Category Archive for: Inflation [Return to Main]

Monday, October 01, 2012

Fed Watch: If QE Causes Commodity Price Inflation...

Tim Duy:

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:

Commodity

If anything, commodity prices have been moving generally sideways since the Fed began expanding its balance sheet:

Fed

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?

Pcepath

What about the surging inflation expectations in the TIPS markets (not necessarily the best measures of inflation expectations, and the ones already falling anyway)?

Infexplong

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

Unfounded Fear of Inflation

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:

Expinf
[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

Rogoff: Central Banks will Eventually ... be Driven to Tolerate Higher Inflation

Ken Rogoff:

...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

Trimmed Mean Inflation

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%:


1-month 6-month 12-month
Mar-12 2.30 1.97 2.02
Apr-12 1.50 1.95 1.93
May-12 1.49 1.85 1.90
Jun-12 1.42 1.75 1.86

Notice any trends?

Saturday, July 28, 2012

What Draghi Hasn’t Done

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

Fed Watch: A Missing Ingredient

Tim Duy:

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

Catastrophic Credibility

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

Plosser on the Risks from Europe

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:

On inflation:
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

Break Them Up

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:

Cleveland

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

Inflation Can Help to Stimulate a Depressed Economy

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

Please Sirs, May We Have Some More?

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"

Paul Krugman:

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

Are the Hawks Correct about the Fall in Productive Capacity?

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

Monetary Policy: More or Less?

Narayana Kocherlakota recently says (and Jason Rave is not happy):

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

Paul Krugman: Not Enough Inflation

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

pgl:

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

No Sign of an Inflation Problem

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

Sep-11
Oct-11
Nov-11
Dec-11
Jan-12
Feb-12
PCE
2.0
0.1
1.1
0.8
2.7
3.8
PCE excluding food & energy
0.0
1.4
1.7
1.8
2.7
1.6
Trimmed mean PCE
1.4
1.7
2.2
1.8
1.8
1.4

 

Six-month PCE inflation, annual rate

Sep-11
Oct-11
Nov-11
Dec-11
Jan-12
Feb-12
PCE
2.4
1.7
1.6
2.0
1.7
1.7
PCE excluding food & energy
2.0
1.8
1.6
1.6
1.6
1.5
Trimmed mean PCE
2.0
1.8
1.9
1.9
1.8
1.7

 

12-month PCE inflation

Sep-11
Oct-11
Nov-11
Dec-11
Jan-12
Feb-12
PCE
2.9
2.7
2.7
2.5
2.4
2.3
PCE excluding food & energy
1.6
1.7
1.8
1.9
1.9
1.9
Trimmed mean PCE
1.7
1.8
1.9
1.9
1.9
1.9
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

Fed Watch: Inflation: Still Nothing to See Here

Tim Duy:

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.  

Pcefeb12A

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%:

Pcefeb12B

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:

Pcefeb12C

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

The Economy’s Great Fall: Are the Losses Permanent?

DeLong and Summers, the debate over potential output, and whether Bernanke has the courage, foresight, and persuasiveness to follow Greenspan's lead:

The Economy’s Great Fall: Are the Losses Permanent?

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

Testing the Inflation "Floodgates"

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

Can the Doves Cage the Hawks?

What I think the Fed should do:

Can the Doves Cage the Hawks?

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

Fed Watch: Will They Or Won't They?

Tim Duy:

Will They Or Won't They?, by Time Duy: Calculated Risk reads this passage in a recent speech by San Francisco Federal Reserve President John Williams:

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.

and concludes:

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:

Corepce

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:

Headline

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

"What Output Gap?"

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

Paul Krugman: Things Are Not O.K.

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

Fed Watch: Output Gaps and Inflation

Tim Duy:

Output Gaps and Inflation, by Tim Duy: Regarding, again, the size of the output gap, this remark is found in the most recent Fed minutes:

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:

1210wagesall

Perhaps a better example is the relatively new series, wages for all workers:

1210wagesprod

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.
This is also covered by Paul Krugman here and here.
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:

1210ulc
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

Paul Krugman: G.O.P. Monetary Madness

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

"Rate of increase slows for Key Measures of Inflation"

Calculated Risk:

Rate of increase slows for Key Measures of Inflation

So, with inflation fears falling, the Fed is more likely to act, right? Don't set your hopes too high:

Fed’s Lacker: U.S. Inflation Still Too High - WSJ

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:

Fed’s Rosengren: Fed Should Take Any Action It Can to Help Economy

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

"Negative Real Interest Rates"

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

Mankiw: I am Not Very Worried about Inflation Just Now

Greg Mankiw:

Why I am not very worried about inflation just now, by Greg Mankiw:

Click on graphic to enlarge.
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

The Fed's Dual Mandate: Responsibilities and Challenges Facing U.S. Monetary Policy

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

Krugman: Stop Worrying and Learn to Love Inflation

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"

David Glasner:

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

What Was Kocherlakota Thinking When He Dissented on Monetary Policy?

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: See Matt Rognlie: Macroeconomics in Action (I've made this point several times in the past, and should have mentioned it here as well).

Update: Here's the view from the right.

Sunday, July 03, 2011

The You're On Your Ownership Society

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

Classic Mistakes

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."

Paul Krugman and Brad DeLong follow up on Lucas's refusal "to concede that, to even consider the possibility that we’re in a demand-shortfall slump of the kind Keynes diagnosed."

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

Fed Watch: The War on Inflation

Tim Duy:

The War on Inflation, by Tim Duy: During World War II, advertisements warning against inflationary behavior were common. One example:

Inf-wwii
[click to enlarge]

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

Fed Fears Wage Increases

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

M2

GrowthM2
LogM2

Tuesday, May 10, 2011

Is a 2% Inflation Target too Low?

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.

Saturday, April 30, 2011

David Andolfatto: Ron Paul's Comments on Bernanke's Press Conference

David Andolfatto continues his battle with Ron Paul and his supporters:

Ron Paul on Bernanke's Press Conference, Macromania: CNBC interview with Congressman Ron Paul yesterday (April 28, 2011); click here. The interviewer begins by quoting a statement Paul made after Bernanke's news conference:

Bernanke continues to ignore his culpability for the inflation all Americans suffer due to the Fed's relentless monetary expansion.

Let's take a look at U.S. inflation since 2008. Here it is.

The average annualized rate of inflation over this time period is a dizzying 1.6%. Note the significant deflation experienced during the economic crisis. Ah, good times. The rate of return on your money was really high back then! I can recall clearly how savers were rejoicing...praising the Fed for the deflation.

PCE inflation measures the nominal price of a basket of consumer goods. You know, the stuff people buy to maintain their material living standards. This price index was actually falling in 2010. For better or worse, the Fed interprets "price stability" as 2% inflation. This explains QE2.

PCE inflation has recently jumped up to near 5%. This jump is attributable primarily to food and energy prices. Despite what some people like to believe, the Fed does not control food and energy prices (at least, not separately from other prices). Most economists attribute these relative price changes to geopolitical events and other temporary global shocks affecting the world supply and demand for food and energy.

It seems that what Congressman Paul means by inflation (judging by this interview) is "commodity price inflation." I think he must have in mind the price of commodities like gold. ...

Recent money supply and gold price dynamics seem to support Congressman Paul's hypothesis, which he states as some sort of obvious universal truth. But if this is so, then what explains the following data?

The graph above plots the price of gold and the (base) money supply over the 20 year period September 1980 to March 2001. As you can see, the Fed created a lot of money "out of thin air" over this 20 year period. The base money supply increased by over 300%.

Imagine that you are 50 years old in September 1980. Imagine that a trusted friend of yours--oh, let's say your doctor--convinces you to put all your savings into gold. The reason he offers is that the Fed is pursuing a policy of "relentless money expansion." He warns you that the money supply is set to grow by 300% over the next 20 years. So you listen to him.

You buy gold at $673 per ounce. And then you wait. You wait until you turn 70. And then you go to withdraw your savings. You discover that the gold price in March 2001 is $263 per ounce. That's a whopping rate of return of...wait for it... -60% over 20 years. That's a minus sixty percent. ... Viva la gold standard! ...

Friday, April 29, 2011

Paul Krugman: The Intimidated Fed

Why won't the Fed do more to help the unemployed?:

The Intimidated Fed, by Paul Krugman, Commentary, NY Times: Last month more than 14 million Americans were unemployed by the official definition... Millions more were stuck in part-time work because they couldn’t find full-time jobs. And we’re not talking about temporary hardship. Long-term unemployment, once rare in this country, has become all too normal: More than four million Americans have been out of work for a year or more. ...
It all adds up to a clear case for more action. Yet Mr. Bernanke indicated that he has done all he’s likely to do. Why?
He could have argued that he lacks the ability to do more, that he and his colleagues no longer have much traction over the economy. But he didn’t. On the contrary, he argued that the Fed’s recent policy of buying long-term bonds, generally referred to as “quantitative easing,” has been effective. So why not do more?
Mr. Bernanke’s answer was deeply disheartening. He declared that further expansion might lead to higher inflation.
What you need to bear in mind here is that the Fed’s own forecasts say that inflation will be below target over the next few years, so that some rise in inflation would actually be a good thing, not a reason to avoid tackling unemployment. ...
The only way to make sense of Mr. Bernanke’s aversion to further action is to say that he’s deathly afraid of overshooting the inflation target, while being far less worried about undershooting — even though doing too little means condemning millions of Americans to the nightmare of long-term unemployment.
What’s going on here? My interpretation is that Mr. Bernanke is allowing himself to be bullied by the inflationistas: the people who keep seeing runaway inflation just around the corner and are undeterred by the fact that they keep on being wrong.
Lately the inflationistas have seized on rising oil prices as evidence in their favor, even though — as Mr. Bernanke himself pointed out — these prices have nothing to do with Fed policy. The way oil prices are coloring the discussion led the economist Tim Duy to suggest, sarcastically, that basic Fed policy is now to do nothing about unemployment “because some people in the Middle East are seeking democracy.”
But I’d put it differently. I’d say that the Fed’s policy is to do nothing about unemployment because Ron Paul is now the chairman of the House subcommittee on monetary policy.
So much for the Fed’s independence. And so much for the future of America’s increasingly desperate jobless.

Monday, April 18, 2011

Liberty Blog: What Is Driving the Recent Rise in Consumer Inflation Expectations?

Giorgio Topa, Wilbert van der Klaauw, Olivier Armantier, and Basit Zafar of the NY Fed's Liberty blog attempt to disentangle the forces behind recent increases in inflationary expectations. It appears to be oversensitivity to food and energy prices:

What Is Driving the Recent Rise in Consumer Inflation Expectations?, by Giorgio Topa, Wilbert van der Klaauw, Olivier Armantier, and Basit Zafar, NY Fed: The Thomson Reuters/University of Michigan Survey of Consumers (the “Michigan Survey” hereafter) is the main source of information regarding consumers’ expectations of future inflation in the United States. The most recent release of the Michigan Survey on March 25 drew considerable attention because it showed a large spike in year-ahead expectations for inflation: as shown in the chart below, the median rose from 3.4 to 4.6 percent and the other quartiles of responses showed similar increases. ... In this post, we draw upon the findings of an ongoing New York Fed research project to shed some light on the possible sources of the recent increase and to gauge its significance. While our research spans both short- and medium-term inflation expectations, this blog post discusses movements in short-term measures only...

Chart1

Inflation expectations are a key consideration in the conduct of modern monetary policy. ... To this end, central banks not only look at market-based measures of inflation expectations and surveys of professional forecasters and businesses, but also track surveys of consumers’ inflation expectations, including the widely followed Michigan Survey. ...
Our research shows that ... the wording of the Michigan question induces mixed interpretations, with many people thinking about the specific prices they pay in their everyday purchases, and especially those prices that undergo large changes, such as food and gasoline prices. As a result, the Michigan measure appears to reflect expectations of food and gasoline price increases to a much larger extent than is suggested by their share in household expenditures and in measures of overall inflation such as the consumer price index. ...
With this background information, we now return to our initial question: What factors could explain the recent large spike in short-term inflation expectations observed in the Michigan Survey? One possible explanation is that the observed rise in inflation expectations is tied to an expected increase in nominal wages. ... As the chart below indicates, year-ahead median wage growth expectations have remained muted since February 2009. While this is a troubling sign for wage earners’ incomes, it suggests that concerns about wages exerting second-order effects on inflation are not founded at present.

Chart3

Another possible explanation for the Michigan Survey reading is that short-term inflation expectations may be responding to concerns about accelerating growth in government debt. In our survey, we also ask respondents about their expectations for the year-ahead change in the level of government debt. We find that these expectations have actually declined in recent months, as shown in the chart below. Therefore, the recent rise in inflation expectations does not seem to be tied to an expected increase in the growth of government debt.

Chart4

Finally, our experimental survey also asks respondents about expected price changes for specific items. The last chart reports year-ahead inflation expectations for gasoline, food, medical costs, and housing costs. The survey responses point to increases in inflation expectations for food and housing costs, as well as an especially large increase in expectations for gasoline inflation. ...

Chart5

In sum, our research shows that expectations of higher nominal wage growth or concerns about increased growth of nominal government debt are unlikely to be behind the recent increase in short-term inflation expectations reported in the Michigan Survey. Instead, we suggest that this rise in inflation expectations reflects two factors: (1) sharp expected increases in food and especially gasoline prices and (2) the use of a survey question (“prices in general”) that results in reported expectations being more sensitive to these types of price change. An important open question concerns the extent to which households act on their expectations of overall inflation as well as on their expectations of specific price changes. As noted earlier, one significant area in which inflation expectations may influence consumer behavior is in the wage negotiation process, but thus far neither the “prices in general” nor the “rate of inflation” measure appears to be feeding into increases in expected future wage growth. We hope to return to this open question in a future post.
Chart data Excel 13 kb
Disclaimer
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

Saturday, April 09, 2011

Fed Watch: Meltzer, Part II

Tim Duy follows up his post about Allan Meltzer:

Meltzer, Part II, by Tim Duy: David Altig gives Allan Meltzer a more charitable read than I did:

Generally speaking, the Meltzer strategy offers what I perceive to be two critical criteria for a viable exit plan. One is that the winding down of the mortgage-backed securities (MBS) and long-term Treasury securities on the Fed's balance sheet should be conducted in a way that avoids market disruption and distortion as much as possible. The second is, of course, that the excess reserves held in the banking system—the liability side of the Federal Reserve’s balance sheet—have to be removed or "locked up" as needed to avoid an inflationary expansion of broad money and credit.

I take Altig seriously, but believe he is giving Meltzer far too much credit.

First off, there is nothing in the Meltzer plan that keeps the excess reserves “locked up.” Instead, Meltzer claims that simply moving a portion of the assets and corresponding liabilities off the Fed’s balance sheet onto another bank’s balance sheet somehow magically changes the monetary situation. From the Wall Street Journal:

The Fed's current operating balance sheet would be back to a more manageable range of about $1 trillion. This proposal removes some of the risk of inflation by removing some of the bank reserves that threaten to fuel it.

This seems pretty clear – Meltzer suggests that bank reserves that are not “officially” part of the balance sheet are no longer available to fuel inflationary pressures. Why? If we split the Fed in half, call one part the “official” Fed, and the other part the “bad” Fed, does the aggregate size of the balance sheet change? Does the aggregate amount of excess reserves change? I don’t see how.

Altig, in the above quote, shows a preference for an orderly plan to wind down the balance sheet. I agree, but think there needs to be flexibility to wind down quickly should the need arise. Meltzer’s plan does not offer that flexibility:

The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature. Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery.

Again, Meltzer implies that if he simply changes the location of the assets, that if they are not “official Fed assets,” they magical change from inflationary to inert. Moreover, he ensures that the assets are not available for immediate sale should it become necessary, thereby depriving the Fed of one tool to rapidly drain reserves.

What I suspect is that Meltzer does not trust the Fed to reduce the balance sheet and thus seeks to create a mechanism that forces it to do so. He thinks this reduces the inflationary risk; I would say just the opposite.

Altig then nails down the fatal flaw of the Meltzer plan:

Which brings me to a point that I don't quite follow about the Meltzer plan: If reserve assets are removed from the banking system, what are the corresponding offsets on the balance sheets of private banks?

The potential problem is that the excess reserves held by private banks do not have to stay at the Federal Reserve – they are free to leave and becoming new lending. Something needs to occur to draw them into the Fed, or any quasi-Fed bad bank. If you want to take away one asset, cash, you need to give them another. It is not an issue of Altig not being able to “follow the Meltzer plan.” Again, he is giving Meltzer too much credit. Meltzer simply does not address this issue. In contrast, Altig does address this issue, and his post contains numerous example of mechanisms, either directly or indirectly through links, to draw excess reserves into the Fed. For example:

My guess is you end up with something like term deposits or their economic equivalent—nonnegotiable sterilization bonds, for instance. And if you match the maturities of those deposits with the maturities of the MBS and long-term security portfolio, it becomes pretty clear that the debate is really less about tactics and more about some pretty familiar, but difficult, issues: When is it time to stand pat on policy, and when is it time to reverse course?

Exactly. Meltzer offers nothing new, just another voice that saying the Fed needs to act sooner than later. Otherwise, he is empty of new ideas. The Federal Reserve staff have already devised a number of actual and potential tools to drain reserves, all of which can be done without creating a “bad” bank. Meltzer offers up an accounting slight of hand that fails to address the key issue of what will prevent private banks from lending out the excess reserves rather than parking them at the Fed. That hole – the crux of the issue – is filled by Altig.

Friday, April 08, 2011

Fed Watch: Misguided Meltzer

Tim Duy:

Misguided Meltzer, by Tim Duy: After scouring the Wall Street Journal for stories by competent journalists, I found myself in the op-ed section. Apparently I feel compelled to make the same mistakes over and over. In any event, I found Allan Meltzer’s latest inflation warning staring me in the face. Most of the piece is not new territory, but it has an interesting twist at the end.

Meltzer begins with the same, tired lament:

Federal Reserve Chairman Ben Bernanke sees little risk of inflation because he doesn't look in the right places. Inflation is a general increase in prices, but increases always occur at different rates. Right now, labor costs are not rising but other costs, such as the prices of raw materials, have been and are continuing to increase. Businesses will pass some of these costs to their customers. Health-care costs also are continuing to rise.

Inflation is not a general increase in prices. That is a one-time price increase, or a shift in relative prices. Inflation is a continuous increase in the price level, which, to be perpetuated, needs to be matched by increasing wages – something Meltzer admits is not happening. Without an increase in wages, the current gains in headline inflation will prove to be transitory. Meltzer then brings up the boogieman of the 1970s:

Mr. Bernanke tells us that inflation won't be a problem as long as unemployment remains at an unacceptable level. But considerable research shows that this reasoning is badly flawed. During the inflation of the 1970s, for example, the discredited "Phillips Curve"—which suggested that high unemployment and rising prices shouldn't go together—persistently underestimated inflation and misled the Fed into pursuing an ever more expansive policy. If the Fed looked, it would find many other countries that experienced high inflation and high unemployment together.

Yes, inflation can coexist with high unemployment, but only in the presence of accelerating wage growth. This combination existed in the 1970s, but not now. Look at the historical record. The path of unit labor cost growth prior to 1980 is very different from that experienced since 1980. Until unit labor costs start accelerating, fears of a return to the 1970s are misplaced. Next Meltzer tries to redefine the CPI:

Those who doubt that the United States is headed for inflation remind us that increases in the consumer price index (CPI), and the "core" CPI that omits food and energy prices, remain modest. But the CPI and the core CPI are currently misleading because 40% of the CPI and 25% of the core CPI represent housing prices and are heavily dependent on statistical estimates of what homeowners would pay to rent their homes. Most of us never see these prices and do not pay them the same way we pay for food, gasoline and health insurance.

First, Meltzer does not even understand when the data is actually poised to work in his favor. Apartment vacancy rates are falling, suggesting that rents, and thus housing component of CPI, are set to rise. Perhaps Meltzer would be happy to use the housing prices that people actually pay, but those are falling, which is not exactly consistent with his argument. Notice also that Meltzer wants to narrow the CPI down to only those items going up in price. Why not to those items going down in price? He continues:

Furthermore, the Fed treats gasoline and oil price increases as a transitory blip. That's almost certainly correct about the effect of Arab unrest or the Japanese tsunami. But much of the rise in oil prices came before these events and was in response to the strengthening world economy. Prices will likely continue to rise as the world economy grows. Meanwhile, world grain prices have been driven up by the foolish U.S. ethanol program. When ethanol raises corn prices, prices for substitutes like wheat and rice rise also. There is no sign that Congress will repeal the ethanol program.

Meltzer conveniently ignores that rising commodity prices have simply reversed the losses sustained during the recession. Apparently he would be happier if the Fed induced a recession to offset that terrible improvement in the global economy. On top of which he wants the Fed to “fix” the relative price changes induced by Congress. Good luck with that.

Then Meltzer finishes with a twist, his grand proposal to save us from inflation:

One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its "quantitative easing" policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?

One idea is for the Fed to create its own version of a "bad bank." The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank's assets…

…The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature…

Yes, that’s right – Meltzer’s solution to the inflation threat is to tie the hands of the Federal Reserve so that they cannot liquidate the balance sheet if necessary. More:

…Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank's assets decline. The reduction in the bad bank's assets means that its liabilities, the excess reserves, would also decline—though that would be years away.

No, if the Fed cannot sell the assets, then they are not “off the table,” they are the centerpiece of the table. If you are worried about inflation, you don’t want to entrench a system that ensures that excess reserves would decline “years away.” You want the exact opposite – to drain the reserves right now.

Rather than admitting that the Fed has not induced a monetary collapse, that the world has not ended, that Treasury rates are mired below 4%, that he is simply wrong, Meltzer offers a completely backwards policy proposal. A short step from there to complete irrelevance.

Tuesday, March 29, 2011

Inflation vs. Jobs: Fed’s Move Can Seal Its Fate

Haven't had a chance to write much the last few days, but here's something you can yell at me about in comments (or not):

Inflation vs. Jobs: Fed’s Move Can Seal Its Fate

Update: I forgot to mention that CBS MoneyWatch asked me to write about a similar topic yesterday (I tried to say something different, but there's still a bit of repetition):

Bernanke’s New Quarterly Press Conferences

Sunday, March 27, 2011

Ron Paul's Money Illusion: The Sequel

David Andolfatto continues his battle with Ron Paul supporters:

Ron Paul's Money Illusion (Sequel), by David Andolfatto: As I promised to do here, I am posting a sequel to my original column: Ron Paul's Money Illusion. ... I ... hope that the nature of my criticism will be more clearly understood.

The purpose of my original post was to critique a statement I've heard Fed critics repeat ad nauseam. The statement can be found in Paul's book End the Fed (p. 25):

One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy.

I think that the first part of this statement is true, so I do not wish to dispute this fact. ... As for the final sentence in the quote above, well, I think it is just plain false. Now let me explain why...

Let me begin with the picture most popular with end-the-fed types--a graph depicting the declining purchasing power of the USD. I use postwar data without loss of generality, since most of US inflation has happened since then.

This picture plots the inverse of the price-level (as measured by the consumer price index). I have normalized the price-level to $1.00 in 1948. It falls to roughly $0.11 in 2010. This corresponds to roughly a nine-fold increase in the price-level or about a 4.6% annual rate of inflation. (Note that the rate of inflation has slowed considerably since 1980).

The picture above is used by some end-the-fed types to great effect in generating anger and fear among some members of the population. Anger via the claim that the Fed has stolen 90% of (the purchasing power) of your money; and fear through the prospect of this purchasing power approaching zero in the not-too-distant future. ...

Let me draw you another picture. This one plots the inverse of the U.S. nominal wage rate (total nominal wage income divided by aggregate hours worked).
This graph plots the purchasing power of the USD, where purchasing power is now measured in terms of labor, rather than goods. This graph shows that you need a lot more money today than you did in 1948 to purchase 1 hour of labor. Another way of saying this is that the average nominal wage rate in the U.S. has increased by a factor of 25 since 1948. ...

Let me now combine the two graphs above into one picture, with both series inverted, and with both the price-level and nominal wage rate normalized to $1.00 in 1948 (the actual nominal wage rate was $1.43).

According to these (publicly available) data, the price-level (CPI) has increased by about a factor of 10 since 1948. But the average nominal wage rate has increased by a factor of 25. (There is, of course, considerable disparity in wage rates across members of the population. But I am aware of no study that attributes significant wage or income heterogeneity to monetary policy. Of course, if readers know of any such studies, I would be grateful to have them sent to me.)

The figure above implies that the real wage (the nominal wage divided by the price-level) has increased by a factor of 2.5 since 1948. This is undoubtedly a good thing because it implies that labor (the factor we are all endowed with) can produce/purchase more goods and services. More output means an increase in our material living standards (Though again, I emphasize that this additional output is not shared equally. ...)

Now, an interesting question to ask is how the picture above might have been altered if the price-level had instead remained more or less constant. ...

I suggested, in my original post, that there is reason to believe that under an hypothetical regime of price-level stability, the nominal wage rate in the graph above would instead have ended up increasing only by a factor of 2.5 (more or less)--the factor by which real wages actually rose. This is what I meant by my claim of long-run neutrality of the price-level increase; and it is also what I meant by Ron Paul's Money Illusion (which is subtly different than claiming the superneutrality of money expansion; more on this later).

Some evidence in favor of my "long-run neutrality view" is to be found in the time-path of labor's share of income (GDP):

I see no evidence in the data here that our higher price level today has whittled the share of income accruing to labor. Moreover, I see no evidence suggesting that episodes of high or low inflation are related in any systematic way to the resources accruing to labor. (In fact, I see some evidence of a rising labor share during the high inflation decade of the 1970s.) But perhaps other data tells a different story. If so, I'd like to see the data (i.e., instead of a short email claiming that I am wrong). ...
To conclude, I think that the ... assertion that "the Fed has stolen 95 cents of every dollar" I view as absurd. There are legitimate criticisms one could level at the monetary institutions of this country, but these are not some of them. ...

Thursday, March 10, 2011

Should the Fed Respond to Commodity Price Increases?

To answer the question in the title of this post, it's useful to think of an island with only two goods. One of the goods is non-renewable, but highly desirable. The other good is less preferred, but it is renewable (thinking of renewable and non-renewable energy resources, for example). The key is to distinguish between changes in prices that reflect changes in the relative scarcity of the two goods, and changes driven by increases in the money supply.

Over time, as the stock of the more desired good falls due to consumption, the price of this good will rise relative to the renewable good. Consumers will be hit by increases in the cost of living -- the same basket of the two goods purchased last year now costs more.

But is this the kind of increase in prices the Fed should respond to? No, the price increase -- and the increase in the cost of living -- reflects increasing scarcity of the desired good. The price of the two goods are changing to balance the relative supplies of the two goods. Unless the price of the non-renewable resource does not properly take account of the preferences of future generations -- and it may not -- or there is some other market failure, there is no reason for government to intervene to change the prices. If the prices are correct, they will allocate the resources optimally.

Now consider a different case. Suppose the central bank in charge of money -- sea shells of a particular type identified with the central bank's special mark -- and the money supply is being increased at a rapid rate. This will drive the prices of both goods up, but so long as the price of each good rises in proportion to the change in the money supply so that the relative price of the two goods is undisturbed, no problem. The price level will adjust to the number of sea shells in circulation, but since relative values remain intact, nothing will change.

However, suppose one of the two prices is sticky. It does not change very fast when the number of sea shells in circulation increases. In this case relative prices will be distorted as the number of sea shells increases, one price will rise faster than the other, and resources will be misallocated. In this case the Fed would want to do something about the inflation since it is having negative effects on the efficient allocation of the two resources. This is, essentially, the Fed's justification for activist policy.

A couple of notes. First, it's interesting to think about how technological change that improves the quality or lowers the price of the renewable good plays into this. Such a change could offset the increase in the cost of living that households face. Thus improving technology, not Fed policy, is the key to helping people on the island struggling with high prices.

Second, this is about the long-run and growth in demand. The central bank may still want to try to offset temporary price spikes, for example when sticky prices can cause problems that persist beyond the spike in the price of one of the two goods (e.g. a spike in the price of oil that leads to long-lived price distortions). But long-run growth that causes the price of one of the goods to rise by more than the other, i.e. relative price changes, is not something the Fed should try to neutralize.

Monday, February 28, 2011

The Fed's Hawkish Stance

At MoneyWatch:

The Fed's Hawkish Stance

It tries to explain why, to quote Christina Romer, "Monetary policy makers are all hawks now."

Monday, January 31, 2011

Paul Krugman: A Cross of Rubber

Central bank authorities should not give in to demands for higher interest rates:

A Cross of Rubber, by Paul Krugman, Commentary, NY Times: Last Saturday, reported The Financial Times, some of the world’s most powerful financial executives were going to hold a private meeting with finance ministers in Davos... The principal demand of the executives ... would be that governments “stop banker-bashing.” Apparently bailing bankers out after they precipitated the worst slump since the Great Depression isn’t enough — politicians have to stop hurting their feelings, too.
But the bankers also had a more substantive demand: they want higher interest rates ... because they say that low rates are feeding inflation. And what worries me is the possibility that policy makers might actually take their advice.
To understand the issues, you need to know that we’re in the midst of ... a “two speed” recovery, in which some countries are speeding ahead, but ... advanced nations — the United States, Europe, Japan — have barely begun to recover. ... To raise interest rates under these conditions would be to undermine any chance of doing better; it would mean, in effect, accepting mass unemployment as a permanent fact of life.
What about inflation? High unemployment has kept a lid on the measures of inflation that usually guide policy. ... But food and energy prices — and commodity prices in general — have ... been rising lately. Corn and wheat prices rose around 50 percent last year; copper, cotton and rubber prices have been setting new records. What’s that about?
The answer, mainly, is growth in emerging markets ... — China in particular — ... has created ... sharply rising global demand for raw materials. Bad weather ... has also played a role in driving up food prices.
The question is, what bearing should all of this have on policy at the Federal Reserve and the European Central Bank? First of all, inflation in China is China’s problem, not ours. ... Neither China nor anyone else has the right to demand that America strangle its nascent economic recovery just because Chinese exporters want to keep the renminbi undervalued.
What about commodity prices? The Fed normally focuses on “core” inflation, which excludes food and energy... And this focus has served the Fed well in the past. ... It’s hard to see why the Fed should behave differently this time...
So why the demand for higher rates? Well, bankers have a long history of getting fixated on commodity prices. Traditionally, that meant insisting that any rise in the price of gold would mean the end of Western civilization. These days it means demanding that interest rates be raised because the prices of copper, rubber, cotton and tin have gone up, even though underlying inflation is on the decline.
Ben Bernanke clearly understands that raising rates now would be a huge mistake. But Jean-Claude Trichet, his European counterpart, is making hawkish noises — and both the Fed and the European Central Bank are under a lot of external pressure to do the wrong thing.
They need to resist this pressure. Yes, commodity prices are up — but that’s no reason to perpetuate mass unemployment. To paraphrase William Jennings Bryan, we must not crucify our economies upon a cross of rubber.

Monday, January 24, 2011

Fed Watch: Inevitable Inflation Fears

Tim Duy notes rising concern about inflation from hawkish central bankers in Europe and elsewhere, and the tension that is building "as emerging markets fight the Fed":

Inevitable Inflation Fears, by Tim Duy: The Wall Street Journal is reporting that ECB head Jean-Claude Trichet is turning increasingly hawkish:

Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent's debt crisis.

In an interview with The Wall Street Journal ahead of this week's annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don't gain a foothold in the global economy…

An interesting development in light of the ongoing (or is it never ending?) European Debt Crisis. Rate hikes will just be adding insult to injury for the peripheral nations already struggling with a debt-deflation spiral. The price for being part of the Euro just keeps getting higher.

Inflation fears have yet to grip the Federal Reserve, for good reason. Back to the Wall Street Journal:

While high unemployment and spare capacity are restraining underlying inflation pressures in the U.S. and elsewhere in the developed world, annual inflation in China is almost 5%—and a sizzling 9.8% economic growth rate in the fourth quarter triggered fears of more price pressures ahead. Inflation in Brazil is even higher.

The next inflation crisis is not occurring in the US, as opponents of QE2 thought likely, but in the developing markets instead. To be sure, my sympathy for developing nations wore thin long ago. They will identify the Federal Reserve as the proximate cause of their problems, whereas they have only themselves to blame. Higher inflation abroad was the only outcome if the protocols of Bretton Woods II did not submit to the onslaught of QE2. And the Federal Reserve has very good reason to keep the pedal to the medal. A review of recent inflation behavior:

FW012311
If inflation abroad is a problem, it is not because the Federal Reserve has set rates too low, but because emerging markets been unwilling to allow their currencies to appreciate sufficiently against the Dollar. See, for example, recent Dollar buying on the part of Brazil. See also Paul Krugman, who illustrates the clear difference in emerging and developed nation industrial production trends. Again, if inflation abroad is a problem, it is one that emerging markets need to tackle themselves.

Expect global tensions to continue building as emerging markets fight the Fed. While the Fed may identify higher commodity prices as a potential concern, policymakers are not likely to reverse course and tighten policy unless higher commodity prices push through to core inflation. Such an outcome appears unlikely given persistently high unemployment. Consider too that the likely outcome of rising commodity prices is to slow US growth, thereby decreasing the odds of pass-through to core.

I have said this before – I do not see how this ends well. Given that the Fed is not likely to back down from this fight, emerging markets need to put the brakes on their internal inflation issues, the sooner the better. Otherwise they will be facing pain of a real inflation crisis, one that requires stepping on the brakes even harder. How this story unfolds this year will determine of the global economy can transition to a sustainable, balanced growth trajectory, or plunges into yet another of the seemingly all-too-frequent crises.