Do Regulators Have Distorted Incentives?

For anyone who might be interested, here's the roundtable discussion at The Economist I mentioned yesterday in class. The lead article by Beatrice Weder di Mauro argues that regulators need better incentives:

• The dog that didn't bark, by Beatrice Weder di Mauro

Here's my response:

• Prioroties at the Top, by Mark Thoma

Here are other responses:

• Devil in the details, by Charles Goodhart
• No perfect solution, by Daron Acemoglu
• The Danger of Capture, by Simon Johnson
• Remove the culpable, by Raghuram Rajan
• Better Regulators Needed, by Harvey Pitt
• Uncomfortable Institutions, by Tyler Cowen
• Not just a failure of markets, by Albert Alesina

"Come With Me to the F.O.M.C.: A Sneak Peak Into Fed Life"

A look inside the FOMC:

Come With Me to the F.O.M.C.: A Sneak Peak Into Fed Life, by Bob McTeer, Economix:Bob McTeer is a former president of the Federal Reserve Bank of Dallas.

Today is the second day of a two-day Federal Open Market Committee meeting. The rate decision along with the accompanying verbiage will be released at 2:15 p.m. If I were still there, I’d go in with a tentative idea of how I would vote, but would try to keep an open mind during the presentations and discussions. Today, I would be inclined toward a half percentage point cut, from 1.50 to 1.00 percent.

I don’t think another rate cut is necessary nor even very helpful, but not cutting would roil financial markets, and the European Central Bank needs more pressure to catch up with another coordinated cut. I called for a coordinated rate cut on my other blog on Oct. 7, and they took me up on it on Oct. 8, between regular meetings. Coincidence?

One might argue that another Fed cut without being matched by the E.C.B. would weaken the dollar, but, given its rapid rise lately, I don’t think that would be a bad outcome. A too-sharp rise in the dollar would hurt the growth of our net exports, which has been our strongest sector.

Without a strong conviction, I would be inclined to go along with the chairman’s majority even if our views differed. Dissents should be used sparingly and only when they are a matter of strong conviction. Also, it’s important to support the chairman and present a united front during a crisis.

“Come With Me to the F.O.M.C.” was the title of a Richmond Fed pamphlet written long ago and updated by others. Its lasting popularity suggests an interest in what goes on behind the closed doors. While I’ve been retired from the Fed almost four years, it changes so slowly that I expect my memories aren’t far off.

Some F.O.M.C. Color

My almost 14 years as an F.O.M.C. member came with the presidency of the Federal Reserve Bank of Dallas from Feb. 1, 1991, to Nov. 4, 2004. Alan Greenspan was chairman during that time and then-Governor Bernanke sat next to me for almost three years. Reserve Bank presidents inherit their place around the table from their predecessors, and Dallas used to sit between St. Louis and Boston. For the first several years of my tenure, Alan Greenspan sat at the head of the long board table, but he announced one day that he was switching to the middle spot. That was a landmark event. We all rotated to keep our relative position, and I got the chairman’s former seat.

Since Chairman Greenspan didn’t normally conduct policy by the seat of his pants, as his successor has been accused of doing, his seat never made me feel smarter. The president of the Boston Fed decided about that time to move to the other end of the table — I don’t know what I did — so I ended up between Bill Poole of the St. Louis Fed and Governor Bernanke, the only two principals around the table with beards. Ben’s was trimmed pretty short, but Bill’s was kind of shaggy. It made my nose itch when I looked his way.

Two-day meetings like the one concluding today used to occur only twice a year — in February and July. Chairman Bernanke added more two-day meetings to the schedule. The July meeting was close to the Fourth, and the British ambassador always had us as dinner guests on the evening between meetings. Those dinners were nice, but they ran on too long. The vice chairman, Alice Rivlin, was the all-time champion at extricating us before midnight. The dialogue during the dinner between the chairman and the ambassador was an education for me — actually for us all — but I’m probably the only one to admit it.

Congress centralized power in Washington in the 1930s, and gave the coveted (in central bank world) title of governor to the seven-member Washington contingent and “demoted” the twelve former regional governors to “president.” It also reduced the number of “presidents” voting from 12 to 5 so Washington would have a 7 to 5 advantage if votes ever split along those lines. The New York Fed president, as vice chairman of the F.O.M.C., always has a vote; 4 of the other 11 regional bank presidents also have a vote, based on an annual rotation.

I mention the voting arrangement because it is often misunderstood. All the presidents participate fully in all the discussions, and an observer would be unable to tell the voters from the nonvoters until the vote at the end of the meeting. A persuasive nonvoting president would probably have more influence on the outcome than a non-persuasive voter.

F.O.M.C. members traditionally don’t discuss their votes or policy before the meeting. If the presidents got together for dinner the night before, they limited their discussion to Reserve Bank business and gossip. Usually they went their separate ways for dinner. Being the introvert that I am, I frequently had take-out Chinese food in my hotel room.

Everyone arrives for the meetings after having done tons of homework. The Reserve Banks have excellent research departments, but they are smaller and less specialized than the board’s research staff. The presidents are expected to say something about their regions, as well as the national and international economy. It’s a lot like cramming for finals. The board staff’s material, mostly contained in the “green book,” included all recent data in context, forecasts made under alternative assumptions, and special topics of current interest. It was always comprehensive and outstanding in quality.

The board staff also prepared a “blue book” with alternative policy choices and commentary. Forecasts based on the board’s econometric models were treated respectfully by everyone, but with a few grains of salt.

I once committed political incorrectness by not treating them respectfully enough. It was sometime during the boom of the late 1990s that I observed out loud that the staff’s growth forecast was usually a percentage point too low and that its inflation forecast was usually a percentage point too high. I announced that I derived my own forecast by moving that one percent from inflation to growth. The obvious truth of my statement only made it worse and added to the coolness of the breeze that came my way for some time after that.

The forecasts of high inflation, while actual inflation remained low, were the cause of my lone dissents in June and August 1999 against raising the target federal funds rate. Actual inflation was nil, but the models always had it right around the corner.

I probably made things worse by saying in speeches that my favorite economists were Yogi Berra and Richard Pryor: Yogi, for saying you can observe a lot just by watching, and Richard for famously asking, “Who are you going to believe — me or your own lying eyes?” Sometimes, I would also paraphrase Mae West and say “too much of a good thing is just about right,” referring, of course, to the booming economy.

These days, I’ll bet F.O.M.C. members really can’t believe their own lying eyes.

See also Come with Me to the FOMC, Remarks by Governor Laurence H. Meyer, Willamette University, Salem, Oregon April 2, 1998.

Fed Watch: Where Is The Rate Cut?

Tim Duy says the Fed may not cut the target interest rate at its next rate setting meeting:

Where Is The Rate Cut?, by Tim Duy: On the surface, the case for a rate cut seems obvious. But, despite an extraordinary and historic two weeks on Wall Street, Bernanke & Co. have failed to deliver. And perhaps the lack of action today, a day of panic in global equity markets, is telling us something about policy – don’t look for a rate cut, at least not yet. Maybe we should be listening.

If there is one thing the Fed has taught us in the last year, it is that they are inclined to meet periods of financial turbulence with a rate cut. Hence growing expectation for a rate cut, expectations that were only heightened by the string of data that confirmed for almost all remaining doubters that the US economy had slid into recession by at least the third quarter, if not much earlier. Last week’s employment and ISM reports for September appeared to seal the deal on that call.

Relatively dovish Fed-speak appeared to confirm these expectations. And if a rate cut was coming, why wait until the end of the month, especially when equity markets needed a boost of confidence? Yet no rate cut emerged. Instead, some Fed speakers have come out against a rate cut, such as St. Louis Fed President James Bullard and Richmond Fed President Jeffrey Lacker. To be sure, perhaps they are simply out of step with the Board. But perhaps the Fed has come to the conclusion that, at least for now, interest rates are not the problem, especially since, relative to the rate of decline in the real economy, the Fed is well ahead of where it would normally be at this point in the cycle.

William Stanley Jevon's Contribution to Index Number Theory

Walter Bagehot responds negatively to William Stanley Jevon's proposal to construct a price index based upon household consumption, and then use the index to adjust contracts to reflect variations in the purchasing power of money. This is from an 1875 edition of The Economist:

A New Standard of Value, by Walter Bagehot, The Economist, November 20, 1875, reprinted in the Economic Journal, volume 2 (1892): Professor Jevons, of Manchester -- so well known in the economical and statistical world by his researches on coal -- has written an excellent treatise on 'Money and the Mechanism of Exchange', which we strongly recommend to our readers. It is extremely clear, brief without being dry, and contains a good deal of very interesting information. And we may add that it is written in a style of scientific modesty rare in currency books. Mr Jevons is perpetually aware that the subject abounds in questions of nicety and difficulty, on which he is quite ready to admit that he may be wrong. It would be a happy thing if persons far less competent than Mr Jevons to write on the subject, but who incessantly do so, could be brought to that admission.

On one point, however, we are at issue with Mr Jevons: he has far more hope from economical science than we have. He thinks that it can point out to mankind a far better theoretical standard of value than gold or silver, and believes that, though it is encumbered with some difficulties, probably the new plan would on the whole, when we got used to it, work better than our present one. But for ourselves we much fear that political economy has no such boon to confer on mankind, and that we must adhere to one or other of the precious metals as a standard of value, like our forefathers. Mr Jevons shall explain his fundamental idea in his own words.

More Tools the Fed Can Use to Inject Liquidity

A nice write-up of some of the tools the Fed has at its disposal to deal with liquidity crises:

More Ways for the Fed to Boost Markets, by Greg Ip, WSJ: Since credit markets began to seize up in late July, the Fed has used a variety of tools to try to restore confidence, short of cutting its main interest rate, the target for the federal funds rate, from its current 5.25%. Economists say it still has several tools left, but whether the Fed would be willing to use any is an open question.

The possibilities include: lowering the discount rate further; accepting a wider range of collateral in open market operations; permit non banks to borrow from the discount window; create a joint lending program with Treasury to lend to needy institutions, as it did in 1989 with thrifts; create a temporary facility for lending against commercial paper similar to what it created in late 1999 for the century date change; and open swap lines with the European Central Bank. A more detailed discussion follows.

Some have praised the Fed for trying to restore confidence to credit markets without cutting the federal funds rate, which they say would create moral hazard by bailing reckless lenders out of their bad decisions. Yet proponents of this logic need to be wary: bending rules and conventions so much to boost particular markets could ultimately create more moral hazard than a rate cut.

Fed vice-chairman Donald Kohn alluded to this very tradeoff in a speech last May5. In it, he said a world in which capital markets have displaced banks as credit intermediaries probably would have more crises requiring cuts in interest rates, but this was "not really bad news." Cutting rates "can greatly ameliorate the effects of market events on the economy, and … will carry less potential for increasing moral hazard than would the discount window lending that was a prominent feature of crisis management" when banks were more important.

Additional options the Fed has for helping markets:

1. Lower the discount rate further. Normally the discount rate, charged on direct Fed loans to banks, sits one percentage point above the fed funds rate, which banks charge each other for overnight loans. On Aug. 17, the Fed cut the discount rate to 5.75% from 6.25%, leaving it just half a point above the fed funds rate.

Many economists have argued it should fall further, to 5.5% or even to 5.25%, equal to the fed funds rate. Banks are reluctant enough to borrow from the discount window given the traditional stigma – in the past it was usually a last resort for troubled banks. It's even harder for a bank to justify its use when it also has to pay 0.5 percentage points over fed funds. Indeed, the Fed's ample supply of additional cash via open market operations has pushed fed funds to below 5% many days, increasing the penalty.

Fed officials have been reluctant to go that step. It needs an active Fed funds market for its open market operations to efficiently guide interest rates to the desired level. Putting the discount rate on a par with Fed funds could "disintermediate" the fed funds market, that is make banks so enthusiastic about discount loans that activity in the fed funds market dries up. The Fed does not want to complicate life for itself when normalcy returns.

Officials also believe lengthening the term of discount window loans, to 30 days from one, should be a clear attraction at a time when banks are reluctant to lend for more than a few days.

(Note: we use the term "banks" here to refer to all federally insured deposit taking institutions: banks, thrifts, industrial loan companies and credit unions.)

2. Widen the range of collateral the Fed accepts for money advanced through open market operations. The Federal Reserve Act limits the Fed to accepting the debt of the U.S. government or its agencies (i.e. Fannie Mae, Freddie Mac and Ginnie Mae) as collateral for open market operations. Dealers, however, are having no trouble financing their inventory of government and agency debt; in general, it's asset-backed securities they need help with. But Deutsche Bank economists in a report note that section 4.4 of the act gives the 12 reserve banks "incidental powers" which could be construed as allowing the acceptance of other collateral. "This was used to resolve questions regarding the authority to offer options for repos around the century date change period, and might well allow for a significant broadening of collateral under unusual circumstances," Deutsche Bank says.

The Fed thus far has taken a stricter interpretation of what it can accept through open market operations and is reluctant to take a significantly more liberal interpretation than some on Wall Street advocate.

3. Permit nonbanks to borrow from the discount window. Since banks are sound and flush with cash, the logic runs, perhaps the Fed should be lending to nonbanks, such as special purpose entities and mortgage finance companies provided they post solid collateral. Section 13.3 of the Federal Reserve Act permits loans to nonbanks only under "unusual and exigent circumstances," with the approval by at least five Fed governors, when adequate funding is not available from other sources and when failure to do so "could have significant adverse consequences for the economy," according to the Fed. It was last done during the Great Depression.

(A useful resource for this and related issues is the Fed's 2001 study "Alternative Instruments for Open Market and Discount Window Operations6" prepared when budget surpluses threatened to leave the Fed with insufficient Treasurys to conduct open market operations.)

But this could, for the Fed, represent a troubling increase in moral hazard. Traditionally, banks got access to the discount window and deposit insurance because they also accepted extensive federal oversight of their activity, and had to keep a lot of capital on hand. Opening the discount window to nonbanks would represent an expansion of the federal safety net with unknown consequences. And its value would be questionable; the terms under which the Fed would lend would be so stringent that few truly distressed borrowers would meet them. Moreover, the Fed believes that the banks should be able to channel discount window funds to needy sectors. It has already exempted several large banks7 from limits on certain loans to their securities dealer units as a way of directing discount window money more directly to the securities market, and notified banks that loans8 used to finance securities purchases would receive favorable treatment when calculating a bank's required capital.

4. Richard Berner of Morgan Stanley says the Fed could create a "joint lending program" as it did with the Treasury and Federal Home Loan Bank Board in 1989 to provide temporary liquidity to thrifts faced with a sharp loss of deposits. "Only two thrifts actually borrowed," he noted, "but the program helped restore confidence and averted potential systemic risk." But he notes it duplicates the discount window functions, and exposes the taxpayer to loss.

5. Mr. Berner also says the Fed could create a "temporary special liquidity facility (SLF) that would accept commercial paper collateral at a haircut to par value." This would get liquidity to where it's needed most, he says. The Fed created such a facility9 to lend to banks that might face funding pressure around the century date change on Jan. 1, 2000. "By ring-fencing the operation from ongoing open market operations and the collateral accepted for them, using an SLF gives the Fed more protection from the risk of setting a bad precedent." But as Mr. Berner noted, it would largely be a replication of the discount window function.

Indeed, the Fed has already taken steps to liberalize the use of discount loans to boost the commercial paper and asset-backed market. Significantly, on Friday the New York Fed began notifying banks they could pledge as collateral asset-backed commercial paper (ABCP) for which they also provided the backup credit line. The inability of issuers to roll over maturing ABCP has been perhaps the single biggest problem in the credit markets, and enabling banks to take any unsold paper to the discount window could have a major impact. This could be of particular appeal to European banks with branches in New York as they have faced the greatest pressure to finance maturing ABCP. Data to be released next Thursday will show if this led to a big increase in discount window loans.

6. Open swap lines with the European Central Bank. Many European banks face pressure to provide dollar funding for maturing commercial paper programs, but the European Central Bank supplies euros in conducting monetary policy. This is one reason Libor, charged largely on short-term, unsecured dollar between European banks, is so high. The Fed could create a swap line with the ECB, giving it the ability to lend dollars in return for the Fed getting the ability to lend an equivalent amount of euros. The Fed opened several such swap lines after the Sept. 11, 2001 terrorist attacks.

Such a swap line would provide some relief but would likely be done only at the behest of the ECB; as such, it is of limited use to the Fed in offsetting domestic pressures.

Inflation and Unemployment: A Layperson’s Guide to the Phillips Curve

This article on the Phillips cuve is from the Richmond Fed:

Inflation and Unemployment: A Layperson’s Guide to the Phillips Curve, by Jeffrey M. Lacker and John A. Weinberg, FRB Richmond, Annual Report: What do you remember from the economics class you took in college? Even if you didn’t take economics, what basic ideas do you think are important for understanding the way markets work? In either case, one thing you might come up with is that when the demand for a good rises—when more and more people want more and more of that good—its price will tend to increase. This basic piece of economic logic helps us understand the phenomena we observe in many specific markets—from the tendency of gasoline prices to rise as the summer sets in and people hit the road on their family vacations, to the tendency for last year’s styles to fall in price as consumers turn to the new fashions.

Estimating Potential Output

This is a very nice summary of how economists measure the economy's maximum sustainable level of output from the author of your text [originally here].

The term "maximum sustainable level of output" is a better description of what we are trying to measure than the more common terms such "potential output" or "full employment." Let me try an example to illustrate. For a graduate student, over the course of an entire quarter, there is a certain maximum sustainable level of effort. It might be, say, 14 hours of class and study per day on average. That is "full employment" or "potential output." But in the short-run it's possible to exceed  that level of output. Right before a test students can work 20+ hours a day, more than full employment, but such a level of output is not sustainable over the longer run. People need a minimum level of sleep, time to eat, etc. So, potential output for students is the level of effort that is sustainable day after day after day, not the most that can be accomplished in a given 24 hour time period.

A business can do the same thing. If it has 10% of its trucks off the road for maintenance at any given time (i.e. "sleeping"), it can keep those on the road when demand is really high to deliver a little extra, keep workers overtime, run the production lines 24 hours a day without maintenance, etc. But that kind of effort, though possible in short bursts, is not sustainable over the longer haul (with the existing level of resources). Trucks and production lines have to be taken down for maintenance every so often or there will be big problems down the road, people won't work long days continuously, etc. Here, too, when we talk about potential output we don't mean how much the economy can produce in the short-run when it's overheated (sort of like just before an exam), but rather what it can do on a sustainable basis over time with a given quantity of inputs.

More formally, then, we can define potential output as the level of output the economy would produce if labor and all other resources are fully and efficiently employed, where full employment means the maximum sustainable level of activity.

But how do we actually measure potential output? Here' Frederic Mishkin with the details on three different approaches. It's not easy:

Estimating Potential Output, by Governor Frederic S. Mishkin, Federal Reserve: This conference focuses on measurement issues, and in my remarks I want to focus on one of the most important measurement issues that we at the Federal Reserve and other central banks face:  How do we determine whether the economy is operating above or below its maximum sustainable level?  That is, how do we estimate the path of potential output?¹

The Federal Reserve operates under a dual mandate to achieve both price stability and maximum sustainable employment.  In that context, it is natural to think of potential output as the level of output that is consistent with the maximum sustainable level of employment:  That is, it is the level of output at which demand and supply in the aggregate economy are balanced so that, all else being equal, inflation tends to gravitate to its long-run expected value.

The combination of the dual mandate and this definition suggests two reasons that estimating the path of potential output is so central to the conduct of monetary policy.  First, to evaluate whether our policies will help achieve the maximum sustainable employment objective of the dual mandate, we need know the level of future output that would be consistent with that objective.  Second, the level of output relative to potential output, which is referred to as the output gap, plays an important role in the inflation process.  When the actual level of output is above potential output--so that the output gap is positive--labor and product markets are excessively tight; then, if things such as expected inflation and temporary supply factors are held constant, inflation will tend to rise.  Conversely, when the output gap is negative and labor and product markets are slack, inflation will tend to fall.  Estimates of the future path of potential output are therefore needed to assess whether the projected path of output that is implied by current monetary policy will lead inflation to move in a direction that is consistent with price stability.

Because estimates of potential output are an important part of central bankers' toolkits, the Federal Reserve and other central banks devote considerable resources to getting the best measures of potential output possible.  In this talk, I want to explore something that Bismarck warned us we shouldn't want to examine:  "what goes into the sausage"--or in this case, what goes into central bankers' thinking about how to estimate potential output.

Broadly speaking, there are three basic approaches to estimating potential output: (1) aggregate approaches; (2) production function, or growth-accounting, approaches; and (3) the newest kid on the block, dynamic stochastic general equilibrium (DSGE) approaches.  Let's look at each of these in turn, with the major focus on the production function approach, one to which we at the Federal Reserve currently pay a lot of attention.

Jeffrey Lacker: Inflation and Unemployment

Jeff Lacker has a nice discussion of the relationship between inflation, unemployment, and economic policy. If you want to learn more about the modern formulation of the Phillips curve and the policy issues surrounding it, this is a good source of information. Those who are familiar with the traditional Phillips curve story and inflation bias from the time-inconsistency literature may want to skip to the discussion in the section on "The Modern Phillips Curve." The "hybrid" Phillips curve is discussed here, and policy is discussed in this section. Here's the speech:

Inflation and Unemployment, by Jeffrey M. Lacker President, Federal Reserve Bank of Richmond: I recently had the opportunity to guest-teach a couple of business school economics classes. It was great to be back in the classroom. ...

I opened my discussions with a pair of questions, asking students to put themselves in the place of a monetary policymaker choosing a target for the federal funds rate. First I gave them a set of hypothetical facts about the state of the economy – a slowdown in housing in the wake of multi-year housing boom; rising mortgage default rates; preliminary indicators of a possible slowing in business investment. And then I asked them: “What are you going to do?” The students dutifully responded that this situation could call for a reduction in the funds rate. They’d obviously been doing their homework.

Next, I gave them a set of hypothetical facts about inflation – core PCE inflation, on a year-over-year basis, has been above 2 percent for nearly three straight years; after some signs of moderation, recent months’ inflation numbers have moved higher; energy prices have been fluctuating around historically elevated levels and futures markets predict further increases to come; and labor compensation is rising after a relatively flat period. Same question: “What are you going to do?” Once again, their response came right out of the textbook – an increase in the funds rate is needed to counter rising inflation, other things equal.

The trick of course is that both sets of hypothetical facts are drawn from the same period – basically right now. My objective was to underscore the fact that sometimes monetary policy decisions are not obvious, and that figuring out the appropriate policy action requires as complete a picture as possible of the state of the economy. Interpreting that picture can be a challenging task.

The situation I presented to the students represents a policy-making dilemma. The actions needed to bring down inflation could work against our desire to see the real outlook solidify. The facts appear to present the policymaker with a tradeoff. You can address one – inflation or real growth – but that puts the other at risk.

There is an element of truth to characterizing this situation as a tradeoff. But that characterization is also, I think, an extreme over-simplification and can be highly misleading. Monetary policy actions today are capable of affecting inflation and unemployment both now and in the future. Consequently, it is a mistake to view policy decision-making as a sequence of one-shot trade-offs. Some understanding of how inflation and unemployment interrelate over time is essential. I’d like to devote my remarks ... to the relationship between inflation and the real side of the economy and to what I think that relationship implies for policy-making.

Econoblog: How Much Do Election Shakeups Affect the Nation's Economy?

Here's a link to the Wall Street Journal piece I talked about in class:

• Econoblog: How Much Do Election Shakeups Affect the Nation's Economy?

Fed Watch: Inflation Concerns Set to Trump the Slowdown?

Tim Duy with a Fed Watch in anticipation of next week's meeting [originally here]:

Inflation Concerns set to Trump the Slowdown?, by Tim Duy: The intensity of disgust for the 2Q06 GDP report – documented excessively at macroblog – caught me somewhat by surprise. It probably caught the Fed by surprise, too. After all, looking at the longer term, it is hard to see a reason to panic just yet:

We should all remember that plenty of people were ready to call it quits for the current expansion after the 4Q05 GDP report, but the economy (or, more accurately, the data) rebounded strongly the following quarter. Now, I doubt we are headed for another rebound of that magnitude – there is little reason to suspect that the consumer is gaining much additional traction. But the incoming data since I last wrote are, from the Fed’s perspective, relatively more supportive of an additional rate hike than not.

As far as the GDP report is concerned, it is consistent with the Fed expectation that the economy is slowing toward potential growth, with that slowing largely driven by changes in consumption spending and residential construction. I tend to believe they will discount the most worrisome part of the report, the 1% contraction in spending on equipment and software. They will view it as largely inconsistent with higher frequency data, notably the durable goods numbers, industrial production, and the ISM report. This is not to say the investment data in the GDP report are wrong (generally, the “data are wrong” story is an unwillingness to accept reality). Instead, there can be considerable volatility in the data that masks the underlying trend. Again, look back to 4Q05. There was hand-wringing over the weak investment numbers, only to see that story reversed in 1Q06. Moreover, the Fed will refer back to the Beige Book for supportive anecdotal evidence, noting:

Among products, demand was especially vigorous for various durable goods. Substantial sales gains were reported for makers of electrical equipment and information technology products such as semiconductors, along with further increases in orders and activity for makers of commercial aircraft and products used for national defense. The reports also pointed to a further rise in demand for makers of heavy equipment, machine tools, and steel, offset in part by reduced demand for smaller equipment that is oriented towards residential construction activity.

In short, I doubt the FOMC will see an impending recession in the GDP data. What they will find in recent data is the suggestion that inflation is becoming increasingly more entrenched. Core PCE inflation in June stood at 2.4% compared to a year ago, and 2.8% annualized compared to 3 months ago. Ouch – any way you slice it, the inflation news is unsettling, running well above the supposed 2% comfort level. And, the Fed will note, wages and salaries continue to climb:

One way to look at this is that consumers are merely demanding sufficient compensation to maintain living standards. The Fed will likely take a different tack – higher wage and salary growth suggests plenty of labor market pressure. Moreover, if higher prices are matched with higher wages, doesn’t that imply that imply that inflation expectations are set to be notched higher? Further supporting the wage/inflation story is the higher than expected ECI numbers. And note that oil breached $76 today, threatening to make a fresh attempt at the previous record. The long awaited stabilization of oil prices looks still to be long awaited.

And while household spending has eased, the Fed does not want households to maintain the rate of spending growth they became accustomed to in recent years anyway; I suspect FOMC members are quite pleased to see consumption spending pull back, and won’t be interested in reversing that process by accommodating higher prices. Yes, some sectors, maybe autos, will be hurt, but any rebalancing of the economy is going to result in some unpleasantness.

The truth is, the more I look at the data, the more I am tilted toward another Fed hike next week (not unlike William Polley). Financial markets, however, are not particularly supportive of that call – the focus of the markets has shifted from inflation to slow growth. Indeed, the predominant view appears to be the next rate hike is the last. Looking at the data, I simply can’t believe this is the thinking on Constitution Ave. And, as reported by David Altig, we have heard from two Fed officials who don’t sound so convinced a pause is a sure thing, with fairly balanced remarks consistent with Fed Chairman Ben Bernanke’s recent testimony on Capitol Hill.

Where then is the case for a pause? It can be largely summarized as:

1. The Fed’s new communication strategy continues to emphasize the expected slowdown.
2. Housing is slowing, and there is considerable amount of uncertainty regarding the ultimate economic impact. The only thing we know for sure is that it won’t be pretty. It is reasonable to expect the Fed to at least slowdown the pace of rate hikes in response.
3. Likewise, the economy does appear to be slowing in line with the Fed’s forecast, maybe even more quickly, depending how you want to read the GDP report. If the economy slows, won’t inflationary pressures ease as well?
4. The view that the inflation data is tainted by aberrant owner occupied rent behavior, and thus can be discounted. See my piece last week. With the OER question eliminated, the remaining inflation can be written off as pass-through from last summer’s energy price spike. Moreover, high productivity costs will contain inflation; note the low unit labor cost growth.

If the slowdown story is the important story on Constitution Ave., then much of the incoming data is supportive of a pause next month, especially because Fed officials continue to trot out the forecast for slowing growth. Overall, as I argued last time, the Beige Book appears consistent with that story. The data on economic activity, however, are sufficiently strong to prevent the Fed from believing a pause means done.

If the inflation numbers dominate, then we have to be looking at another rate hike next week. Yes, the inflationary pressures in the Beige Book looked pretty benign, but the actual PCE inflation data is simply not pretty. Will FOMC members want to look like they are disinterested observers in the face of these numbers? It’s one thing to let inflation creep up when the economy is clearly set to run below trend. But with the economy only expected to slow to potential, it becomes likely that the more inflation-wary policymakers will start thinking that they need to pull growth BELOW potential to reverse the inflationary uptick. That would be a whole new ballgame.

In short, I want to believe the “growth slowdown means a pause” story, but the inflation numbers keep circling around me like a pack of hyenas just waiting for me to drop my guard. Central bankers tend to hold onto hawkish leanings longer than expected. I simply suspect that while financial markets appear to be more focused on the slowdown story, the Fed will focus on the inflation story. Moreover, I doubt the Fed finds the GDP report to be particularly dismal. Consequently, I think the call is much closer than the betting on Wall Street indicates, close enough for me to expect another hike next week.

Perhaps tomorrow’s employment report will help lift the cloud…

The Stone Money of Yap

The stone money of Yap is an interesting case to consider when thinking about what money is and what role it plays in the economic and social affairs of a community. This article by Michael Bryan of the Federal Reserve Bank of Cleveland describes the stone wheels of Yap, how they were obtained and used as gift markers both within and between tribes, and whether the stones fit the textbook definition of money:

Federal Reserve Bank of Cleveland, Island Money, by Michael F. Bryan: ...In this Commentary, I … consider… the unique and curious money of Yap, a small group of islands in the South Pacific. … For at least a few centuries leading up to today, the Yapese have used giant stone wheels called rai when executing certain exchanges. The stones are made from a shimmering limestone that is not indigenous to Yap, but quarried and shipped, primarily from the islands of Palau, 250 miles to the southwest. The size of the stones varies; some are as small as a few inches in diameter and weigh a couple of pounds, while others may reach a diameter of 12 feet and weigh thousands of pounds. A hole is carved into the middle of each stone so that it may be carried, either by coconut rope strung through the smaller pieces, or by wooden poles inserted into the larger stones. These great stones require the combined effort of many men to lift. Expeditions to acquire new stones were authorized by a chief who would retain all of the larger stones and two-fifths of the smaller ones, reportedly a fairly common distribution of production that served as a tax on the Yapese. In effect, the Yap chiefs acted as the island’s central bankers; they controlled the quantity of stones in circulation...

The quarrying and transport of rai was a substantial part of the Yapese economy. In 1882, British naturalist Jan S. Kubary reported seeing 400 Yapese men producing stones on the island of Palau for transport back to Yap. Given the population of the island at the time … more than 10 percent of the island’s adult male population was in the money-cutting business. Curiously, rai are not known to have any particular use other than as a representation of value. The stones were not functional, nor were they spiritually significant to their owners, and by most accounts, the stones have no obvious ornamental value to the Yapese. If it is true that Yap stones have no nonmonetary usefulness, they would be different from most “primitive” forms of money. Usually an item becomes a medium of exchange after its commodity value—sometimes called intrinsic worth—has been widely established...

Precisely how the value of each stone was determined is somewhat unclear. We know that size was at best only a rough approximation of worth and that stone values varied depending upon the cost or difficulty of bringing them to the island. For example, stones gotten at great peril, perhaps even loss of life, are valued most highly. Similarly, stones that were cut using shell tools and carried by canoes are more valuable than comparably sized stones that were quarried with the aid of iron tools and transported by large Western ships. The more valuable stones were given names, such as that of the chief for whom the stone was quarried or the canoe on which it was transported. Naming the stone may have secured its value since such identification would convey to all the costs associated with obtaining it...

Consider the case of the Irish American David O’Keefe from Savannah, Georgia, who, after being shipwrecked on Yap in the late nineteenth century, returned to the island with a sailing vessel and proceeded to import a large number of stones in return for a bounty of Yapese copra (coconut meat). The arrival of O’Keefe (and other Western traders) increased the number and size of the stones being brought back to the island, and by one accounting, Yap stones went from being “very rare” in 1840 to being plentiful—more than 13,000 were to be found on the island by 1929. No longer restricted by shell tools and canoes, the largest stones arriving grew from four feet in diameter to the colossal 12-foot stones that are now a part of monetary folklore. Yet the great infusion of stones did not inflate away their value. Since the stones of Captain O’Keefe were obviously more easily obtained, they traded on the island at an appropriately reduced value relative to the older stones gotten at much greater cost. In essence, O’Keefe and other Westerners were bringing in large numbers of “debased” stones that could easily be identified by the Yapese.

While it’s clear that the Yap stones have value for the Yapese, can the stones really be called money? The answer, of course, depends upon how you define money. If you rely on a standard textbook definition, you’d describe money in terms of its functions, for example, “Whatever is used as a medium of exchange, unit of account, and store of value.” Certainly, Yap stones performed at least one of these functions quite well—they were an effective store of value (form of wealth). But every asset—from bonds to houses—stores value and is not necessarily labeled money.

To be called money, at least according to the textbook definition, an asset must serve two other functions. It must be a medium of exchange, meaning that it can be readily used either to purchase goods or to satisfy a debt, and it must be a unit of account, or something used as a measure of value. Yap stones were not the unit of account for the islands. Pricing goods and services in terms of the stones would probably have been difficult for the average islander. ... According to Paul Einzig, prices on the islands were set in terms of baskets of a food crop, taro, or cups of syrup, staples that would be easy for a typical islander to appreciate. Furthermore, there is some question whether Yap stones were commonly used as a medium of exchange. To be used in exchange, an item must possess certain characteristics—it must be storable, portable, recognizable, and divisible. Certainly, the stones were storable; they can still be found in abundance on Yap, and they have maintained their purchasing power reasonably well over time (particularly compared with other fiat monies, including dollars). And while it is sometimes claimed that Yap stones suffer as an exchange medium because they lack portability, this may not be completely accurate. In the case of the larger, more easily identified stones, physical possession is not necessary for the transfer of purchasing power. Those involved in the exchange need only communicate that purchasing power has been transferred…

But while storability and portability may not have limited the use of these stones as a medium of exchange, the other two characteristics—recognizability and divisibility—probably did. The stones were primarily used in exchanges between Yap islanders. … Yap historically did not have close cultural ties with any of its trading partners and trade with off-islanders was somewhat infrequent, the stones did not facilitate transactions on these occasions. When transacting with other islands, the Yapese used woven mats (a common exchange medium throughout the South Pacific), while trade with Westerners often involved an exchange of coconuts. Even on the island, the indivisibility of the stones necessitated the use of other items as media of exchange for most transactions. Most rai are highly valued: By one account, a stone of “three spans” (about 25 inches across) would have been sufficient in the early twentieth century to purchase 50 baskets of food or a full-sized pig, while a stone the size of a man would have been worth “many villages and plantations.” Obviously, these stones do not change hands very frequently, since expenditures of such magnitude are rare. For more ordinary transactions, the Yapese either used pearl shells or resorted to barter. Clearly the stones of Yap do not fit neatly within the textbook definition of money…

But … what role do the stones play and how is that role similar to that played by dollars?... [T]he stones, particularly the larger ones, acted as markers, changing hands in recognition of a “gift.” Stones were often merely held until the gift was reciprocated and the stone could be returned to its original owner. For example, islanders wishing to fish someone’s waters might do so by leaving a stone in recognition of the favor. After an appropriate number of fish were given to the owner of the fishing waters, the stone would simply be reclaimed. Occasionally a stone was “exchanged” when one tribe came to the aid of another, say for support against a rival tribe or in celebration of some event. But the stone would reside with the new tribe only until such time as aid of a similar value could be given in return. The stones, then, act as a memory of the contributions occurring between islanders. Anthropologists refer to this as a “gift economy,” where goods aren’t traded as much as they are given with the expectation of a comparable favor at some later date. So Yap stones serve as a memory of one’s contributions on the island. … But this raises an intriguing question. If the stones of Yap were merely markers and nothing more, why did the Yapese expend such great resources to carve them out of the mountains of Palau and carry them all the way back to their island? Wouldn’t any marker work just as well? It may be that the Yap chiefs did not have sufficient “credibility” to simply decree an object’s value. That is, the Yapese may have needed some assurance that the object on which value has been assigned could not be easily replicated for the mere benefit of the issuer...

Central Bank Independence and Inflation

From "Central Bank Independence and Macroeconomic Performance: Some Comparative Evidence," by Alberto Alesina and Lawrence H. Summers, Journal of Money, Credit and Banking, Vol. 25, No. 2. (May, 1993), pp. 151-162  (the link will work on UO net, but I don't expect you to read the paper as it is a bit technical):

This has changed with the adoption of inflation targeting by central banks. Note also that Adam Posen casts doubt on whether causality runs from central bank independence to improved macroeconomic performance in Central Bank Independence and Disinflationary Credibility: A Missing Link?, NY Fed Staff Report, May 1995.

Technology and Class Attendance

This is something I posted last winter:

I posted this on my blog today about posting class material on the web and how that impacts class attendance. I'd be curious to hear your comments (you might be interested in the comments people have left, there are comments here also):

Dual Banking in the U.S.

Banks can be chartered by either federal or state authorities. Why do we have a dual banking system today? Alan Greenspan discussed this topic in a 1998 speech.

Federal Funds Rate Probabilities for Future Meetings

These are from David Altig at macroblog and are based on the programs and data given at the end (click on the figures for larger versions). David is part of the research division at the Cleveland Fed. They are the probabilities, based upon futures markets, of rate hikes at the next few FOMC meetings:

macroblog: Funds Rate Probabilities: Locking In 5, By David Altig The big move of the week in the Carlson-Craig-Melick estimates of market expectations for the federal funds rate path was not in the March meeting, where there wasn't much room to move in the first place...

... but in the May meeting, where another 25 basis points is now being priced in the options market as a dead cinch:

Sentiments in the direction of yet another move at the June meeting ran hot and cold over the week:

I'll declare that race wide open.

The usual data...
Download Imp_pdf_slides_for_blog_031006.ppt
Download implied_pdf_march_031006.xls
Download implied_pdf_may_031006.xls
Download implied_pdf_june_031006.xls

... and a new item the menu, the pictures in flash format:
Download Imp_pdf_slides_for_blog_031006.swf

Paul Krugman's Introduction to Keynes' General Theory

I thought some of you might want to read this. It's Paul Krugman's introduction to Keynes' General Theory of Employment, Interest, and Money:

Introduction by Paul Krugman to The General Theory of Employment, Interest, and Money, by John Maynard Keynes

SYNOPSIS:

Introduction

In the spring of 2005 a panel of “conservative scholars and policy leaders” was asked to identify the most dangerous books of the 19th and 20th centuries. You can get a sense of the panel’s leanings by the fact that both Charles Darwin and Betty Friedan ranked high on the list. But The General Theory of Employment, Interest, and Money did very well, too. In fact, John Maynard Keynes beat out V.I. Lenin and Frantz Fanon. Keynes, who declared in the book’s oft-quoted conclusion that “soon or late, it is ideas, not vested interests, which are dangerous for good or evil,” [384] would probably have been pleased.

Over the past 70 years The General Theory has shaped the views even of those who haven’t heard of it, or who believe they disagree with it. A businessman who warns that falling confidence poses risks for the economy is a Keynesian, whether he knows it or not. A politician who promises that his tax cuts will create jobs by putting spending money in peoples’ pockets is a Keynesian, even if he claims to abhor the doctrine. Even self-proclaimed supply-side economists, who claim to have refuted Keynes, fall back on unmistakably Keynesian stories to explain why the economy turned down in a given year.

In this introduction I’ll address five issues concerning The General Theory. First is the book’s message – something that ought to be clear from the book itself, but which has often been obscured by those who project their fears or hopes onto Keynes. Second is the question of how Keynes did it: why did he succeed, where others had failed, in convincing the world to accept economic heresy? Third is the question of how much of The General Theory remains in today’s macroeconomics: are we all Keynesians now, or have we either superseded Keynes’s legacy, or, some say, betrayed it? Fourth is the question of what Keynes missed, and why. Finally, I’ll talk about how Keynes changed economics, and the world.

Inflation Fighting Credentials

I hear a lot about Bernanke needing to establish his inflation fighting credentials, something I don't think is necessary, but others apparently do. So I was curious to see how Greenspan fared in this regard in comparison.

Regulatory Relief for Banking Organizations

Today, Federal Reserve Governor Donald Kohn testified before the Committee on Banking, Housing, and Urban Affairs in the Senate on regulatory relief proposals for banking organizations the Fed would like to see implemented. Here are four of the thirty six proposals: 

Appendix: Regulatory Relief, Proposals Supported by the Board of Governors of the Federal Reserve System, Testimony of Donald Kohn: The Board believes the first 20 items listed below would provide meaningful regulatory relief to banking organizations within the jurisdiction of the Federal Reserve. The remaining 16 items would improve the supervision of banking organizations, facilitate the resolution of failed banks, streamline procedural or other requirements under the federal banking laws, or eliminate outdated provisions of law.

1. Authorize the Federal Reserve to pay interest on balances held at Reserve Banks ...gives the Federal Reserve explicit authority to pay interest on balances held by depository institutions at the Federal Reserve Banks....
   
2. Authorize depository institutions to pay interest on demand deposits ...repeals the provisions in current law that prohibit depository institutions from paying interest on demand deposits. If adopted, the amendment would allow all depository institutions that have the authority to offer demand deposits to pay interest on those deposits.
   
3. Ease restrictions on interstate branching and mergers in a competitively equitable manner ...authorizes national and state banks to open de novo branches on an interstate basis. Currently, banks may establish de novo branches in a new state only if the state has affirmatively authorized de novo branching. This existing limitation places banks at a disadvantage to federal savings associations ...
   
4. Allow insured banks to engage in interstate merger transactions with savings associations and trust companies ...would allow an insured bank to directly acquire, by merger, an insured savings association or uninsured trust company in a different home state without first converting ... into an insured bank. As under current law, the insured bank would have to be the survivor of the merger.

For me, an interesting feature of this is the following:

Having the authority to pay interest on excess reserves also could help mitigate potential volatility in overnight interest rates. If the Federal Reserve was authorized to pay interest on excess reserves, and did so, the rate paid would act as a minimum for overnight interest rates, because banks generally would not lend to other banks at a lower rate than they could earn by keeping their excess funds at a Reserve Bank. Although the Board sees no need to pay interest on excess reserves in the near future, the ability to do so would be a potentially useful addition to the monetary policy toolkit of the Federal Reserve.

The discussion, discussed previously here, brings up the possibility of a "channel" or "corridor" system for setting the federal funds rate as is currently in place in Canada, Australia, and new Zealand. This system makes open market operations unnecessary and allows the Fed, as proposed elsewhere on the proposed list or regulatory changes, to remove reserve requirements. Currently, the federal funds rate is capped by the discount rate. Since the Fed will lend to banks at the discount rate, no bank would pay a higher rate in the federal funds market so the federal funds rate cannot go any higher than the discount rate. Similarly, with the ability to pay interest on deposits, no bank would lend to another bank at less than the rate the Fed will pay on deposits, so the federal funds rate cannot be lower than this. These two bounds are shown in the figure below (copied from Mishkin's text). Notice that if these bounds are fairly tight, the federal funds rate will be controlled precisely (for more on this point, see Woodford). In addition, keeping the federal funds rate on target does not require open market operations, only discount window (lombard facility) borrowing and lending.

Vice Chairman Ferguson Resigns from Board of Governors

This is a surprise[originally here]:

For immediate release: Roger W. Ferguson, Jr., submitted his resignation Wednesday as Vice Chairman and as a member of the Board of Governors of the Federal Reserve System, effective April 28, 2006. ... He will not attend the March 27-28 meeting of the Federal Open Market Committee. ... Ferguson, 54, was first appointed to the Board by President Clinton to fill an unexpired term ending January 31, 2000. He was then appointed by President Bush to a full term that expires on January 31, 2014. ...

Ferguson is the only Democrat on the Board and his departure will give president Bush the opportunity to appoint all seven Board members. That is not how it was intended to work. One possible hint about the resignation comes from Bloomberg:

The vice chairman had been publicly at odds with Bernanke on announcing a numerical inflation target. Bernanke described such a goal at his Nov. 15 confirmation hearing as a "possible step toward greater transparency.''

Ferguson said in October 2004 that an inflation goal may limit the Fed's flexibility to respond to economic shocks, and two months ago said any progress toward such a change "would be very slow.'' Edward Gramlich, who resigned as a Fed governor last year, has said their disagreement "never got acrimonious.''

But I'm hesitant to jump to any conclusions on the reasons for the resignation until we know more. Here's the letter:

FOMC Meeting Minutes Leave Room for More Rate Hikes

The Fed released its minutes from the last FOMC meeting. No surprises. While rates are nearing their destination, the committee expresses more worry about the inflation risk than the risk to output growth and is poised to raise rates again if needed. The bias is toward further rate increases, but all members agree that the next move is far more data dependent than other recent moves [originally here]:

Minutes of the Federal Open Market Committee January 31, 2006: ...The information reviewed at this meeting suggested that underlying growth in aggregate demand remained solid, even though the expansion of real GDP was estimated to have slowed in the fourth quarter. ... Headline consumer inflation had been held down by falling consumer energy prices; more recently, however, crude oil prices climbed back up to high levels. Meanwhile, core inflation had moved up a bit from low levels seen last summer. ...

Money as a "Showcase for Art"

From here:

The Paper Currency of 1876 is a fascinating look at the Bureau of Engraving and Printing's decision in 1876 to use paper money as a "showcase for art." ... Link...

I think the date should be 1886, and the notes were released in 1896. Here are images of the one, two, five, and ten dollar silver certificates, though the ten was never released. Can you guess what the two figures in the foreground on the ten dollar certificate represent, or the themes of the two and five dollar notes (e.g. the one dollar note is entitled History Instructing Youth)? The answer is in the Link above:

Click on figures to enlarge

WSJ Econoblog: Stitching a New Safety Net

Andrew Samwick of Dartmouth (in 2003 and 2004, he served as the chief economist on the staff of the President's Council of Economic Advisers) and I just finished an Econoblog for the Wall Street Journal Online. The issue we were asked to address is:

WSJ Econoblog: Stitching a New Safety Net: For many years, workers could manage their medical expenses with employer-provided health insurance and Medicare and look forward to underwriting their golden years with payments from a defined-benefit pension and Social Security.

But the landscape of social insurance is shifting. Many large corporations are moving their employees from traditional pensions to riskier 401(k)s and asking workers to pay more out of their own pockets for health insurance. At the same time, Social Security and Medicare, the two venerable entitlement programs, are facing growing demographic strains as the vast baby boom generation reaches retirement age.

The Wall Street Journal Online asked economist bloggers Mark Thoma and Andrew Samwick to explore how we how arrived at this point and discuss what workers and retirees might expect in the future, as the composition of the social safety net continues to shift.

Here's the free link once again. And thanks to Andrew for an enjoyable discussion. [Originally posted here]

Bush is Moving to Fill Two Slots at the Federal Reserve

As we just talked about this in class, I thought I'd pass along news from Greg Ip and John McKinnon at the Wall Street Journal on Bush's choice to fill the two open seats on the Federal Reserve Board of Governors [posted here]:

Bush Is Moving To Fill Two Slots At Federal Reserve, by Greg Ip and John D. McKinnon, WSJ: With leadership at the Federal Reserve about to change, the White House is moving to fill two vacancies on the central bank's seven-member board of governors. President Bush plans to soon nominate Kevin M. Warsh, a White House adviser on domestic finance and capital markets, to fill one of the two vacancies, two people familiar with the matter said. Mr. Bush aims to fill the other seat with an academic economist, and the likeliest candidate is Randall S. Kroszner, who teaches at the University of Chicago's Graduate School of Business, one of these people said...

The nominations would tilt the board's composition toward financial-industry expertise rather than macroeconomics. Mr. Warsh, a lawyer by training, was an investment banker at Morgan Stanley before joining the White House National Economic Council. He has been the White House's point person on financial-industry issues. Mr. Kroszner, who served on the Council of Economic Advisers during Mr. Bush's first term, specializes in banking, banking regulation, international-financial crises and monetary economics...

From Brad DeLong on Richard Kroszner:

I know I'm proud to have played a (alas, very small) part in the education of Randy Kroszner and Robin Hanson, both far to my right.

From Institutional Economics:

Both Clarida and Kroszner would be excellent appointments.  Appointing non-specialists with financial market backgrounds would be a mistake in my view, increasing the risk of ... regulatory capture by Wall Street...

That doesn't sound like a strong endorsement of Warsh. I know little about him. BusinessWeek Online has a bit more, but not much:

Warsh is the NEC's point man for contact with the financial-services industry. He has recently sought to raise his public profile by speaking to more industry groups and was mentioned as a candidate for chairman of the Securities & Exchange Commission before Bush tapped Rep. Christopher Cox (R-Calif.) for the job.

Fed Watch: Ready to Invert

Tim Duy with his latest Fed Watch [Originally posted here]:

Military Currency

From Boing Boing:

Lileks examines currency Jame Lileks comments on paper currency from around the world. As Coop notes, It's "jawdroppingly weird old ephemera, pleasantly seasoned with acerbic comments."

Any note that shows Johnny Cash as a jet pilot is a dollar bill I'd be proud to spend.

Of course, that's not really the Man in Black, but it has his noble cast and sorrowful mouth. Also, his left eye appears to be scarred shut, but obviously that's not the case if he's a pilot. If there had been a military coup in the US in the 60s, this is what our money would have looked like. Link

Financial Market Deregulation Under Greenspan: Did It Go Too Far?

[Originally here.]

Steven Pearlstein of the Washington Post talks about an area of Greenspan's tenure that hasn't received as much press at it might, his penchant for financial deregulation:

The Laissez-Fairest of Them All, by Steven Pearlstein, Washington Post: ...Perhaps Greenspan's most important contribution has been as the policymaker who... engineered the wholesale deregulation of the U.S. banking and financial system. In this respect, his most enduring legacy is an American economy that is not only more prone to assets bubbles, corporate scandal and financial crises, but robust enough to absorb such shocks while continuing to deliver long-term economic growth.

A determination to substitute the wisdom of markets for the heavy hand of government runs through the Greenspan story. ... There was, for example, his work on behalf of Lincoln Savings and Loan seeking permission for thrifts to branch out from boring old home loans to invest directly in commercial real estate ventures. Greenspan told Congress such powers were "essential for the financial stability and survival of the savings and loan industry." Congress agreed, but this first bit of financial deregulation spawned a crisis that nearly wiped out the industry, cost taxpayers more than $100 billion and landed Lincoln's top executive in prison.

Once installed at the Fed, Greenspan immediately began pushing Congress to repeal the Depression-era law that prevented banks from competing with investment banks in underwriting stocks and bonds. When Congress dallied, he used the Fed's supervisory authority to allow banks to circumvent the law and usher in the era of the megabank. ...

When crisis struck, Greenspan was quick on the scene with liquidity to prevent it from spreading. But he almost never saw in such episodes a reason for new regulation. Even after derivatives trading bankrupt Orange County, Calif., and the venerable Barings investment house, Greenspan fought efforts to regulate these newfangled financial instruments. And while the near collapse of Long-Term Capital required the Fed's jawboning to prevent a global financial meltdown, Greenspan opposed efforts by the Securities and Exchange Commission to initiate even modest regulation of the $1 trillion hedge fund industry.

After the Enron scandal, accounting regulators set out to draft rules to prevent companies and their lenders from using "special purpose entities" to hide indebtedness from investors. Objections from the Fed stalled adoption of the new rules, and eventually watered them down. And just yesterday came Greenspan's latest salvo in his campaign to dismantle Fannie Mae and Freddie Mac. In a letter to Sen. John E. Sununu (R-N.H.), he reprises his view that there's nothing the government-sponsored mortgage lenders do that private banks couldn't do at less cost to taxpayers, with less threat to the financial system.

As you can probably tell, I didn't much like most of these decisions. There was, and is, plenty of evidence that skillful regulation and intervention can help deter corporate fraud, protect investors from Wall Street sharpies and reduce the frequency and severity of assets bubbles and financial crises.

At the same time, Greenspan is probably right that deregulation sparked a flurry of financial innovation that has made capital cheaper and more readily available, done a better job of pricing and spreading risk and shielded the economy from the impact of financial crises. ... Greenspan summed up the trade-offs behind his deregulatory philosophy in a series of unusually lucid speeches in London in 2002, on the eve of being knighted by Queen Elizabeth. "The extent of government intervention in markets to control risk-taking," he said, "is a trade-off between economic growth and its associated potential instability, and a more civil but less stressful way of life with a lower standard of living."...

I have the same reaction. Compared to twenty years ago, there has been remarkable transition and innovation in the financial services industry driven by competition. So far, so good. But I also worry that deregulation has gone too far and made us more vulnerable to financial meltdown in the face of large and unexpected shocks. Housing markets are a good example of this. The promotion of home ownership though creative financing allows many to purchase homes that could not have done so not that long ago. But have people taken on excessive risk and thereby increased our vulnerability to a crash?

The Decline in Workplace Provided Health Coverage

[This is about health care coverage, so it's not directly related to monetary policy, but thought it might be of interest ... originally posted here.]

This is from Table 132 of this report from the CDC web site. It's a graph of the percentage of people with workplace provided private health coverage from 1984-2003. There's quite a bit of detail in the table including breakdowns of coverage by age, sex, race, and income level. For example, here's coverage by age:

The numerical overall changes by age are:

Age

	1984	2003	Change
Under 18 years	66.5	58.6	-7.9
18-44 years	69.6	62.2	-7.4
45-64 years	71.8	70.0	-1.8

Thus, the largest decline is for those under 45.

Here are the numerical endpoint data by sex along with the overall changes. Given the standard errors in the table (not shown here), there is little difference between males and females:

Sex

	1984	2003	Change
Male	69.8	63.3	-6.5
Female	68.4	63.3	-5.1

There are, however, big differences by income level, and the changes are larger for those under 18. As the following table shows, the decline in workplace provided health care coverage has been largest among those earning between 100% and 200% of the poverty level, a change of over 20%, while the change for those outside this range is less than 10%:

Age and Percent of Poverty Level

All ages	1984	2003	Change
Below 100 %	24.1	19.9	-4.2
100-149 %	52.4	31.8	-20.6
150-199 %	69.5	46.8	-22.7
200 % or more	85.0	78.6	-6.4
Under 18 years
Below 100 %	23.0	14.0	-9.0
100-149 %	58.3	30.1	-28.2
150-199 %	75.8	47.0	-28.8
200 % or more	86.9	79.9	-7.0

These data show that middle income families have been affected most by the decline in employer provided private health care coverage.

Update: A colleague writes to tell me:

The explanation for the decline in coverage (at least through the late 90s) is also quite interesting.  David Cutler has a paper (NBER WP #9036), arguing that the reason for the decline was not a decrease in employers offering HI, but a decrease in employees choosing to purchase insurance from their employers, primarily due to rising premiums.

New Support for Friedman's Plucking Model

[Something I thought might interest one or two of you ... originally posted here.]

Milton Friedman's "plucking model" is an interesting alternative to the natural rate of output view of the world. The typical view of business cycles is one where the economy varies around a trend value (the trend can vary over time also). Milton Friedman has a different story. In Friedman's model, output moves along a ceiling value, the full employment value, and is occasionally plucked downward through a negative demand shock. Quoting from the article below:

In 1964, Milton Friedman first suggested his “plucking model” (reprinted in 1969; revisited in 1993) as an asymmetric alternative to the self-generating, symmetric cyclical process often used to explain contractions and subsequent revivals. Friedman describes the plucking model of output as a string attached to a tilted, irregular board. When the string follows along the board it is at the ceiling of maximum feasible output, but the string is occasionally plucked down by a cyclical contraction.

Friedman found evidence for the Plucking Model of aggregate fluctuations in a 1993 paper in Economic Inquiry. One reason I've always liked this paper is that Friedman first wrote it in 1964. He then waited for almost twenty years for new data to arrive and retested his model using only the new data. In macroeconomics, we often encounter a problem in testing theoretical models. We know what the data look like and what facts need to be explained by our models. Is it sensible to build a model to fit the data and then use that data to test it to see if it fits? Of course the model will fit the data, it was built to do so. Friedman avoided that problem since he had no way of knowing if the next twenty years of data would fit the model or not. It did. I was at an SF Fed Conference when he gave the 1993 paper and it was a fun and convincing presentation. Here's a recent paper on this topic that supports the plucking framework (thanks Paul):

Asymmetry in the Business Cycle: New Support for Friedman's Plucking Model, Tara M. Sinclair, George Washington University, December 16, 2005, SSRN: Abstract This paper presents an asymmetric correlated unobserved components model of US GDP. The asymmetry is captured using a version of Friedman's plucking model that suggests that output may be occasionally "plucked" away from a ceiling of maximum feasible output by temporary asymmetric shocks. The estimates suggest that US GDP can be usefully decomposed into a permanent component, a symmetric transitory component, and an additional occasional asymmetric transitory shock. The innovations to the permanent component and the symmetric transitory component are found to be significantly negatively correlated, but the occasional asymmetric transitory shock appears to be uncorrelated with the permanent and symmetric transitory innovations. These results are robust to including a structural break to capture the productivity slowdown of 1973 and to changes in the time frame under analysis. The results suggest that both permanent movements and occasional exogenous asymmetric transitory shocks are important for explaining post-war recessions in the US.

Let me try, within my limited artistic ability, to illustrate further. If you haven't seen a plucking model, here's a graph to illustrate (see Piger and Morley and Kim and Nelson for evidence supporting the plucking model and figures illustrating the plucking and natural rate characterizations of the data). The "plucks" are the deviations of the red line from blue line representing the ceiling/trend:

Notice that the size of the downturn from the ceiling from  a→b (due to the "pluck") is predictive of the size of the upturn from b→c that follows taking account of the slope of the trend. I didn't show it, but in this model the size of the boom, the movement from b→c, does not predict the size of the subsequent contraction. This is the evidence that Friedman originally used to support the plucking model. In a natural rate model, there is no reason to expect such a correlation. Here's an example natural rate model:

Here, the size of the downturn a→b does not predict the size of the subsequent boom b→c. Friedman found the size of a→b predicts b→c supporting the plucking model over the natural rate model.

Fed Links

I posted this on my blog tonight:

There were two speeches today by Fed officials. First, there was a speech by Fed Governor Susan Bies:

Productivity and Economic Outlook

Bottom line: Likes current situation, but worried about capacity and resource constraints driving up input prices and causing in inflationary pressure.

There was also a speech by Richmond Fed President Jeffrey M. Lacker:

The Economic Outlook for 2006

Bottom line: Likes current situation, but not sure that the pass-through risk from high energy prices to core inflation is over. One more rate hike, then assess incoming data to see where to go next.

Here's the Bloomberg write-up of the speeches:

Fed Officials See Inflation Risks From Oil, Rising Factory Use

And also from Bloomberg, Gene Sperling assesses Greenspan's record. He has quarrels with particular episodes such as the 2001 tax cut, but overall sees Greenspan's record in a positive light:

Time to Judge the Whole Record of Alan Greenspan

A Brief History of the U.S. Payments System

Anthony M. Santomero, President of the Philadelphia Fed, discusses the evolution of our payments system.  The history starts at a time in the U.S. when each bank issued its own checks and currency and banks are chartered and regulated by individual states rather than by the federal government.  He talks about some of the problems that arrangement causes for transactions, particularly over long distances, and how the federal government attempts to solve this by introducing a national currency and check clearing system.

The Evolution of Central Banking in the United States

A very nice history of central banking in the United States from Federal Reserve Vice Chairman Roger W. Ferguson, Jr. with comparisons to the introduction of the Euro and the European Central Bank:

The Evolution of Central Banking in the United States, Vice Chairman Roger W. Ferguson, Jr., The European Central Bank, Frankfurt, Germany, April 27, 2005

…I would like to discuss the evolution of central banking in the United States, with particular reference to currency, relations between the regions and the center, mandates, and communication. Along the way, I will compare our experience with that of the ECB…

Fed Watch: A Little Something for Everyone

[This originally appeared here. Brad DeLong is using it as part of his class at Berkeley on journalism and economics.  See here.]

Tim Duy looks through the eyes of monetary policymakers at today's employment report and its impact on the course of monetary policy:

What better way to return from a long winter break than to tackle a muddled labor report!  I suspect that we will find many stories told about this report, and I will try to summarize all of them (Kash at Angry Bear was out of the gates early with the pessimist’s take).  But what is most important – from a FedWatch perspective – is the view at Constitution Ave. I tend to think that despite a few setbacks in the details, policymakers will walk away with a relatively upbeat perspective on the labor markets. And that means it may be premature to think the Fed will shortly be done for good.

But first, a quick look back at the Fed minutes. Wall Street’s stamp of approval implies a wide expectation of “one and done” for this tightening cycle. That’s not quite my interpretation, although I can’t blame traders for looking for good news after a dreary December.  Instead, I left the minutes with the sense that another rate hike at the end of the month is in the bag, but beyond that, future changes in policy are not automatic but instead data dependent.  That is decidedly not the same thing as “done.”  “Done” means you are betting against the economy – and I doubt the Fed is ready to make that call just yet.

As far as the labor report goes, the headline payroll gain of 108,000 was clearly a disappointment.  But optimists will point to the revision that pushed the October gain to 305,000 jobs, which yields a respectable two-month average of just over 200,000. Optimists will point to the decline in the unemployment rate to 4.9%; pessimists will focus on the decline in the labor force participation rate.  Pessimists will focus on the slight fall in aggregate hours worked; optimists will point to the 5 cent wage gain.

Some other details popped out at me.  The 18,000 gain in manufacturing employment should be happy news to many, although my initial scan of the blogs does not show a focus on this number.  In contrast, the decrease in construction employment could reflect cooling housing markets.  While many expect those jobs will eventually show up in Gulf Coast rebuilding efforts, only in macroeconomic textbooks does a worker move from San Diego to New Orleans instantaneously and at zero cost. 

So, what will policymakers make of all of this? First of all, it is always important to remember that one month of a single data report is not likely to fundamentally alter the perceptions on Constitution Ave. We will have two more of these reports – not to mention dozens of other data points – by the time the March meeting rolls around.  If, then, the overall trends are what is important, can we find some consistency in the data of the optimists and pessimists? For this I turn to Table A12 of the employment report, a personal favorite of mine. Table A12 reports different measures of labor underutilization. The most optimistic measure is:

Percent of Civilian Labor Force Unemployed 15 Weeks & Over

The most pessimistic measure is:

Total Unemployed, Plus All Marginally Attached Workers Plus Total Employed Part Time For Economic Reasons, As A Percent Of All Civilian Labor Force Plus All Marginally Attached Workers

The headline unemployment rate at 4.9% basically splits the difference.

What do both of these pictures have in common? Both measures place labor market utilization near the rates seen prior to the great boom of the late 1990’s. Do policymakers believe that the late 1990’s can be repeated? Or was that period an aberration, and attempts to recreate that environment will only lead to higher inflation expectations?

I tend to believe that policymakers favor the latter interpretation. That implies if overall economic data points to stabilization in these measures, the Fed will be content to sit back after this next hike and wait to see how their medicine works. But if these measures continue to decline in concert with strong coincident and leading data, the Fed will feel obligated to move rates higher in March and possibly beyond. I believe this interpretation will not be well received by the labor market pessimists.

What about the employment to population ratio? PGL an Angry Bear points to a decline over the past five years as a sign of a weak labor market.  This short run view of the data raises the same question: Was the push higher in the late 1990’s a reflection of a once-in-a-generation stock market boom? Do we really want the Fed to recreate those conditions? Do we really expect them to? And a longer run view raises another batch of questions:

Employment to Population Ratio

Here you are stuck with disentangling the cyclical behavior with the secular trends.  If we attribute rising employment participation to increased female participation in the labor force, and if that trend has pretty much been maxed out while male labor force participation continues to slide, and we believe the boomers are starting to retire, then I am not sure we can expect much higher employment to population numbers short, again, of 1990’s style boom.

Similar thoughts can be said of Mark Thoma’s questions regarding stagnant numbers among marginally attached workers in the post below this one.  You have to raise the question of what type of environment is necessary to draw these workers back into the labor force, and will the Fed attempt to do so?

Truth be told, I honestly don’t know the “correct” level for any of these measures of the labor market. Nor would I, or anyone at the Federal Reserve, say the job market is as strong as in the late 1990s.  My point is that from a policy perspective, the last cycle may not be the relevant reference point.  Pointing to the Clinton Era might be like pointing to the 1980’s in Japan – remember when Tokyo had all the answers?  It was fun while it lasted, but it isn’t likely to happen again. If instead, we assume that the Fed sees labor markets as relatively healthy, and that they see this view as supported by rising wages (accelerating to 3.1% over the past year), then the next step for the Fed is to determine the impact on the inflation outlook. And that again raises enough questions to keep a central banker awake at night:

• To what extent do rising wages reflect productivity gains, tight labor markets, and pass through from this summer’s surge in headline inflation?
• How much of the wage gain will firms be able to pass through to core prices?
• Has past monetary policy already put enough tightening into the system to head off any pass through to core prices?
• What about the pressure exerted through rising commodity prices?  Note that oil prices are creeping upward toward $70 again.  Also watch metals (copper and gold).
• Is the housing market slowdown turning into a full blown bust?

With so many variables in play, it is not surprising that the Fed wants to change the game plan.  To date, policy has been driven by the desire to normalize interest rates. But now that we are at a more neutral level, the next policy steps aren’t so clear. This is why policy is now data dependent, and why anything beyond Greenspan’s final move is fuzzy.  [All Fed Watch posts.]

[Update from Mark Thoma: Dallas Fed president Richard Fisher and Boston Fed president Cathy Minehan gave speeches today (1/6/06) at the ASSA meetings in Boston. From Bloomberg:

"We may be entering a period in which policy changes are even more dependent than they have been on current readings of the economy, with all the uncertainty such readings can bring,'' Minehan said. "As the Committee's minutes have suggested and its recent policy statement confirms, its communication is evolving.''

And also:

Fisher didn't speak in any detail about the near-term course of interest-rate policy. Minehan said policy makers will have to watch economic data to determine their next steps now that the Fed has removed most of the "accommodation'' from the economy. Investors should understand that Fed statements aren't going to give them a clear road map of future rate moves in that environment, Minehan said.]

And Never is Heard a Discouraging Word?

[This originally appeared here. Brad DeLong is using it as part of his class at Berkeley on journalism and economics.  See here - the link is towards the bottom of the reading list.]

The Labor Department reported today that employment increased by 108,000 over November, a number that is lower than expected, and the unemployment rate held steady at 4.9%. This is a brief follow-up to PGL's post at Angry Bear on the unemployment, labor force participation, and discouraged worker numbers (Kash has more). A sign of an improving labor market is a fall in discouraged workers. However, according to today's report from the BLS:

Persons Not in the Labor Force (Household Survey Data)

The number of persons marginally attached to the labor force was 1.6 million in December, about the same as a year earlier. (Data are not seasonally adjusted.) These individuals wanted and were available to work and had looked for a job sometime in the prior 12 months. They were not counted as unemployed, however, because they did not actively search for work in the 4 weeks preceding the survey. Among the marginally attached, there were 451,000 discouraged workers in December, essentially the same as a year earlier. Discouraged workers were not currently looking for work specifically because they believed no jobs were available for them. The other 1.1 million marginally attached persons had not searched for work for reasons such as school attendance or family responsibilities. (See table A-13.)

It's puzzling why the number of marginally attached discouraged workers isn't falling if the labor market is strengthening. The news is a bit better relative to a year ago for part-time workers wanting to work full-time:

Total Employment and the Labor Force (Household Survey Data)

Total employment, at 142.8 million in December, was little changed over the month but was 2.6 million higher than a year earlier. The employment- population ratio held at 62.8 percent in December, 0.4 percentage point higher than a year earlier. The labor force participation rate, at 66.0 percent, was unchanged over the year. (See table A-1.)

The number of persons who work part time for economic reasons, at 4.1 million, was about unchanged in December but was down by 327,000 over the year. This category includes persons who indicated that they would like to work full time but were working part time because their hours had been cut back or because they were unable to find full-time jobs. (See table A-5.)

See PGL's post for a look at these figures over a longer time period. With both employment and real income behaving sluggishly by historical standards, the labor market is not as robust as would be expected in a recovery.

FedStuff: Santomero to Step Down, Auto Parts, Education, and ATMs

From the Philadelphia Fed web site:

Philadelphia Fed President to Leave Bank Next Year: Anthony M. Santomero, president of the Federal Reserve Bank of Philadelphia, announced that he will leave his position as president effective March 31, 2006 . Dr. Santomero has headed the Philadelphia Fed for nearly six years, and is completing his year as a voting member of the Federal Open Market Committee. “... The president’s choice of Ben Bernanke is an excellent one, and the Federal Reserve is in good hands. However, if I am to move on to one more new career, now is the opportune time to make the transition,” Santomero said. ...

And, as Bloomberg notes, Sanotmero was an advocate of explicit inflation targeting so his departure may change the degree of support for moving in this direction depending, of course, on the views of his replacement, and he is also relatively hawkish on inflation:

Santomero, Philadelphia Fed Bank President, to Step Down on March 31, Bloomberg: Federal Reserve Bank of Philadelphia President Anthony Santomero will leave his job March 31 ... The departure means Ben S. Bernanke ... will lose an ally in his effort to set a specific U.S. inflation target. ... "Santomero was an important supporter of inflation targeting,'' said Chris Rupkey, senior financial economist at Bank of Tokyo-Mitsubishi in New York. ... Santomero stressed the need for the Fed to raise rates to contain inflation in speeches this year. "It is incumbent upon the Fed to make every effort to keep these price pressures well- contained,'' he said in June remarks in Washington. ... "He took a consistently hard stance against inflation,'' said Mark Vitner, a senior economist at Wachovia Corp. in Charlotte, North Carolina. ... Of the 12 regional Fed presidents, Santomero is among the six who support creating some form of a numerical description of the Fed's low-inflation mandate. Bernanke backs the idea ...

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From the Chicago Fed:

Chicago Fed Letter A newsletter featuring an essay on economic policy issues of regional or national interest. January 2006

Competition and trade in the U.S. auto parts sector by Thomas H. Klier and James M. Rubenstein: Exports of U.S. made auto parts have stalled in recent years, while import levels of auto parts have continued to increase. The authors detail the magnitude and destination of U.S. imports and exports of specific auto parts in order to assess the challenges facing U.S. parts suppliers. (PDF,106KB)

Higher education and economic growth by Richard H. Mattoon: The future of higher education and its relationship to economic growth were the focus of a one-day conference at the Chicago Fed on November 2, 2005. Cosponsored by the bank, the Committee on Institutional Cooperation, and the Midwestern Higher Education Compact, the event brought together over 100 academic, business, and government leaders. (PDF,48KB)

Higher education and economic growth: A conference report by Richard H. Mattoon: This is an expanded summary of the conference on higher education that was held at the Federal Reserve Bank of Chicago on November 2, 2005. This edition is only available online. (PDF,69KB)

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From the San Francisco Fed:

FRBSF Economic Letter

Bank ATMs and ATM Surcharges This Letter reports on recent research into the proliferation of ATMs and the pricing schemes that accompany them, which sheds some light on how banks compete against each other in the current environment. — Gautam Gowrisankaran & John Krainer, Economic Letter 2005-36 (December 16)