Fed Watch: Fear Not Plosser

Tim Duy assesses the Fed's next moves in light of recent speeches by members of the FOMC and new data on the state of the economy:

Fear Not Plosser, by Tim Duy: Philadelphia Fed President Charles Plosser delivered a sobering speech today, including a reference to the 1970’s:

Unfortunately, I expect little progress to be made in reducing core inflation this year or next, and I am skeptical that slower economic growth will help. All you have to do is recall the 1970s when we experienced both high unemployment and high inflation to appreciate that slow economic growth and lower inflation do not necessarily go hand in hand. …

The speech threw cold water on today’s nascent equity rally, but was consistent with my expectations that Fed officials may try to reestablish some control over expectations. It did little to change my expectations: That the Fed will ease 50bp in March remains a safe bet. Plosser should be largely ignored, at least as far as the near term path of policy is concerned.

It is difficult to take Plosser’s warning seriously in the wake of the ISM service sector report. True, like its manufacturing counterpart, the prices paid index was less than comforting. But let’s just say that you believe that inflation is a problem, and likely to continue to be a problem. Fine – I think you can make a reasonable argument in that direction. But do you believe that the Fed Board shares your concern? Beyond, of course, the usual lip service about monitoring “inflation expectations?” Do you believe that, in the face of economic weakness, the Fed will be able to stand pat? Considering the direction and pace of recent policy, I see little reason to expect that Plosser’s warnings will be sufficient to forestall additional easing.

Consider also Senator Dodd’s meeting today with Fed Chairman Ben Bernanke, in which Dodd reached a certain understanding:

''The chairman is committed to using the tools available,'' said Dodd, a Connecticut Democrat. ''It's been evidenced already, and I'm confident he'll continue.''

Giving Bernanke the benefit of the doubt, he likely didn’t commit to additional easing. But Dodd is certainly leveraging market expectations to set the path toward additional easing. Also note that Dodd is holding up three Fed governor nominees, including the current Governor Randall Krozner. Senator Reid is also drawing a line in the sand on nominees. Indeed, I am surprised that we currently hear so little commentary about the possible erosion of Fed independence (although, arguably the Fed opened the door to such erosion when it abdicated regulatory responsibilities).

And note the Plosser’s message contained a “no recession” forecast. Considering that the ISM services number is a significant signal that a recession began in January, he may already be well behind the curve. Moreover, Bloomberg is reporting that the labor market is significantly worse than recent data would believe, as the exodus of the self-employed from the labor force (or, at a minimum, a significant reduction in their hours worked) is not accurately captured in the establishment data or initial unemployment claims. Yet another little twist from the nature of this downturn, as it hits an industry in which roughly 1 out of 6 workers is self-employed.

While Plosser might be off base with regard to near term policy, his longer term worries will appeal to inflation pessimists. There are a number of parallels with the 1970s, including a commodity price boom and slowing productivity growth. That, coupled with declining labor force growth, sets that stage for a substantial decrease in potential growth. Overall, I doubt very much that Americans will be happy with those rates of growth after the 1990’s boom, and there will be policy resistance. For example, note the difference between the Fed’s and the White House’s estimate of potential growth. Sure, 0.4 percentage points might not sound like much, but such policy mismatch can lead to a slow but steady increase in inflation over time. Moreover, note that this does not account for the weaker domestic demand growth necessary to adjust US consumption to production, or, in other words, eliminate the current account deficit. Lower domestic consumption growth will almost certainly meet with voter dissatisfaction.

In the near term, however, the inflation story will remain a risk second to the imperative of sustaining growth. Inflation is a potential story for 2009, at least as far as Fed policy is concerned. Indeed, the more bearish are moving in the direction of deflation predictions. And the government will soon be pulling out all the stops to boost spending power, via additional monetary easing and fiscal stimulus, to prevent any such outcome. I expect these forces to come into play gradually through the year, offsetting any real risk of deflation. Central bankers are far too willing to push liquidity into the system, and US banks are actively seeking funds from abroad to recapitalize (opposite of the behavior of Japanese banks in the 1990s), the combination of which will have a positive impact.

Adding to the current excitement is the often overlooked international dimension. There is clearly a growing concern about the weakness of the dollar, particularly against the European and Canadian currencies. From the WSJ:

"We don't want the euro to have to bear the brunt of currency adjustments by itself," German Deputy Finance Minister Thomas Mirow told reporters yesterday. A senior Canadian official complained this week about the spillover effects of the falling U.S. dollar, while French Finance Minister Christine Lagarde said last month that the euro is "a very strong currency" that disadvantages French companies.

Of course, the issue here is how are Europe and Canada aiding the US adjustment in the wake of the mortgage market collapse. There are two choices. The first is to accept the depreciation of the dollar and, and with it, recognize the Fed’s efforts at inflating the US economy are coming via a deflationary impact in the counterpart economy. The weak dollar stimulates an adjustment via an improvement in the US current account. Alternatively, a nation can fight the depreciation of the US dollar by purchasing US assets and thus supporting (or maybe simply preventing) the US adjustment by sustaining those capital inflows that support the US current account deficit. See Brad Setser for recent evidence on these approaches.

The European Central Bank, and, to a lesser extent, the Bank of England, choose the first approach, while China, oil exporting nations, and anyone else holding a dollar peg choose the second. Europeans are growing unhappy with this approach, and the expectation is that the ECB and BOE will have to relent, which has limited the Greenback’s fall in recent weeks, and redirect some fixed income flows back to the US by cutting rates. The ECB will be unhappy if forced down this road, especially considering their credibility on inflation fighting is being called into question. Alternatively, the ECB could just join the party and accumulate US assets and sterilize the monetary stimulus on the other side. Given the anticipated explosion in US fiscal red ink, there will be plenty of Treasury bonds to go around.

Note the growing calls to recognize the fundamental US problems as that of an emerging market undergoing a currency crisis. See for example Kenneth Rogoff and Ricardo Hausmann.

In other words, things are a complete mess. The housing bubble adjustment is not simply domestic in nature. The excessive consumption driven by the bubble was being supported by a steady stream of capital inflows, the mortgage-related portion of which dried up. To offset the adjustment, the Fed is cutting rates aggressively, driving down the Dollar in some cases and in others forcing foreign central banks to purchase Dollars, reducing the external imbalance on one hand and supporting it on the other. US fiscal policy will soon be attempting to offset the adjustment as well, flooding the markets with additional paper. And if the first round fails to hold, expect another. This stimulus will be hitting the US economy with an uncertain impact just as the potential growth rate appears to be decelerating. Through it all, US policymakers across the board appear to believe that the rest of the world will accept this state of affairs indefinitely. And as long as the rest of the world does, I imagine we can keep the party going.

Bottom Line: I anticipate the Fed will be forced into additional rate cuts, with a total of another 100bp a reasonable bet. The Fed left itself little choice but to drive rates down to ultra-low levels by cutting rates so aggressively before confirmation of recession. This is forcing the rest of the world to deliver substantial stimulus as well, with the ECB perhaps the next domino to fall. I do not believe this stimulus will be ineffectual. But I do not look for a pleasant economic environment on the other side.

I believe I underestimated the willingness of US policymakers to resist the adjustment necessary to bring internal demand in line with internal production. I suspect they will remain unwilling to change course unless significant signs of inflation arise.  On the other hand, if growth rebounds sooner than anticipated, the John Berry scenario, the Fed may tighten as quickly as it eased. I assign a low probability to this scenario.

I sound downright dismal tonight; information overload, perhaps, as I try to pull all these pieces together.

Comments

[Bruce Wilder]

TD: "I believe I underestimated the willingness of US policymakers to resist the adjustment necessary to bring internal demand in line with internal production. I suspect they will remain unwilling to change course unless significant signs of inflation arise."

I actually think a higher rate of inflation is an appropriate response to circumstance. Not being able to acknowledge an inflationary policy is just the beginning of a resistance to reality and a moral cowardice, which characterizes the whole policy muddle.

[Mike]

I broadly concur.

There is no pretty way out of this. The optimists seem to believe there will be a short downturn, no recession, then back to business as normal by H2 this year. This is despite of rising unemployment, high food and energy inflation hitting poorer consumers hard, and of course falling house prices. Of course, the Fed and the White House have already exposed themselves as both cowards and hypocrites and are willing to go whatever route is necessary to try to keep spending around US$1.07 for every US$1.00 they earn. And they may even have enough military muscle and economic blackmail potential ("we will stop buying your products!") to get away with it.

But if they do, then the inflation genie will be well and truly out if the bottle. I mean, with 4%+ headline CPI already, imagine where we go from here if growth takes off again with rates at around 2% (or 1%!) - and especially if rates CAN'T rise again because it would just see a re-run of what we are currently experiencing. US$200pb oil over time?

Seriously, I really would like an intellectually honest answer as to how we get out of this without either (i) recession and deflation, or (ii) a debasing of the USD and huge inflation. "Growth will be better in H2" just doesn't do it for me, somehow. Decoupling and Asians suddenly becoming consumers? Seems unlikely given China's huge structural problems and 'game plan', doesn't it?

[esb]

Tim, Tim, Tim ... you have finally come around to my way of thinking.

The boys and girls in the Marriner S. Eccles building are going to replay "that 70s show."

With the same outcome, of course.

The question is, why?

And I believe the answer is that the post-WWII US-centric economic expansion has come to an end.

And that, my friend, is a very, very and very hard thing to swallow. Nations that have enjoyed hegemony do not fall down gracefully. Usually they go down shooting, both monetary projectiles and those of a more lethal kind. Hell, we're doing both right now.

In any event, I suggest that each and every one of you visiting here, through a "proxy" of course, position yourself to take advantage of the "gifting of a house" which will be available to first-time buyers in Q2 2009 under the "New New Deal." And for those of you unwilling to compromise your integrity, position yourselves in inflation hedges (with as much leverage as you can manage) in Q1 2009.

Because, well, why should any of us go down with the ship?

[Bruce Wilder]

esb: "The boys and girls in the Marriner S. Eccles building are going to replay "that 70s show."

"With the same outcome, of course.

"The question is, why?

Because they are Republicans, and the last time, the outcome was Reagan and a huge redistribution of income and wealth upward.

[spencer]

I can understand the worries about a repeat of the 1970s, but let me suggest a different approach.

I'm much more worried that we are sliding into a Japanese style stagnation-depression. Japan had it technology- housing bubbles concurrently and it left them with a 15 year hangover. the US has had its technology-housing bubbles serially. So what are the differences? What will be the source of growth that will cause the US to experience an inflationary cycle--a plunging dollar and import replacement? I'm much more concerned that the US has nothing to generate growth in the next cycle and we will come out of this downturn with no growth and deflation.

KMZM seems to have this concern at times, but why does nobody else seem to worry about this possibility?

[The Trust is Gone]

TD..."The housing bubble adjustment is not simply domestic in nature. The excessive consumption driven by the bubble was being supported by a steady stream of capital inflows, the mortgage-related portion of which dried up."

American workers are no longer willing to consume less than they produce, because they have no way to safely store purchasing power for the future. Consume what you produce today, or you will lose it. Foreign workers are no longer willing to loan excess production to US workers, because they have lost hope of one day being paid back the production they loaned. Coercive measures are now being implemented.

[robertdfeinman]

Why is Plosser talking about core inflation? According to Mark Thoma economists (as opposed to reporters and pundits) understand that this is just a useful forecasting tool.

So is Plosser just saying that the tool has become less accurate because some of the components it ignores aren't following traditional patterns (that is trending upward continuously instead of fluctuating around a longer-term trend)?

It would seem not, as he talks about reducing "core" inflation specifically. Just when I thought I understood the role of core inflation I've gotten confused again.

Or is he saying that since the Fed can't do anything about the cost of international commodities like fuel and food they will have to make up for it by throwing people out of work as they squeeze the economy in the areas where they can exercise influence?

[kharris]

I am engaged in a campaign against taking the January ISM non-factory survey seriously. In order to take the January results seriously, you have to believe one of two things. The first possibiliity is that the January result is an accurate reflection of conditions in the economy, but that the preceeding half year of very steady, non-volatile ISM readings were wrong. If you believe that, you are really imposing a view on the data, rather than taking the data at face value.

The other option is to believe that the ISM non-factory survey has been right all along. There was a very modest deterioration in economic conditions through the second half of the year, accompanied by a drastic reduction in the volatility of economic performance, and then the bad news pounced in January. The nation's economy went from modest growth in December to serious contraction in January.

I don't find the second option credible. The sharp reduction in GDP growth in Q after the rapid rise in Q3 should be reflected in a more volatile ISM series. It ain't there. If the data from the prior 6 months were nor prepresentative of underlying economic activity, there is no justification for taking the January ISM non-factory survey seriously. That leaves the first option, which is that we are simply agreeing with the ISM results because we think they are right now, even though they were wrong before. We can assert our own views without the help of the ISM data.

[hari]

The British Central Bank cut rates by 25bp today.

ECB left its rate untouched saying the downside risk is now bigger. But ECB is trying to contain short-term inflationary spiral across EU-15 (those members adopting euro currency).

Fx markets ended-up striking euro down almost 2% close to 1.4 to dollar. Meanwhile dollar gained against all its trading partners. This tendency is good for euro because it doesn't exacerbate the problems with exports from EU.
Remember it had reached 1.9 just few days ago!

[taq]

Thank you, Dr. Du, once again, for an excellent analysis.

I am fearful regarding the long-term effects of our current policies, which do not appear to support long term investment where it would most benefit the american or world economy. The misallocation of US and world resources is widely discussed on this an related blogs. Chalmers Johnson's recent article further implicates this profligacy.

In trying to understand the effects of policy on our economy (I am personally more concerned about the world my children live in than my own), i reread a statement from Brad DeLong's blog:

" I tell my undergraduates:
• At a time horizon of 0-3 years, be a Keynesian: the most important things are the fluctuations in unemployment, in real demand, and in capacity utilization.
• At a time horizon of 3-8 years, be a demand-side monetarist: you can assume (provisionally) that fluctuations in employment, real demand, and capacity utilization die out; the most important things are the fluctuations in the composition of real demand (investment vs. consumption vs. government vs. net exports) and in inflation- and deflation-causing nominal demand assuming (provisionally) stable growth of the economy's productive capacity.
• At a time horizon of 8 years or greater, be a sane supply-sider: the most important things are the processes of investment in physical, human, and organizational capital that raise the economy's productive capacity.
Thus I was happy telling my undergraduates in 1985 that the reason the dollar was strong was because of the five years of Reagan deficits--high domestic interest rates, you see, pushing up the value of the dollar (and raising the trade deficit). And I was happy in 1992 telling my undergraduates that the reason the dollar was weak was because of the twelve years of Reagan-Bush deficits--large budget deficits starving the economy of capital that made us less productive than in some counterfactual in which we had elected some Eisenhower Republican in 1981."

As I see it all the actions currently being undertaken will likely benefit us in the next three years, maybe eight, but will it not actually harm the economy in the long-term? Is there not a way to allow the painful reallocation pushing the weight of the pain towards the wealthy (myself included)who have benefitted the most in the short term from this misallocation? Decreasing the value and quality of the capital base from which my children will earn a living and increasing their financial obligation (increased federal debt) seems like taxation without representation in the worst way.

Why not take 75% of all income over, say, $600,000/year (retroactively tax) over the last 10 years and disburse that to the (employable)unemployed in return for labor on our decaying infrastructure?

Although, i think the process should have been started 18 months ago, when the Feds still thought the risk of inflation outweighed growth risks, that would help in the short and long term, no?

[Public Works Projects]

taq..."Why not take 75% of all income over, say, $600,000/year (retroactively tax) over the last 10 years and disburse that to the (employable)unemployed in return for labor on our decaying infrastructure?"

I'm not sure a retroactive tax would work. However, using a higher tax on 600k plus incomes to employ the unemployed in public works projects would make more sense than the current system. It would at least have the merit of taking purchasing power from those who could afford it, and directing the funds toward activities that may bear future fruit.

[calmo]

Plosser should be largely ignored, at least as far as the near term path of policy is concerned.No problem with my attention span, now where were we?
O yes, back in the 60s rotflol from a similar (near term path or faint recollection) quip from a student who responded to a volley from a fellow student, an ardent Baptist, who opined at some length and some fervor, that without the New Testament, the Bible would be just such an unbearable bore. That quip: "With or without the New Testament." The philosophy prof nearly swallowed his pipe, but it was one of those TKOs in which humor trumps any rational, any rigorous, logical response.
So important to keep those funny bones in shape...you hear me, you unticklables?

[billy]

Because they are Republicans, and the last time, the outcome was Reagan and a huge redistribution of income and wealth upward.

Quibble there. The outcome is already baked in. The time to raise the warning was 5 years back, not now. Now the script just has to be executed.

When will economists admit that Greenspan is a crook, and the lopsided policy to deal with bubbles eventually concludes in a repeat of the 70s?

I actually think a higher rate of inflation is an appropriate response to circumstance. Not being able to acknowledge an inflationary policy is just the beginning of a resistance to reality and a moral cowardice, which characterizes the whole policy muddle.

Hah! Acknowledging that means that monetary policy + regulatory position of the Fed, for the last decade, was all hogwash.

It's not because of any fear of inflation expectations getting out of hand. It is simply an arrogance that never admits mistakes.

Do you hear of anyone being held accountable for the Iraq mess? No. It's all about winning now, and coming out with intact honour. The people who protested are still called dirty f##ing hippies.

Like that, it is all about saving the system now. The people who called out Greenspan and the Fed's dirty tricks will always be called 'nuts', goldbugs, 'moral hazardists' and ridiculed.

The policy that really created this mess and the people who drove that policy - will they be discredited? No way. In due time it will be resurrected again. For another repeat of the show.

To understand this, look at this spiel about the Fed's new mortgage rules by Kozner, and how, even after all this $hit has occurred, they still push the kool-aid that the market is going to fix all this. (http://www.federalreserve.gov/newsevents/speech/kroszner20080204a.htm)

For a take on how toothless and spineless that new regs are (and that too after sitting on that power to regulate till the horse left the barn) read, http://calculatedrisk.blogspot.com/2008/02/kroszner-on-proposed-mortgage.html

So leave out all the nuts, gold-bugs, fire-and-brimstone punishments gluttons. Inflate or deflate or whatever. Fix the mess.

But alongwith that, can economists stand up and acknowledge that the Fed under Greenspan was running a crooked policy to move wealth upwards? That it was a mistake, and what was being pushed was kool-aid?

Or has Economics now become a religion, that admits no mistakes, and tolerates no heresies?

[calmo]

spencer remarks I'm much more concerned that the US has nothing to generate growth in the next cycle and we will come out of this downturn with no growth and deflation. and I wonder if the "nothing" is always that speck on the horizon before it is confirmed as The Next Big Thing.
The worse view: the Thing on our plate now that is thoroughly undigestable, the Housing Market, has turned rancid --incapacitating our ability to ignite any little specs on the horizon. Not only was it a crummy Next Big Thing, it morphs into a dangerous blob (the spirit of Roubini is upon me) for the next business cycle...postponed until further notice.
With the IT boom, we acquired vastly improved communication skills (lookit kharris' "It ain't there." and see if it ain't so), in contrast to this improvement in housing stock that gave us such wonders as the TanMan and took mosquitoes off the endagered species list...maybe mo.
So all those realtors might go back to their previous employment where they actually performed and were not merely paid? where they made a contribution from honest-to-god real contributions (that needed no marketing to make up for serious deficiencies in that department)? where productive humans (not just illegal aliens) actually took note and counted those hours as the deployment of human resources?
The worse view: the IT boom was vastly over-rated...not worth the piles spent then nor the piles later as that sloshed into housing...not worth incapacitating the consumer. BB's famous (and crowding out) "Savings Glut" in China is cover for the Consumer Bloat now coming to a close, yes?

[calmo]

I wonder if kharris poses that dilemma with the knowledge that ISM revised the NMI weightings of those subcomponents?
http://www.reuters.com/article/pressRelease/idUS205781+18-Jan-2008+BW20080118
JDH at Econobrowser has a graph of your heartbeat concerns about this matter and waits to see if that plunge will be born out by retail numbers. I find his mention of the writer's strike almost comical as a possible explanation for this dive in non-manufacturing, but maybe I should consider how many service providers are now suffering serious bouts of entertainment withdrawal...I know I am.
I am again reminded of spencer's opinion of the deteriorating data collection...which seems to be kh's conclusion: ISM data is not inspiring confidence.