Saturday, January 19, 2013
Tuesday, January 08, 2013
Inflation versus Price-Level Targeting in Practice, by David Altig and Mike Bryan: In last Wednesday's Financial Times, Scott Sumner issued a familiar indictment of "modern central banking practice" for failing to adopt nominal gross domestic product (GDP) targets, for which he has been a major proponent. I have expressed my doubts about nominal GDP targeting on several occasions—most recently a few posts back—so there is no need to rehash them. But this passage from Professor Sumner's article provoked my interest:
Inflation targeting also failed because it targeted the growth rate of prices, not the level. When prices fell in the U.S. in 2009, the Federal Reserve did not try to make up for that shortfall with above target inflation. Instead it followed a "let bygones be bygones" approach.
In principle, there is no reason why a central bank consistently pursuing an inflation target can't deliver the same outcomes as one that specifically and explicitly operates with a price-level target. Misses with respect to targeted inflation need not be biased in one direction or another if the central bank is truly delivering on an average inflation rate consistent with its stated objective.
So how does the Federal Reserve—with a stated 2-percent inflation objective—measure up against a price-level targeting standard? The answer to that question is not so straightforward because, by definition, a price-level target has to be measured relative to some starting point. To illustrate this concept, and to provide some sense of how the Fed would measure up relative to a hypothetical price-level objective, I constructed the following chart.
Consider the first point on the graph, corresponding to the year 1993. (I somewhat arbitrarily chose 1993 as roughly the beginning of an era in which the Fed, intentionally or not, began operating as if it had an implicit long-run inflation target of about 2 percent.) This point on the graph answers the following question:
By what percent would the actual level of the personal consumption expenditure price index differ from a price-level target that grew by 2 percent per year beginning in 1993?
The succeeding points in the chart answer that same question for the years 1994 through 2009.
Here's the story as I see it:
- If you accept that the Fed, for all practical purposes, adopted a 2 percent inflation objective sometime in the early to mid-1990s, there arguably really isn't much material distinction between its inflation-targeting practices and what would have likely happened under a regime that targeted price-level growth at 2 percent per annum. The actual price level today differs by only about 1/2 to 1 1/2 percentage points from what would be implied by such a price-level target.
Hitting a single numerical target for the price level at any particular time is of course not realistic, so an operational price-level targeting regime would have to include a description of the bounds around the target that defines success with respect to the objective. Different people may have different views on that, but I would count being within 1 1/2 percentage points of the targeted value over a 20-year period as a clear victory.
- If you date the hypothetical beginning of price-level targeting sometime in the first half of the 2000s, then the price level would have deviated above that implied by a price-level target by somewhat more. There certainly would be no case for easing to get back to the presumed price-level objective.
- A price-level target would start to give a signal that easing is in order only if you choose the reference date for the target during the Great Recession—2008 or 2009.
I'm generally sympathetic to the idea of price-level targeting, and I believe that an effective inflation-targeting regime would not "let bygones be bygones" in the long run. I also believe that the Federal Open Market Committee (FOMC) has effectively implemented the equivalent price-level target outcomes via its flexible inflation-targeting approach over the past 15 to 20 years (as suggested in point number 1 above).
In fact, the FOMC has found ample scope for stimulus in the context of that flexible inflation targeting approach (which honors the requirements of the Fed's dual mandate of price stability and maximum employment). I just don't think it is necessary or helpful to recalibrate an existing implicit price-level target by restarting history yesterday.
Wednesday, December 19, 2012
Why would a reputable economist endorse nonsense like this from Mickey Kaus (you know who you are):
If increased concentration lets ”corporations use their growing monopoly power to raise prices” couldn’t that be, you know, inflationary? But Krugman’s spent another trillion pixels lecturing us about how inflation is not a threat. Discuss.
One possible answer, Krugman Derangement Syndrome. [There's more nonsense where that came from, and not just in this article, but I just can't link the Daily Caller in good conscience.]
Monday, December 17, 2012
The Fed rolls the dice, by Robert J. Samuelson, Commentary, Washington Post: It was big news last week when the Federal Reserve announced that it wants to maintain its current low-interest rate policy until unemployment, now 7.7 percent, drops to at least 6.5 percent. The Fed was correctly portrayed as favoring job creation over fighting inflation, though it also set an inflation target of 2.5 percent. What was missing from commentary was caution based on history: the Fed has tried this before and failed — with disastrous consequences.
By “this,” I mean a twin targeting of unemployment and inflation. In the 1970s, that’s what the Fed did. Targets weren’t announced but were implicit. The Fed pursed the then-popular goal of “full employment,” defined as a 4 percent unemployment rate; annual inflation of 3 percent to 4 percent was deemed acceptable. The result was economic schizophrenia. Episodes of easy credit to cut unemployment spurred inflation... By 1980, inflation was 13 percent and unemployment, 7 percent. ...
Today’s problem is similar. Although the Fed has learned much since the 1970s ... its economic understanding and powers are still limited. It can’t predictably hit a given mix of unemployment and inflation. Striving to do so risks dangerous side effects, including a future financial crisis. ...
It’s seductive to think the Fed can engineer the desired mix of unemployment and inflation. And the motivation is powerful. About 5 million Americans have been jobless for six months or more. The present job market represents, as Bernanke said, “an enormous waste of human and economic potential.” But the Fed is bumping against the limits of its powers. Are potential short-term benefits worth the long-term risks? It’s a close call.
What does he think a dual mandate means if not the "twin targeting of unemployment and inflation"? That's not unique to the 1970s, it's essentially the Taylor rule (the Taylor principle comes into play as well, but I want to focus on something else). Anyway, he is trying to tell the story about shifting Phillips curve due to rising inflationary expectations, but he misses a key part of the story. A popular explanation for problems in the 1970s, one I think has a lot of veracity, is that the Fed was shooting at the wrong unemployment target (you can find this story in most textbooks, e.g. see Mishkin's text on demand-pull inflation). The Fed was shooting at a 4 percent unemployment target, but because of a large influx of new workers from the baby boom and women entering the workforce, the natural rate of unemployment was actually much higher than 4 percent (new workers tend to have high frictional unemployment rates, and there were also structural changes going on within the economy that led to a higher natural rate of unemployment as well). All told, it's not unreasonable to think of the natural rate had drifted as high as 7 percent, maybe even higher. It eventually came down to closer to 4 percent as the surge of new workers ended and structural change abated somewhat, but for awhile it was elevated above the Fed's 4 percent target. Unfortunately, the Fed didn't not realize this.
Here's how the story goes. The Fed, seeing unemployment drifting toward its natural rate of, say, 7 percent responded to its full employment mandate by using more aggressive policy to create inflation. In the short-run, the policy worked, unemployment did fall due to the inflationary surprise, but as soon as people adjusted their inflationary expectations (and demanded higher wages, etc.), the Phillips curve shifted and we ended up with the inflation we wanted, but the employment gains were lost as the unemployment rate moved toward its natural rate of 7 percent. At that point the Fed says to itself, we must not have been aggressive enough, we need a second round of stimulus and it pumps up the inflation rate even further. Again, this works so long as the inflation is a surprise, unemployment falls in the short-run, but as soon as inflationary expectations adjust once again the employment gains are eliminated, but the inflation remains. As this continues, inflation continues to drift upward until eventually we end up with double-digit inflation and nothing whatsoever to show for it in terms of employment gains.
The fundamental problem here is a miscalculation of the natural rate of the natural rate of unemployment. So the question is, has the Fed made this mistake again? Is the natural rate of unemployment a lot higher than 6.5 percent so that shooting for this target is likely to end up with double-digit, 1970s type inflation?
No for several reasons. First, the Fed is fully aware of this past mistake, and many opposed more stimulus for precisely this reason (e.g. Narayana Kockerlakoata would not support more stimulus until Bernanke convinced him in a series of phone calls that the employment problem was largely cyclical, not structural). If they are shooting at the wrong target, then the policy will not work and they will not continue doing so as they did in the 1970s. They are much more aware of the signs to look for that indicate they've made this mistake. Second, there has been considerable effort to measure the structural/cyclical/frictional unemployment mix for precisely this reason, and the estimates, for the most part, point to a mostly cyclical problem. We didn't have this type of information in the 1970s, in fact we weren't even asking this question. We simply assumed that full employment meant 4 percent and set policy accordingly. Finally, there is an inflation threshold of 2.5 percent, a relatively low level of tolerance for mistakes of this type. If the Fed is wrong about the structural rate, we'll see inflation, and if it the projected inflation rate drifts above 2.5 percent, the program will be reversed. I have no doubt that the Fed is serious abut pulling the plug if inflation rises above 2.5 percent. That's true even if unemployment is still above 6.5 percent.
Samuelson can worry all he wants, he's good at playing the Very Serious Person role (inflation is coming!, the debt will cause interest rates to spike!, there could even be "dangerous side effects, including a future financial crisis"!), but the Fed is not risking a repeat of the 1970s, not even close.
Update: Dean Baker comments on the Samuelson article.
Thursday, December 13, 2012
Paul Krugman on the Fed:
Bernanke’s Non-Stupidity Pact: So, how big a deal was yesterday’s Fed announcement? Philosophically, it was pretty major; in terms of substantive policy implications, not so much.
What the Fed did was pledge not to raise rates until unemployment is considerably lower than it is now, or inflation is running significantly above the 2 percent target. One fairly important wrinkle I haven’t seen emphasized: the inflation criterion was couched in terms of the inflation projection, rather than past inflation. This would let the Fed hold rates low even in the face of a blip caused by, say, a sharp rise in commodity prices.
It’s fairly clear — although not explicitly stated — that the goal of this pronouncement is to boost the economy right now through expectations of higher inflation and stronger employment than one might otherwise have expected. ...
What do we know about the expectations channel? Larry Ball via Greg Mankiw:
Interpreting the Fed: My friend and sometime coauthor Larry Ball sends me his quick analysis of the Federal Reserve's recent announcement:
I think the FOMC announcement is big news: for the first time, the Fed clearly says it will be more dovish in the future than the pre-crisis Taylor Rule (TR) dictates. ...
This deviation from the TR has not happened since the TR was discovered. In particular, the Fed was NOT more dovish than the TR in 2003. ...
It is not clear whether the Fed’s announcement of future dovishness will have significant effects today. The efficacy of announcements about future monetary policy is unproven.
There are two expectations channels here. One is expected inflation (the traditional channel), the other is "stronger employment than one might otherwise have expected" due to interest rates staying lower for a longer period of time than might have otherwise been expected (this is the channel that many at the Fed are relying upon). We have little evidence on this latter channel. As for the traditional channel, it may be difficult to move inflation expectations now that they "are almost perfectly anchored" (there is much more background and explanation in the article):
Inflation Expectations Have Become More Anchored Over Time, Economic Letter, by J. Scott Davis, FRB Dallas: The Organization of Arab Petroleum Exporting Countries imposed an oil embargo on the United States in October 1973 in response to U.S. support of Israel during the Yom Kippur War. The embargo was lifted in March 1974, and although it lasted less than six months, the effects on inflation and inflation expectations in the United States would persist for a decade.
Oil prices spiked, increasing by more than 350 percent from June 1973 to June 1974, propelling a sharp increase in U.S. inflation (Chart 1). Consumer prices jumped 12 percent in 1974, from a 3 percent rise in 1972. Although the 1973 oil price shock was transitory—the price of oil declined over the next two years—inflation proved more persistent. After exceeding 5 percent in 1973, it didn’t fall below that level again until 1982.
The experiences of the 1970s show that when inflation expectations become unanchored, they may become self-fulfilling, or in the words of former Federal Reserve Chairman Paul Volcker, “inflation feeds in part on itself.” This helps explain how a transitory oil price spike in 1973—along with a second oil shock in the late 1970s (associated with the 1979 Iranian Revolution)—could lead to a decade of high inflation. Over the past 30 years, Federal Reserve policy has succeeded in better anchoring inflation expectations, producing diminished expectations that a short-term shock leads to sustained high inflation. ...
Measuring Inflation Anchoring
One way to gauge such anchoring is calculating the responsiveness of expected inflation in the next few years to a shock to current inflation. If expectations are well-anchored, the response will be minimal. ...
A plot of the changes in the five-year-ahead, five-year-forward expected inflation rate shows that during the early part of the 1983–2011 period, long-run inflation expectations were quite variable and highly correlated with unexpected inflation (Chart 3). For instance, in early 1984, when inflation turned out to be almost 1 percentage point higher than expected, the expectation of long-run inflation also increased by nearly 1 percentage point. A few years later, in 1986, when inflation turned out to be 3 percentage points lower than expected, people reduced their expectations of long-run inflation by 1 percentage point.
The chart shows that over this nearly 30-year sample, long-run inflation expectations became less volatile and less responsive to surprises in current inflation. For example, between 2008 and 2011, unexpected inflation fluctuated: 3 percent in 2008, negative 5 percent in 2009, 3 percent in early 2010, negative 2 percent later in 2010 and 3 percent in 2011—yet, long-run inflation expectations over this period, as measured by revisions in the five-year-ahead, five-year-forward rate, barely moved.
The statistical methodology of ordinary least-squares regression allows analysis of the relationship between two or more variables. This “averaging” tool helps measure how short-run surprises affect long-term inflation expectations. For example, if inflation over the past year is 1 percentage point higher than expected, the least-squares regression results show that people tend to raise their long-run expectations by some number γ of percentage points—for 1983–2011, γ is 0.11 (Table 1). This means that, on average over the period 1983 to 2011, a 1 percentage point surprise in the inflation rate raised long-term inflation expectations by 0.11 percentage points. The smaller the value of γ, the more anchored are long-run inflation expectations—if γ is not significantly different from zero, then long-run expectations are perfectly anchored.
Anchoring of inflation expectations over the past 30 years has changed markedly, as shown by the results in the bottom half of Table 1. In the 1980s, confronted with a 1 percentage point higher-than-anticipated inflation rate, people boosted their expectations for long-run inflation by 0.28 percentage points. However, since 2000, people raise their expectations by about 0.03 percentage points following a similar surprise, suggesting that long-run expectations are almost perfectly anchored.
As few as 30 years ago, long-run inflation expectations were quite responsive to short-term shocks. Over the ensuing period, the Fed has been better able to anchor such expectations so that now long-run expectations barely change following a series of dramatic, but ultimately transitory, inflation surprises. ...
Gas Prices Falling: Gas prices continued to decline last week, falling to the bottom of the roughly $3.50-$4.00 range of the past two years:
Ever notice that when gas prices rise, Fed critics starting jumping up-and-down and screaming inflation, but never say a word about deflation when gas prices fall?
Tuesday, November 20, 2012
This is a bit technical at times, but it makes an important point that is a bit buried in the discussion that I'd like to highlight.
The first step in the discussion is to explain what a non-linear Phillips curve is, and why a non-linear specification is needed:
Compensation Growth and Slack in the Current Economic Environment, by M. Henry Linder, Richard Peach, and Robert Rich, NY Fed: ...Our analysis is based on the estimation of a nonlinear wage-inflation Phillips curve that draws upon the modeling approach outlined in a Boston Fed paper by Fuhrer, Olivei, and Tootell. The key feature of the nonlinear Phillips curve is that the impact of a change in slack depends on the level of slack. These features are illustrated in the chart below, where the slope of the Phillips curve becomes steeper as the unemployment rate moves further below the natural rate of unemployment (higher resource utilization), while the slope becomes flatter as the unemployment rate moves further above it (lower resource utilization).
Why might the Phillips curve flatten out as the unemployment rate rises further above the natural rate of unemployment? As a reminder, what matters for labor market decisions is the real wage rate—the nominal wage adjusted for the price level (or cost of living). One explanation for the flattening of the Phillips curve is downward real wage rigidity—that is, a more sluggish response of real wages when the unemployment rate is high (see the Boston Fed paper by Holden and Wulfsberg for a more detailed discussion of theories of real wage resistance during an economic downturn). In a situation of high unemployment, wage growth becomes relatively stable around the recent level of underlying inflation, so that real wages don’t fall sufficiently to clear the labor market.
Here's how they estimate the non-linear Phillips curve and an explanation of why the sample begins in 1997:
Our Phillips curve model relates four-quarter growth in nominal compensation per hour (for the nonfarm business sector) to economic slack, controlling for movements in trend productivity growth and expected inflation. Our measure of slack is the Congressional Budget Office (CBO) estimate of the unemployment gap—the percentage point deviation between the actual unemployment rate and the CBO estimate of the natural rate of unemployment. For trend productivity growth, we use an average of the (annualized) quarterly growth rate of productivity. For expected inflation, we construct a ten-year personal consumption expenditure (PCE) survey measure by adjusting the Survey of Professional Forecasters’ ten-year expected CPI inflation series to account for the average differential between CPI and PCE inflation. As the chart below shows, expected inflation has been extremely stable during the post-1997 period. To provide additional observations for estimation and to conduct the analysis in a low-inflation environment with well-anchored expectations, we use data that cover the period from 1997 through the present.
Our model relates economic slack to an adjusted compensation measure, where we subtract the values of trend productivity growth and expected inflation from the compensation growth series. This adjustment imposes the standard restriction that increases in the real wage rate equal increases in labor productivity in the long run. The chart below provides a scatter plot of the adjusted compensation growth series and the unemployment gap. Negative (positive) values of the unemployment gap represent conditions in which unemployment is below (above) the natural rate of unemployment.
The estimated Phillips curve should have the shape predicted above, and it does:
An examination of the scatter plot shows that the general shape of the data points bears a close resemblance to the chart of the nonlinear Phillips curve, and estimation of the model provides evidence of a statistically significant nonlinear relationship between (adjusted) compensation growth and slack. ...
We also consider two additional criteria to evaluate the nonlinear Phillips curve model—within-sample fit and out-of-sample forecast performance. The within-sample fit is based on estimation of the model using data from the full sample to compare the predicted and actual values of growth in compensation per hour. The out-of-sample forecast performance is based on estimation of the model only using data through 2007:Q4 on the unemployment gap, trend productivity growth, and expected inflation. With the resulting estimated model, we input the actual values of the unemployment gap, trend productivity growth, and expected inflation during the post-2007:Q4 period to generate forecasts of compensation growth. The first forecast corresponds to compensation growth from 2008:Q1 to 2009:Q1.
The next chart plots the four-quarter change in compensation growth, the within-sample predictions, and the post-2007:Q4 out-of-sample forecasts. While the within-sample predictions fail to track some short-run movements in compensation growth, they do capture the general movements in the series. Moreover, both the within-sample predictions and out-of-sample forecasts capture the magnitude of the decline in compensation growth since 2008 as well as its subsequent stability.
Our analysis suggests that a nonlinear wage-inflation Phillips curve fits the data well during the post-1997 episode and complements the results of Fuhrer, Olivei, and Tootell, who find evidence of a nonlinear relationship between price inflation and activity gap measures.
Here's what I want to highlight:
An important conclusion from our analysis is that recent stability in the growth rate of labor compensation measures may not be informative about the extent of slack or its change. That is, stability in labor compensation measures doesn’t imply that the output gap has closed, while changes in the output gap may only have a modest impact on compensation growth.
They also note that this implies real rather than nominal wage rigidity:
In an inflation environment where actual and expected price changes are low, someone might interpret the earlier scatter plot as reflective of downward nominal wage rigidity—the idea that workers and firms have incentives to avoid reductions in nominal wages. However, the nonlinearity between wage growth and slack appears to be evident in other episodes in which large fluctuations in real activity were accompanied by high inflation and high compensation growth (this point is also discussed by Fuhrer, Olivei, and Tootell). Thus, the mild trade-off between compensation/wage growth and resource slack when slack is sizable isn’t unique to recent experience. Moreover, the source of the nonlinearity must stem from downward real wage rigidity, as downward nominal wage rigidity can generate this feature only in a low-inflation environment.
They conclude with:
We recognize that our analysis comes with important caveats... Nevertheless, if the nonlinear relationship between slack and wage/price inflation is an important feature of the data, then it will be critical for policymakers to identify other indicators that may be more responsive to slack and provide a quick and more reliable read on its movements.
It is not surprising at all that wage movements would be uninformative about labor market conditions when wages adjust sluggishly to economic conditions, but the prevalence of claims about the condition of the labor market based upon measures of compensation is a signal that people have missed this point. There can be both considerable slack in the economy (so let's do something about it), and relatively stable wages.
Friday, November 02, 2012
The Economist asks:
Above-normal inflation has been proposed as a solution (or salve) to a number of the rich world's economic problems. In conjunction with financial repression, it could help erode sovereign debt loads. In the euro area, differential inflation could facilitate rebalancing. It could help lower real interest rates in economies up against the zero lower bound, and it could help facilitate real wage adjustments in economies plagued by nominal wage stickiness. Of course, there are risks to higher inflation, including efficiency costs and the possibility that "de-anchored" inflation expectations could be difficult and costly to contain.
Will the rich world use above-normal inflation as a way to address economic ills? Should it?
Here are the responses, including mine:
- We need a normal price level - Brad DeLong
- Better to renege on citizens than on bondholders - Ajay Shah
- There is little scope for catch-up inflation - John Makin
- Higher inflation would only increase "short-termism" - Michael Heise
- Higher inflation might provide Europe a short but costly reprieve - Gilles Saint-Paul
- More inflation would help, but probably won't be forthcoming - Mark Thoma
Sunday, October 14, 2012
Ben Bernanke responds to foreigners complaining about US monetary policy (including saying that if some countries want to enjoy the benefits of an undervalued currency, then they must also pay the costs, "including reduced monetary independence and the consequent susceptibility to imported inflation":
U.S. Monetary Policy and International Implications, Speech by Ben Bernanke: Thank you. It is a pleasure to be here. This morning I will first briefly review the U.S. and global economic outlook. I will then discuss the basic rationale underlying the Federal Reserve's recent policy decisions and place these actions in an international context. ...
Federal Reserve's Recent Policy Actions
All of the Federal Reserve's monetary policy decisions are guided by our dual mandate to promote maximum employment and stable prices. With the disappointing progress in job markets and with inflation pressures remaining subdued, the FOMC has taken several important steps this year to provide additional policy accommodation. ...
As I have said many times, however, monetary policy is not a panacea. Although we expect our policies to provide meaningful help to the economy, the most effective approach would combine a range of economic policies and tackle longer-term fiscal and structural issues as well as the near-term shortfall in aggregate demand. Moreover, we recognize that unconventional monetary policies come with possible risks and costs; accordingly, the Federal Reserve has generally employed a high hurdle for using these tools and carefully weighs the costs and benefits of any proposed policy action.
International Aspects of Federal Reserve Asset Purchases
Although the monetary accommodation we are providing is playing a critical role in supporting the U.S. economy, concerns have been raised about the spillover effects of our policies on our trading partners. In particular, some critics have argued that the Fed's asset purchases, and accommodative monetary policy more generally, encourage capital flows to emerging market economies. These capital flows are said to cause undesirable currency appreciation, too much liquidity leading to asset bubbles or inflation, or economic disruptions as capital inflows quickly give way to outflows.
I am sympathetic to the challenges faced by many economies in a world of volatile international capital flows. And, to be sure, highly accommodative monetary policies in the United States, as well as in other advanced economies, shift interest rate differentials in favor of emerging markets and thus probably contribute to private capital flows to these markets. I would argue, though, that it is not at all clear that accommodative policies in advanced economies impose net costs on emerging market economies, for several reasons.
First, the linkage between advanced-economy monetary policies and international capital flows is looser than is sometimes asserted. Even in normal times, differences in growth prospects among countries--and the resulting differences in expected returns--are the most important determinant of capital flows. The rebound in emerging market economies from the global financial crisis, even as the advanced economies remained weak, provided still greater encouragement to these flows. Another important determinant of capital flows is the appetite for risk by global investors. Over the past few years, swings in investor sentiment between "risk-on" and "risk-off," often in response to developments in Europe, have led to corresponding swings in capital flows. All told, recent research, including studies by the International Monetary Fund, does not support the view that advanced-economy monetary policies are the dominant factor behind emerging market capital flows.1 Consistent with such findings, these flows have diminished in the past couple of years or so, even as monetary policies in advanced economies have continued to ease and longer-term interest rates in those economies have continued to decline.
Second, the effects of capital inflows, whatever their cause, on emerging market economies are not predetermined, but instead depend greatly on the choices made by policymakers in those economies. In some emerging markets, policymakers have chosen to systematically resist currency appreciation as a means of promoting exports and domestic growth. However, the perceived benefits of currency management inevitably come with costs, including reduced monetary independence and the consequent susceptibility to imported inflation. In other words, the perceived advantages of undervaluation and the problem of unwanted capital inflows must be understood as a package--you can't have one without the other.
Of course, an alternative strategy--one consistent with classical principles of international adjustment--is to refrain from intervening in foreign exchange markets, thereby allowing the currency to rise and helping insulate the financial system from external pressures. Under a flexible exchange-rate regime, a fully independent monetary policy, together with fiscal policy as needed, would be available to help counteract any adverse effects of currency appreciation on growth. The resultant rebalancing from external to domestic demand would not only preserve near-term growth in the emerging market economies while supporting recovery in the advanced economies, it would redound to everyone's benefit in the long run by putting the global economy on a more stable and sustainable path.
Finally, any costs for emerging market economies of monetary easing in advanced economies should be set against the very real benefits of those policies. The slowing of growth in the emerging market economies this year in large part reflects their decelerating exports to the United States, Europe, and other advanced economies. Therefore, monetary easing that supports the recovery in the advanced economies should stimulate trade and boost growth in emerging market economies as well. In principle, depreciation of the dollar and other advanced-economy currencies could reduce (although not eliminate) the positive effect on trade and growth in emerging markets. However, since mid-2008, in fact, before the intensification of the financial crisis triggered wide swings in the dollar, the real multilateral value of the dollar has changed little, and it has fallen just a bit against the currencies of the emerging market economies. ...
Wednesday, October 10, 2012
David Altig of the Federal Reserve Bank of Atlanta argues that the Fed's quantitative easing and twist polices were necessary to preserve price stability (Dave will be in Portland, Oregon on Thursday along with Bruce Bartlett and others at the annual Oregon Economic Forum (scroll down) that Tim Duy puts on, and I am disappointed I can't be there this year -- I'm headed to the St. Louis Fed today for a conference):
Supporting Price Stability, by David Altig: All of the five questions that Chairman Ben Bernanke addressed in his October 1 speech to the Economic Club of Indiana rank high on the list of most frequently asked questions I encounter in my own travels about the Southeast. But if I had to choose a number one question, on the scale of intensity if not frequency, it would probably be this one: "What is the risk that the Fed's accommodative monetary policy will lead to inflation?"
The Chairman gave a fine answer, of course, and I hope it is especially noted that Mr. Bernanke was not dismissive that risks do exist:
"I'm confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. ...
"Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to 'take away the punch bowl' is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools. I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions."
While the world waits for "take away the punch bowl" time to arrive, here is another question that I think worthy of consideration: "Looking back over the past several years, what is the risk that the Fed's price stability mandate would have been compromised absent accommodative monetary policy?"
As the Chairman noted in his speech, it isn't easy to take the evidence at hand and argue any inconsistency between the Federal Open Market Committee's (FOMC) policy actions and its price stability mandate:
"I will start by pointing out that the Federal Reserve's price stability record is excellent, and we are fully committed to maintaining it. Inflation has averaged close to 2 percent per year for several decades, and that's about where it is today. In particular, the low interest rate policies the Fed has been following for about five years now have not led to increased inflation. Moreover, according to a variety of measures, the public's expectations of inflation over the long run remain quite stable within the range that they have been for many years."
To the question I posed earlier, I am tempted to take those observations one step further. Without the policy steps taken by the FOMC over the past several years, the "excellent" price stability record would indeed have been compromised.
Consider the so-called five-year/five-year-forward breakeven inflation rate, a closely monitored market-based measure of longer-term inflation expectations. If you are not completely familiar with this statistic—and you can skip this paragraph if you are—think about buying a Treasury security five years from now that will mature five years after you buy it. When you make such a purchase, you are going to care about the rate of inflation that prevails between a period that spans from five years from today (when you buy the security) through 10 years from today (when the asset matures and pays off). By comparing the difference between the yield on a Treasury security that provides some insurance against inflation and one that does not, we can estimate what the people buying these securities believe about future inflation. The reason is that, if the two securities are otherwise similar, you would only buy the security that does not provide inflation insurance if the interest rate you get is high enough relative to inflation-protected security to compensate you for the inflation that you expect over the five years that you hold the asset. In other words, the difference in the interest rates across an inflation-protected Treasury and a plain-vanilla Treasury that does not provide protection should mainly reflect the market's expected rate of inflation.
When you look at a chart of these market-based inflation expectations along with the general timing of the FOMC's policy actions, from the first large-scale asset purchase in 2008–2009 (QE1) to the second asset purchase program (QE2) in 2010 to the maturity extension program (Operation Twist) in 2011, the relationship between monetary policy and inflation expectations is pretty clear:
In each case, policy actions were generally taken in periods when the momentum of inflation expectations was discernibly downward. A simple-minded conclusion is that FOMC actions have been consistent with holding the bottom on inflation expectations. A bolder conclusion would be that as inflation expectations go, so eventually goes inflation and, had these monetary policy actions not been taken, the Fed's price stability objectives would have been jeopardized.
Statements like this do not come without caveats. A perfectly clean measure of inflation expectations requires that Treasuries that do and do not carry inflation protection really are otherwise identical. If that is not the case, differences in rates on the two types of assets can be driven by changes in things like market liquidity, and not changes in inflation expectations. Calculations of five-year/five-year-forward breakeven rates attempt to control for some of these non-inflation differences, but certainly only do so imperfectly.
Perhaps more pertinent to the current policy discussion, inflation expectations have, in fact, moved up following the latest policy action—which I guess people are destined to call QE3. But unlike the periods around QE1, QE2, and Twist, QE3 was not preceded by a period of generally falling longer-term breakeven inflation rates. So this time around there will be another, and perhaps more challenging, chance to test the proposition that monetary accommodation is consistent with price stability. As for previous actions, however, I'm pretty comfortable arguing the case that the price stability mandate was not only consistent with accommodation, it actually required it.
Monday, October 08, 2012
Preliminary evidence from Brent Meyer and Guhan Venkatu of the Cleveland Fed shows that the median CPI is a robust measure of underlying inflation trends:
Trimmed-Mean Inflation Statistics: Just Hit the One in the Middle Brent Meyer and Guhan Venkatu: This paper reinvestigates the performance of trimmed-mean inflation measures some 20 years since their inception, asking whether there is a particular trimmed-mean measure that dominates the median CPI. Unlike previous research, we evaluate the performance of symmetric and asymmetric trimmed-means using a well-known equality of prediction test. We find that there is a large swath of trimmed-means that have statistically indistinguishable performance. Also, while the swath of statistically similar trims changes slightly over different sample periods, it always includes the median CPI—an extreme trim that holds conceptual and computational advantages. We conclude with a simple forecasting exercise that highlights the advantage of the median CPI relative to other standard inflation measures.
In the introduction, they add:
In general, we find aggressive trimming (close to the median) that is not too asymmetric appears to deliver the best forecasts over the time periods we examine. However, these “optimal” trims vary slightly across periods and are never statistically superior to the median CPI. Given that the median CPI is conceptually easy for the public to understand and is easier to reproduce, we conclude that it is arguably a more useful measure of underlying inflation for forecasters and policymakers alike.
And they conclude the paper with:
While we originally set out to find a single superior trimmed-mean measure, we could not conclude as such. In fact, it appears that a large swath of candidate trims hold statistically indistinguishable forecasting ability. That said, in general, the best performing trims over a variety of time periods appear to be somewhat aggressive and almost always include symmetric trims. Of this set, the median CPI stands out, not for any superior forecasting performance, but because of its conceptual and computational simplicity—when in doubt, hit the one in the middle.
Interestingly, and contrary to Dolmas (2005) we were unable to find any convincing evidence that would lead us to choose an asymmetric trim. While his results are based on components of the PCE chain-price index, a large part (roughly 75% of the initial release) of the components comprising the PCE price index are directly imported from the CPI. It could be the case that the imputed PCE components are creating the discrepancy. The trimmed-mean PCE series currently produced by the Federal Reserve Bank of Dallas trims 24 percent from the lower tail and 31 percent from the upper tail of the PCE price-change distribution. This particular trim is relatively aggressive and is not overly asymmetric—two features consistent with the best performing trims in our tests.
Finally, even though we failed to best the median CPI in our first set of tests, it remains the case that the median CPI is generally a better forecaster of future inflation over policy-relevant time horizons (i.e. inflation over the next 2-3 years) than the headline and core CPI.
One note. They are not saying that trimmed or median statistics are the best way to measure the cost of living for a household. They are asking what variable has the most predictive power for future (untrimmed, non-core, i.e. headline) inflation ("specifically the annualized percent change in the headline CPI over the next 36 months," though the results for 24 months are similar). That turns out, in general, to be the median CPI.
Monday, October 01, 2012
If QE Causes Commodity Price Inflation..., by Tim Duy: If QE causes commodity price inflation, what caused commodity prices to rise before QE? It never ceases to amaze me that critics of quantitative easing fail to remember that commodity prices were rising well before the Federal Reserve engaged in quantitative easing:
If anything, commodity prices have been moving generally sideways since the Fed began expanding its balance sheet:
And please don't say "commodity prices have surged since the beginning of 2009." I think it is pretty obvious that virtually everyone would not want to return to the economic conditions of 2009 to achieve lower commodity prices. The rebound of commodity prices was a natural consequence of expanding global activity; if QE is to blame, it must also be blamed for the economic rebound. Also, why have headline consumer prices grown more slowly since the Fed initiated quantitative easing?
What about the surging inflation expectations in the TIPS markets (not necessarily the best measures of inflation expectations, and the ones already falling anyway)?
At best, quantitative easing is keeping inflation expectations propped up, barely. And once again, does anyone really want to return to the collapsing inflation expectations at the height of the recession? And are expectations any higher than before quantitative easing? No.
Bottom Line: If anything, inflation is lower, both for commodity prices and headline PCE, after quantitative easing. So isn't it finally time to put to rest the myth that quantitative easing is causing runaway inflation? Nothing to see here folks, move along.
Saturday, August 25, 2012
As a follow up to this post on Inflation Lessons from Paul Krugman:
Demand-siders like me saw this as very much a slump caused by inadequate spending: thanks largely to the overhang of debt from the bubble years, aggregate demand fell, pushing us into a classic liquidity trap.
But many people — some of them credentialed economists — insisted that it was actually some kind of supply shock instead. Either they had an Austrian story in which the economy’s productive capacity was undermined by bad investments in the boom, or they claimed that Obama’s high taxes and regulation had undermined the incentive to work (of course, Obama didn’t actually impose high taxes or onerous regulations, but leave that aside for now).
How could you tell which story was right? One answer was to look at the behavior of ... inflation. For if you believed a demand-side story, you would also believe that even a large monetary expansion would have little inflationary effect; if you believed a supply-side story, you would expect lots of inflation from too much money chasing a reduced supply of goods. And indeed, people on the right have been forecasting runaway inflation for years now.
Yet the predicted inflation keeps not coming. ... So what we’ve had is as good a test of rival views as one ever gets in macroeconomics — which makes it remarkable that the GOP is now firmly committed to the view that failed.
Note what's been happening to estimated inflation expectations lately:
[Source: Cleveland Fed]
The Fed has used fear of inflation to argue against doing more for the unemployed, but what's the Fed so afraid of? Where's the evidence fo their fears?
(When fear of inflation fails as an argument against further easing, as it has, the Fed also relies upon a vague fear that further quantitative easing would somehow break overnight money markets. But as FT Alphaville has noted several times -- and I've noted this as well -- those fears are hard to understand, and the minutes from the last Fed meeting seemed to indicate they were largely unfounded.
So I, too, "remain curious to get some details about exactly what Bernanke meant when he said that further easing shouldn’t be undertaken lightly because it would pose a risk to 'market functioning' and 'financial stability.'" That's especially true in light of the statement in the the most recent FOMC minutes that they have looked at this worry and determined that, repeating a quote from FT Alphaville, there is "substantial capacity for additional purchases without disrupting market functioning."
Thus, it appears the biggest worries about further easing -- inflation and market disruption -- are unfounded, and it will be intersting to see what new excuses are invented to forestall action. I'm guessing it will be the old, "it's not in the data yet, but just wait, you'll see, inflation really will be a problem. Soon. Very soon." Never mind that we've been hearing this for years already.)
Tuesday, August 07, 2012
...many (if not necessarily all) central banks will eventually figure out how to generate higher inflation expectations. They will be driven to tolerate higher inflation as a means of forcing investors into real assets, to accelerate deleveraging, and as a mechanism for facilitating downward adjustment in real wages and home prices.
It is nonsense to argue that central banks are impotent and completely unable to raise inflation expectations, no matter how hard they try. In the extreme, governments can appoint central bank leaders who have a long-standing record of stating a tolerance for moderate inflation – an exact parallel to the idea of appointing “conservative” central bankers as a means of combating high inflation.
But Bernanke did have this reputation, at least among some on the right, e.g. John Tamney in the NRO when Bernanke's name came up as a possible successor to Greenspan:
a June New York Times article noted Bernanke’s belief that the gold standard made the Great Depression worse. Plus, in a 2002 speech, he lauded the ability of the government to use the printing press to “generate higher spending and hence positive inflation.” If his adherence to a Phillips Curve orthodoxy made his belief in a price-rule already seem shaky, his direct comments about money should remove all doubt. ... For his views on money, Bernanke has the potential to be very dangerous.
Despite his reputation among the Tamney types, I think Bernanke favors more aggressive policy, but he hasn't been unable to sway others on the committee that further easing is needed. But maybe that gives him too much credit, or credit for a view he doesn't really hold. If Bernanke does believe the Fed should do more, he's kept it pretty well hidden lately and it would be nice to see more leadership from the Fed Chair.
As for Rogoff's claim that "central banks will eventually ... be driven to tolerate higher inflation," I am not as convinced of this as he is where the Fed is concerened. The argument for tolerating higher inflation is strong already, yet the Fed hasn't acted yet, and it appears to be looking for excuses not to act in the future (and some members of the Fed want to raise interest rates now to head off the possibility of future inflation). It's easy to imagine the Fed fighting inflation no matter what, or at least having policy gridlocked by the inflation hawks, and arguing that in doing so it is helping rather than hurting the recovery.
Saturday, August 04, 2012
PCE Trimmed mean inflation since March. This measure from the Dallas Fed is intended to isolate and highlight trends in inflation and help the Fed stay near its target inflation rate of 2%:
Notice any trends?
Saturday, July 28, 2012
Will the ECB come to the rescue? Paul Krugman is skeptical:
What Draghi Didn’t Do, by Paul Krugman: ...it’s now widely hoped that the ECB will start buying government bonds (although it’s not at all clear whether the Germans will allow this, particularly on a sufficient scale); this has caused a significant decline in Spanish interest rates from their peak.
Limiting interest rates on peripheral borrowing is, however, only part of what the euro needs. ...Europe also needs sufficiently high inflation over the next few years to make it possible for Spain etc. to regain competitiveness without devastating deflation. So have market expectations of inflation risen from their unworkably low levels of recent months? No:
This still looks unworkable.
Update: And this sounds like a “nein” from the Germans.
Tuesday, July 24, 2012
A Missing Ingredient, by Tim Duy: Ryan Avent makes a good point about San Francisco Federal Reserve President John Williams' recent FT interview.
Avent is less impressed than me on Williams' conversion to open-ended QE as a policy tool because it by itself does not communicate a willingness to allow inflation to exceed 2%. I think that Avent is on the right path. While Williams did make what I think is a big step, he could go one step further and not only call for open-ended QE, but to do so in the context of Chicago President Charles Evans' suggestion for explicitly tolerating inflation up to 3%. That said, I also think this is too much to hope for, as I haven't seen any indication that Williams would be willing to deviate from the 2% target.
Also, you can interpret open-ended QE as a higher possibility that the Federal Reserve will not be able to pull-back the increase in the money supply, thus one could expect higher inflation in the future. And by leaving the program as open-ended, you remove the uncertainty created by arbitrary end dates and purchase amounts. So I do think that Williams is making a significant shift in the right direction. But I agree with Avent that a clear communication of tolerance for higher inflation would be even more effective.
Ultimately, I think the Federal Reserve made a huge policy error in committing to an explicit 2% inflation target. I think policymakers were under the impression that such a commitment would give them more flexibility by removing concerns that QE would be inflationary. In reality, I think it had the opposite effect - it eliminated a policy tool, thereby reducing their flexibility. And that commitment stands as a barrier to Evans' suggested policy path. I think the rest of the Fed would loathe accepting inflation as high as 3% given they just committed to 2% at the beginning of this year. In doubt, they would view such backtracking as a threat to their much-cherished credibility.
Interestingly, they don't see Treasury rates below 1.4% as a threat to their credibility. They really should.
Here's what I said on this topic a few months ago:
...why does the Fed put so much value on its credibility?
An abundance of credibility allows the Fed to bring the inflation rate down from, for example, 5 percent to 2 percent at minimal cost to the economy. It also makes it less likely that inflation will become a problem in the first place, because high credibility makes long-run inflation expectations less sensitive to temporary spells of inflation. So maintaining high credibility has substantial benefits.
Does this mean the Fed should do its best to keep the inflation rate at 2 percent?Sticking to a 2 percent target independent of circumstances is not optimal. There are times, such as now, when allowing the inflation rate to drift above target would help the economy. Higher inflation during a recession encourages consumers and businesses to spend cash instead of sitting on it, it reduces the burden of pre-existing debt, and it can have favorable effects on our trade with other countries.
If inflation begins to rise before the recovery is complete the Fed could, for example, announce that it is willing to allow the inflation rate to stay above target temporarily in the interest of helping the economy. But once unemployment hits a pre-set rate, for example 6.25 percent, or core inflation rises above some predetermined threshold, for example, 5 percent, then, and only then, will the Fed step in and take action. ...
So no disagreement here, except that I would set the limit even higher than 3 percent inflation since I am not at all worried about the Fed's long-run credibility on inflation. As I noted, "I have no doubt that, once the economy has finally recovered, the Fed will ensure that the inflation rate is near its target value, so long-run credibility is not at risk."
One further note: I have asked Federal Reserve officials directly why the 2% inflation target is treated as a ceiling rather than a central value, and have been assured that it is, in fact, a central value (so that inflation should fluctuate around the target value instead of staying at or below target as it would if the target is a ceiling). But the data suggests otherwise -- the errors have been mostly one-sided (i.e. inflation has generally been below target). Even if the Fed is unwilling to raise the target, it should at least tolerate enough of a rise in the inflation rate to get two-sided errors, but it hasn't even been willing to do that.
Saturday, June 02, 2012
Paul Krugman today:
Catastrophic Credibility, by Paul Krugman: A little while ago Ben Bernanke responded to suggestions that the Fed needed to do more — in particular, that it should raise the inflation target — by insisting that this would undermine the institution’s “hard-won credibility”. May I say that what recent events in Europe, and to some extent in the US, really suggest is that central banks have too much credibility? Or more accurately, their credibility as inflation-haters is very clear, while their willingness to tolerate even as much inflation as they say they want, let alone take some risks with inflation to rescue the real economy, is very much in doubt. ...
I took this up in a recent column:
Breaking through the Inflation Ceiling: At some point during the recovery, the Fed may face an important decision. If the inflation rate begins to rise above the Fed’s 2 percent target and the unemployment rate is still relatively high, will the Fed be willing to leave interest rates low and tolerate a temporary increase in the inflation rate?
Probably not. Even though higher inflation can help to stimulate a depressed economy, Ben Bernanke, Chairman of the Federal Reserve, is not in favor of allowing higher inflation because it could undermine the Fed’s “hard-won inflation credibility.” And recent Fed communications seem to be setting the stage for the Fed to abandon its commitment to keep interest rates low through the end of 2014. This adds to the likelihood that the Fed will raise interest rates quickly if inflation begins increasing above the 2 percent target even if the economy has not yet fully recovered.
As I’ll explain in a moment, that’s the wrong thing to do. But first, why does the Fed put so much value on its credibility?
An abundance of credibility allows the Fed to bring the inflation rate down from, for example, 5 percent to 2 percent at minimal cost to the economy. It also makes it less likely that inflation will become a problem in the first place, because high credibility makes long-run inflation expectations less sensitive to temporary spells of inflation. So maintaining high credibility has substantial benefits.
Does this mean the Fed should do its best to keep the inflation rate at 2 percent?
Sticking to a 2 percent target independent of circumstances is not optimal. There are times, such as now, when allowing the inflation rate to drift above target would help the economy. Higher inflation during a recession encourages consumers and businesses to spend cash instead of sitting on it, it reduces the burden of pre-existing debt, and it can have favorable effects on our trade with other countries.
If inflation begins to rise before the recovery is complete the Fed could, for example, announce that it is willing to allow the inflation rate to stay above target temporarily in the interest of helping the economy. But once unemployment hits a pre-set rate, for example 6.25 percent, or core inflation rises above some predetermined threshold, for example, 5 percent, then, and only then, will the Fed step in and take action. And it should leave no doubt at all about its commitment to step in if either condition is met.
But there is a tradeoff to consider. Allowing a temporary spell of higher inflation during the recovery does pose some risk to the Fed’s credibility. I think the risk is small precisely because the Fed has been so careful to establish its inflation fighting credibility in the past. And the risk is even smaller with the 5 percent limit on the Fed’s tolerance for inflation described above. But the risk is there.
When the economy is near full employment, the tradeoff between the risk to credibility and the prospect for a faster recovery is unattractive. There’s little room to stimulate the economy and hence little room to benefit from a higher inflation rate. And the loss of credibility is potentially large because creating inflation in such a circumstance – when the economy is already growing robustly – would be viewed as irresponsible. Thus, the tradeoff is negative overall.
But when there is considerable room for the economy to expand, as there is now, the potential benefits from the increase in employment that this policy is likely to bring about are much larger. Why the Fed places so little weight on these benefits when unemployment remains so high is a mystery.
In comparison to the risks to credibility, which are smaller than they are near full employment, the benefits are large and the tradeoff is positive rather than negative. There does come a point when the tradeoff is negative again – hence the 6.25 percent unemployment and 5 percent inflation triggers described above – but in the interim we should be willing to allow modestly higher inflation. I have no doubt that, once the economy has finally recovered, the Fed will ensure that the inflation rate is near its target value, so long-run credibility is not at risk.
If inflation begins to rise before the economy has fully recovered, the Fed shouldn’t react as though its world is coming to an end and immediately begin reversing its stimulus efforts. The resulting increase in interest rates would make the recovery even slower. In fact, given the net benefits that more inflation would provide right now, the Fed should try to raise the inflation rate through additional stimulus programs.
Unfortunately, the Fed has made it abundantly clear that’s not going to happen. But at the very least the Fed should continue its present attempts to help the economy, even if that means a temporary increase in the inflation rate.
Monday, May 28, 2012
Philadelphia Fed president Charles Plosser on the risks from Europe:
Q&A: Philadelphia Fed President Charles Plosser, by Brian Blackstone, WSJ: On whether Europe could have a significant effect on the U.S. economy:
Plosser: Europe is clearly near recession. That impacts the U.S. in part through trade ... but Europe is not our largest trading partner at the end of the day. The thing that people really worry about is you have some financial implosion in Europe and markets freeze up and you have some serious financial disruptions.
There are several ways this could go. At one level the U.S. has been trying to insulate itself from that risk. The Fed and regulators have tried to stress to money market funds, for example, to reduce their exposure to European financial institutions. So on a pure exposure basis I would say U.S. financial institutions are taking the steps they need to ensure that ... financial distress in Europe it doesn’t necessarily lead to distress for them...
People have made the analogy that an implosion in Europe would be a Lehman Brothers-type event. It might be a Lehman Brothers-kind of event for Europe. And if the market is sort of indiscriminate in whom they withdraw funding to, you could have indiscriminate funding restrictions on U.S. institutions just because everybody’s scared.
There’s another scenario that is exactly the opposite. There might be–and you already see some of this–a flight to safety. So rather than the markets freezing access to short-term funding for U.S. institutions, you could have a flood of liquidity that gets withdrawn from European institutions ... and floods into the United States. That’s exactly the opposite problem.
On which scenario is more likely:
Plosser: I don’t have the answer to that. ... I don’t think a flood of liquidity is a huge problem. That would be manageable. The bigger problem is if it dries up for everybody. The Fed still has the tools it used during the crisis. ... So I think we have the tools at our disposal if they become necessary. ...
Thus, he thinks the Fed can handle whatever comes its way, and hence sees no need to alter his forecast:
On his economic forecasts:
Plosser: I’m still looking for 2.5% to 3% growth over the course of this year. I think the unemployment rate is going to continue to drift downward to 7.8% by the end of this year. I would think for 2013 we’ll see similar developments. As long as that’s continuing then I don’t see the case for ever increasing degree of accommodation.
Since he believes output will grow no matter what happens in Europe, inflation is the biggest risk:
Plosser: I think headline will drift down just because of oil and gasoline. It will be interesting to see what happens with the core. The inflation risk we have is longer term. The problem is that as the U.S. economy grows we have provided substantial amounts of accommodation. We have $1.5 trillion in excess reserves. Inflation is going to occur when those excess reserves start flowing into the economy. When that begins to happen we’ll have to restrain it somehow. The challenge for the Fed is will we act quickly enough or aggressively enough to prevent that from happening.
It may be a challenge politically when we have to start selling assets, particularly if we have to start selling (mortgage backed securities) to shrink the balance sheet and to prevent those reserves from becoming money.
My view is different. I'm more worried about output and employment being affected by events in Europe than he is, and less worried about long-run risks from inflation (both the chance that it will happen and the consequences if it does). So I see a far greater need for policymakers -- monetary and fiscal -- to take action now as insurance against potential problems down the road.
It is interesting, however, that he sees the political risk as the primary challenge for controlling inflation for a supposedly independent Fed, especially since several Fed presidents recently assured us that politics plays no role whatsoever in the Fed's decision making process (I also wonder why he didn't mention raising the amount paid on reserves as a way of keeping reserves in the banks).
Finally, I'm glad he said "I don’t see the case for ever increasing degree of accommodation," rather than saying he thought we needed to begin reducing accommodation. We may not get any further easing, but perhaps there's a chance we can keep what we have, at least for now.
Thursday, May 17, 2012
This was unexpected:
Federal Reserve Bank of St. Louis President James Bullard said Thursday that banks deemed “too big to fail” should be split up. “We do not need these companies to be as big as they are,” Bullard said. His remarks come a week after J.P. Morgan Chase & Co. disclosed a $2 billion trading loss. “We should say we want smaller institutions so that they can safely fail if they need to fail,” he said...
I don't like excessively large banks because of the economic and political power that they have. For me, that is the main reason to break them up (especially since I have yet to see convincing evidence that we need banks this large in order to exploit economies of scope and scale).
But when it comes to stabilizing the financial system, it's not so clear. If we break a big bank into smaller banks, and a systemic shock hits that threatens to cause all of the small banks to fail, it may be harder to shore up the system and prevent a domino-style collapse than it would be if there was just one large bank to deal with. The Great Depression, for example, was characterized by the failure of many, many smaller banks rather than the toppling of a few large, systemically important institutions.
But that is not an insurmountable problem. A coordinated policy across the smaller banks can be equivalent to policy at a single, large institution, and we simply have to be ready to implement the appropriate policies when trouble threatens. So although it may be somewhat easier to deal with one bank rather than, say, 10 or 20, that's not a reason to allow banks to be so large. So I'm glad to see Bullard's comments.
However, Tim Duy is less pleased with his views on inflation:
Don't Let the Data Get in the Way of Your Story, by Tim Duy: St. Louis Federal Reserve President James Bullard:
The main risk lies in potentially overcommitting to the ultra-easy monetary policy, reigniting the global inflation debacle of the 1970s.
Ten-year inflation expectations via the Cleveland Federal Reserve:
Bullard is obviously a Serious Central Banker, because Serious Central Bankers only see inflation everywhere.
Undue fear of inflation generally among FOMC memebers is holding policy back. There are those who favor more aggressive policy, but not enough to make a difference.
Tuesday, May 08, 2012
If inflation begins to increase before the economy has fully recovered, the Fed shouldn't panic:
Federal Reserve Policy: Exceptions Improve the Rule: At some point during the recovery, the Fed may face an important decision. If the inflation rate begins to rise above the Fed’s 2% target and the unemployment rate is still relatively high, will the Fed be willing to leave interest rates low and tolerate a temporary increase in the inflation rate?
Probably not. Even though higher inflation can help to stimulate a depressed economy, Ben Bernanke, Chairman of the Federal Reserve, is not in favor of allowing higher inflation because it could undermine the Fed’s “hard-won inflation credibility.” And recent Fed communications seem to be setting the stage for the Fed to abandon its commitment to keep interest rates low through the end of 2014. This adds to the likelihood that the Fed will raise interest rates quickly if inflation begins increasing above the 2% target even if the economy has not yet fully recovered.
As I’ll explain in a moment, that’s the wrong thing to do. But first, why does the Fed put so much value on its credibility? ...[continue reading]...
Tuesday, May 01, 2012
Nobel Prize winner Robert Engle says more inflation would help:
New York University professor Robert Engle said policy makers should consider allowing slightly higher inflation as a way to spur the U.S. economy, joining fellow Nobel Prize winner Paul Krugman who says it could reduce unemployment.
“A little bit of inflation would do a whole lot of good for the U.S. economy, would certainly do a lot of good for the housing market,” Engle, who won the Nobel Prize in economics in 2003...
Friday, April 20, 2012
Plutocrats and Printing Presses, by Paul Krugman: These past few years have been lean times in many respects — but they’ve been boom years for agonizingly dumb, pound-your-head-on-the-table economic fallacies. The latest fad — illustrated by this piece in today’s WSJ — is that expansionary monetary policy is a giveaway to banks and plutocrats generally. Indeed, that WSJ screed actually claims that the whole 1 versus 99 thing should really be about reining in or maybe abolishing the Fed. And unfortunately, some good people, like Daron Agemoglu and Simon Johnson, have bought into at least some version of this story.
What’s wrong with the idea that running the printing presses is a giveaway to plutocrats? Let me count the ways.
First, as Joe Wiesenthal and Mike Konczal both point out,... quantitative easing isn’t being imposed on an unwitting populace by financiers and rentiers; it’s being undertaken, to the extent that it is, over howls of protest from the financial industry. ...
Beyond that, let’s talk about the economics. The naive (or deliberately misleading) version of Fed policy is the claim that Ben Bernanke is “giving money” to the banks. What it actually does, of course, is buy stuff, usually short-term government debt but nowadays sometimes other stuff. It’s not a gift.
To claim that it’s effectively a gift you have to claim that the prices the Fed is paying are artificially high, or equivalently that interest rates are being pushed artificially low. And you do in fact see assertions to that effect all the time. But if you think about it for even a minute, that claim is truly bizarre.
I mean, what is the un-artificial, or if you prefer, “natural” rate of interest? As it turns out,... the natural rate of interest is the rate that would lead to stable inflation at more or less full employment.
And we have low inflation with high unemployment, strongly suggesting that the natural rate of interest is below current levels... Fed policy isn’t some kind of giveway to the banks, it’s just an effort to give the economy what it needs.
Furthermore, Fed efforts to do this probably tend on average to hurt, not help, bankers. Banks are largely in the business of borrowing short and lending long; anything that compresses the spread between short rates and long rates is likely to be bad for their profits. And the things the Fed is trying to do are in fact largely about compressing that spread...
Finally, how is expansionary monetary policy supposed to hurt the 99 percent? Think of all the people living on fixed incomes, we’re told. But who are these people? ... The typical retired American these days relies largely on Social Security — which is indexed against inflation. ...
No, the real victims of expansionary monetary policies are the very people who the current mythology says are pushing these policies. And that, I guess, explains why we’re hearing the opposite. It’s George Orwell’s world, and we’re just living in it.
We shouldn't let fiscal policymakers -- who have their own set of "agonizingly dumb, pound-your-head-on-the-table economic fallacies" to support inaction -- off the hook either.
Thursday, April 12, 2012
There is a growing contingent at the Fed advocating interest rate increases sooner rather than later. I continue to think that is a mistake.
The reasoning from those who think it's time to begin reducing monetary stimulus is that the natural rate of output -- the full employment level of output -- has fallen so much that even though the recovery to date has been slow, nevertheless we are nearing potential output. Thus, any further push to increase output further could be highly inflationary.
Why do I think this is incorrect? I believe there are several types of shocks that can hit the economy. There are both permanent and temporary shocks to aggregate demand, and there are both permanent and temporary shocks to aggregate supply. As I explained here, analysts who conclude we are almost back to potential output may very well be confusing permanent and temporary shocks to aggregate supply.
As Charlie Plosser explained to me recently, it is difficult to sort aggregate demand and aggregate supply shocks. Aggregate demand shocks can produce supply shocks, and supply shocks can have an effect on demand. The explanation I was given by Plosser was, I think, intended to convince me that what look like aggregate demand shocks are actually the result of supply shocks. However, I think the explanation works better in the other direction. For example, repeating a previous argument:
When there as a large AD shock in the form of a change in preferences, say that people no longer like good A as it has gone out of fashion and have now decided B is the must have good, then there will be high unemployment in industry A and excess demand for labor and other resources in industry B. As workers and resources leave industry A, our productive capacity falls and it stays lower until the workers and other resources eventually find their way into industry B. When this process is complete, productive capacity returns to where it was before, or perhaps goes even higher. Thus, there is a short-run cycle in productive capacity that mirrors the business cycle.
Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, close factories, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.
The point is that there can be short-run cyclical AS effects, and failing to account for these can lead to policy errors.
So it may be true that productive capacity has fallen, but I beleive the fall is largely temporary, not permanent. (To be clear, I think there is a permanent component, but it is nowhere near as large as the inflation hawks are assuming -- i.e. the full employment target, once temporary effects have been cleared out of the way, is higher than the estimates that are behind the hawkery. Essentially, what I am arguing is that the temporary supply shocks are, in part, a function of AD shocks, but the effect of the AD shocks on AS wanes over time.)
If this is correct, policymakers should not be concluding that the shocks are permanent, throwing up their hands, and saying there is nothing more we can do. Instead, if, as I believe, much of the fall in productive capacity is temporary, then the job of policymakers is to make sure that employment recovers as fast as the temporary supply shocks wane. That won't be easy, employment so far has been very slow to recover and if that continues it's entirely possible that productive capacity will recover faster than employment. If policymakers try to freeze employment at a level that is too high out of misguided worries about inflation, then they will hold back the recovery and make this problem worse. That's the opposite of what they should be doing.
I could be wrong, which is what I'd like the hawks to consider. That is, what are the costs of being wrong versus the costs of being correct? My view is that the costs of doing too much -- the inflation cost -- is much lower than the costs of doing too little, i.e. the costs of higher than necessary unemployment (though see David Altig). I'm aware that we differ on this point, those in favor of relatively immediate interest rate increases see the costs of inflation as very high and it's this point that I hope will generate further discussion. In reality, how high are the costs of a temporary bout of inflation -- I have faith that the Fed won't allow an increase in inflation to become a permanent problem -- and are they so high that they justify erring on the side of doing too little rather than too much? I don't think they are, but am willing to listen to other views.
Wednesday, April 11, 2012
I would say that it would be appropriate to change the Fed’s current forward guidance to the public about the future course of interest rates. Currently, the FOMC statement reads that the Committee believes that conditions will warrant extraordinarily low interest rates through late 2014. My own belief is that we will need to initiate our somewhat lengthy exit strategy sometime in the next six to nine months or so, and that conditions will warrant raising rates sometime in 2013 or, possibly, late 2012.
But I hope that John Williams, and others with similar views, carry the day:
Let me summarize where the Fed stands in terms of achieving its congressionally mandated goals. We are far below maximum employment and are likely to remain there for some time. The housing bust and financial crisis set in motion an extraordinarily harsh recession, which has held down consumer, businesses, and government spending. By contrast, inflation is contained and may even fall next year below our 2% target.
Under these circumstances, it’s essential that we keep strong monetary stimulus in place. The recovery has been sluggish nationwide... High unemployment, restrained demand, and idle production capacity are national in scope. These are just the sorts of problems monetary policy can address. ...
The hawks will keep pushing to tighten sooner rather than later, so let's hope those who want to do more, or at least not do less, can at least produce the gridlock needed to keep current policy in palce.
Friday, April 06, 2012
The unemployed need more help from the Fed:
Not Enough Inflation, by Paul Krugman, Commentary, NY Times: A few days ago, Alan Greenspan ... spoke out in defense of his successor. Attacks on Ben Bernanke by Republicans, he told The Financial Times, are “wholly inappropriate and destructive.” He’s right...
But why are the attacks on Mr. Bernanke so destructive? ... The attackers want the Fed to slam on the brakes when it should be stepping on the gas... Fundamentally, the right wants the Fed to obsess over inflation, when the truth is that we’d be better off if the Fed paid ... more attention to unemployment. ...
O.K.,... let me take this in stages. First, about inflation obsession: For at least three years, right-wing economists, pundits and politicians have been warning that runaway inflation is just around the corner, and they keep being wrong. ... At this point, inflation is ... a bit below the Fed’s self-declared target of 2 percent.
Now, the Fed has, by law, a dual mandate: It’s supposed to be concerned with full employment as well as price stability. And while we more or less have price stability by the Fed’s definition, we’re nowhere near full employment. So this says that the Fed is doing too little, not too much. ...
To be sure, more aggressive Fed policies to fight unemployment might lead to inflation above that 2 percent target. But remember that dual mandate: If the Fed refuses to take even the slightest risk on the inflation front, despite a disastrous performance on the employment front, it’s violating its own charter. And, beyond that,... a rise in inflation to 3 percent or even 4 percent ... would almost surely help the economy. ...
Which brings me back to those Republican attacks and their chilling effect on policy.
True, Mr. Bernanke likes to insist that he and his colleagues aren’t affected by politics. But that claim is hard to square with the Fed’s actions, or rather lack of action. As many observers have noted, the Fed’s own forecasts indicate that ... it still expects low inflation and high unemployment for years to come. Given that prospect, more of the “quantitative easing” ... should be a no-brainer. Yet the recently released minutes from a March 13 meeting show a Fed inclined to do nothing unless things take a turn for the worse.
So what’s going on? I think that Fed officials, whether they admit it to themselves or not, are feeling intimidated — and that American workers are paying the price for their timidity.
Thursday, April 05, 2012
Feldstein v. Lazear on the Size of the Output Gap , econospeak: Martin Feldstein is worried that the Federal Reserve will not reverse its increase in the monetary base even as we approach full employment:
Here is what worries me... If the unemployment rate is still very high when product markets begin to tighten, the US Congress will want the Fed to allow more rapid growth in order to bring it down, despite the resulting risk to inflation. The Fed is technically accountable to Congress, which could apply pressure on the Fed by threatening to reduce its independence. So inflation is a risk, even if it is not inevitable. The large volume of reserves ... makes that risk greater. It will take skill – as well as political courage – for the Fed to avoid the rise in inflation that the existing liquidity has created.
Dr. Feldstein is implicitly saying that the GDP gap is not as large as what Ed Lazear wants us to believe:
During the postwar period up to the current recession (1947-2007), the average annual growth rate for the U.S. was 3.4%. The last three decades have experienced somewhat slower growth than the earlier periods, but even in the period 1977-2007, the average growth rate was 3%. According to the National Bureau of Economic Research, the recovery began in the second half of 2009. Since that time, the economy has grown at 2.4%, below our long-term trend by either measure. At this point, the economy is 12% smaller than it would have been had we stayed on trend growth since 2007. ...
Lazear wants us to believe that the economy could have continued to grow by 3.4% per year since 2007QIV... In other words, Lazear wants us to believe that the current GDP gap is 12%. ...
Republicans are simultaneously pushing two themes. One theme is that current Federal Reserve policy is endangering an inflationary spiral, which seems to be the concern of Dr. Feldstein. The other theme is that the Obama Administration is somehow making the recession worse, which Dr. Lazear was so happy to echo. Funny thing – these two themes appear to be contradictory.
Andy Harless on Twitter:
Feldstein says inflation is a "risk." I would express the same point by saying that there is "some hope" for inflation. Not much, though.
Andy will be disappointed to hear that James Bullard is also convinced that the gap is smaller than most people believe, and that the Fed's commitment to keep interest rates low through the end of 2014 is harming the economy:
Concerning the FOMC’s communications tool, the “late 2014” language describing the length of the near-zero rate policy may be counterproductive, he said. “The Committee’s practice of including distant dates in the statement sends an unwarranted pessimistic signal concerning the future of the U.S. economy.”
Regarding the output gap and housing markets, “the U.S. output gap may be smaller than typical estimates suggest,” Bullard said, adding that typical estimates count the “housing bubble” as part of the normal level of output. However, he said, “It is neither feasible nor desirable to attempt to re-inflate the U.S. housing bubble of the mid-2000s.”
At least he's not calling for interest rates to go up --- at least not yet:
Federal Reserve Bank of St. Louis President James Bullard ... said that brighter prospects for the U.S. economy provide the Federal Open Market Committee (FOMC) with the opportunity to pause in its aggressive easing campaign. “An appropriate approach at this juncture may be to continue to pause to assess developments in the economy,” he stated.
But he seems to be setting the stage to call for the Fed to abandon its interest rate commitment, e.g. statements such as "low interest rates hurt savers" (see here on this point).
I think that would be a mistake. How much uncertainty does Bullard have around his estimate of potential output? If it's not a substantial amount, it ought to be and the best policy in the face of such uncertainty is to lean against the more costly outcome (it also seems to me that he has chosen a forecast with one-sided errors -- it's unlikely that potential output is much lower than his current estimate, but it couldbe much higher). As I've been stressing recently (along with Stevenson and Wolfers, DeLong, and others), since high unemployment is far more costly than a temporary bout of inflation, policy ought to be directed primarily at the unemployment problem. If and when there are signs that inflation is increasing, and that labor markets are close to full recovery, then the Fed can start laying the groundwork for interest rate increases prior to 2014. But any talk of easing off its commitment before then and the loss of credibility that comes with it would be, to echo Bullard's term, counterproductive.
Monday, April 02, 2012
Via the Dallas Fed, once the volatile prices have been stripped out there's no evidence of inflation. If anything, inflation has been falling in recent months (before objecting that these measures do not capture actual changes in the cost of living for households, please see here):
Trimmed Mean PCE Inflation Rate, FRB Dallas: February 2012 The trimmed mean PCE inflation rate is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). ...
The trimmed mean PCE inflation rate for February was an annualized 1.4 percent. According to the BEA, the overall PCE inflation rate for February was 3.8 percent, annualized, while the inflation rate for PCE excluding food and energy was 1.6 percent.
The tables below present data on the trimmed mean PCE inflation rate and, for comparison, the overall PCE inflation and the inflation rate for PCE excluding food and energy. The tables give annualized one-month, six-month and 12-month inflation rates.
|One-month PCE inflation, annual rate|
|Six-month PCE inflation, annual rate|
|12-month PCE inflation|
|NOTE: These data are subject to revision ...|
James Bullard is trying to make the case that domestic inflation depends upon the global output gap, and that gap looks inflationary, but I just don't see evidence for an emerging inflation problem in the tables. For the last four months or so, inflation has been stable or falling depending on the measure you choose, and that's not what you'd expect if there was increasing price pressure due to either global or domestic forces.
Friday, March 30, 2012
Inflation: Still Nothing to See Here, By Tim Duy: The Februrary Personal Income and Outlays report came out this morning, and with it a fresh read on the Federal Reserve's preferred inflation measure, the PCE price index. On a year-over-year basis, headline inflation is trending down to the 2% target, while core is settling in just below that target.
As a reminder, the Fed targets headline over the longer run, but watches core as a signal to where headline is headed. Headline is trending down to core, as expected. The Fed was right to dismiss last year's energy-induced headline increase as a temporary phenomenon. Is there any near term trends to be concerned about? The three-month core trend edged down a notch to just above 2%:
Still less than the rise experienced in the first part of 2011. What about the path of prices? Still tracking along a trend below that of prior to the recession:
Opportunistic disinflation at work.
Bottom Line: Inflation remains contained - by itself, price trends provide no reason for the Fed to turn hawkish. Moreover, there is nothing here to stop Federal Reserve Chairman Ben Bernanke from easing policy should the US recovery falter.
Tuesday, March 27, 2012
DeLong and Summers, the debate over potential output, and whether Bernanke has the courage, foresight, and persuasiveness to follow Greenspan's lead:
I wrote this before Bernanke's speech on the labor market on Monday. He says, echoing the topic of the column:
Is the current high level of long-term unemployment primarily the result of cyclical factors, such as insufficient aggregate demand, or of structural changes, such as a worsening mismatch between workers' skills and employers' requirements? ... I will argue today that ... the continued weakness in aggregate demand is likely the predominant factor.
So maybe the structural impediment, inflation hawk types at the Fed will be vanquished after all. We shall see. [See Tim Duy's comments on as well.]
Thursday, March 15, 2012
Simon Wren-Lewis on fear of inflation:
The inflation floodgates, mainly macro: Mark Thoma bemoans the attitude of inflation hawks on the FOMC (the US equivalent of the Bank’s Monetary Policy Committee). He writes “Unfortunately, the hawks on the committee seem to be afraid that if they allow inflation to creep up even a little bit over their long-run target, the inflation flood gates will open and they won’t be able to help themselves from a repeat of the 1970s.” From this profile by Roger Lowenstein, the floodgates view may not be confined to the hawks (HT Karl Smith). It occurred to me that we have just had a little experiment in the UK to test this floodgates view, and it looks like being completely rejected. ...[continue reading]...
Robert Waldmann also comments.
Tuesday, March 13, 2012
What I think the Fed should do:
Why does overshooting the inflation target in the short-run induce such fear in so many members of the Fed's monetary policy committee?
Friday, February 17, 2012
This is a situation in which there’s no conflict between maximum employment and price stability. With regard to both of the Fed’s mandates, it’s vital that we keep the monetary policy throttle wide open.
QE3 is coming.
Dallas Federal Reserve President Richard Fisher states:
“In my view, it’s not going to happen,” he said. “It’s a fantasy. Wall Street keeps dangling QE3 out there [but] I just don’t see it happening.”
I guess we are going to see who knows more about monetary policy - CR or Fisher. My instinct tells me CR, but Fisher seems just a little too certain to dismiss entirely. Reviewing the most recent minutes, one find to the now oft-repeated line:
A few members observed that, in their judgment, current and prospective economic conditions--including elevated unemployment and inflation at or below the Committee's objective--could warrant the initiation of additional securities purchases before long.
Presumably, Williams is among the few. I would like the Fed to publish their definition of a "few." In my book that is three or less, which is well short of the the majority necessary to shift policy. That said, the next line of the minutes is:
Other members indicated that such policy action could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.
Now you have a solid majority willing to move forward with QE3 if the economy sags or inflation remains below 2%. The recent US data flow, however, has been generally positive, and it is hard to ignore the steady drop in initial unemployment claims. To be sure, we have been fooled by seemingly upbeat data in the past. But I suspect the median FOMC member will be wary about dismissing the generally positive data - sooner or later, some parts of the US economy, such as home building, are going to come back on line. Which leaves us pondering inflation data. With gasoline prices marching higher, headline inflation will head in that direction as well. Typically, however, the Fed will look toward core inflation as a gauge of where headline will eventually settle, and recently core has been soft:
Still, notice the recent uptick. And if FOMC members want to focus on the year-over-year numbers, it looks like core and headline are set to converge at the 2% mark:
All in all, I tend to view the Fed as generally in wait and see mode. I doubt very much the case is as clear cut as Fisher or CR believes. However, I tend to think the general mood of the FOMC favors CR's position, as long as core inflation stays on the weak side of 2%. But if inflation ticks up and general economic data remains solid, hope of QE3 may quickly be dashed.
Update: In a second post, Tim adds:
Who Thinks Unemployment Isn't Too High, by Tim Duy: I noticed this line in the most recent Fed minutes:
While overall labor market conditions had improved somewhat further and unemployment had declined in recent months, almost all members viewed the unemployment rate as still elevated relative to levels that they saw as consistent with the Committee's mandate over the longer run.
"[A]lmost all" means that as least one FOMC member does not believe that the unemployment rate is not well above the natural rate. Who is it?
Wednesday, February 08, 2012
I have been more optimistic than most about the return to long-run trend, i.e. that the shock we experienced is mostly temporary rather than permanent, but here's another view arguing that we have had a substantial decline in the natural rate of output:
What output gap?, by David Andolfatto, Macromania: In case you haven't seen it, you may be interested in this speech given recently by Jim Bullard, president of the St. Louis Fed: Inflation Targeting in the USA.
This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below "potential" GDP owing to "deficient demand," the correct view? Or should we instead be thinking in terms of a large negative shock to "potential" GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?
I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.
The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential). Among other things, he says:But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.Precisely how such a policy "distorts fundamental decision-making" needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.
At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it's shown that we shouldn't grow complacent over what we think we understand.
I believe that costs are asymmetric -- doing too little to help the economy is worse than doing too much -- and the conclusion that the shock is mostly permanent rather than temporary is more likely to lead to policymakers giving up too soon (resulting in the more serious error). Thus, those that hold this view need to recognize the asymmetric nature of the mistakes they are likely to make and adjust their policy recommendations accordingly.
However, inflation hawks see the costs as more symmetric, and they are convinced the shock is mostly permanent, so they would disagree with the need to adjust their policy recommendations. But as noted above, I think the shock is highly persistent but ultimately mostly temporary, and I just don't see the equivalence between a marginal increase in inflation versus a marginal decrease in unemployment. For me, unemployment is a much higher priority (and yes, I understand the argument that inflation problems ultimately impact employment).
Update: There are two concerns here that I may not have done enough to separate in the comments above. First, there is the concern that the asymmetric nature of the costs of inflation and unemployment is being ignored in policy recommendations (though, again, inflation hawks see inflation as more costly than I do, and hence see the costs as more symmetric, and they believe that a short burst of inflation to fight a recession is likely to lead to a long-run inflation problem -- I have more faith in the Fed than that). This means, for me anyway, that policy ought to tilt toward unemployment (i.e., I disagree with Ben Bernanke's recent assertion in testimony before Congress that inflation and unemployment should be and are weighted equally).
The second concern is the assumption that the natural rate has fallen permanently. Making this assumption when in fact the shock is largely temporary will lead to a miscalculation of the chance that we will face an inflation problem -- the calculated odds will be too high -- and the undue fear of inflation will cause policy to tighten too soon. This results in an error where unemployment rather than inflation is higher than desired. The opposite belief -- the belief that the shock is temporary when it turns out to be permanent -- leads to the opposite policy error, i.e. unemployment lower and inflation higher than desired, but to me that is more tolerable. That's not why I hold the view it's mostly a temporary shock -- that's a conclusion based upon economic considerations -- but given that the costs are asymmetric the belief that the shock is temporary does result in a less serious policy error if it is wrong.
Monday, February 06, 2012
We seem to have turned the corner, but policymakers should not relax yet -- we still have a long way to go to get back to full employment:
Things Are Not O.K., by Paul Krugman, Commentary, NY Times: ...So, about that jobs report:... for once falling unemployment was the real thing, reflecting growing availability of jobs rather than workers dropping out of the labor force... That said, our economy remains deeply depressed. As the Economic Policy Institute points out,... even at January’s pace of job creation it would take us until 2019 to return to full employment.
And we should never forget that the persistence of high unemployment inflicts enormous, continuing damage on our economy and our society,... in particular,... that long-term unemployment ... means more Americans permanently alienated from the work force, more families exhausting their savings, and, not least, more of our fellow citizens losing hope.
So this encouraging employment report shouldn’t lead to any slackening in efforts to promote recovery. ... Policy makers should be doing everything they can to get us back to full employment as soon as possible.
Unfortunately, that’s not the way many people with influence on policy see it. Very early in this slump — basically, as soon as the threat of complete financial collapse began to recede — a significant number of people within the policy community began demanding an early end to efforts to support the economy. Some of their demands focused on the fiscal side, with calls for immediate austerity... But there have also been repeated demands that the Fed ... raise interest rates.
What’s the reasoning behind those demands? Well, it keeps changing. Sometimes it’s about the alleged risk of inflation... And the inflation hawks ... seem undeterred ... by the way the predicted explosion of inflation keeps not happening...
But there’s also a sort of freestanding opposition to low interest rates, a sense that there’s something wrong with cheap money and easy credit even in a desperately weak economy. I think of this as the urge to purge, after Andrew Mellon, Herbert Hoover’s Treasury secretary, who urged him to let liquidation run its course, to “purge the rottenness” that he believed afflicted America.
And every time we get a bit of good news, the purge-and-liquidate types pop up, saying that it’s time to stop focusing on job creation. ... And the sad truth is that the good jobs numbers have definitely made it less likely that the Fed will take the expansionary action it should.
So here’s what needs to be said about the latest numbers: yes, we’re doing a bit better, but no, things are not O.K. — not remotely O.K. This is still a terrible economy, and policy makers should be doing much more than they are to make it better.
I'm also worried that "Policymakers are Too Anxious to Reverse Course."
Wednesday, January 11, 2012
However, a couple of participants noted that the rate of inflation over the past year had not fallen as much as would be expected if the gap in resource utilization were large, suggesting that the level of potential output was lower than some current estimates.
I think this has less to do with the size of the output gap and more to do with downward nominal wage rigidities. Note that wages are still rising, although the pace of wage growth for production and nonsupervisory workers is still falling:
Perhaps a better example is the relatively new series, wages for all workers:
Overall private wage growth bottomed out in 2009 and held around 1.75%, perhaps just beginning to rise in recent months.
Despite very high unemployment and underemployment, wage growth is still positive. It tends to be very difficult to induce workers to take wages cuts (think also how the newly unemployed will resist taking new jobs with a substantially lower pay), which in-turn helps put a downside to inflation. In other words, one would expect the relationship between the output gap (or, similarly, high unemployment) and inflation to flatten as inflation rates fall toward zero.
Also note that rising wages doesn't necessarily imply higher inflation. Between the two is productivity growth. To account for the latter, we can look at unit labor costs:
Not exactly a lot of inflationary pressures stemming from unit labor cost growth. Presumably, high real wages could come by redistributing productivity gains to workers in the context of low inflation. For that to happen, however, I think we will need a lot more upward pressure on the labor market than we are seeing right now.
Friday, December 16, 2011
Ron Paul's hard-money doctrine has taken over the GOP:
G.O.P. Monetary Madness, by Paul Krugman, Commentary, NY Times: Apparently the desperate search of Republicans for someone they can nominate not named Willard M. Romney continues. New polls suggest that in Iowa, at least, we have already passed peak Gingrich. Next up: Representative Ron Paul. ...
Mr. Paul identifies himself as a believer in “Austrian” economics... Austrians see “fiat money,” money that is just printed without being backed by gold, as the root of all economic evil, which means that they fiercely oppose the kind of monetary expansion Friedman claimed could have prevented the Great Depression — and which was actually carried out by Ben Bernanke this time around. ...
After Lehman Brothers fell, the Fed began lending large sums to banks as well as buying a wide range of other assets, in a (successful) attempt to stabilize financial markets... In the fall of 2010, the Fed began another round of purchases, in a less successful attempt to boost economic growth. The combined effect of these actions was that the monetary base more than tripled in size.
Austrians, and for that matter many right-leaning economists, were sure about what would happen as a result: There would be devastating inflation. One popular Austrian commentator who has advised Mr. Paul, Peter Schiff, even warned (on Glenn Beck’s TV show) of the possibility of Zimbabwe-style hyperinflation in the near future.
So here we are, three years later. How’s it going? Inflation has ... risen ... an average annual ... rate of only 1.5 percent. Who could have predicted that printing so much money would cause so little inflation? Well, I could. And did. And so did others who understood the Keynesian economics Mr. Paul reviles. But Mr. Paul’s supporters continue to claim, somehow, that he has been right about everything.
Still, while the original proponents of the doctrine won’t ever admit that they were wrong ... you might think that having been so completely off-base about something so central to their belief system would have caused the Austrians to lose popularity, even within the G.O.P. ...
What has happened instead, however, is that hard-money doctrine and paranoia about inflation have taken over the party, even as the predicted inflation keeps failing to materialize. ...
Now, it’s still very unlikely that Ron Paul will become president. But ... his economic doctrine has, in effect, become the official G.O.P. line, despite having been proved utterly wrong by events. And what will happen if that doctrine actually ends up being put into action? Great Depression, here we come.
Wednesday, November 16, 2011
So, with inflation fears falling, the Fed is more likely to act, right? Don't set your hopes too high:
But not all members of the FOMC share this sentiment. From the WSJ story:
John Williams, who leads the San Francisco Fed, Tuesday joined a rising chorus of central bank officials calling for continued action to bolster the economy.
But it also says:
Other officials remain staunchly opposed to taking further unconventional steps to spur growth, such as buying more mortgage bonds–and Lacker is among them.
And there's this from Boston:
While the Fed is taking it's time trying to figure out what to do, it should remember how many people are hoping that somebody does something to spur job creation, that most of the forces driving the recent spurt of headline inflation appear to be temporary (as today's data attests), and that the economic outlook is very risky -- we could use some insurance against future problems (especially with evidence that the potential cost of that insurance, i.e. the potential for inflation, is falling).
Thursday, November 03, 2011
David Andolfatto notes that the real interest rate is near zero, even negative in some cases, and says "Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow":
Negative real interest rates, Macromania: ...In macroeconomic theory, the nominal interest rate plays second-fiddle to the so-called real interest rate. The real rate of interest is ... a relative price. It is the price of output today measured in units of future output... So, if the risk-free annual interest rate on an inflation-indexed U.S. treasury is 2%, then one unit of output today is valued at 1.02 units of output in the future....
Economists typically focus on the real interest rate because people presumably care about output and not money (they care about money only to the extent that it may be used to purchase output). ... The higher the real interest rate, the more output is valued today vis-a-vis future output. A high real interest rate reflects the market's strong desire to have you part with your output today (in exchange for a promise of future output). Unlike the nominal interest rate, however, there is nothing that naturally prevents the real interest rate from becoming negative; see Nick Rowe. And indeed, this appears to have happened recently in the U.S. The following diagram plots the real interest rate as measured by the n-year treasury inflation-indexed security (constant maturity) for n = 5, 10, 20; see FRED.
Prior to the Great Recession, real interest rates are hovering around 2% p.a. and the yield curve is upward sloping (long rates higher than short rates), at least until early 2006 (when it flattens). Following the violent spike up in real interest rates (associated with the Lehman event), real interest rates have for the most part declined steadily since then. The 20 year rate is below 1%, the 10 year rate is basically zero, and the 5 year rate is significantly negative. What does this mean?
The decline in real rates that has taken place, especially since the beginning of 2011, is a troubling sign. ... This premium may be signaling an expected scarcity of future output. If so, then this is a bearish signal.
The decline in market real interest rates is consistent with a collapse (and anemic recovery) of investment spending (broadly defined to include investments in job recruiting). For whatever reason, the future does not look as bright as it normally does at the end of a recession. To some observers, this looks like a "deficient aggregate demand" phenomenon. To others, it is the outcome of a rational pessimism reflecting a flow of new regulatory burdens and a potentially punitive tax regime. Both hypotheses are consistent with the observed "flight to safety" phenomenon and the consequent decline in real treasury yields.
Unfortunately, the two hypotheses yield very different policy implications. The former calls for increased government purchases to "stimulate demand," while the latter calls for removing whatever barriers are inhibiting private investment expenditure. There seems to be room for compromise though. Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow (assuming that borrowed funds are not squandered, of course).
In the event of an impasse, can the Fed save the day? It is hard to see how. The Fed's influence on real economic activity is usually thought to flow through the influence it has (or is supposed to have) on the real interest rate. One could make the case that real interest rates are presently low in part owing to the Fed's easing policies. But this would be ignoring the fact that the Fed's easing policies were/are largely driven by the collapse in investment spending. (I am suggesting that in a world without the Fed, these real interest rates would be behaving in more or less the same way.)
In any case, real interest rates are already unusually low. How much lower should they go? Is it really the case that our economic ills, even some of them, might be solved in any significant manner by driving these real rates any lower? My own view is probably not. If there is something the Fed can do, it is likely to operate through some other mechanism. ...
David also looks at inflation expectations and concludes:
there is no evidence to suggest that inflation expectations are whirling out of control, one way or the other. I'm not sure to what extent this constitutes success. At the very least it is not utter failure.
I am more confident that David is that the Fed can still help the economy, but it can't do it on its own and too much focus on the Fed takes the pressure off of Congress to do its part to help to overcome the unemployment crisis. Members of Congress need to be worried that their own jobs are at risk if they don't do something to help the unemployed (and they shouldn't be allowed to get away with claiming that cutting the deficit by cutting social insurance programs is a means to this end). That's one of the reasons I keep calling for fiscal policy as well -- both sets of policymakers need to feel as much pressure to act as possible.
Friday, September 23, 2011
Several people have asked me in recent days if the Fed's aggressive attempts to get the economy going will lead to galloping inflation to go along with our weak economic growth. It is possible that this might occur down the road, of course, but I don't see it happening just now. The slack labor market has kept growth in nominal wages low, and labor represents a large fraction of a typical firm's costs. A persistent inflation problem is unlikely to develop until labor costs start rising significantly. Notice in the graph above that the period of stagflation during the 1970s is well apparent in the nominal wage data. The same thing is not happening now. This is one reason I think the Fed is on the right track worrying more about the weak economy than about inflationary threats.
Wednesday, September 07, 2011
It's nice to see that at least one member of the FOMC gets it, and is willing to act:
The Fed's Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy, by Charles Evans, President, FRB Chicago: In the summer of 2009, the U.S. economy began to emerge from its deepest recession since the 1930s. But today, two years later, conditions still aren’t much different from an economy actually in recession. GDP growth was barely positive in the first half of the year. The unemployment rate is 9.1%, much higher than anything we have experienced for decades before the recession. And job gains over the last several months have been barely enough to keep pace with the natural growth in the labor force, so we’ve made virtually no progress in closing the "jobs gap".
The Federal Reserve has responded aggressively to the deep recession and weak recovery, cutting short-term interest rates to essentially zero and purchasing assets that expanded its balance sheet by a factor of three. But since undertaking the so-called QE2 round of asset purchases last fall, the Fed’s aggressive policy actions have been on hold.
Some believe that this pause is entirely appropriate. They claim that the economy faces some kind of impediment that limits how much more monetary policy can do to stimulate growth. And, on the price front, they note that the disinflationary pressures of 2009 and 2010 have given way to inflation rates closer to what I and the majority of Fed policymakers see as the Fed’s objective of 2%. These considerations lead many to say that when adding up the costs and benefits of further accommodation, the risk of over-shooting our inflation objective through further policy accommodation exceeds the potential benefits of speeding the improvement in labor markets.
I would argue that this view is extremely, and inappropriately, asymmetric in its weighting of the Fed’s dual objectives to support maximum employment and price stability.
Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.
In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.
The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment. ...[continue reading]...
Monday, August 22, 2011
Paul Krugman is taking a break from his column today (Arrrr!), so here's a summer rerun. Can you guess when he wrote this?:
Stop worrying and learn to love inflation, by Paul Krugman: ...depression economics - the kinds of problems that characterized much of the world economy in the 1930s but have not been seen since - has staged a stunning comeback.
Five years ago hardly anybody thought that modern nations would be forced to endure bone-crushing recessions for fear of currency speculators; that a major advanced country could be persistently unable to generate enough spending to keep its workers employed; that even the Federal Reserve would worry about its ability to counter a financial market panic. The world economy has turned out to be a much more dangerous place than we imagined. For the first time in two generations, failures on the demand side of the economy - insufficient private spending to make use of the available productive capacity - have become the clear and present limitation on prosperity for much of the world.
Economists and policymakers weren't ready for this. The specific set of silly ideas known as 'supply-side economics' is a crank doctrine, which would have little influence if it did not appeal to the prejudices of wealthy men; but over the past few decades there has been a steady drift in thinking away from the demand side to the supply side of the economy. The truth is that good old -fashioned demand-side macroeconomics has a lot to offer in our current predicament - but its defenders lack all conviction.
Paradoxically, if the theoretical weaknesses of demand-side economics are one reason we were unready for the return of depression-type issues, its practical successes are another. Central banks have repeatedly managed demand - cutting rates to keep spending high - so effectively that a prolonged slump due to insufficient demand became inconceivable. Except in the very short run, then, the only limitation on economic performance was an economy's ability to produce - that is, the supply-side. ...
The question of how to keep demand adequate to make use of the capacity has become crucial. Depression economics is back. ... The free-market faithful tend to think of Keynesian policies - deliberate efforts by governments to stimulate demand - as the enemy of what they stand for. But they are wrong. For in a world where there is often not enough demand to go around, the case for free markets is a hard case to make. ...
The right perspective is to realize how very much good free markets and globalization have done; the point is to preserve those gains. One cannot defend globalization merely by repeating free-market mantras as economy after economy crashes. If we want to see more nations making the transition from abject poverty to the hope of a decent life, we had better find answers to the problems of depression economics. ...
I don't like the idea that countries will need to interfere in markets - to limit the free market in order to save it. But it is hard to see how anyone who has been paying attention can still insist that nothing of the kind needs to be done, that financial markets will always reward virtue and punish only vice.
One of the most important obstacles to sensible action, however, is prejudice -by which I mean the adherence of too many influential people to orthodox views that are no longer relevant to our changed world. ...
This brings us to the deepest sense in which depression economics has returned. The quintessential economic sentence is supposed to be 'There is no free lunch'; it says that there are limited resources; to have more of one thing you must accept less of another. Depression economics, however, is the study of situations where there is a free lunch, if we can figure out how to get our hands on it, because there are unemployed resources that could be put to work.
In 1930, John Maynard Keynes wrote that 'we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand'. The true scarcity in his world - and ours - was therefore not of resources, or even virtue, but understanding.
Originally published, 6.20.99
Then, as now, he points to inflation as the answer to a liquidity trap:
So what should we be doing differently? ... Japan, having fallen in its liquidity trap - unable to recover by means of conventional monetary policy, because even a zero interest rate is not low enough - and having exhausted its ability to spend its way out with budget deficits, must now radically expand its money supply. It must convince savers and investors that its current deflation will turn into sustained, though modest, inflation. Once the Japanese make up their mind to do this, the results will startle them. ... There is no economic evidence suggesting that inflation at the ... 4 per cent rate I believe Japan should target, does any noticeable harm; and the things advanced countries need to do to counter depression economics do not involve any compromise of the commitment to free markets. ...
Thursday, August 18, 2011
Defending the Dollar, Uneasy Money: After administering a pro-forma slap on the wrist to Texas Governor Rick Perry for saying that it would be treasonous for Fed Chairman Bernanke to “print more money between now and the election,” The Wall Street Journal in today’s lead editorial heaps praise on the governor for taking a stand in favor of “sound money.” First there was Governor Palin, and now comes Governor Perry to defend the cause of sound money against a Fed Chairman who, in the view of the Journal editorial page, is conducting a massive money-printing operation that is debasing the dollar.
Well, let’s take a look at Mr. Bernanke’s record of currency debasement. The Bureau of Labor Statistics announced the latest reading (for July 2011) of the consumer price index (CPI); it stood at 225.922. Thirty-six months ago, in July 2008, the index stood at 219.133. So over that entire three-year period, the CPI rose by a whopping 3.1%. That is not an annual rate, that it the total increase over three years, so the average annual inflation rate over the whole period was less than 1%. The last time that the CPI rose by as little as 3% over any 36-month period was 1958-61. It is noteworthy that during the administration of Ronald Reagan — a kind of golden age, in the Journal‘s view, of free-market capitalism, low taxes, and sound money — there was no 36-month period in which the CPI increased by less than 8.97%, or about 3 times as fast as the CPI has risen during the quantitative-easing, money-printing, dollar-debasing orgy just presided over by Chairman Bernanke. Here is a graph showing the moving 36-month change in the CPI from 1950 to 2011. If you can identify which planet the editorial writers for The Wall Street Journal are living on, you deserve a prize. ...
“Mr. Perry,” the Journal continues, “seems to appreciate that the Federal Reserve can’t conjure prosperity from the monetary printing presses.” A huge insight to be sure. But the Journal is oblivious to the possibility that there are circumstances in which monetary stimulus in the form of rising prices and the expectation of rising prices could be necessary to overcome persistent and debilitating entrepreneurial pessimism about future demand. How else can one explain the steady decline in real (inflation-adjusted) interest rates over the past six months? On February 10 the yield on the 10-year TIPS bond was 1.39%; today the yield has dropped below zero. For the Journal to attribute the growing pessimism to the regulatory burden and high taxes, as it reflexively does, is simply laughable now that Congressional Republicans have succeeded in preserving the Bush tax cuts, preventing any new revenue-raising measures, and blocking any new regulations that were not already in place 6 months ago. ...
Friday, August 12, 2011
Narayana Kocherlakota makes it clear that the rate at which the recovery is proceeding is just fine with him. No more accommodation from the Fed is necessary given that "Since November, inflation has risen and unemployment has fallen."
But he doesn't acknowledge that the November date is cherry-picked to some extent. Since January -- just two months from when he starts his measurement -- unemployment has actually risen. He's happy with that? As for inflation -- the worry that is stopping him from endorsing a more aggressive policy -- using his preferred time period from last November until now, core PCE has risen from 1.0% to 1.3%. And it didn't move at all between May and June, it was 1.3% in both months. Uh oh, hyperinflation! Assuming a target of 2.0%, at this rate the Fed will reach it's inflation target in about a year and a half. Sounds kind of like the guidance they issued (and there is a good argument that the Fed should overshoot its target in the short-run). Perhaps lag effects can explain his response, if we tighten now we may not feel it until a year later, but that doesn't seem to be his argument:
In its August 9 meeting, the Committee changed this “extended period” language to say instead that it “currently anticipates economic conditions … are likely to warrant extraordinarily low levels of the federal funds rate through mid-2013.” This statement is designed to let the public know that the fed funds rate is likely to stay between 0 and 25 basis points over the next two years, not just over the next three to six months. Hence, the new language is intended to provide more monetary accommodation than before.
I dissented from this change in language because the evolution of macroeconomic data did not reflect a need to make monetary policy more accommodative than in November 2010. In particular, personal consumption expenditure (PCE) inflation rose notably in the first half of 2011, whether or not one includes food and energy. At the same time, while unemployment does remain disturbingly high, it has fallen since November. I can summarize my reasoning as follows. I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.
Again, "well-calibrated" should include both the direction and pace of change. Even if the direction is correct, is he satisfied with the pace of change for employment? I realize he thinks we will have to tighten in 3-6 months, but it's hard to see how a data-based projection takes you to this outcome (even more so if you believe, as I do, that the risks are asymmetric, i.e. that unemployment is more costly than inflation).
Finally, this is not a rock solid commitment from the Fed. This is their view of the most likely path for the federal funds rate, they have not said this is what they will do independent of how the data evolve. All they have said is that economic conditions are likely to warrant this outcome. The dissenters seem to believe that another outcome is more likely, the view is that economic conditions will force the Fed into a different posture -- you know, that high inflation and rapid recovery we've been seeing to date -- in as soon as 3-6 months. Anything is possible, but again, it's hard to see how recent data point to this outcome.
Update: Here's the view from the right.
Sunday, July 03, 2011
Richmond Federal Reserve president Jeffrey Lacker says the Fed should forget about the unemployed and focus on inflation:
Fed’s Lacker: Central Bank Needs to Focus on Inflation, Not Jobs, WSJ: The Federal Reserve should focus on keeping prices under control, leaving the government to try to boost the U.S. economy and jobs, Richmond Federal Reserve Bank President Jeffrey Lacker said in an interview Friday.
Though frustrated by a recovery that continues to be slow and choppy two years after the recession ended, Lacker said further monetary stimulus by the Fed would likely show up “almost entirely” in inflation, which is already too high. ...
[T]he Fed official urged President Barack Obama and Congress to come up with a credible long-term plan to cut the budget deficit without worrying too much about the short-term effects on growth.
The Fed is worried about inflation, Congress is worried about the deficit, but who is worried about the unemployed? I don't mean worried in the sense of acknowledging it's a problem and saying empathetic things -- oh those poor unemployed, too bad for them -- I mean worried enough to try to do something about it.
Wednesday, June 01, 2011
Gavyn Davies discusses the Lucas lecture I noted the other day, and makes many of the same points -- the banking analysis is fairly standard, but the classical analysis of the crash leaves out any role for demand, and that is puzzling. (The lecture is a bit hidden and hard to find -- I stumbled on it by clicking on the graph in this post). As I said in my post, "It's not the 'lack of confidence' fairy that is holding things back, it's lack of demand."
While were on this topic, Gauti Eggertsson of the NY Fed is worried about repeating the mistakes of the past -- mistakes we will make if we adopt the classical view of people like Lucas:
Commodity Prices and the Mistake of 1937: Would Modern Economists Make the Same Mistake?, by Gauti Eggertsson, FRBNY: In 1937, on the eve of a major policy mistake, U.S. economic conditions were surprisingly similar to those in the nation today. Consider, for example, the following summary of economic conditions: (1) Signs indicate that the recession is finally over. (2) Short-term interest rates have been close to zero for years but are now expected to rise. (3) Some are concerned about excessive inflation. (4) Inflation concerns are partly driven by a large expansion in the monetary base in recent years and by banks’ massive holding of excess reserves. (5) Furthermore, some are worried that the recent rally in commodity prices threatens to ignite an inflation spiral.
While this summary arguably describes current trends, it is taken from an account of conditions in 1937 that appears in “The Mistake of 1937: A General Equilibrium Analysis,” an article I coauthored with Benjamin Pugsley. What we call “the Mistake of 1937” was, in broad terms, a decision by the Fed and the administration to implement a series of contractionary policies that choked off the recovery of 1933-37 and brought on the recession of 1937-38, one of the worst on record. What is particularly noteworthy is that the inflation fears that triggered the Mistake of 1937 were largely driven by a rally in commodity prices. These circumstances invite direct comparison with our own time, when a substantial recent rise in commodity prices (which now seems to be abating somewhat) stoked inflation fears and led some commentators to call for an increase in the federal funds rate. ...[continue reading]...
His bottom line is a bit more optimistic than mine given that we have people like John Taylor calling for immediate rate hikes and contractionary fiscal policy:
The bottom line, then, is that it is unlikely that a modern economist transported back in time to 1937 would have preemptively tightened policy on the scale that policymakers did at the time. ...
Monday, May 23, 2011
The War on Inflation, by Tim Duy: During World War II, advertisements warning against inflationary behavior were common. One example:
This is a simple description of a wage-price spiral, something that was a real threat at the time as massive resources were being directed at the war effort. Some members of the Federal Reserve appear to believe this threat is as real today as it was then. Mark Thoma directs us to the Wall Street Journal, where Kathleen Madigan reads the FOMC minutes and concludes:
Windfall for commodity producers, no problem. Bigger paychecks for U.S. workers, now wait a minute…
That’s one reading of the minutes from the Federal Reserve‘s April 26-27 Federal Open Market Committee. The strategy makes sense from an economics’ standpoint; but it carries risks on both the political and growth fronts.
The extreme end of these fears can be found in Kansas City Federal Reserve President Thomas Hoenig’s recent Washington Post interview:
WP: One place where there’s not any inflation is in wages. Can you really have an inflation problem without wages rising?
TH: Not initially. But people are losing real purchasing power, and that changes how they’re going to negotiate. People want this lost purchasing power back in time. In negotiating, they’ll say, “Prices have been rising, we deserve more.” We’re already seeing it in some of the surveys that we run. Businesses are telling us, “Yes, we had a pay freeze a year and a half ago, but we’re doing some catch up now. We want to make sure we keep our good people.”
Any significant wage gains in the current environment appear to be sector specific – it certainly does not appear in the aggregate data. And note Hoenig’s distress that some firms are looking to play catch-up. I think you could interpret this as Hoenig desiring to see a downward level shift in trend wages. In other words, Hoenig expects the recession should result in a permanently lower level of standard of living than would have been the case otherwise.
For the moment, however, calmer minds prevail, pushing the Fed to delay tightening. From the minutes:
In their discussion of monetary policy, some participants expressed the view that in the context of increased inflation risks and roughly balanced risks to economic growth, the Committee would need to be prepared to begin taking steps toward less-accommodative policy. A few of these participants thought that economic conditions might warrant action to raise the federal funds rate target or to sell assets in the SOMA portfolio later this year, but noted that even with such steps, monetary policy would remain accommodative for some time to come. However, some participants indicated that underlying inflation remained subdued; that longer-term inflation expectations were likely to remain anchored, partly because modest changes in labor costs would constrain inflation trends; and that given the downside risks to economic growth, an early exit could unnecessarily damp the ongoing economic recovery.
If unit labor cost growth remains constrained, the Fed will tend to delay tightening, as the overriding economic reality is that simply described by New York Federal Reserve President William Dudley:
...the recovery remains moderate and we still have a considerable way to go to meet the Fed's dual mandate of full employment and price stability.
That said, it is worth considering that even the Fed doves probably have something of an itchy trigger finger when it comes to tightening. They are willing to stay the course given the lack of pass-through to wages, but one could imagine that changing quickly with the slightest whiff of rising unit labor costs. Which brings to mind an interesting topic. Way back in 2009, spencer at Angry Bear noted that labor payments as a share of output have been falling since the early 1980’s. Can this situation ever be reversed if the Fed steps on the brakes every time workers get a little too confident for their own good?
Mark concludes his review of the Madigan piece with:
We are much too worried about a wage-price inflation cycle breaking out and causing problems. If the Fed is too trigger happy, it could snuff out the recovery it is hoping to bring about.
The Fed is much, much better at slowing the economy down than it is at speeding it up. Thus, if the Feds is going to make an error, it should be biased toward the error it can fix the easiest. That is, in the face of uncertainty the Fed should be biased toward policy that is too loose rather than policy that is too tight -- a policy that is too loose is easier to correct if it's wrong. Unfortunately, I don't think the Fed sees it this way.
No, the Fed doesn’t see it this way. I think I know exactly how the Fed would respond to Mark: You think the 1980’s were easy? The expansion of the balance sheet has given rise to too many fears of the 1970’s within the Fed, and those fears will drive the Fed to try to stay far ahead of the inflation curve. That argues for a premature tightening. This year? Still seems difficult to imagine given the state of the economy. But next year seems reasonable, as further strengthening of the labor market will enhance fears that inflationary wage gains are just around the corner.
Finally, for those in Congress chastising the Fed for inflation, note point 4 in the advertisement above:
Support higher taxes…pay them willingly.
Thursday, May 19, 2011
I think this is correct in terms of how the Fed is viewing inflation risks:
Fed Fears of Wage Increases Carry Risks, by Kathleen Madigan, RTE: Windfall for commodity producers, no problem. Bigger paychecks for U.S. workers, now wait a minute…
That’s one reading of the minutes from the Federal Reserve‘s April 26-27 Federal Open Market Committee. The strategy makes sense from an economics’ standpoint; but it carries risks on both the political and growth fronts.
According to the minutes, Fed officials continue to think the impact from higher commodity prices will be “transitory.” The bigger concern would be if wage increases took hold. After all, labor remains the biggest expense for most U.S. businesses. If wages were to increase rapidly, companies would be under more pressure to raise their selling prices — which would cause workers to ask for bigger raises to cover the higher prices.
So far, the Fed sees little evidence of that inflationary cycle — mostly because there is so much slack in the labor markets. ... And as long as the pressures on labor costs remain muted, “a large, persistent rise in inflation would be unusual,” the minutes added. In other words, higher prices concentrated in energy and raw materials won’t bring a response from the central bank. But if wages pick up, the Fed may step in.
In theory, the policy is sound, given the dominance of labor costs to pricing decisions. ... But don’t expect the public to welcome the idea that wage gains need to remain “subdued.” The Fed could face more threats of greater oversight from Washington politicians if central bankers are seen as turning a deaf ear to the wants of working voters. Congressional meddling would complicate the Fed’s job.
Second, the price increases being tolerated by the Fed are wreaking havoc on household budgets. ... Without faster real income growth, consumers won’t provide the demand needed to power the recovery. Keeping the recovery going is another ball the Fed needs to keep juggling.
We are much too worried about a wage-price inflation cycle breaking out and causing problems. If the Fed is too trigger happy, it could snuff out the recovery it is hoping to bring about.
The Fed is much, much better at slowing the economy down than it is at speeding it up. Thus, if the Feds is going to make an error, it should be biased toward the error it can fix the easiest. That is, in the face of uncertainty the Fed should be biased toward policy that is too loose rather than policy that is too tight -- a policy that is too loose is easier to correct if it's wrong. Unfortunately, I don't think the Fed sees it this way.
Thursday, May 12, 2011
Tuesday, May 10, 2011
I seem to be more hesitant about calling for a higher inflation target than people I generally agree with on economic policy:
A 2% Inflation Target Is too Low..., by Brad DeLong: Live at the Economist: Economist Debates: Inflation: Guest:
...should we be targeting a higher rate? I believe that the answer is yes.
To explain why, let me take a detour back to the early nineteenth century and to the first generations of economists--people like John Stuart Mill who were the very first to study in the industrial business cycle in the context of the 1825 crash of the British canal boom and the subsequent recession. John Stuart Mill noted the cause of slack capacity, excess inventories, and high unemployment: in the aftermath of the crash, households and businesses wished to materially increase their holdings of safe and liquid financial assets. The flip side of their plans to do so--their excess demand for safe and liquid financial assets--was a shortage of demand for currently-produced goods and services. And the consequence was high unemployment, excess capacity, and recession,.
Once the root problem is pointed out, the cure is easy. The market is short of safe and liquid financial assets? A lack of confidence and trust means that private sector entities cannot themselves create safe and liquid financial assets for businesses and households to hold? Then the government ought to stabilize the economy by supplying the financial assets the market wants and that the private sector cannot create. A properly-neutral monetary policy thus requires that the government buy bonds to inject safe and liquid financial assets--what we call "money"--into the economy.
All this is Monetarism 101. Or perhaps it is just Monetarism 1. We reach Advanced Macroeconomics when the short-term nominal interest rate hits zero. When it does, the government cannot inject extra safe and liquid money into the economy through standard open-market operations: a three-month Treasury bond and cash are both zero-yield government liabilities, and buying one for the other has no effect on the economy-wide stock of safety and liquidity. When the short-term nominal interest rate hits zero, the government has done all it can through conventional monetary policy to fix the cause of the recession. The economy is then in a "liquidity trap."
Now this is not to say that the government is powerless. It can buy risky and long-term loans for cash, it can guarantee private-sector liabilities. But doing so takes risk onto the government's books that does not properly belong there. Fiscal policy, too, has possibilities but also dangers.
My great uncle Phil from Marblehead Massachusetts used to talk about a question on a sailing safety examination he once took: "What should you do if you are caught on a lee shore in a hurricane?" The correct answer was: "You never get caught on a lee shore in a hurricane!" The answer to the question of what you should do when conventional monetary policy is tapped out and you are at the zero interest rate nominal bound is that you should never get in such a situation in the first place.
How can you minimize the chances that an economy gets caught at the zero nominal bound where short-term Treasury bonds and cash are perfect substitutes and conventional open-market operations have no effects? The obvious answer is to have a little bit of inflation in the system: not enough to derange the price mechanism, but enough to elevate nominal interest rates in normal times, so that monetary policy has plenty of elbow room to take the steps it needs to take to create macroeconomic stability when recession threatens. We want "creeping inflation."
How much creeping inflation do we want? We used to think that about 2% per year was enough. But in the past generation major economies have twice gotten themselves stranded on the rocks of the zero nominal bound while pursuing 2% per year inflation targets. First Japan in the 1990s, and now the United States today, have found themselves on the lee shore in the hurricane.
That strongly suggests to me that a 2% per year inflation target is too low. Two macroeconomic disasters in two decades is too many.