Category Archive for: Monetary Policy [Return to Main]

Monday, November 23, 2015

Fed Watch: Mission Accomplished

Tim Duy:

Mission Accomplished, by Tim Duy: Federal Reserve policymakers have pretty much taken all of the mystery out of this next meeting. Federal Reserve Vice Chair Stanley Fischer, via Reuters:

"In the relatively near future probably some major central banks will begin gradually moving away from near-zero interest rates," Fed Vice Chairman Stanley Fischer told the San Francisco Fed's biannual Asia Economic Policy conference.

"While we at the Fed continue to scrutinize incoming data, and no final decisions have been made, we have done everything we can to avoid surprising the markets and governments when we move, to the extent that several emerging market (and other) central bankers have, for some time, been telling the Fed to 'just do it'."

New York Federal Reserve President William Dudley, via Reuters:

The Federal Reserve should "soon" be ready to raise interest rates as U.S. central bankers grow confident that low inflation will rebound and that employment remains stable, William Dudley, the influential head of the New York Fed, said on Friday.

"We hope that relatively soon we will become reasonably confident that inflation will return to our 2 percent objective," he said at Hofstra University. Dudley said it was "very logical" to expect that the Fed's inflation and employment conditions would be met "soon," allowing policymakers to "start thinking about raising the short-term interest rates."

Atlanta Federal Reserve President Dennis Lockhart, via CNBC:

A top Federal Reserve official said Thursday he is "comfortable" with raising the federal funds rate "soon," as concerns about low inflation and global risks are not persuasive enough to keep interest rates near zero.

"I'm comfortable with moving off zero soon," said Atlanta Fed President Dennis Lockhart in prepared remarks.

San Francisco Federal Reserve President John Williams, via Reuters:

"The data I think have been overall encouraging, especially on the labor market," San Francisco Fed President John Williams told reporters after a conference at University of California Berkeley's Clausen Center.

"Assuming that we continue to get good data on the economy, continue to get signs that we are moving closer to achieving our goals and gaining confidence getting back to 2-percent inflation... If that continues to happen there's a strong case to be made in December to raise rates."

Obviously serial dissenter Richmond Federal Reserve President Jeffrey Lacker is also looking for a rate hike. And so too is Cleveland Federal Reserve President Loretta Mester. To be sure, they all give a nod to “data dependence,” implying that a rate hike is not a sure thing. But, barring an outright collapse in financial markets, it is very difficult to see the data evolve between now and December 15-16 in such a way that the Fed suddenly has a change of heart. And note there is little reason for them to think at this point that growth has slowed well below trend. It is widely expected that Q3 GDP is this week revised up to 2.1% while current quarter GDP is tracking at 2.3%. While in 1990s terms these are not staggering numbers, in 2010 terms they exceed the Fed’s estimate of potential GDP growth. And with more and more Fed officials convinced the economy is operating near full employment, anything over 2% raises worries on Constitution Avenue that the economy might overheat.

Now, we still have one employment report ahead of us. Aside from the now-reversed equity declines in August, recall from the last minutes that uncertainty regarding the labor market helped stay the Fed’s hand:

In assessing whether economic conditions and the medium-term economic outlook warranted beginning the process of policy normalization at this meeting, members noted a variety of indicators, including some weaker-than-expected readings on measures of labor market conditions, and almost all members agreed it was appropriate to wait for additional information to clarify whether the recent deceleration in the pace of progress in the labor market was transitory or reflected more persistent factors that might jeopardize further progress.

It would seem that the October labor report put an end to those concerns. Consequently, the following comes into play:

Members emphasized that this change was intended to convey the sense that, while no decision had been made, it may well become appropriate to initiate the normalization process at the next meeting, provided that unanticipated shocks do not adversely affect the economic outlook and that incoming data support the expectation that labor market conditions will continue to improve and that inflation will return to the Committee's 2 percent objective over the medium term.

I suspect that only an outright disaster in the November labor report would prompt the Fed to take a pass at the December meeting. It is just simply the case that given their Phillips curve framework, they are running out of reasons not to raise rates. They would need enough weak data to fundamentally alter their outlook to the downside, and it is hard to see that happening in the short time remaining.

Consequently, it is hard to come to any other conclusion than that they are going to raise the target range on the federal funds rate in December. In Fedspeak, they might as well be screaming it into your ears.

While they may be taking the mystery out of the first rate hike, however, they are trying to put the mystery into subsequent rate hikes. Lockhart, via Reuters:

"The pace of increases may be somewhat slow and possibly more halting than historic episodes of rising rates," Lockhart said in a speech to the DeKalb Chamber of Commerce in Atlanta.

Williams, via Reuters:

"We definitely do not want to, either through our actions or our words, indicate a preference for a very mechanical path of interest rates, whether it’s every other meeting or however you think about it," Williams said. "Since economic data can surprise on the upside and the downside, maybe there will be opportunities to show we are data dependent."

And St. Louis Federal Reserve President James Bullard, via Bloomberg:

“When we had a normalization in 2004 to 2006 we moved at the same 25 basis points per meeting for 17 meetings in a row,” Bullard said. “I am virtually certain that was not optimal monetary policy. That was a very mechanical approach to increasing rates. This time I am hopeful we can be more flexible and reactive to data.”

How will they communicate uncertainty in the path of rate hikes? I wonder if they can simply retain this sentence in the next statement:

In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.

It seems like this could be used to convey uncertainty in subsequent meetings, especially if they choose not to hike in January.

Bottom Line: The Fed is set to declare “Mission Accomplished” at the next FOMC meeting. Indeed, many policymakers have already said as much. Absent a very significant change in the outlook, failure to hike rates in December would renew the barrage of criticism regarding their communications strategy that prompted them to highlight the December meeting in their last statement. Once they have communicated their intentions for subsequent rate hikes, they will turn their attention to the issue of normalizing the balance sheet. Even though officials have not committed to a specific path, I am working with a baseline of 100bp of tightening between now and next December, or roughly 25bp every other meeting. I expect that by the second quarter of next year they will begin communicating the fate of the balance sheet. Whether they should hike or not remains a separate issue. Over the next twelve months we will learn the extent of which the Federal Reserve can resist the global downward pull of interest rates. Other central banks have been less-than-successful in their efforts to pull off of the zero bound – not exactly a hopeful precedent.

Wednesday, November 18, 2015

'A More Inflexible Fed Would Cause More Crises'

Adam Posen:

A More Inflexible Fed Would Cause More Crises: Having saved the US economy from a second Great Depression, the Federal Reserve has become a political scapegoat in the Congress for its own failures to secure the recovery. Rather than improving our tax code, investing in our future, or simply passing a budget that is little more than avoiding default, the House is prioritizing so-called “reform” of the Fed.  Just as throughout the global financial crisis and recovery, Congress is abdicating its economic responsibilities to the American people and attacking one of the few policy institutions that worked instead.
Both Republicans and Democrats have already curtailed the ability of the US central bank to respond proactively to any financial crisis... They have done this by restricting the Fed’s ability to lend to troubled institutions in a crisis—even though such lending is the very essence of why the central bank exists: ...
Now, there are new legislative efforts trying to force the Fed to follow strictly a narrow policy rule when setting monetary policy even in normal times—and report to Congress in a very literal-minded short-term way about any deviations from that rule. ...
More closely examined, any imposition of a simplistic rigid policy rule with mechanistic monitoring will only serve to politicize monetary policy to an unprecedented extent. And that, for good reason, is almost universally seen in the economics profession as something that would inevitably lead to ongoing higher inflation and bigger, more frequent boom-bust cycles. ...
Any effort to limit US monetary policy to an inflexible rule with politicized short-term oversight should be opposed..., doing so would bring severe harm to the workers, savers, and investors in the US economy.

Monday, November 16, 2015

'Inflation and Activity – Two Explorations and their Monetary Policy Implications'

Olivier Blanchard, Eugenio Cerutti, and Lawrence Summers (the results are preliminary):

Inflation and Activity – Two Explorations and their Monetary Policy Implications Olivier Blanchard, Eugenio Cerutti, and Lawrence Summers NBER Working Paper No. 21726 November 2015: Introduction: We explore two empirical issues triggered by the Great Financial Crisis. First, in most advanced countries, output remains far below the pre-recession trend, leading researchers to revisit the issue of hysteresis... Second, while inflation has decreased, it has decreased less than was anticipated (an outcome referred to as the “missing disinflation’’), leading researchers to revisit the relation between inflation and activity.
Clearly, if confirmed, either the presence of hysteresis or the deterioration of the relation between inflation and activity would have major implications for monetary policy and for stabilization policy more generally. ...
First, we revisit the hysteresis hypothesis, defined as the hypothesis that recessions may have permanent effects on the level of output relative to trend. ... We find that a high proportion of recessions, about two-thirds, are followed by lower output relative to the pre-recession trend even after the economy has recovered. Perhaps more surprisingly, in about one-half of those cases, the recession is followed not just by lower output, but by lower output growth relative to the pre-recession output trend. That is, as time passes following recessions, the gap between output and projected output on the basis of the pre-recession trend increases. ...
Turning to the Phillips curve relation, we ... find clear evidence that the effect of the unemployment gap on inflation has substantially decreased since the 1970s. Most of the decrease, however, took place before the early 1990s. Since then, the coefficient appears to have been stable, and, in most cases, significant...
Finally, in the last section, we explore the implications of our findings for monetary policy. The findings of the second section have opposite implications for monetary policy... To the extent that recessions are due to the perception or anticipation of lower underlying growth, this implies that estimates of potential output, based on the assumption of an unchanged underlying trend, may be too optimistic, and lead to too strong a policy response to movements in output. However, to the extent that recessions have hysteresis or super-hysteresis effects, then the cost of allowing downward movements in output in response to shifts in demand increases implies that a stronger response to output gaps is desirable.
The findings of the third section yield less dramatic conclusions. To the extent that the coefficient on the unemployment gap, while small, remains significant, the implication is that, within an inflation targeting framework, the interest rate rule should put more weight on the output gap relative to inflation. ...

Friday, November 13, 2015

'Where Fed's Critics Got it Wrong in GOP Debate'

Couldn't resist commenting on this:

Where Fed's critics got it wrong in GOP debate, by Mark Thoma: The Federal Reserve was instrumental in easing the impact of the Great Recession. As bad as the downturn was, it could have have been worse if central bankers hadn't aggressively used monetary policy to curb the severity of the crisis and help put the U.S. economy on the path to recovery.
So it has been disappointing to hear Republican presidential candidates bash the Fed in their debates and on the campaign trail. ...

Paul Krugman: Republicans’ Lust for Gold

Why have Republican candidates for president embraced hard money policies?:

Republicans’ Lust for Gold, by Paul Krugman, Commentary, NY Times: It’s not too hard to understand why everyone seeking the Republican presidential nomination is proposing huge tax cuts for the rich. Just follow the money...
But what we saw in Tuesday’s presidential debate was something relatively new on the policy front: an increasingly unified Republican demand for hard-money policies, even in a depressed economy. Ted Cruz demands a return to the gold standard. Jeb Bush ... is open to the idea. Marco Rubio wants the Fed to focus solely on price stability, and stop worrying about unemployment. Donald Trump and Ben Carson see a pro-Obama conspiracy behind the Federal Reserve’s low-interest rate policy.
And let’s not forget that Paul Ryan ... has spent years berating the Fed for policies that, he insisted, would “debase” the dollar and lead to high inflation. Oh, and he has flirted with Carson/Trump-style conspiracy theories, too...
As I said, this hard-money orthodoxy is relatively new. ... George W. Bush’s economists praised the “aggressive monetary policy”... And Mr. Bush appointed Ben Bernanke... But now it’s hard money all the way. ...
This turn wasn’t driven by experience. The new Republican monetary orthodoxy has already failed the reality test with flying colors... But years of predictive failure haven’t stopped the orthodoxy from tightening its grip on the party. What’s going on?
My main answer would be that the Friedman compromise — trash-talking government activism in general, but asserting that monetary policy is different — has proved politically unsustainable. You can’t, in the long run, keep telling your base that government bureaucrats are invariably incompetent, evil or both, then say that the Fed, which is ... basically a government agency run by bureaucrats, should be left free to print money as it sees fit. ...
The interesting question is what will happen to monetary policy if a Republican wins next year’s election. As best as I can tell, most economists believe that it’s all talk, that once in the White House someone like Mr. Rubio or even Mr. Cruz would return to Bush-style monetary pragmatism. Financial markets seem to believe the same. At any rate, there’s no sign in current asset prices that investors see a significant chance of the catastrophe that would follow a return to gold.
But I wouldn’t be so sure. True, a new president who looked at the evidence and listened to the experts wouldn’t go down that path. But evidence and expertise have a well-known liberal bias.

Thursday, November 12, 2015

'Being An Inflation Hawk Means Never Having To Say You’re Sorry'

I was considering saying a few words about the Binyamin Appelbaum interview with Richmond Fed president Jeff Lacker, but Paul Krugman beat me to it:

Being An Inflation Hawk Means Never Having To Say You’re Sorry: Jeffrey Lacker, president of the Richmond Fed, is worried about inflation unless the Fed tightens quickly, ignoring the worriers. Here’s what he just said:
If we hope to keep inflation in check, we cannot be paralyzed by patches of lingering weakness.
Oh, wait: That’s what he said six years ago. It is, however, pretty much indistinguishable from what he is saying now.
It seems to me that this is a bit of much-needed context.

I prefer the approach by Charles Evans, president of the Chicago Fed where the asymmetric risks of making a policy mistake (due to the asymmetric difficulties of recovering from a policy mistake) are at the forefront:

... So why do I lack confidence in our ability to achieve our 2 percent inflation target over the medium term? One reason is that there exist a number of important downside risks to the inflation outlook. Now I recognize that “medium term” is somewhat vague. To a central banker it can mean two to three years or three to four years. It is more a term of art than science.
So what are these inflation risks? With prospects of slower growth in China and other emerging market economies, low energy and import prices could exert downward pressure on inflation longer than most anticipate. That’s a risk. In addition, while many survey-based measures of long-term inflation expectations have been relatively stable in recent years, we shouldn’t take them as confirmation that our 2 percent target is assured. In fact, some survey measures of inflation expectations have ticked down in the past year and a half. Furthermore, measures of inflation compensation derived from financial markets have moved quite low in recent months. These could reflect either lower expectations of inflation or a heightened concern over the nature of the economic conditions that will be associated with low inflation. Adding to my unease is anecdotal evidence: I talk to a wide range of business contacts, and virtually none of them are mentioning rising inflationary or cost pressures. No one is planning for higher inflation. My contacts just don’t expect it.
How does this asymmetric assessment of risks to achieving the dual mandate goals influence my view of the most appropriate path for monetary policy over the next three years? It leads me to conclude that 1) a later liftoff and 2) a more gradual normalization of our monetary policy setting will best position the economy for the potential challenges ahead.
More specifically, before raising rates, I would like to have more confidence than I do today that inflation is indeed beginning to head higher. Given the current low level of core inflation, some evidence of true upward momentum in actual inflation is critical to this assessment. I believe that it could be well into next year...
Historically, central bankers have established their credibility by defending their inflation target from above — to fight off undesirably high inflation. Today, policy needs to defend our inflation target from below. This is necessary to validate our claim that we aim to achieve our 2 percent inflation target in a symmetric fashion. Failure to do so may weaken the credibility of this claim. The public could begin to mistakenly believe that 2 percent inflation is a ceiling — and not a symmetric target. As a result, expectations for average inflation could fall, lessening the upward pull on actual inflation and making it even more difficult for us to achieve our 2 percent target.
Another factor underlying my thinking about policy is a consideration of policy mistakes we could make. One possibility is that we begin to raise rates only to learn that we have misjudged the strength of the economy or the upward tilt in inflation. In order to put the economy back on track, we would have to cut interest rates back to zero and possibly even resort to unconventional policy tools, such as more large-scale asset purchases. I think our multiple rounds of asset purchases were effective, but they clearly are a second-best alternative to traditional policy. This scenario is not merely hypothetical. Just consider the recent challenges experienced in Europe and Japan. Policymakers tried to raise rates that were near or at their lower bounds; but faced with faltering demand, they were forced to reverse course and deploy nontraditional tools more aggressively than before. And we all know the subsequent difficulties Europe and Japan have had in rekindling growth and inflation. So I see substantial costs to premature policy normalization.
An alternative potential policy mistake would be that sometime during the gradual policy normalization process, inflation begins to rise too quickly. Well, we have the experience and the appropriate tools to deal with such an outcome. Given how slowly underlying inflation would likely move up from the current low levels, we probably could keep inflation in check with only moderate increases in interest rates relative to current forecasts. And given how gradual the projected rate increases are to start with, the concerns being voiced about the risks of rapid increases in policy rates if inflation were to pick up seem overblown to me. For example, we could raise the funds rate 100 basis points more than envisioned by the median participant’s projection in a year simply by increasing rates 25 basis points at every meeting instead of at every other meeting — that’s hardly a steep path of rate increases.
All told, I think the best policy is to take a very gradual approach to normalization. The outlook for economic growth and the health of the labor market continues to be good. But the outlook for inflation remains too low. A gradual path of normalization would balance both the various risks to my projections for the economy’s most likely path and the costs that would be involved in mitigating those risks. ...

Wednesday, November 11, 2015

'A Debate With Bernanke Over the Fed’s Easy Money Policies'

William Cohan ("a former senior mergers and acquisitions banker") argues with Ben Bernanke over the Fed's interest rate policy. These people (the one who isn't Bernanke in this case) are nuts:

A Debate With Bernanke Over the Fed’s Easy Money Policies: By the end of our recent conversation, Ben S. Bernanke ... and I had a gentleman’s bet. I believe the easy money policies he ... put in place while serving as Fed chairman starting in 2008 ... will lead inevitably to a near-term financial crisis; he thinks that idea is beyond ridiculous...
“The low rate of interest isn’t something that God gave us,” he explained. “It’s something that is a feature of the economy. There’s a lot of savings in the world looking for a relatively small number of good-return investments, and so the equilibrium real interest rate in the economy is very, very low.” ...
There is a target interest rate that is consistent with full employment. “And for most of the recovery,” he said, “that number was actually negative. Any economist can explain why ..., “policy did lower the interest rate ... but even after lowering them, they were still too high ... because of the zero lower bound. ...
He said the blame for the extended period of low interest rates belonged with Congress... “Go complain to Congress because the fiscal policy turned very contractionary, which meant the Fed had to bear the entire burden of creating a recovery,” he continued. “If fiscal policy had been more balanced, then we could’ve had the same recovery with higher interest rates. ...Congress said essentially, ‘The Fed will take care of it,’ then the Fed could use the only tool it had.” ...
But he will owe me a beer when the next financial crisis hits, sooner than anyone would like.

Related to the post before this one:

He said that it was “a red herring” that quantitative easing or the zero interest rate policy helped make the rich richer...
“It’s been going on for a long time,” he said. “It’s been increasing since the 1970s. ... The Fed’s effects on inequality are modest and temporary, and the fact that the Fed’s policies created jobs means that the absolute benefits for the working class are very substantial.”

Trickle Down, Starve the Beast, Supply-Side, and Sound Money Fantasies

From the WSJ editorial page:

...On the other hand, Mr. Cruz’s pitch for “sound money” that helps the middle class stands out in the GOP field and deserves more elaboration. It’s also notable that nearly all of the GOP candidates identify the Federal Reserve’s post-crisis monetary policy as a source of rising inequality that has favored the wealthy. This is a populist note that has the added benefit of being true. ...

Rising inequality for four decades can be blamed on the Fed's response to the financial crisis? Seriously? On taxes:

Then there’s tax policy, in which all of the candidates offered up reform plans that would be an improvement over the status quo.

But it has to be the right kind of tax policy (tax cuts or credits for the wealthy:

Marco Rubio was challenged on his child tax credit, which he would increase to $2,500 from $1,000. ... Mr. Rubio’s diagnosis of the changing economy has particular appeal to anxious voters. It’s too bad his tax credit is such an expensive political pander.

But of course cutting taxes on the wealthy is not an expensive pander, it will generate growth!!! Tax revenue will rise and the deficit will fall!!! The benefits will trickle down to the middle class (unless that evil Fed gets in the way decades later)!!! None of which has actually happened according to the empirical evidence. Republicans seem to have a talent for telling economic stories about how their policies will benefit the middle class all the while disguising the true intent of the legislation. So long as it can be true in theory (the confidence fairy comes to mind), the actual evidence doesn't matter.

James Pethokoukis says it's time to end the supply-side charade:

A last hurrah for Republican tax slashers: The Republican party’s raison d’être is cutting taxes. ... Republicans should pray for a new purpose. Their standing with middle-class voters is little improved from 2012. ... Their “supply-side” orthodoxy would merit much of the blame. Big tax cuts, particularly for the wealthiest, do not work in an age of high inequality and heavy debt. ...
Many of the party’s 2016 candidates seem to disagree that change is needed. ... Almost all have released economic plans built around “pro-growth” tax cuts costing trillions. ... But there are good reasons to view the next election as a last hurrah for Republican-style supply-side policy.
First, voters do not much care about taxes. ... Second, America’s fiscal situation makes deep tax cuts implausible. ... Third, tax cuts look like an answer desperately searching for a problem. Today’s top US marginal tax rate is 39.6 per cent...
There are signs candidates are starting to wriggle out of the supply-side straitjacket. At this week’s Republican presidential debate in Wisconsin, Marco Rubio said a larger tax credit for families was just as important as tax cuts for business. ... While 1980s-style supply-side doctrine still rules the Republican roost, it may not beyond November 2016.

There are also signs that these proposals, while perhaps helping candidates draw votes, have little chance of success in Congress. Republicans may need a new cover story -- a new "economic" argument or the middle class that obscures the true intent of the policy -- but it's not clear there's anything as magical as trickle down, starve the beast, supply-side, sound money fantasies that have served them so well.

Update: From Kevin Drum:

...Well, the Tax Foundation is a right-leaning outfit, so you have to figure they're going to give Republican plans a fair shake. And their distributional analysis of Rubio, Bush, Trump, and Cruz shows that their tax plans are all pretty similar: tiny gains for middle-income workers and huge gains for the top 1 percent. I've used the static analysis, since it's the most tethered to reality, but even if you use the magic dynamic estimates you get roughly the same result: the rich make out a whole lot better than the middle class.
That said, you really have to give Ted Cruz credit. When it comes to giving huge handouts to the rich, he's the true Republican leader.


Tuesday, November 10, 2015

Questions for Monetary Policy

James Bullard, president of the St. Louis Fed, says there are five questions for monetary policy:

The five questions

  • What are the chances of a hard landing in China?
  • Have U.S. financial market stress indicators worsened substantially?
  • Has the U.S. labor market returned to normal?
  • What will the headline inflation rate be once the effects of the oil price shock dissipate?
  •  Will the U.S. dollar continue to gain value against rival currencies?

I would add:

  • Will wage gains translate into inflation (or something along those lines)?

Anything else?

Monday, November 09, 2015

'Budgetary Sleight-of-Hand'

Congress enjoys a "political free lunch," budgetary illusions that make it appear that tax cuts, new spending -- whatever -- will not require cuts in other spending, an increase in taxes, or change the deficit. Ben Bernanke reveals the trickery behind the latest attempt at deception:

Budgetary sleight-of-hand: The House voted Thursday to pay for planned highway construction by drawing on the Federal Reserve’s capital. The idea of using Fed capital to pay for government spending, which comes up periodically, is a bad one, for several reasons. ... More substantively—and this is what I want to focus on in this post—“paying” for highway spending with Fed capital is not paying for it at all in any economically meaningful sense. Rather, this maneuver is a form of budgetary sleight-of-hand that would count funds that are already designated for the Treasury as “new” revenue.

To see why, first note that the Fed, as a side effect of its other activities, is already a major source of revenue for the federal government. The Fed earns interest on its portfolio of securities. This income, less the Fed’s operating expenses and interest paid on Fed liabilities, is sent to the Treasury on a pretty much continuous basis. These remittances are large: Over the past half dozen years the Fed has sent nearly half a trillion dollars to the Treasury, funds which directly reduce the government’s budget deficit. ... The Fed’s capital account provides a buffer that absorbs any losses on the Fed’s portfolio and allows the payments to the Treasury to be smoothed over time.

Unlike the Fed’s remittances, which are real resources whose availability reduces the burden on the taxpayer, drawing down the Fed’s capital provides no net new funding for the government. ...

Legislators who care about the integrity of the budgeting process should not support this budgetary sleight-of-hand.

Fed Watch: Onto The Next Question

Tim Duy:

Onto The Next Question, by Tim Duy: It would seem that a December rate hike is all but certain barring some dramatic deterioration in financial conditions. The October employment report should remove any residual concerns among FOMC members over the underlying pace of activity, clearing the way for the Fed to make good on the strongly worded October FOMC statement. Given the resilience of recent trends, it is tough to see that even a weak-ish November employment report would dissuade the Fed from hiking rates. Quite frankly, regardless of whether you think they should hike rates, if they don't hike rates, the divergence between what they say and what they do would become truly untenable from a communications perspective.
Nonfarm payrolls jumped 271k in October, a relief after two weaker reports. Note though that the three-month moving average still indicates that job growth has lost some momentum:


That said, momentum remains sufficient to sustain ongoing improvement in a wide array of labor market indicators. Those pervasively identified by Federal Reserve Chair Janet Yellen:



Notably, wage growth accelerated, giving fresh hope that it has broken out of its multiyear doldrums. The Fed will see this as evidence that their estimates of the natural rate of unemployment are more right than wrong:


Another way to see that wage growth may be set to break higher:


If nominal wage growth were to break higher, would that reflect the impact of productivity gains, margin compression, or higher inflation? Your view on that question will influence your rate outlook.
With unemployment edging below the Fed's current estimate of the natural rate (note that we get updated forecasts in December) and wages showing signs of life, it seems that the Fed is positioned to move forward with a rate hike in December. This is especially if they want to make good on their promise to hike rates at a gradual pace. San Francisco Federal Reserve President John Williams reiterated that point last week. Via the Wall Street Journal:
“An earlier start to raising rates would also allow a smoother, more gradual process of policy normalization, giving us space to fine-tune our responses to any surprise changes in economic conditions,” Mr. Williams said. “If we were to wait too long to raise rates, the need to play catch-up wouldn’t leave much room for maneuver,” he said.
Note that the first hike and pace of tightening were never really separate as the Fed would like you to believe. Williams makes clear the the pace was in fact dependent on the timing of the first hike. The earlier they start, the more gradual the subsequent pace.
The question now arises, however, of what is "gradual"? The general consensus is the "gradual" means 25bp every other meeting. St. Louis Federal Reserve President James Bullard says there is not fixed definition as of yet. Via Reuters:
"Once 'liftoff' occurs the debate will immediately shift to when is the next move going to come? How fast is the pace of increases going to be? ... What does 'gradually' actually mean?" Bullard said. "That is going to be a hot debate and we won't really have credibility as a committee for the notion of gradualness until we make that second move."
Has the Fed already waited too long to sustain a path of 25bp every other meeting? That is what we should be asking. Indeed, I believe the next labor report will have more implications for the January meeting than the December meeting. Anxiety among Fed officials regarding whether or not they are falling behind the curve is inversely proportional to the unemployment rate. If it ticks down to 4.8% in the November report, they will start to get very nervous that 25bp every other meeting is not tenable. It of course goes without saying that if core-inflation starts to firm in the next two months and tend toward trend more quickly than anticipated, policymakers will break into a cold sweat.
Still unknown is how rate hikes will interact in the global environment. Fed Governor Lael Brainard has yet to give up her concerns. Via MarketWatch:
Brainard said the "feedback loop" between market expectations of divergence between the U.S. and its major trading partners and financial tightening in the U.S. means that "material restraint to U.S. conditions is already in place."
How much tightening Fed tightening can the US sustain in a world driven the zero lower bound globally? Such concerns are generally downplayed by Fed officials; that lack of concern is something I view as a key risk. The tipping point between loose and tight financial conditions is likely lower than in the past. The Fed may blow past that tipping regardless of how fast they hike rates. In some sense, one can argue that the end point for rate hikes is more important than whether the Fed moves on average at 12.5bp or 25bp every meeting.
Bottom Line: The debate is shifting. It is soon to be no longer about the first rate hike. Fed officials, the question is shifting from whether they should go at all to whether they waited too long.

Wednesday, November 04, 2015

Fed Watch: What 2016 Might Bring

Tim Duy:

What 2016 Might Bring, by Time Duy: I recently predicted the following:
One of two things is going to happen. Either the US economy is or will soon be slowing on the back of already tighter financial conditions. Or the US economy will soon be slowing on the back of future tighter financial conditions as directed by the Federal Reserve.
My baseline expectations for next year need more explanation, particularly in light of the weak third quarter GDP report and the early signals on fourth quarter growth via the Atlanta Fed’s GDPNow tracker (currently at the low-end of consensus). Three caveats, however, to keep in mind. First, I avoid over-analyzing the quarterly fluctuations in GDP preferring instead to track trends over a longer period. Second, similarly, the initial release will be subject to substantial revision. Third, the Atlanta Fed number may or may not evolve over the course of the quarter; where it is now is not necessarily where it will be when fourth quarter data is released.
That said, GDP growth slowed noticeably in the third quarter, dragging down recent trends:


Negative inventory adjustment, however, was a significant factor. When we look at recent trends in final sales to domestic purchases, domestic momentum remains solid:


Generally, housing, autos, services, and the government sectors remain solid. The soft spots are the external sector and manufacturing. These two are obviously related; weakness in manufacturing is closely tied to a stronger dollar and reduced activity in the oil and gas exploration. ISM surveys reveal a striking divergence between the manufacturing and services sides of the economy:


It is thus quite arguable that, after accounting for inventories, little momentum has been lost. The softening of the job growth, however, suggests that the underlying pace of growth has pulled back from full throttle (at least our current definition of full throttle):


Perhaps then growth has in fact softened, possibly a consequence of already tighter monetary policy. Minneapolis Federal Reserve President Narayana Kocherlakota:
In mid-2013, the FOMC announced its intention to taper its ongoing asset purchase program. We can see that this announcement represented a dramatic change in policy from the sharp upward movements in long-term bond yields that it engendered. Personally, I interpret this policy change back in 2013 as the onset of what the Committee currently intends to be a long, gradual tightening cycle. As I noted earlier, we would typically expect that such a change in monetary policy should affect the economy with a lag of about 18 to 24 months. Viewed through this lens, the slow rate of labor market improvement in 2015 is not all that surprising.
We will get a reading on the labor market Friday to help confirm or deny recent trends. Suppose the numbers both this month and next are better than expected, thus belying the recent softness. What will be the Fed’s reaction? I think it is fairly safe to say the “raise rates” contingent will have the upper hand in December, thus formally beginning the “normalization” process with a first rate hike of the cycle.
In other words, if growth is not in fact slowing, then the Federal Reserve will likely soon take action to slow growth. How many rate hikes follow? And how rapidly do they follow? The Fed appears to believe that they have roughly 375bp ahead of them and can raise rates every other meeting to get there. What actually happens will depend on how hard they think they will be running up against any constraints in the economy. As a summary indicator, note that the unemployment rate already sits at something near policymaker’s estimate of the natural rate of unemployment:


My interpretation of the Fed’s intentions is that they would like to see the unemployment rate temporarily stabilize at something below the natural rate to allow for further reduction in underemployment. To accomplish this job growth will need to slow over the next year to that necessary to absorb growth in the labor force. What does that mean for the numbers? San Francisco Federal Reserve President John Williams offers what is probably a reasonable middle ground among officials:
As we make our way back to an economy that’s at full health, it’s important to consider what constitutes a realistic view of the way things will look. The pace of employment growth, as well as the decline in the unemployment rate, has slowed a bit recently…but that’s to be expected. When unemployment was at its 10 percent peak during the height of the Great Recession, and as it struggled to come down during the recovery, we needed rapid declines to get the economy back on track. Now that we’re getting closer, the pace must start slowing to more normal levels. Looking to the future, we’re going to need at most 100,000 new jobs each month. In the mindset of the recovery, that sounds like nothing; but in the context of a healthy economy, it’s what’s needed for stable growth.
As the next year unfolds, what we want to see is an economy that’s growing at a steady pace of around 2 percent. If jobs and growth kept the same pace as last year, we would seriously overshoot our mark. I want to see continued improvement, but it’s not surprising, and it’s actually desirable, that the pace is slowing.
All else equal, if they are not seeing evidence of that slowing by the middle of next year I would expect them to accelerate the pace of rate increases. That is probably when we need to worry about overshooting. Not so much from the faster rate increases, but from the failure to account for policy lags. It may be a challenge to see the impacts of policy tightening early on if rate hikes are at a glacial pace. Hence the Fed may erroneously believe they need to play “catch-up” more than is truly necessary.
Overshooting, however, is a consideration for a later day. At this point it is sufficient to recognize that, at least under the current monetary policy framework, either the economy will slow by itself or the Fed will eventually work to force it to slow. That would seem to suggest that growth is at or past its peak for this cycle. That is the situation I am most wary of at the moment, leading me to the conclusion that growth is headed down in 2016.
I am not wedded to that scenario. I can envision sustained higher growth on the back of either faster than anticipated labor force growth or faster productivity growth. Recent trends tend not to be terribly supportive, but nonetheless I remain watchful that those trends shift. Indeed, perhaps we will see productivity rise as firms react to tighter labor markets. Such a scenario could deliver a sustained growth with accelerating wages. That would obviously be something of a win-win situation.
To be sure, the inflation outlook has an impact on the Fed's timing, but it remains something of a wildcard. The Fed expects to normalize only after they are reasonably confident that inflation will return to target. Two more solid job reports are enough to get there. The pace of subsequent rate hikes depends on the evolution of inflation relative to that target. As Federal Reserve Chair Janet Yellen said today, via the Wall Street Journal:
Referring to recent remarks by Fed governor Lael Brainard on the subdued state of U.S. inflation, Ms. Yellen told lawmakers that “if we were to move, say in December, it would be based on an expectation -- which I believe is justified -- that with an improving labor market and transitory factors fading, that inflation will move up to 2%. But of course if we were to move, we would need to verify over time that expectation was being realized, and if not, adjust policy appropriately.”
Near term inflation perked up a bit in September, but still remains below target:


One might think that persistently low inflation eventually wears on inflation expectations. Yellen raised this concern in September:
Although the evidence, on balance, suggests that inflation expectations are well anchored at present, policymakers would be unwise to take this situation for granted. Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation's "normal" behavior, and, furthermore, that a persistent failure to keep inflation under control--by letting it drift either too high or too low for too long--could cause expectations to once again become unmoored. Given that inflation has been running below the FOMC's objective for several years now, such concerns reinforce the appropriateness of the Federal Reserve's current monetary policy, which remains highly accommodative by historical standards and is directed toward helping return inflation to 2 percent over the medium term.
Interestingly, the University of Michigan’s survey of inflation longer-term inflation expectations continues to drift lower just as the Fed is considering rate hikes:


Contrast with the cycle of tightening in the middle of the last decade:


The accuracy of survey-based measures is in doubt, however. For example, via the St. Louis Federal Reserve, economist Kevin Kliesen concludes:
Going forward, most Federal Reserve officials expect inflation to eventually return to 2 percent. But when using measures of inflation expectations to forecast future inflation, policymakers and forecasters should focus on market-based measures of inflation expectations. They are much more accurate than survey-based measures.
Yellen, however, hesitates to embrace market-based measures of inflation expectations (although I suspect she would quickly embrace them if they headed higher). Discarding both measures thus leaves us with little guidance, unfortunately. My take is that there is probably some information from the direction of both measures, and that information is generally not supportive of the Fed’s confidence that inflation will return to target in a timely fashion. The Fed would have a hard time justifying ongoing hikes, even if the economy outperforms their expectations, if inflation remains tame. My suspicion is that under such a scenario the Fed would pivot away from their current inflation framework to financial stability concerns to justify tighter policy.
Bottom Line: I tend to believe that growth has peaked for this cycle, or, more accurately, that sustaining these growth rates will likely require faster productivity or labor force growth. Indeed, it appears the Fed will force such an outcome if they remain committed to their basic policy framework. This seems like a reasonable baseline from which to think about the next 4 or 5 quarters. Productivity growth could pick up such that a stabilizing unemployment rate remains consistent with steady growth. Assuming growth is not yet softening, a 25bp rate hike every other meeting beginning in December is also a reasonable baseline for monetary policy; if the Fed doesn't see that having an impact, they will likely step up the pace. It should go without saying that a slowing economy is not to be equated with a recession.

'Yellen Signals a Fed Tilt Toward December Rate Increase'

Here we go again:

Yellen Signals a Fed Tilt Toward December Rate Increase, by Binyamin Appelbaum: Janet L. Yellen, the Federal Reserve chairwoman, told Congress on Wednesday that the Fed would consider raising its benchmark interest rate in December, citing an economy that she said was “performing well.”
“It could be appropriate” to act at the Fed’s final policy-making meeting of the year, Ms. Yellen told the House Financial Services Committee. She suggested that if growth continued apace, the Fed was inclined to start raising interest rates, although she added the cautionary note that “no decision has been made.” ...

Monday, November 02, 2015

'You Should Sit Down with Your Nobel Prize Winning Husband'

Ralph Nader thinks Janet Yellen needs to consult with her husband on monetary policy:

... But anyway, Nader's questionable and sometimes wholly inaccurate policy analysis—don’t get me started on his aside about student loans—isn't really the most remarkable part of the letter. Rather, it's when the man gets personal. He writes:

Chairwoman Yellen, I think you should sit down with your Nobel Prize winning husband, economist George Akerlof, who is known to be consumer-sensitive. Together, figure out what to do for tens of millions of Americans who, with more interest income, could stimulate the economy by spending toward the necessities of life.

Yes, Ralph Nader just told the most powerful woman in the world to take more tips from her husband. Akerlof is a brilliant man. I'm sure he has interesting thoughts on monetary policy that they discuss over dinner. But Yellen is Fed chair for a reason.

Anyway, just in case Yellen wants advice from another man in her life, Nader has a second suggestion...

Thursday, October 29, 2015

'The Tragedy of Ben Bernanke'

I would send you to Brad DeLong's piece on Ben Bernanke through a short excerpt if I could, but when I post just a few sentences from anything appearing at Project Syndicate they get mad at me. So I mostly just put their articles in links, if I link them at all. Not sure why they don't want me to send them traffic.

Fed Watch: December Still Very Much A Live Meeting

Tim Duy:

December Still Very Much A Live Meeting, by Tim Duy: One of two things is going to happen. Either the US economy is or will soon be slowing on the back of already tighter financial conditions. Or the US economy will soon be slowing on the back of future tighter financial conditions as directed by the Federal Reserve.

In a worst case scenario, both of these things will happen.

And the odds of both of these things happening seems higher after this week's FOMC meeting. Rather than being a nonevent as expected, it was actually quite exciting. We learned that the majority of the FOMC remains wedded to the idea of a December rate hike. That was made very clear with this sentence:

In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation.

That was a fairly clear warning that December is really, really in play. No, really this time. They mean it. After all, a number of them are on record repeatedly saying that they expect to hike interest rates this year. I tend to wonder if they feel compelled to act on these statements? The opportunities to show their mettle are fairly limited at this point.

It also seems as if Federal Reserve Governors Lael Brainard and Daniel Tarullo were schooled hard this week. They argued publicly that they did not see reason to raise rates this year. I doubt they changed their opinions - at least not privately. But they very clearly did not change any opinions on the FOMC. Indeed, one wonders if they only hardened their colleagues positions on a rate hike this year. Consider Paul Krugman's response to me:

Maybe, but it’s also worth noting the difference in perspective that comes from having your original intellectual home in international versus domestic macroeconomics. I would say that Brainard’s experience is dominated not so much by the Great Moderation as by the Asian financial crisis and Japan’s stagnation; internationally oriented macro types were aware earlier than most that Depression-type issues never went away. And if you read Brainard’s argument carefully, she devotes a lot of it to the drag America may be facing from weakness abroad and the stronger dollar, which acts as de facto monetary tightening

Krugman is right; I should have mentioned this. Regardless, note what key line was removed from the September statement:

Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term.

Downplaying these concerns appears to be an effort to cut the knees out from under Brainard. To be sure, US markets rebounded, but have we seen much in the last six weeks to so quickly remove global concerns? I am wary to believe so with data like these:

CRB spot raw industrial price index set new 6 year low this week.
— Caroline Baum (@cabaum1) October 28, 2015

In any event, it seems reasonable to believe that the bar for a rate hike at the next FOMC meeting is fairly low. Prior to the meeting I said this:

The middle range of closer to 150,000 jobs a month—a more lackluster reading similar to the past two months—is the gray area. This is the range in which the proper application of risk management principles becomes critical. In that range—a range I find likely—the degree to which Brainard & Co. shape the debate at this week’s meeting will determine the policy outcome in December, and likely beyond.

I am thinking we now we know how little Brainard shaped the debate. Lackluster numbers seem likely to suffice at this juncture. Hence why market expectations moved as they did:

The "hawkish" shift in hike expectations (yest => today)... Dec: 34% => 46% Jan: 41% => 54% Mar: 57% => 68%
— Charlie Bilello, CMT (@MktOutperform) October 28, 2015

The willingness of the Fed to hike in the face of lackluster numbers is a bit disconcerting, to say the least. Lackluster numbers, by definition, indicate slower activity, and one would think that the Fed would like to see how that played out before piling on. But assuming this from Jon Hilsenrath at the the Wall Street Journal:

Mr. Fischer is among those more eager to raise rates.

It is easy to see how the Fed gets behind tighter policy. I don't know that Brainard could easily counter the gravitas of Fischer.

Bottom Line: December stays on the table. Very much so, in fact. Indeed, in all reality the only reason market participants have not gone all in on December is because they recognize that the Fed has repeatedly cried "wolf" this year. Makes one distrustful of the Fed's proclamations. At this juncture, my expectation is that only disappointing data prevents the Fed from moving in December. It will be interesting to see how well the Fed statement holds up to the light of this week's GDP report and the next two employment reports.

Wednesday, October 28, 2015

''The 'Most Confused' Critique of the Fed This Year''

Larry Summers provides another "huh?" response to the WSJ editorial by Mike Spence and Kevin Warsh claiming "that overly easy monetary policy reduces business investment. Indeed, they blame the weakness of business investment during the current recovery on the Fed":

I just read the ‘most confused’ critique of the Fed this year: My friends Mike Spence and Kevin Warsh, writing in the Wall Street Journal on Wednesday, have produced what seems to me the single most confused analysis of U.S. monetary policy that I have read this year. Unless I am missing something -- which is certainly possible -- they make a variety of assertions that are usually exposed as fallacy in introductory economics classes. (Brad DeLong has expressed related views).
My problem is not with their policy conclusion, though I do not share their highly negative view of quantitative easing (QE). There are many harshly critical analyses of QE ... which are entirely coherent and consistent with the macroeconomics of the last 50 years. My differences are based on judgments about empirical magnitudes and relative risks -- not questions of basic logic. ...
Perhaps Spence and Warsh are on to something that I am missing. I'm curious whether they can point to any peer reviewed economic research, or indeed any statistical work, that backs up their views. I am certainly open to any new evidence or new argument after all that has happened in recent years that easy money reduces business investment. And there is plenty of room for debate over policy.
For now, though, I would put the Spence-Warsh doctrine that easy money reduces investment in a class of propositions backed by neither logic nor evidence.

No Rate Hike

No rate hike, but door still open for later this year, appears a bit less worried about international conditions, a bit more worried about conditions in the US:

Press Release, Release Date: October 28, 2015, For immediate release: Information received since the Federal Open Market Committee met in September suggests that economic activity has been expanding at a moderate pace. Household spending and business fixed investment have been increasing at solid rates in recent months, and the housing sector has improved further; however, net exports have been soft. The pace of job gains slowed and the unemployment rate held steady. Nonetheless, labor market indicators, on balance, show that underutilization of labor resources has diminished since early this year. Inflation has continued to run below the Committee's longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation moved slightly lower; survey-based measures of longer-term inflation expectations have remained stable.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring global economic and financial developments. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.

To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining whether it will be appropriate to raise the target range at its next meeting, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.

The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.

When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.

Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams. Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting.

'Check Out Our Low, Low (Natural) Rates'

Paul Krugman:

Check Out Our Low, Low (Natural) Rates: ...Thomas Laubach and John C. Williams of the Fed have a new paper updating their estimates of the natural real rate of interest. For those new to the term, the natural rate is a standard economic concept dating back a century; it’s the rate of interest at which the economy is neither depressed and deflating nor overheated and inflating. And it’s therefore the rate monetary policy is supposed to achieve.


Laubach and Williams find that the natural rate has plunged in recent years, and is now very, very low. The particular statistical method they use is reasonable, but in any case — as they document — the result pops out for pretty much any plausible methodology. ...
L-W attribute the decline in the natural rate largely to the slowing of potential output, which in turn reflects demography and what looks like a slowdown in technological progress. That’s more speculative. But the low natural rate is as solid a result as anything in real time can be.
This in turn tells you several things. It says that all the complaints that the Fed is artificially keeping rates low are nonsense; rates are low because that’s what the real economy wants, and the Fed’s only alternative would be to create a depression.
It also casts even more doubt on the wisdom of the Fed’s urge to raise rates. Nothing in the economic situation suggests that rates are too low right now. ...
In any case, the message about what the Fed should do now is clear: nothing.

Tuesday, October 27, 2015

QE Has NOT Retarded Business Investment!

Brad DeLong:

Department of “Huh!?!?”: QE Has Retarded Business Investment!?: Kevin Warsh and Michael Spence attack Ben Bernanke and his policy of quantitative easing, which they claim “has hurt business investment.” ...

I score this for Bernanke: 6-0, 6-0, 6-0.

In fact, I do not even think that Spence and Warsh understand that one is supposed to have a racket in hand when one tries to play tennis. As I see it, the Fed’s open-market operations have produced more spending–hence higher capacity utilization–and lower interest rates–has more advantageous costs of finance–and we are supposed to believe that its policies “have hurt business investment”?!?!

Michael Spence and Kevin Warsh: The Fed Has Hurt Business Investment.“Bernanke[‘s view]… may well be true according to economic textbooks…

…But textbooks presume the normal conduct of policy and that the prices of financial assets like stocks and bonds are broadly consistent with expectations for the real economy. Nothing could be further from the truth in the current recovery…. Earnings of the S&P 500 have grown about 6.9% annually… pales in comparison to prior economic expansions… half of the profit improvement… from… share buybacks. So the quality of earnings is as deficient as its quantity…. Extremely accommodative monetary policy… $3 trillion in… QE pushed down long-term yields and boosted the value of risk-assets…. Business investment in the real economy is weak. While U.S. gross domestic product rose 8.7% from late 2007 through 2014, gross private investment was a mere 4.3% higher. Growth in nonresidential fixed investment remains substantially lower than the last six postrecession expansions….

As I have said before and say again, weakness in overall investment is 100% due to weakness in housing investment. Is there an argument here that QE has reduced housing investment? No. Is nonresidential fixed investment below where one would expect it to be given that the overall recovery has been disappointing and capacity utilization is not high? No. The U.S. looks to have an elevated level of exports, and depressed levels of government purchases and residential investment. Given that background, one would not be surprised that business investment is merely normal–and one would not go looking for causes of a weak economy in structural factors retarding business investment. One would say, in fact, that business investment is a relatively bright spot.

Yes, businesses have been buying back shares. How would the higher interest rates and higher risk spreads in the absence of QE retard that? They wouldn’t. Yes, earnings growth from business operations over the past five years has been slower than in earlier expansions. How has QE dragged on earnings growth. It hasn’t. ...

And the Federal Reserve’s undertaking of QE has hampered efforts to engage in “fundamental tax reform” how, exactly? Is an argument given here? No, it is not. ......

The point by point rebuttal continues, with the conclusion:

... If you are going to argue that QE has reduced real business investment, argue that QE has reduced real business investment. I see no such argument anywhere in the column.
So Warsh and Spence should not be surprised at my reaction: “Huh!?!?!” and “WTF!?!?!?!?”

Saturday, October 24, 2015

'Central Banks Are Not Agricultural Marketing Boards'

Brad DeLong:

Central Banks Are Not Agricultural Marketing Boards: Depression Economics, Inflation Economics and the Unsustainability of Friedmanism: Insofar as there is any thought behind the claims of John Taylor and others that the Federal Reserve is engaged in “price controls” via its monetary policy actions. ...

Insofar as one did want to think, and so construct an argument that the Federal Reserve’s monetary policy operations are destructive and in some ways analogous to “price controls”, the argument would go something like this:

The Federal Reserve’s Open Market Committee’s operations are like those of an agriculture marketing board–a government agency that sets the price for, say, some agricultural product like butter or milk. Some of what is offered for sale at that price that is not taken up by the private market, and the rest is bought by the government to keep the price at its target. And the next month the government finds it must buy more. And more. And more.

Such policies produce excess supplies that then must be stored or destroyed: they produce butter mountains, and milk lakes.

The resources used to produce the butter mountains and milk lakes is wasted–it could be deployed elsewhere more productively. The taxes that must be raised to pay for the purchase of the butter and milk that makes up the mountains and the lakes discourages enterprise and employment elsewhere in the economy, and makes us poorer. Taxes are raised (at the cost of an excess burden on taxpayers) and then spent to take the products of the skill and energy of workers and… throw them away. Much better, the standard argument goes, to eliminate the marketing board, let the price find its free-market equilibrium value, provide incentives for people to move out of the production of dairy products into sectors where private demand for their work exists, and keep taxes low.

Now you can see that a central bank is exactly like an agricultural marketing board, except for the following little minor details:

  1. An agricultural marketing board must impose taxes to raise the money finance its purchases of butter and milk. A central bank simply prints–at zero cost–the money to finance its purchase of bonds.
  2. The butter mountains and milk lakes that the agricultural marketing board owns cannot be sold without pushing the price down below its free-market equilibrium and thus negating the purpose of the board. A central bank does not want to sell its bond mountains, but merely to collect interest and hold them to maturity, at which point they are simply money mountains.
  3. The butter mountains and milk lakes are useless for the agricultural marketing board: all it can do with them is simply watch them rot away. The bond mountain turns into a money mountain–seigniorage–which the central bank then gives to the government, which lowers taxes as a result.

So a central bank is exactly like an agricultural marketing board–NOT!!! They are identical–except that they are completely different.

But, somewhat smarter John Taylor and others might say, a central bank is like an agricultural marketing board. The extra money it puts into circulation when its bonds mature and it transfers profits to the government devalue and debauch the currency. It raises the real resources needed to finance its bond purchases by levying an “inflation tax” on money holders–by reducing the value of their cash just as an income tax reduces the (after-tax) value of incomes.

And I would agree, if the inflation comes. ...

But what if the inflation does not come? What if our economy’s phase is one of not Inflation Economics but Depression Economics, in which the central bank is not pushing the interest rate below its Wicksellian natural rate but is instead stuck trying to manage a situation in which the Wicksellian natural rate of interest is less than zero?

Then the analogies break down completely. Money-printing is then not an inflationary tax but instead a utility-increasing provision of utility services. Bond purchases do not create an overhang that cannot be sold without creating an opposite distortion from the optimal price but instead push the temporal slope of the price system toward what a benevolent central planner would want the temporal slope of the price level to be. ...

And let me offer all kudos to those like David Beckworth, Scott Sumner, and Jim Pethokoukis who are trying to convince their political allies of these points that I regard as basic and Wicksellian–cutting-edge macro from 125 years ago. But I think that Paul Krugman is right when he believes that they are going to fail. ...

Friday, October 23, 2015

'A Bridge Too Far?'

Roger Farmer:

A Bridge Too Far?: There is much current angst on the difficult problem of how to escape a liquidity trap. Paul Krugman points out that in Japan, the ratio of debt to GDP is growing, leaving little room for a further tame fiscal expansion. He favors something more aggressive.
Tony Yates argues instead for a helicopter drop. Print money and give it to Japanese citizens. The benefit of that approach is that it does not leave the government with an increase in interest bearing debt. Simon Wren Lewis looks more closely at the technical aspects of this idea.
What are the differences between aggressive fiscal expansion financed by debt creation; and printing money and giving it to citizens? There are two.
First, an aggressive fiscal expansion, as envisaged by Keynesians, would be spent on infrastructure. A money financed transfer would be spent by citizens.
Second, an aggressive fiscal expansion, as envisaged by Keynesians, would be financed by issuing long term bonds. A money financed transfer would be financed by printing money.
While infrastructure expenditure is sorely needed, at least in the U.S., I see no reason to give up on sound cost benefit analysis to decide which projects are worth pursuing and which are not. That’s why I favor giving checks to citizens over building a bridge to nowhere. ...
I prefer private sector investment over government sector investment. But there are also good arguments for more public infrastructure projects. Build a bridge if it is needed; but make sure that it goes somewhere first. More importantly; finance the project by printing money: not by issuing thirty year bonds.

Wednesday, October 21, 2015

'Central Bankers and Their Irrational Fear'

Quantitative easing has had a difficult time stimulating demand (which would put pressure on prices and raise inflation). The money mostly piles up in banks instead of turning into new loans and new spending. Helicopter money would, I think, do much better, especially if it was distributed to people with a very high propensity to spend the money (so it would have much better distributional consequences as well). But central banks seem afraid to try this, or even consider it seriously. Simon Wren-Lewis says those fears are unfounded:

Central bankers and their irrational fear: Mervyn King said
“Central banks are often accused of being obsessed with inflation. This is untrue. If they are obsessed with anything, it is with fiscal policy.”
As an academic turned central banker, King knew of what he spoke. The fear is sometimes called fiscal dominance: that they will be forced to monetize government debt in such a way that means inflation rises out of control.
I believe this fear is a key factor behind central banks’ reluctance to think seriously about helicopter money. Creating money is no longer a taboo: with Quantitative Easing huge amounts of money have been created. But this money has bought financial assets, which can subsequently be sold to mop up the money that has been created. Under helicopter money the central bank creates money to give it away. If that money needs to be mopped up after a recession is over in order to control inflation, the central bank might run out of assets to do so. A good name for this is ‘policy insolvency’. [1]
There is a simple way to deal with this problem. [2] The government commits to always providing the central bank with the assets they need to control inflation. If, after some doses of helicopter money, the central bank needs and gets refinanced in this way, then helicopter money becomes like a form of bond financed fiscal stimulus, but where the bond finance is delayed. In my view that delay may be crucial in overcoming the deficit fetishism that has proved so politically successful over the last five years, as well as giving central banks a much more effective unconventional monetary instrument than QE. [3] But central banks do not want to go there, partly because they worry about the possibility of a government that would renege on that commitment.
The fear is irrational for two reasons... [explains]...
Central banks overcame one big psychological barrier when they undertook Quantitative Easing. That was the first, and perhaps the more important, stage in ending their primitive fear of fiscal dominance. They now need to complete the process, so we can start having rational discussions about alternatives to QE.

Tuesday, October 20, 2015

A Plea to Free Marketers

David Beckworth:

A Plea to My Fellow Free Marketers: As a free-market loving individual, it pains me to see so many of my fellow travelers claim the Fed has artificially suppressed interest rates since the onset of the crisis. Recently, I was disappointed to see George Will and Bill Gross repeat these claims. They have made these claims before, but I was hoping after all these years they would begin to question the premise of their views. But alas, it did not happen. Here is George Will's latest volley on this issue :

[S]even years of ZIRP — zero interest-rate policy — have not restored the economic dynamism essential for social mobility but have had the intended effect of driving liquidity into equities in search of high yields, thereby enriching the 10 percent of Americans who own approximately 80 percent of the directly owned stocks. ...

And here is Bill Gross in his latest newsletter:

So the Fed has chosen to hold off on their goal of normalizing interest rates and... and the investment community wonders how long can this keep goin’ on. For a long time I suppose, as evidenced by history at least. Ken Rogoff and Carmen Reinhart have meticulously documented periods of “financial repression”[.]

There is no doubt the low interest rates over the past seven years has caused many problems: they have harmed individuals living on fixed income, incentivized unusual reaching for yield by investors, and made it easier to run large budget deficits. But are the low rates behind these developments really the Fed's doing?

What I wish George Will, Bill Gross, and other free market advocates would consider is the possibility that the Fed itself is not the source of the low rates, but simply is a follower of where market forces have pushed interest rates. That is, the Great Recession and the prolonged slump that followed  caused interest rates to be depressed and the Fed did its best to keep short-term interest rate near this low market-clearing level.

But there is more to this story. ...

Monday, October 19, 2015

Paul Krugman: Something Not Rotten in Denmark

The important lessons we can learn from Denmark:

Something Not Rotten in Denmark, by Paul Krugman, Commentary, NY Times: No doubt surprising many of the people watching the Democratic presidential debate, Bernie Sanders cited Denmark as a role model for how to help working people. Hillary Clinton demurred slightly, declaring that “we are not Denmark,” but agreed that Denmark is an inspiring example. ... But how great are the Danes, really? ...
Denmark maintains a welfare state ... that is beyond the wildest dreams of American liberals. ... To pay for these programs, Denmark collects a lot of taxes..., almost half of national income, compared with 25 percent in the United States. Describe these policies to any American conservative, and he would predict ruin. Surely those generous benefits must destroy the incentive to work, while those high taxes drive job creators into hiding or exile.
Strange to say, however, Denmark ... a prosperous nation that does quite well on job creation. ... It’s hard to imagine a better refutation of anti-tax, anti-government economic doctrine...
But ... is everything copacetic in Copenhagen? Actually, no..., its ... recovery from the global financial crisis has been slow and incomplete. ...
What explains this poor recent performance? The answer, mainly, is bad monetary and fiscal policy. Denmark hasn’t adopted the euro, but it manages its currency as if it had... And while the country has faced no market pressure to slash spending ... it has adopted fiscal austerity anyway.
The result is a sharp contrast with neighboring Sweden, which doesn’t shadow the euro (although it has made some mistakes on its own), hasn’t done much austerity, and has seen real G.D.P. per capita rise while Denmark’s falls.
But Denmark’s monetary and fiscal errors don’t say anything about the sustainability of a strong welfare state. In fact, people who denounce things like universal health coverage and subsidized child care tend also to be people who demand higher interest rates and spending cuts in a depressed economy. (Remember all the talk about “debasing” the dollar?) That is, U.S. conservatives actually approve of some Danish policies — but only the ones that have proved to be badly misguided.
So yes, we can learn a lot from Denmark, both its successes and its failures. And let me say that it was both a pleasure and a relief to hear people who might become president talk seriously about how we can learn from the experience of other countries, as opposed to just chanting “U.S.A.! U.S.A.! U.S.A.!”

Friday, October 16, 2015

The Financial Crisis: Lessons for the Next One

Alan S. Blinder and Mark Zandi:

The Financial Crisis: Lessons for the Next One: The massive and multifaceted policy responses to the financial crisis and Great Recession -- ranging from traditional fiscal stimulus to tools that policymakers invented on the fly -- dramatically reduced the severity and length of the meltdown that began in 2008; its effects on jobs, unemployment, and budget deficits; and its lasting impact on today's economy.

Without the policy responses of late 2008 and early 2009, we estimate that:

  • The peak-to-trough decline in real gross domestic product (GDP), which was barely over 4%, would have been close to a stunning 14%;
  • The economy would have contracted for more than three years, more than twice as long as it did;
  • More than 17 million jobs would have been lost, about twice the actual number.
  • Unemployment would have peaked at just under 16%, rather than the actual 10%;
  • The budget deficit would have grown to more than 20 percent of GDP, about double its actual peak of 10 percent, topping off at $2.8 trillion in fiscal 2011.
  • Today's economy might be far weaker than it is -- with real GDP in the second quarter of 2015 about $800 billion lower than its actual level, 3.6 million fewer jobs, and unemployment at a still-dizzying 7.6%.

We estimate that, due to the fiscal and financial responses of policymakers (the latter of which includes the Federal Reserve), real GDP was 16.3% higher in 2011 than it would have been. Unemployment was almost seven percentage points lower that year than it would have been, with about 10 million more jobs.

To be sure, while some aspects of the policy responses worked splendidly, others fell far short of hopes. Many policy responses were controversial at the time and remain so in retrospect. Indeed, certain financial responses were deeply unpopular, like the bank bailouts in the Troubled Asset Relief Program (TARP). Nevertheless, these unpopular responses had a larger combined impact on growth and jobs than the fiscal interventions. All told, the policy responses -- the 2009 Recovery Act, financial interventions, Federal Reserve initiatives, auto rescue, and more -- were a resounding success.

Our findings have important implications for how policymakers should respond to the next financial crisis, which will inevitably occur at some point because crises are an inherent part of our financial system. As explained in greater detail in Section 5:

  • It is essential that policymakers employ "macroprudential tools" (oversight of financial markets) before the next financial crisis to avoid or minimize asset bubbles and the increased leverage that are the fodder of financial catastrophes.
  • When financial panics do come, regulators should be as consistent as possible in their responses to troubled financial institutions, ensuring that creditors know where their investments stand and thus don't run to dump them when good times give way to bad.
  • Policymakers should not respond to every financial event, but they should respond aggressively to potential crises -- and the greater the uncertainty, the more policymakers should err on the side of a bigger response.
  • Policymakers should recognize that the first step in fighting a crisis is to stabilize the financial system because without credit, the real economy will suffocate regardless of almost any other policy response.
  • To minimize moral hazard, bailouts of companies should be avoided. If they are unavoidable, shareholders should take whatever losses the market doles out and creditors should be heavily penalized. Furthermore, taxpayers should ultimately be made financially whole and better communication with the public should be considered an integral part of any bailout operation.
  • Because fiscal and monetary policy interactions are large, policymakers should use a "two-handed" approach (monetary and fiscal) to fight recessions -- and, if possible, they should select specific monetary and fiscal tools that reinforce each other.
  • Because conventional monetary policy -- e.g., lowering the overnight interest rate -- may be insufficient to forestall or cure a severe recession, policymakers should be open to supplementing conventional monetary policy with unconventional monetary policies, such as the Federal Reserve's quantitative easing (QE) program of large-scale financial asset purchases, especially once short-term nominal interest rates approach zero.
  • Discretionary fiscal policy, which has been a standard way to fight recessions since the Great Depression, remains an effective way to do so, and the size of the stimulus should be proportionate to the magnitude of the expected decline in economic activity.
  • Policymakers should not move fiscal policy from stimulus to austerity until the financial system is clearly stable and the economy is enjoying self-sustaining growth.

The worldwide financial crisis and global recession of 2007-2009 were the worst since the 1930s. With luck, we will not see their likes again for many decades. But we will see a variety of financial crises and recessions, and we should be better prepared for them than we were in 2007. That's why we examined the policy responses to this most recent crisis closely, and why we wrote this paper.

We provide details of the methods we used to generate the findings summarized above....

Thursday, October 15, 2015

'Fed Debates and the EMU Technocratic Illusion'

Francesco Saraceno:

Fed Debates and the EMU Technocratic Illusion, Gloomy European Economist: ...I have read with lots of interest the speech that newly appointed Federal Reserve Board Member Lael Brainard gave last Monday. The speech is a plea for holding on rate rises, and uses a number of convincing arguments. Much has been said on the issue (give a look at comments by Tim Duy and Paul Krugman). I have little to add, were it not for the point I made a number of times, that the extraordinarily difficult task of central bankers would be made substantially easier if fiscal policy were used more actively.
What I’d like to express here is my jealousy for the discussions (and the confrontation) that we observe in the US. These discussions are a sideproduct, a very positive one if you ask me, of the institutional design of the Fed. I just returned from a series of engaging policy meetings on central bank policy in Costa Rica, facilitated by the local ILO office, where I pleaded for the introduction of a dual mandate.
I wrote a background paper (that can be seen here) in which my main argument is that a central bank following a dual mandate will always be able to take an aggressive stance on inflation, if it deems it necessary to do so. ... No choice of weights, on the other hand, would allow a central bank following an inflation targeting mandate to explicitly target employment as well. Thus, the dual mandate can embed inflation targeting strategies, while the converse is not true. In terms of policy effectiveness, therefore, the dual mandate is a superior institutional arrangement.
I also cited evidence showing, and here we come at my jealousy for the Fed, that inflation targeting central banks, like the ECB, de facto target the output gap, but timidly and without explicitly saying so. This leads to low reactivity and opaque communication, that hamper the capacity of central banks to manage expectations and effectively steer the economy. I am sure that those who followed the EMU policy debate in the past few years will know what I am talking about.
One may argue that the cacophony currently characterizing the Federal Reserve Board is hardly positive for the economy, and that in terms of managing expectations, lately, the Fed did not excel. This is undeniable, and is the result of the Fed groping its way out of unprecedented policy measures. The difference with the ECB is that for the Fed the opacity results from an ongoing debate on how to best attain an objective that is clear and shared. We are not there yet, but the debate will eventually lead to an unambiguous (and hopefully appropriate) policy choice. The ECB opacity, is intrinsically linked to the confusion between its mandate and its actual action, and as such it cannot lead to any meaningful discussion, but just to legalistic disputes on the definition of price stability, of how medium is the medium term and the like.
And I can now come to my final point: a dual mandate has the merit to let the political nature of monetary policy emerge without ambiguities. It is indeed true that monetary policy with a dual mandate requires hard choices, as the ones that are debated these days, and hence is political in nature. The point is, that so is monetary policy with a simple inflation targeting objective. The level of inflation targeted, and the choice of the instruments to attain it, are all but neutral in terms of their consequences on the economy, most notably on the distribution of resources among market participants. Thus, an inflation targeting central bank is as political in its actions as a bank following a dual mandate, the only difference being that in the former case the political nature of monetary policy is concealed behind a technocratic curtain. The deep justification of exclusive focus on price stability can only lie in the acceptance of a neoclassical platonic world in which powerless governments need to make no choice. Once we dismiss that platonic view, monetary policy acquires a political role, regardless of the mandate it is given. A dual mandate has the merit of making this choice explicit, and hence to dispel the technocratic illusion.
I am not saying there would be no issues with the adoption of a dual mandate. The institutional design should be carefully crafted, in order to ensure that independence is maintained, and accountability (currently very low indeed) is enhanced. What I am saying is that after seven years (and counting) of dismal economic performance, and faced with strong arguments in favor of a broader central bank mandate, EMU policy makers should be engaged in discussions at least as lively as the ones of their counterparts in Washington. And yet, all is quiet on this side of the ocean… Circulez y a rien à voir

Wednesday, October 14, 2015

FRBSF: The Current Economy and the Outlook

"Reuven Glick, group vice president at the Federal Reserve Bank of San Francisco, stated his views on the current economy and the outlook as of October 8, 2015":

GDP growth rebounded to 3.9% in Q2

FRBSF: The Current Economy and the Outlook: Real GDP jumped to 3.9% in the second quarter of 2015, well above first-quarter growth of 0.6%. Personal consumption expenditures, business investment, and residential investment all made positive contributions to growth. In the six years since the Great Recession ended, real GDP growth has averaged 2.2% at an annual rate, near the economy’s long-term trend of 2%.
We expect the U.S. economy to slow modestly in the third quarter because of reduced inventory buildups and weaker net exports. Propelled by solid momentum in consumption spending, moderate growth around the economy’s long-term trend should resume heading into 2016. Ongoing risks to the growth outlook include possible spillovers from economic slowdowns in China and other foreign markets and a further strengthening of the U.S. dollar.

Employment growth continues

Employment growth has slowed somewhat but remains consistent with an improving labor market. Payroll employment increased by 142,000 in September, and the number of jobs added for July and August combined was revised down by 59,000. Significant job losses were recorded in recent months for the industries most exposed to overseas conditions, the energy sector and manufacturing. Still, average gains over the past six months have been around 200,000.

Unemployment near natural rate

The unemployment rate in August remained at 5.1%, which is very close to the 5.0% level that we judge to be the natural rate of unemployment. Other signs of progress include lower unemployment insurance claims and declines in broader measures of unemployment that include discouraged and marginally attached workers. However, some measures of labor market slack, such as the labor force participation rate and employment-to-population ratio, remain well below pre-recession levels. We expect that the ongoing pace of job creation, though slowing, will be sufficient to bring the economy temporarily below the natural rate in 2016.

Inflation remains low

Inflation, as measured by the change in the personal consumption expenditures (PCE) price index, was 0.3% in the 12 months through August. Very low overall inflation is largely attributable to lower prices of energy goods and services, which have fallen by over 16% in the past year. Excluding energy as well as the typically volatile food component of spending, core PCE rose 1.3% over the past 12 months. Inflation has remained below the Federal Open Market Committee’s 2% target since mid-2012. Absent further declines in energy prices or a further strengthening of the U.S. dollar, we expect that stable inflation expectations and diminishing slack will push core and overall PCE inflation up gradually towards 2%.

Personal consumption expenditure components

The PCE is a composite of the price changes of different products and services. Food and energy account for roughly 11% of total consumer spending, while core goods (excluding food and energy) account for 23% of spending, and core services (excluding energy costs of housing) account for the remaining 66%.

Price inflation for goods and services is down

In recent years, core services inflation has tended to be positive, except during the recession and the early recovery. Core goods inflation has tended to be negative, with brief exceptions around 2009–10 because of tobacco tax hikes and 2011–12 because of rising textile and apparel costs. In recent months both core goods and services inflation have slowed, that is, services inflation has been less positive and goods inflation has been more negative.

Lower import prices reduce goods inflation

The decline in core goods inflation can be attributed to declining import costs associated with the appreciating value of the dollar as well as lower costs abroad. Because goods account for most international trade, movements in exchange rates and foreign prices tend to exert more pressure on goods prices than on service prices. Lower prices of imported consumption goods directly affect core goods inflation. They also affect goods prices indirectly through imports of raw materials, such as metals, plastic, and rubber, used in the U.S. production of goods for domestic consumers.

Health care pulling down services inflation

Core service inflation has been pulled down by more subdued increases in health-care service costs, which represent a quarter of core services spending and 19% of overall core spending. Health-care services inflation has been slowing for several years and fell off sharply in 2014, primarily from capping of increases in Medicare payments to physicians.

Inflation higher without certain sectors

The impact of import, energy, and health-care costs on core inflation can be gauged by “what-if” exercises that remove these sectors from the calculation. Excluding relatively import-intensive (for example, apparel and other nondurables) and energy-intensive (for example, transportation) sectors would raise core inflation modestly, by around 0.2%. Removing health-care services spending from the calculations would raise core inflation by an additional 0.3%.
The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are not intended to represent the views of others within the Bank or within the Federal Reserve System. FedViews generally appears around the middle of the month.

Tuesday, October 13, 2015

'Global Dovishness'

Paul Krugman:

Global Dovishness: Tim Duy points us to a striking speech by Lael Brainard, who recently joined the Fed Board of Governors, which takes a notably more dovish line than we’ve been hearing from Yellen and Fischer. Basically, Brainard comes down on the ... precautionary principle side of the debate, arguing that given uncertainty about the path of the natural rate of interest, and great asymmetry in the consequences of moving too soon versus too late, rate hikes should be put on hold until you see the whites of inflation’s eyes.

Why does she sound so different from Fischer and Yellen? Duy argues that it is in part a generational thing...

Maybe, but it’s also worth noting the difference in perspective that comes from having your original intellectual home in international versus domestic macroeconomics. I would say that Brainard’s experience is dominated not so much by the Great Moderation as by the Asian financial crisis and Japan’s stagnation; internationally oriented macro types were aware earlier than most that Depression-type issues never went away. And if you read Brainard’s argument carefully, she devotes a lot of it to the drag America may be facing from weakness abroad and the stronger dollar, which acts as de facto monetary tightening...

So does her speech matter? She is, as I indicated, pretty much saying what some of us on the outside have been saying, although she does it very clearly and well; but does it make a difference that someone on the inside is laying down a marker warning that raising rates could be a big mistake? I guess we’ll see.

Fed Watch: Brainard Drops A Policy Bomb

Tim Duy:

Brainard Drops A Policy Bomb, by Tim Duy: What if a Federal Reserve Governor drops a policy bomb in the woods and no one is there to hear it? Did it really make a noise?

That's what happened today. While the bond market was closed and whatever financial journalists were left focusing their efforts on newly-minted Nobel Prize recipient Angus Deaton, Federal Reserve Governor Lael Brainard dropped a policy bomb with her speech to the National Association of Business Economists. It was nothing short of a direct challenge to Chair Janet Yellen and Vice Chair Stanley Fischer. Is was, as they say, a BFD.

That, at least, is my opinion. Consider, for example, Brainard's opening salvo:

The will-they-or-won't-they drumbeat has grown louder of late. To remove the suspense, I do not intend to make any calendar-based statements here today. Rather, I would like to give you a sense of the considerations that weigh on both sides of that debate and lay out the case for watching and waiting.

Wait, who is making calendar-based statements? Yellen:

...these two judgments imply that the real interest rate consistent with achieving and then maintaining full employment in the medium run should rise gradually over time. This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.

and Fischer:

In the SEP, the Summary of Economic Projections prepared by FOMC participants in advance of the September meeting, most participants, myself included, anticipated that achieving these conditions would entail an initial increase in the federal funds rate later this year.

After essentially saying that such calendar-based guidance is beneath her, she says what she is going to do: Explain why policymakers should delay further. Note however this stands in sharp contrast with Yellen and Fischer. Their efforts have been spent on explaining why rates need to rise soon. Hers will be spent on why they do not.

After assessing the quality of the recovery, Brainard asserts:

In contrast to the considerable progress in the labor market, progress on the second leg of our dual mandate has been elusive. To be clear, I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation. A variety of econometric estimates would suggest that the classic Phillips curve influence of resource utilization on inflation is, at best, very weak at the moment. The fact that wages have not accelerated is significant, but more so as an indicator that labor market slack is still present and that workers' bargaining power likely remains weak.

Recall that Yellen, in her most recent speech, made the Phillips Curve the primary basis for her case that rates will soon need to rise:

What, then, determines core inflation? Recalling figure 1, core inflation tends to fluctuate around a longer-term trend that now is essentially stable. Let me first focus on these fluctuations before turning to the trend. Economic theory suggests, and empirical analysis confirms, that such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy--as approximated, for example, by the gap between the actual unemployment rate and its so-called natural rate, or by the shortfall of actual gross domestic product (GDP) from potential output. This relationship--which likely reflects, among other things, a tendency for firms' costs to rise as utilization rates increase--represents an important channel through which monetary policy influences inflation over the medium term, although in practice the influence is modest and gradual. Movements in certain types of input costs, particularly changes in the price of imported goods, also can cause core inflation to deviate noticeably from its trend, sometimes by a marked amount from year to year. Finally, a nontrivial fraction of the quarter-to-quarter, and even the year-to-year, variability of inflation is attributable to idiosyncratic and often unpredictable shocks.

Yellen concludes, after breaking down the inflation shortfall into its constituent parts, that the resource utilization component is now fairly small and will soon dissipate, having only the temporary components to worry about:

Although an accounting exercise like this one is always imprecise and will depend on the specific model that is used, I think its basic message--that the current near-zero rate of inflation can mostly be attributed to the temporary effects of falling prices for energy and non-energy imports--is quite plausible. If so, the 12-month change in total PCE prices is likely to rebound to 1-1/2 percent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeably further.

Brainard, however, is not buying this story. Brainard's focus:

Although the balance of evidence thus suggests that long-term inflation expectations are likely to have remained fairly steady, the risks to the near-term outlook for inflation appear to be tilted to the downside, given the persistently low level of core inflation and the recent decline in longer-run inflation compensation, as well as the deflationary cross currents emanating from abroad--a subject to which I now turn.

While Yellen sees the risks weighted toward rebounding inflation, Brainard sees the opposite. Moreover, policymakers have been twiddling their thumbs as the world economy turns against them:

Over the past 15 months, U.S. monetary policy deliberations have been taking place against a backdrop of progressively gloomier projections of global demand. The International Monetary Fund (IMF) has marked down 2015 emerging market and world growth repeatedly since April 2014.

While all of you have been arguing about when to raise rates, the case for raising rates has been falling apart! As a consequence:

Over the past year, a feedback loop has transmitted market expectations of policy divergence between the United States and our major trade partners into financial tightening in the U.S. through exchange rate and financial market channels. Thus, even as liftoff is coming into clearer view ahead, by some estimates, the substantial financial tightening that has already taken place has been comparable in its effect to the equivalent of a couple of rate increases.

Brainard buys into the view that recent activity in financial markets has already tightened monetary conditions. Later:

There is a risk that the intensification of international cross currents could weigh more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in U.S. policy could impose restraint through additional tightening of financial conditions. For these reasons, I view the risks to the economic outlook as tilted to the downside. The downside risks make a strong case for continuing to carefully nurture the U.S. recovery--and argue against prematurely taking away the support that has been so critical to its vitality.

Not balanced, but to the downside. That calls for different risk management:

These risks matter more than usual because the ability to provide additional accommodation if downside risks materialize is, in practice, more constrained than the ability to remove accommodation more rapidly if upside risks materialize.

In effect, the Fed can't cut rates quickly, but they can raise rates quickly:

...many observers have suggested that the economy will soon begin to strain available resources without some monetary tightening. Because monetary policy acts with a lag, in this scenario, high rates of resource utilization may lead to a large buildup of inflationary pressures, a rise in inflation expectations and persistent inflation in excess of our 2 percent target. However, we have well-tested tools to address such a situation and plenty of policy room in which to use them.

Brainard is willing to risk a rapid rise in rates. Yellen is not. Indeed, quite the opposite. Yellen desperately wants a very slow pace of rate increases:

If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.

The more I think about it, the less I am worried about this issue. Suppose that the Fed needs raise rates at twice the pace they currently anticipate. What does that mean? 25bp at every meeting instead of every other meeting? Is that really an "abrupt tightening?" Not sure that Yellen has a very strong argument here. Or one that would withstand repeated attacks from her peers.

I feel like I haven't scratched the surface on this speech, but I will cut to the chase: This is an outright challenge to the Yellen/Fischer view.

I think these three players are all products of their experience. Yellen received her Ph.D in 1971. Fischer in 1969. Both experienced the Great Inflation first hand. Brainard earned her Ph.D in 1989. Her professional experience is dominated by the Great Moderation.

I think Yellen wants to raise interest rates. I think Fischer wants to raise rates. I think both believe the downward pressure on inflation due to labor market slack is minimal, and the Phillips Curve will soon assert itself. I think both do not find the risks as asymmetric as does Brainard. I think they believe the risk of inflation is actually quite high. Or, probably more accurately, that the risk of destabilizing inflation expectations is quite high.

I think that Brainard knows this. I think that this speech is a very deliberate action by Brainard to let Yellen and Fischer know that she will not got quietly into the night if they push forward with their plans. I think that she is sending the message that they will not have just one dissent from a soon-to-be-replace regional president (Chicago Federal Reserve President Charles Evans), but a more-difficult-to-ignore Fed governor still voting when January 1 rolls around.

And now that Brainard has laid down the gauntlet, it will look very, very bad for Yellen and Fischer if their plans go sideways. This is very likely the last big decision of their careers. They know what happened to Greenspan’s legacy. I doubt they want the same treatment. Why risk their reputations when the cost of waiting is a 25bp move every meeting instead of every other meeting? Is it worth it?

Brad DeLong suggested the Fed commit to one of two policy messages:

I must say that they are not doing too well at the clear-communication part. I want to see one of following things in Fed statements:

  1. We will begin raising interest rates in December at a pace of basis points per quarter, unless economic growth and inflation fall substantially short of our current forecast expectations.
  2. We will delay raising interest rates until we are confident that it will not be appropriate to return them to the zero lower bound after liftoff.

If we had one of these, we would know where we stand.

But Stan Fischer's speech provides us with neither.

I think that Fischer wants the first option, but knows Brainard’s views, and hence knows that December is not a sure thing if Brainard can build momentum for her position. Hence the muddled message. Brainard could be the force that drives the Fed toward option number two. An option closer to that of Evans and Minneapolis Federal Reserve President Narayana Kocherlakota. That would be a game changer.

Bottom Line: This is the most exciting speech I have read in forever. Not necessarily for the content. But for the politics. Evans and Kocherlakota are no longer the lunatic fringe. This could be a real game changer that shifts the Fed toward the Evans view of the world, with no rate hike until mid-2016. Brainard muddied further the already murky December waters.

Monday, October 12, 2015

'Why So Slow? A Gradual Return for Interest Rates'

This Economic Letter from Vasco Cúrdia of the SF Fed finds that even though interest rates are very low, so is the natural rate of interest, and that implies that monetary policy is "relatively tight."  "The model projections for the natural rate are consistent with the federal funds rate only gradually returning to normal over the next few years, although substantial uncertainty surrounds this forecast":

Why So Slow? A Gradual Return for Interest Rates: Short-term interest rates in the United States have been very low since the financial crisis. Projections of the natural rate of interest indicate that a gradual return of short-term interest rates to normal over the next five years is consistent with promoting maximum employment and stable inflation. Uncertainty about the natural rate that is most consistent with an economy at its full potential suggests that the pace of normalization may be even more gradual than implied by these projections.
To boost economic growth during the financial crisis, the Federal Reserve aggressively cut the target for its benchmark short-term interest rate, known as the federal funds rate, to near zero around the beginning of 2009. Since then the time projected for the rate to return to more normal historical levels has been continually postponed.
To understand the level of the federal funds rate and when it might be normalized it is useful to consider the concept of the natural rate of interest first proposed by Wicksell in 1898 and introduced into modern macroeconomic models by Woodford (2003). The natural rate of interest is the real, or inflation-adjusted, interest rate that is consistent with an economy at full employment and with stable inflation. If the real interest rate is above (below) the natural rate then monetary conditions are tight (loose) and are likely to lead to underutilization (overutilization) of resources and inflation below (above) its target.
This Economic Letter analyzes the recent behavior of the natural rate using an empirical macroeconomic model. The results suggest that the natural rate is currently very low by historical standards. Because of this, monetary conditions remain relatively tight despite the near-zero federal funds rate, which in turn is keeping economic activity below potential and inflation below target. The model projections for the natural rate are consistent with the federal funds rate only gradually returning to normal over the next few years, although substantial uncertainty surrounds this forecast. ...

And the conclusion:

... This Letter suggests that the natural rate of interest is expected to remain below its long-run level for some time. This implies that low interest rates over the next few years are consistent with the most efficient use of resources and stable inflation. The analysis also finds that the output gap is expected to remain negative even after the natural rate is close to its long-run level. Additionally, there is considerable uncertainty about both the short-run dynamics as well as what level should be expected in the longer run. All these considerations reinforce the possibility that interest rate normalization will be very gradual.

Fed Watch: Fed Struggles With The High Water Mark

Tim Duy:

Fed Struggles With The High Water Mark, by Tim Duy: Gavyn Davies reviews the evidence on the apparent slowing of US economic activity and concludes:

So is the US slowdown for real? Yes, but it is not yet very severe — and some of it is the result of the temporary inventory correction, and some to the rising dollar. Unless it grows worse in the next few weeks, it is unlikely to dislodge the Fed from the path it has now firmly chosen.

This I think is broadly consistent with views on the FOMC and explains why many policymakers insist that a rate hike this year remains likely. Vice Chair Stanley Fischer was the latest to reiterate the point. Via his prepared remarks for the IMF:

In the SEP, the Summary of Economic Projections prepared by FOMC participants in advance of the September meeting, most participants, myself included, anticipated that achieving these conditions would entail an initial increase in the federal funds rate later this year.

They will want look through any near term GDP volatility, and discount volatility related to inventories. Look then to real final sales rather than GDP. Avoid getting caught up in the headline numbers; watch the underlying trends instead.

Still, there is a range of views on the FOMC, from Richmond Fed Jeffrey Lacker, who believes the Fed should already have raised rates, to Minneapolis Federal Reserve President Narayana Kocherlakota, who would like the Fed to consider a negative rate. And arguably even the center is not particularly committed to a particular policy path. To be sure, they like to talk tough, but every time they get ready to jump, they walk back from the edge.

Why the lack of conviction? Essentially, the economy is resting on what is likely its high water mark for growth in this cycle, leaving the Fed perplexed regarding their next move. They want the economy to slow from its current pace and glide into a soft landing. But acting too early will leave their job half finished and sow the seeds of the next recession. Acting too late, however, will yield the inflationary outcome they so fear. And they don't know the exact definitions of "too early" and "too late."

This chart (modified from Davies' version) illustrates the evolution of US growth since 2012:


In broad terms, consumption, investment, and government spending jointly accelerated during 2013. The external side of the economy offset some of this acceleration by first moving from a slightly positive contribution to none and then, beginning in 2014, a substantial negative contribution. The net effect is that overall economy largely normalize around a 2.5% growth rate in 2014 and remained there since.

That 2.5% growth is what the economy delivers given the combination of long-term factors (labor and productivity growth) and the current set of fiscal, monetary, and external conditions. The actual composition of output will evolve around that 2.5% rate. It is likely the high-water mark, in terms of growth, for this recovery. Faster growth likely requires a net easier combination of monetary and fiscal policy. Slower growth may already be locked in by past policy, or maybe the economy just moves generally sideways from here.

Most important is to remember that monetary policymakers expect and want the economy to slow as it gently glides down to that mythical soft-landing. They aren't looking for faster growth. The current pace of growth will, in their view, force unemployment further below the natural rate next year than they are willing to tolerate. Hence the most recent employment reports are not necessarily unmitigated bad news from their perspective. New York Federal Reserve President William Dudley, via Bloomberg:

Dudley said the key to liftoff will be whether the labor market continues to improve, thereby putting more upward pressure on wages and inflation. Last month’s jobs report was “definitely weaker,” but even monthly gains of 120,000 or 150,000 are enough to continue to push the U.S. unemployment rate lower, he said.

Or, more explicitly, from San Fransisco Federal Reserve President John Williams:

The pace of employment growth, as well as the decline in the unemployment rate, has slowed a bit recently…but that’s to be expected. When unemployment was at its 10 percent peak during the height of the Great Recession, and as it struggled to come down during the recovery, we needed rapid declines to get the economy back on track. Now that we’re getting closer, the pace must start slowing to more normal levels. Looking to the future, we’re going to need at most 100,000 new jobs each month. In the mindset of the recovery, that sounds like nothing; but in the context of a healthy economy, it’s what’s needed for stable growth. (emphasis added)

Williams is looking for 2% growth in the second half of this year and next year. He expects the economy to slow, and believes it needs to slow to sustain healthy, long-run growth. But I don't think he knows exactly when and how much the Fed needs to tap the breaks to achieve that healthy growth. And he would not be alone - lack of consensus around the question is exactly why communication appears so muddled. They can't tell you what they don't know.

Further confusing the issue is the cat that Kocherlakota let out of the bag last week:

In mid-2013, the FOMC announced its intention to taper its ongoing asset purchase program. We can see that this announcement represented a dramatic change in policy from the sharp upward movements in long-term bond yields that it engendered. Personally, I interpret this policy change back in 2013 as the onset of what the Committee currently intends to be a long, gradual tightening cycle. As I noted earlier, we would typically expect that such a change in monetary policy should affect the economy with a lag of about 18 to 24 months. Viewed through this lens, the slow rate of labor market improvement in 2015 is not all that surprising.

I believe the FOMC should take actions to facilitate a resumption of the 2014 improvement in the labor market by adopting a more accommodative policy stance...

As group, monetary policymakers have stuck by the line that "tapering is not tightening." Kocherlakota is not following the party line. He explicitly connects the dots and concludes that the current inflection point in the economy is the result of the tapering debate begun over two years ago. He essentially argues that had it not been for the taper and end of QE3, then financial conditions would be more accommodative today and the economy would not yet be at an inflection point.

Kocherlakota is an outlier; he is not interested seeing the labor market throttle back just yet, fearing that such an outcome will end improvement in underemployment indicators. This would lock the economy into a suboptimal state of persistent excess slack and impede the return of inflation to the Fed's target. The general consensus on the FOMC is that such a goal can be achieved with more a more moderate pace of improvement in labor markets that holds unemployment modestly below the natural rate for a time. Hence he is alone in his view that more easing is needed at this time. Chicago Federal Reserve President Charles Evans probably comes closest with his explicit calls to hold rates at current levels until the middle of 2016.

But even if the party line is that "tapering is not tightening," Kocherlakota must have planted the seeds of doubt in the minds of his colleagues. After all, it is a risk management exercise. If they are wrong, and Kocherlakota is right, then they will look like the dropped the ball if they pull the trigger too early. Something of a big risk to take when inflation remains persistently below trend and you lack traditional tools to respond to a renewed slowdown in activity.

Bottom Line: So where does all of this leave Fed policy? Confused, I think, like September when economists saw the outcome of that meeting as a coin toss. Don't expect communications to become much clearer. October is off the table (despite what Lacker might believe). They first need to decide if the last two months of jobs data were aberrations or signals of slowing job growth. They can't do that before October. And I am not confident they can do so by December. If we get two more reports hovering around 200k a month between now and December, matched with generally consistent data across other indicators, then December is on the table. That would indicate the economy is not coming off its high water mark without some help from the Fed. If jobs growth slows to 100k a month, again with a broad swath of generally consistent data, then we are looking at deep into 2016 before any hike. Around 150k is the gray area. They won't know if the economy is poised to head lower on its own, or if that is sufficient to contain inflationary pressures. They don't know if they should be tapping on the breaks or not. Risk management under the assumption of constrained inflation suggests they push off action until January or March. But they would not send such a clear message. Indeed, I suspect that more numbers like the last two will make the December meeting much like September's. That I fear is my current baseline - another close call in which the Fed concludes to take a pass.

Sunday, October 11, 2015

'One Reason Why Monetary Policy is Preferred by New Keynesians'

Simon Wren-Lewis:

One reason why monetary policy is preferred by New Keynesians: ...Suppose, for example, individuals decide for some reason that they want to hold more money. They expect to sell their output, but plan to buy less. If everyone does this, aggregate demand will fall, and producers will not sell all their output. If goods cannot be stored, and if producers cannot consume their own good, this could lead to pure waste: some goods remain unsold and rot away. (If all producers immediately cut their prices, then a new equilibrium is possible where producers’ desire to hold more real money balances is achieved by a fall in prices. So we need to rule this possibility out by having some form of price rigidity.)
The government could prevent waste in two ways. It could persuade consumers to hold less money and buy more goods, which we can call monetary policy. Or it could buy up all the surplus production and produce more public goods, which we could call fiscal policy. Both solutions eliminate waste, but monetary policy is preferable to fiscal policy because the public/private good mix remains optimal.
Three comments on this reason for preferring monetary policy. First, if for some reason monetary policy cannot do this job, clearly using fiscal policy is better than doing nothing. It is better to produce something useful with goods rather than letting them rot. We could extend this further. If for some reason the impact of monetary policy was uncertain, then that could also be a reason to prefer fiscal policy, which in this example is sure to eliminate waste. Second, the cost of using fiscal rather than monetary policy obviously depends on the form of public spending. If the public good was repairing the streets the market was held in one year earlier than originally planned the 'distortion' involved is pretty small. Third, another means of achieving the optimal solution, besides monetary policy, is for the government to give everyone the extra money they desire.

Thursday, October 08, 2015

'The Slow Rate of Labor Market Improvement in 2015 is Not All That Surprising'

Federal Reserve Bank of Minneapolis president Narayana Kocherlakota:

...Why has the rate of labor market improvement slowed so much in 2015 relative to 2014? In thinking about this question, I find the timing of monetary policy changes to be highly suggestive.
In mid-2013, the FOMC announced its intention to taper its ongoing asset purchase program. We can see that this announcement represented a dramatic change in policy from the sharp upward movements in long-term bond yields that it engendered. Personally, I interpret this policy change back in 2013 as the onset of what the Committee currently intends to be a long, gradual tightening cycle. As I noted earlier, we would typically expect that such a change in monetary policy should affect the economy with a lag of about 18 to 24 months. Viewed through this lens, the slow rate of labor market improvement in 2015 is not all that surprising.
I believe the FOMC should take actions to facilitate a resumption of the 2014 improvement in the labor market by adopting a more accommodative policy stance. Remember, inflation is low, and is expected to remain low, relative to the FOMC’s target. In particular, I don’t see raising the target range for the fed funds rate above its current low level in 2015 or 2016 as being consistent with the pursuit of the kind of labor market outcomes that we are charged with delivering. Indeed, I would be open to the possibility of reducing the fed funds target funds range even further, as a way of producing better labor market outcomes.
There is, of course, a risk that inflationary pressures could build up more rapidly than I (or others) currently anticipate. But the solution to this scenario is relatively simple: Raise interest rates. Given my current outlook, I believe that it would be appropriate to wait until 2017 to initiate liftoff and then raise the fed funds rate at about 2 percentage points per year. My preferred pace of tightening mirrors the pace of tightening from 2004 to 2006—a pace of tightening that is often seen as gradual. (In fact, some would argue, with the benefit of hindsight, that it was overly gradual.) In response to unanticipated inflationary pressures, the FOMC could simply react as it did in 1994, and raise the fed funds rate more rapidly than this gradual pace.
... The lesson of 2014 is clear: We can do better. Given 2014, and given how low inflation is expected to be over the next few years, I see no reason why the Committee should not aim to facilitate continued improvement in labor market conditions. Indeed, I currently see no reason why we should not aim for the kind of strong labor market conditions that prevailed at the end of 2006.
But we will get there only if we make the right choices. The FOMC can achieve its congressionally mandated price and employment goals only by being extraordinarily patient in reducing the level of monetary accommodation. Indeed, to best fulfill its congressional mandates, the Committee should be considering reducing the target range for the fed funds rate, not increasing it. ...

Wednesday, September 30, 2015

Overly Optimistic Forecast's Have Caused Poor Fed Communication

I think I buried the main point on this one for MoneyWatch. There has been quite a bit of criticism of the Fed's messaging on the timing of a rate liftoff. But while the messaging has been far from perfect, the bigger problem is the Fed's overly rosy forecasts. The Fed's forecasting models generally impose what is known as a stationarity assumption in response to demand-side shocks -- that is, the models have a relatively fast return to full employment baked into them. The rosy forecasts lead the Fed to adopt a relatively hawkish stance that has to be adjusted as more sobering data arrive. Thus, observers see the Fed continually revising its message, putting itself on a different "data dependent" path each time, and the succession of revisions causes observers to conclude that the Fed's messaging is off-base. But if the forecasts had been better, messaging wouldn't be so much of a problem:

Is communication the Fed's big problem?, Commentary: The Federal Reserve has gotten plenty of criticism for its recent communications about its monetary policy intentions. For example, Mark Gilbert at Bloomberg complained that "...the forward guidance policy adopted in recent years by many central banks is in tatters, and is probably doing more harm than good in telling companies and consumers when borrowing costs are likely to rise and at how fast."
Edward Luce at the Financial Times had similar sentiments, concluding that "Ms Yellen has juggled with different types of communication. They call this learning by doing. As the next countdown begins, her goal must be to share her thinking more clearly."
Is the Fed guilty as charged, and why is this important? ...

Tuesday, September 29, 2015

'Trump World and the Fed'

Magic plans meet the reality called the Fed:

Trump World and the Fed, by Dean Baker: ...Suppose that Donald Trump's tax cut really is the magic elixir that would get the economy to 6.0 percent annual growth. But what if the people at the Fed's Open Market Committee (FOMC) don't recognize this fact? Suppose the FOMC thinks the economy is still bound by the pre-Trump tax cut rules and believes that inflation will start to accelerate out of control if the unemployment rate falls much below its current 5.1 percent level.
In this case, we would expect to see the Fed raise interest rates sharply as they saw the Trump tax cuts boosting growth. ... If the Fed raises interest rates high enough, it could fully offset the boost that Trump's tax cut is giving to the economy. In this case, even though the Trump tax cuts might have been the best thing for the economy since the Internet (okay, better than the Internet), we wouldn't see any dividend because the Fed would not allow it.
For this reason, the Fed's likely response to a tax cut is a fundamental question that reporters should be asking. If the Fed is likely to simply slam on the brakes to offset any possible stimulus, then a tax plan will have little prospect of providing a growth dividend.

Maybe they aren't asking because they know in their heart of hearts that the plan will be lucky to boost growth at all.

Thursday, September 24, 2015

'Inflation Dynamics and Monetary Policy'

Federal Reserve Chair Janet L. Yellen:

Inflation Dynamics and Monetary Policy, by Chair Janet L. Yellen: ... In my remarks today, I will discuss inflation and its role in the Federal Reserve's conduct of monetary policy. I will begin by reviewing the history of inflation in the United States since the 1960s, highlighting two key points: that inflation is now much more stable than it used to be, and that it is currently running at a very low level. I will then consider the costs associated with inflation, and why these costs suggest that the Federal Reserve should try to keep inflation close to 2 percent. After briefly reviewing our policy actions since the financial crisis, I will discuss the dynamics of inflation and their implications for the outlook and monetary policy. ...

It's a relatively long speech. Skipping ahead:

Policy Implications
Assuming that my reading of the data is correct and long-run inflation expectations are in fact anchored near their pre-recession levels, what implications does the preceding description of inflation dynamics have for the inflation outlook and for monetary policy?
This framework suggests, first, that much of the recent shortfall of inflation from our 2 percent objective is attributable to special factors whose effects are likely to prove transitory. ...
To be reasonably confident that inflation will return to 2 percent over the next few years, we need, in turn, to be reasonably confident that we will see continued solid economic growth and further gains in resource utilization, with longer-term inflation expectations remaining near their pre-recession level. Fortunately, prospects for the U.S. economy generally appear solid. ... My colleagues and I, based on our most recent forecasts, anticipate that this pattern will continue and that labor market conditions will improve further as we head into 2016.
The labor market has achieved considerable progress over the past several years. Even so, further improvement in labor market conditions would be welcome because we are probably not yet all the way back to full employment ... which most FOMC participants now estimate is around 4.9 percent...  
Reducing slack ... may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilizing at 2 percent. For example, attracting discouraged workers back into the labor force may require a period of especially plentiful employment opportunities and strong hiring. Similarly, firms may be unwilling to restructure their operations to use more full-time workers until they encounter greater difficulty filling part-time positions. Beyond these considerations, a modest decline in the unemployment rate below its long-run level for a time would, by increasing resource utilization, also have the benefit of speeding the return to 2 percent inflation. Finally, albeit more speculatively, such an environment might help reverse some of the significant supply-side damage that appears to have occurred in recent years, thereby improving Americans' standard of living.33
Consistent with the inflation framework I have outlined, the medians of the projections provided by FOMC participants at our recent meeting show inflation gradually moving back to 2 percent, accompanied by a temporary decline in unemployment slightly below the median estimate of the rate expected to prevail in the longer run. ... This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.
By itself, the precise timing of the first increase in our target for the federal funds rate should have only minor implications for financial conditions and the general economy. What matters for overall financial conditions is the entire trajectory of short-term interest rates that is anticipated by markets and the public. As I noted, most of my colleagues and I anticipate that economic conditions are likely to warrant raising short-term interest rates at a quite gradual pace over the next few years....
The economic outlook, of course, is highly uncertain... Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.
To conclude, let me emphasize that, following the dual mandate established by the Congress, the Federal Reserve is committed to the achievement of maximum employment and price stability. To this end, we have maintained a highly accommodative monetary policy since the financial crisis; that policy has fostered a marked improvement in labor market conditions and helped check undesirable disinflationary pressures. However, we have not yet fully attained our objectives under the dual mandate: Some slack remains in labor markets, and the effects of this slack and the influence of lower energy prices and past dollar appreciation have been significant factors keeping inflation below our goal. But I expect that inflation will return to 2 percent over the next few years as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored. Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.

Tuesday, September 22, 2015

'Central Banks Have Made the Rich Richer'

Paul Marshall, chairman of London-based hedge fund Marshall Wace, in the FT:

Central banks have made the rich richer: Labour’s new shadow chancellor has got at least one thing right. ... Quantitative easing ... has bailed out bonus-happy banks and made the rich richer. ...
It is no surprise that the left is angry about this, nor that they are looking for other versions of QE that do not so directly benefit bankers and the rich. Instead of increasing the money supply by buying sovereign bonds from banks, central banks could spread the love evenly by depositing extra money in every person’s bank account..., it might have been fairer.
Mr McDonnell and Jeremy Corbyn, the new Labour leader, advocate a second approach: targeting QE at infrastructure projects. The central bank would buy bonds direct from the Treasury on the understanding that the funds would be used to improve housing and transport infrastructure. ...
QE had clear wealth effects, which could have been offset by fiscal measures. All political parties should acknowledge this. So should those of us who want free markets to retain their legitimacy.

Monday, September 21, 2015

'Can We Rely on Market-Based Inflation Forecasts?'

Michael Bauer and Erin McCarthy of the SF Fed:

Can We Rely on Market-Based Inflation Forecasts?, Michael D. Bauer and Erin McCarthy, Economic Letter, FRBSF: The Federal Reserve’s dual mandate requires monetary policy to aim for both maximum employment and price stability. Although employment has recovered since the recession, inflation has consistently remained below the Fed’s 2% longer-run objective. Because expectations of future inflation play an important role in determining current inflation, decreases in measures of inflation expectations based on market prices have raised some concerns. For example, between June 2014 and January 2015, one-year inflation swap rates, which measure market-based expectations of inflation in the consumer price index (CPI) one year ahead, dropped over 2.5 percentage points. Large decreases were also observed in breakeven inflation rates, the difference between yields on nominal and inflation-indexed Treasury securities, known as TIPS.
Market-based measures of inflation expectations are calculated from the prices of financial securities. Their advantage is that they are readily available at high frequency and therefore are widely monitored. However, they reflect not only the public’s inflation expectations but also other idiosyncratic factors that affect market prices, which are difficult to quantify. For example, they include a risk premium to compensate investors for inflation uncertainty and are affected by changes in liquidity, unusual demand flows, and, more broadly, “animal spirits” that change prices but are unrelated to expectations (see Bauer and Rudebusch 2015). Hence it is unclear how much useful information they provide, and how much one should pay attention to these rates when forecasting inflation.
If market-based inflation expectations provided accurate inflation forecasts, then one surely would want to pay close attention to their evolution. In this Economic Letter, we evaluate their performance in comparison with a variety of alternative forecasts for CPI inflation. ...
Conclusions We find that market-based measures of inflation are poor predictors of future inflation. In particular, they perform much worse than forecasts constructed from survey expectations of future inflation, which incorporate all the information used by professional forecasters. Interestingly, a simple constant inflation rate corresponding to the Federal Reserve’s 2% inflation target consistently performs best. While our analysis is based on a short sample that displays a lot of volatility during the Great Recession, our results appear quite robust as they are consistent across two subsamples.
Our results add to the discussion about how much attention policymakers and professional forecasters should pay to market-based inflation forecasts. These measures mostly reflect current and past inflation movements, and do not contain a lot of useful forward-looking information. Idiosyncratic market forces and inflation risk premiums appear to be important drivers of market-based inflation expectations. Overall, it is important to keep this caveat in mind when interpreting market-based inflation expectations.

Paul Krugman: The Rage of the Bankers

Why are bankers so angry about the Fed's decision not to raise interest rates?:

The Rage of the Bankers, by Paul Krugman, Commentary, NY Times: Last week the Federal Reserve chose not to raise interest rates. It was the right decision. In fact, I’m among the economists wondering why we’re even thinking about raising rates right now. ... Yet the Fed has faced constant criticism for its low-rate policy. Why?
The ... story keeps changing. In 2010-2011 the Fed’s critics issued dire warnings about looming inflation. You might have expected some change in tune when inflation failed to materialize. Instead, however, those who used to demand higher rates to head off inflation are still demanding higher rates, but for different reasons. The justification du jour is “financial stability,” the claim that low interest rates breed bubbles and crashes. ... Why does anyone take this stuff seriously?
Well, when you see ever-changing rationales for never-changing policy demands, it’s a good bet that there’s an ulterior motive. And the rate rage of the bankers — combined with the plunge in bank stocks that followed the Fed’s decision not to hike — offers a powerful clue... It’s the bank profits, stupid. ...
For banks make their profits by taking in deposits and lending the funds out at a higher rate of interest. And this business gets squeezed in a low-interest environment... The ... difference between the interest rate banks receive on loans and the rate they pay on deposits ... has fallen sharply over the past five years.
The appropriate response of policy makers ... should be, “So?” There’s no reason to believe that what’s good for bankers is good for America. But bankers are different from you and me: they have a lot more influence. Monetary officials meet with them all the time, and in many cases expect to join their ranks when they come out on the other side of the revolving door. ...
So we shouldn’t be surprised to see institutions that cater to bankers, not to mention much of the financial press, spinning elaborate justifications for a rate hike that makes no sense in terms of basic economics. And the debate of the past few months, in which the Fed has seemed weirdly eager to raise rates..., suggests that even U.S. monetary officials aren’t immune.
But the Fed did the right thing last week: nothing. And the howling of the bankers should be taken not as a reason to reconsider, but as a demonstration that the clamor for higher rates has nothing to do with the public interest.

Saturday, September 19, 2015

'Less Worried about a Hard Landing for China'

SF Fed President John Williams on China:

China, Rates, and the Outlook: May the (Economic) Force Be with You: ...China has garnered almost as much editorial ink in the past month as U.S. presidential candidates—which may or may not be a complimentary comparison. I don’t want to sound pejorative by calling some of the commentary “hand-wringing”—though to be fair, some of it has been downright apocalyptic—but I don’t see the situation as dire. I’ve said publicly over the past few months that after going to China, and after talking to academics and officials there, I came away a lot less concerned than when I arrived. And I have to say that recent events have not changed my thinking to any serious extent.
This is where I’ll reuse one of the more helpful quotes for forecasting: “It’s difficult to make predictions, especially about the future.” With the dangers of prognostication acknowledged, I’ll tread into that territory anyway.
The China story is remarkable, and its growth over the past 30 years has been unprecedented.5 But now China’s at something of a crossroads, facing tradeoffs in their goals, dealing with a new normal for growth expectations, and pivoting to a new source of economic momentum.
It’s important to see the situation not through the filters of our own paradigms, but from the perspective of China’s unique position. China is not the U.S. Or the U.K. Or Japan. Its goals, structure, government, and place on its growth trajectory are very different, and looking to impose foreign expectations on China’s markets or actions can lead one astray.
Growth versus reform
In a nutshell, China is facing a tradeoff between its short-term growth goals and its longer-term reform agenda.
China’s government has made it abundantly clear that it is willing to intervene when necessary, ensuring that growth stays on its target path, even if that means extending the timeline on reform. That willingness to do “whatever it takes” to keep growth on target is what made me less worried about a hard landing for China.
Of course, that very disposition for intervention is the source of much hue and cry on this side of the globe. China has made important incremental steps on the road to liberalization, and from the perspective of a fully open, free-market, Western-oriented paradigm or advocacy, the recent stock market interventions seem anathema to that goal. But that’s a view through a narrow lens that may obscure the bigger picture.
For all its moves towards liberalization, China’s markets are not the same as ours. Yes, they have a reform agenda, but it’s a mistake to think that in the foreseeable future China will have fully open capital and financial markets in the way that we in the U.S. and other countries think about them. They are relaxing their grip on the exchange rate—allowing the renminbi to respond to economic news, letting its value be more market-determined—and as a policy approach, this is a positive; it’s something we as economists wanted to see happen. But it’s very clear that China is not going to let its exchange rate float completely freely. They’ll continue to have buffers to ensure that, should some dramatic event unfold, they can step in again and stop that interfering with their other goals. To some extent, we can see these moves as something akin to beta-testing liberalization. It is happening, which is a remarkable shift. But completely free, open markets are not in the cards, and the government has made clear that those are not their intention.
This, incidentally, is why talk about the renminbi replacing the dollar as an international reserve currency is unrealistic. The role of a reserve currency is to be a harbor during a storm; it’s where people flock when the unexpected happens. As we saw in the financial crisis, as we’ve seen in other crises, the market’s instinct is, when in doubt, go to the dollar. As long as China has controls in place to mediate the free flow of money, the dollar will be the refuge, not the renminbi.
In the context of China’s dual—oftentimes conflicting—goals, the recent stock market intervention by the government should be seen as what I believe it was: A move to keep growth on pace. It’s a pattern we’ve seen before. When the Chinese authorities see growth struggling, or other economic warning lights, they take steps, including reversing or postponing reforms, to keep growth at pace. Fiscal and economic policymakers can pull a number of levers and the Chinese government has proved again and again its willingness to do just that.
China’s growth rate
In balancing these objectives, the Chinese government has realistically moderated its expectations for growth. For decades we all marveled at China’s double-digit growth, and there was, perhaps, some expectation that it would persist in perpetuity. But growth like that is unsustainable. If you look at the progression of Japan, for instance, from the 1960s to the 1980s, or South Korea from the 1980s to the 2000s, you see the pattern China will likely follow.6 At low income levels, growth can be rapid, because low domestic wages make exports very competitive and there is so much untapped potential in moving workers to more productive pursuits.
But as income or GDP per capita rise, these advantages begin to ebb, and growth naturally slows. The pattern is clear, with a rapid decline in the growth rate and eventual leveling out as domestic income and wages rise. This is the natural progression of economies moving into maturity. The further they have to go, the faster they can grow; but once they’ve come to a place like Japan or Korea—that is, around 80 or 90 percent of U.S. per capita GDP—their growth expectations will be lower because they’re closer to the finish line. China obviously isn’t close yet, but it’s a good indicator of how much further it can go. What China’s accomplished has been amazing—but we also called Japan a growth miracle and Korea’s success was remarkable as well. There were challenges along the way for both countries, but ultimately, what slowed growth was entering the middle-income bracket and the inevitability of slower growth for wealthier countries.   
The officials and economists I spoke to in China know that not only are the days of 10 percent growth behind them, but that it will move below the current 7 percent target. Seven will likely become 6, which will become 5, and so on as their economy moves into a middle-income economy and progresses to a high-income one.
Shift in focus
Of course, China faces challenges in continuing that advance. One is a refocus of its economic engine. Given the global environment, how do they successfully pivot their economy to more domestic consumption, moving the emphasis more toward services and away from manufacturing? That’s clearly a challenge, but also a central objective of the government.
For people who have concerns about China, one of the red flags they point to is that industrial production has slowed a lot, more so than the economy overall. I fall on the side of commentators who’ve pointed out that this isn’t surprising.7 China’s been talking for years about switching from industry to services. They’re moving from making steel and concrete to making consumer goods. One of the interesting things I heard this summer was the plan to build more tourism in China for China. That’s something that’s virtually nonexistent at the moment. They don’t have the abundance of recreational resources we do; in California alone, you can go skiing or surfing, to wine country or Disneyland. As high- or low-brow as you want it, we as Americans have become incredibly used to spending our leisure dollars domestically. That’s something China’s looking to do for itself.
When you look at where China’s priorities lie—in switching to services, in expanding tourism—it makes absolute sense that industrial production is slowing.
Liberalization and the impact of risks from abroad
I’ve mentioned that China is seen by some as a risk; but conversely, what effect does U.S. policy have on them? Right now, China is more susceptible to the shifts in U.S. monetary policy. But as they liberalize their exchange rate, it will automatically adjust to changes in situations around the world. This is a huge advantage and an automatic stabilizer. When China pegs to the dollar, they’re too linked to U.S. policy, so that when the U.S. tightens or loosens, they effectively follow suit. By allowing market-based influence, China will have a buffer when the U.S. economy is moving in a different direction than theirs. And that’s going to make it easier in the end for China to manage its economy.
An outside observer might ask why they haven’t done this already. I think that China was wary that unpegging would’ve interrupted the double-digit growth. When a country’s exchange rate and capital flows suddenly start shifting around dramatically, it can interfere with the ability to deliver on growth targets. As China’s growth targets have come down, and as they begin to shift away from an export-reliant economy, instead fueling itself via domestic consumption, they can start allowing their exchange rate to move—though again, it won’t be the free floating exchange rate that we have.
This is all just one economist’s take. ...

'Is the Fed Pulling or Pushing?'

John Cochrane:

Is the Fed Pulling or Pushing?: ... Is the Fed in fact "holding down" interest rates? Is there some sort of natural market equilibrium that features higher rates now, but the Fed is pushing down rates? That's the conventional view...
Well, let's think about that. If a central bank were holding down rates, what would it do? Answer, it would lend a lot of money at low rates. Money would be flowing out the discount window (that's where the Fed lends to banks), to banks, and through banks to the rest of the economy, flooding the place with low-rate loans. The interest rate the Fed pays on reserves and banks pay to borrow from the Fed would be low compared to market rates; credit and term spreads would be large, as the Fed would be trying to drag down those market rates.
That is, of course, the exact opposite of what's happening now. Banks are lending the Fed about $3 trillion worth of reserves, reserves the banks could go out and lend elsewhere if the market were producing great opportunities. Spreads of other rates over the rates banks lend to or borrow from the Fed are very low, not very high. Deposits are flooding in to banks, not loans out of banks.
If you just look out the window, our economy looks a lot more like one in which the Fed is keeping rates high, by sucking deposits out of the economy and paying banks more than they can get elsewhere; not pushing rates down, by lending a lot to banks at rates lower than they can get elsewhere.

Thursday, September 17, 2015

No Rate Hike

Tim Duy called it. No rate hike (and only one dissent, lacker). Here's the statement:

Press Release, Release Date: September 17, 2015: Information received since the Federal Open Market Committee met in July suggests that economic activity is expanding at a moderate pace. Household spending and business fixed investment have been increasing moderately, and the housing sector has improved further; however, net exports have been soft. The labor market continued to improve, with solid job gains and declining unemployment. On balance, labor market indicators show that underutilization of labor resources has diminished since early this year. Inflation has continued to run below the Committee's longer-run objective, partly reflecting declines in energy prices and in prices of non-energy imports. Market-based measures of inflation compensation moved lower; survey-based measures of longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Recent global economic and financial developments may restrain economic activity somewhat and are likely to put further downward pressure on inflation in the near term. Nonetheless, the Committee expects that, with appropriate policy accommodation, economic activity will expand at a moderate pace, with labor market indicators continuing to move toward levels the Committee judges consistent with its dual mandate. The Committee continues to see the risks to the outlook for economic activity and the labor market as nearly balanced but is monitoring developments abroad. Inflation is anticipated to remain near its recent low level in the near term but the Committee expects inflation to rise gradually toward 2 percent over the medium term as the labor market improves further and the transitory effects of declines in energy and import prices dissipate. The Committee continues to monitor inflation developments closely.
To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that the current 0 to 1/4 percent target range for the federal funds rate remains appropriate. In determining how long to maintain this target range, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments. The Committee anticipates that it will be appropriate to raise the target range for the federal funds rate when it has seen some further improvement in the labor market and is reasonably confident that inflation will move back to its 2 percent objective over the medium term.
The Committee is maintaining its existing policy of reinvesting principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities and of rolling over maturing Treasury securities at auction. This policy, by keeping the Committee's holdings of longer-term securities at sizable levels, should help maintain accommodative financial conditions.
When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent. The Committee currently anticipates that, even after employment and inflation are near mandate-consistent levels, economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.
Voting for the FOMC monetary policy action were: Janet L. Yellen, Chair; William C. Dudley, Vice Chairman; Lael Brainard; Charles L. Evans; Stanley Fischer; Dennis P. Lockhart; Jerome H. Powell; Daniel K. Tarullo; and John C. Williams. Voting against the action was Jeffrey M. Lacker, who preferred to raise the target range for the federal funds rate by 25 basis points at this meeting.

Fed Watch: Final Thoughts On September

Tim Duy:

Final Thoughts On September, by Tim Duy: Everyone's bets are placed for the outcome of tomorrow's FOMC statement and subsequent press conference. Final thoughts heading into the meeting:
I expect the Fed will pass on raising rates this meeting. This is a highly contentious issue, and reasonable arguments can be made for either case. Economists appear to be roughly split, while financial market participants taking the under with a roughly 25% probability of a rate hike. Whatever the outcome, roughly half of the economists on Wall Street will be wrong. Good thing, as misery loves company.
I believe FOMC participants will arrive at a consensus for the timing and direction of policy for subsequent meetings. The FOMC has had something of a luxury in that economic conditions have not forced them to choose a defined policy path. I believe they no longer have that luxury. They will need to commit policy to one side of the mandate or the other. At this meeting they will decide if their Phillips curve view of the world in concert with their estimate of the natural rate of unemployment dominates the fact that inflation continues to drift away from their target.
I expect the Fed will ultimately pledge allegiance to the Phillips curve. I think they believe that stable inflation is incompatible with sub-5% unemployment if short term interest rates remain at zero. Hence, they will signal that the first rate hike is imminent.
Fed Chair Janet Yellen has the opportunity to prove her mettle. Assuming that I am correct that the Fed needs to forge a consensus, Yellen will be the guiding influence on that consensus. The best outcome for her is a consensus with no dissenting votes. That said, it may be that only an immediate rate hike would be acceptable to Richmond Federal Reserve President Jeffrey Lacker.
I expect Yellen will make a strong attempt to open the door for October. The Fed has established expectations that, outside of obvious exigent circumstances, they can only make major decisions when there is a scheduled press conference. Yellen will push back hard. Indeed, I think there is a possibility that this becomes the "rate hike" press conference in spirit, with the actual hike in October. Something to think about.
The Fed will try to take the sting out of any hawkish signals with a dovish message. I expect the terminal rate forecasts in the dot plot to drift lower. In addition, I expect Yellen will emphasize that low inflation provides room for a slow and halting pace of rate increases. (My expectation, however, is that assuming the first hike goes smoothly, subsequent hikes will come at regular intervals.) Finally, the estimate of the natural rate of unemployment may drift down further. 
If I am wrong...two potential alternatives. First is that everything above remains the same, but they pull the trigger today. They tend not to surprise, but maybe this time is different. Maybe they don't need to built a consensus, although I think that unlikely.  Second is that Yellen pushes the FOMC into a dramatically more dovish direction that re-emphasizes the issue of underemployment and shifts expectations to 2016. I don't think that is likely as I think she is fairly entrenched in the 5% NAIRU camp, but we will see tomorrow.
Enjoy the day's excitement!

Tuesday, September 15, 2015

'Why the Fed Is Likely to Stand Pat This Week'

Tim Duy at Bloomberg:

Why the Fed Is Likely to Stand Pat This Week: What a week it might have been?

Speeches and interviews have made it fairly clear that Federal Reserve officials were building a case to begin normalizing interest rate policy as soon as this month, but they are increasingly wary that a misstep could derail the economy at a time when they perceive a lack of tools to address renewed weakness.

From the policy discussion of the June Federal Open Market Committee meeting:

Another concern related to the risk of premature policy tightening was the limited ability of monetary policy to offset downside shocks to inflation and economic activity when the federal funds rate was near its effective lower bound.

This concern will weigh heavily on the policy discussion as the Fed begins what promises to be a tumultuous two-day meeting this week. While the central bank was likely prepared to raise interest rates this month at the conclusion of the last FOMC meeting, deteriorating global economic conditions and market volatility will likely derail those plans.

Nor is the inflation picture particularly supportive at this juncture. ...[continue]...

Wednesday, September 09, 2015

The Fed Must Act Soon? Why?

I tried to argue against the points Richard Fisher is making in my column yesterday.

First, he tells us to ignore the headline inflation rate since it is subject to lots of short-run variation from factors such as food and commodity prices, and instead focus on the Dallas Fed's trimmed mean measure. Here it is:

12-month PCE inflation
  Feb-15 Mar-15 Apr-15 May-15 Jun-15 Jul-15
PCE excluding food & energy
Trimmed Mean PCE

See the problem? The Fed's target rte of inflation is 2.0 percent, but trimmed mean inflation, which is intended to isolate long-run inflation trends and ignore short-run variation, is holding steady at 1.6 percent.

Actually, Fisher is a bit loose with the numbers. He says:

conventional core PCE inflation has averaged 1.65 per cent, nearly 30 basis points below headline inflation’s 1.94 per cent average.

But, his preferred measure of inflation, the trimmed mean, shows inflation:

coming in at 1.83 per cent over the past decade, 10 basis points below the headline rate.

But for policy, who cares about 10 years ago? Recently, as shown above, the measure has been close to 1.6 percent, and that's a big miss on the downward side. He does acknowledge this, but still acts as though it is only a near miss:

the Dallas Fed trimmed mean rate has been running steadily at 1.6 per cent over the past year, lower than policymakers are shooting for, but less discouraging than the most watched measures suggest.

Yes, 1.6 versus 1.2 percent for July (see above) is a bit better, but let's not pretend it's close to target. Maybe it is "less discouraging," but it is still discouraging.

In any case, if you are a hawk and want rates up, what do you argue at this point? First, that labor markets are tightening (he ignores the secular stagnation point others use to argue labor markets are tighter than they seem), and inflation is just around the corner (as it always is if you are Richard Fisher, go back and look at what he has been saying throughout the crisis -- inflation has always been just ahead):

History tells us that wage growth initially picks up slowly when unemployment starts to fall but, as it approaches more fulsome levels, wage rises accelerate.
That is the territory we are approaching now. Unemployment has reached 5.1 per cent sooner than the Fed’s rate setters expected. Wage-inflation pressures are not yet nettlesome but they have been rising, smack dab in line with past experience.

But as I explained in my column, recent research says much of that history can be ignored since the relationship between wage inflation and price inflation has changed considerably over the years (pass-through has diminished quite a bit since 1980, i.e. wage increases no longer translate into price increases as they once did, for example in the 1970s Fisher remembers so well). And as the WSJ recently explained, where is the wage inflation the hawks are so worried about?:

U.S. employers aren’t yet being squeezed by workers demanding higher wages. The employment-cost index, a broad gauge of wage and benefit expenditures, rose a seasonally adjusted 0.6% in the fourth quarter last year, the Labor Department said Friday. That’s down from 0.7% in the two earlier quarters and jibes with other data showing only limited wage pressure across the U.S. 

But inflation is coming. It's always coming, right?

Okay, price inflation is below target, wage inflation is really hard to find, and there are many reasons to suspect that labor markets are not as robust as the unemployment rate suggests (not to mention uncertainties in the world economy). But if you are a hawk, you don't give up merely because the data is stacked against you. Instead, you fall back on the "long lags" argument:

Monetary policy ... operates with a lag. If the Fed waits for full employment and then has to throttle back sharply, there will be a nasty shock. The upcoming Fed meetings present a timely opportunity to start slowing down the engines

The question I raised yesterday is whether, with advances in digital technology, we should expect these lags to be as long as they were in the past, e.g. in the 1970s. It seems to me that they have likely shortened, perhaps quite a bit, and that gives the Fed more room for patience than it had in the past. Couldn't it at least wait for clear signs of a problem before acting?

Finally, why the huge fear over a little bit of inflation rather than huge fear over higher than necessary unemployment? Why not reserve the same level of fear for those who struggle with unemployment and all the troubles that come with it? Which is the greater problem to avoid? If we make a mistake, should it be to allow a bit of inflation, which the Fed can quickly reverse, or allow a higher level of unemployment, a problem that is much more costly and much harder to deal with? Why does inflation get so much more attention from some people? Why the hurry to raise rates?

Tuesday, September 08, 2015

The Fed Must Banish the 1970’s Inflation Devil

I have a new column:

The Fed Must Banish the 1970’s Inflation Devil: Will the Fed raise rates when it meets later this month? Inflation remains below the Fed’s two percent target, and that argues against a rate increase. But labor markets appear to be tightening and that is raising worries that higher inflation is just ahead. Should the Fed launch a preemptive strike against the possibility of wage-fueled inflationary pressure? ...

Hopefully there's at least one argument against raising rates that you have not heard before.

Fed Watch: Flying Mostly Blind Heading Into the September FOMC Meeting

Tim Duy:

Flying Mostly Blind Heading Into the September FOMC Meeting, by Tim Duy: Last year, I would have said you were crazy if you told me that short-term rates would still be hugging zero even as unemployment fell to 5.1 percent. Yet here we are, gearing up for a FOMC meeting that promises to be the most contentious in years. The era of data dependence yielded substantially less clarity on the direction of policy than one would hope for, leaving expectations for the meeting’s outcome all over the place. That means this meeting is not just about 25 basis points – it’s about defining the parameters of the Fed’s reaction function. We will learn what data dependence means not just in theory, but in practice.
The argument for a move next week is straightforward. Actual and underlying economic activity remains sufficient to sustain further improvement in the labor market. Indeed, dramatic progress has been made when viewed through the eyes of Federal Reserve Chair Janet Yellen as she scoped out the economic landscape in 2013:


With unemployment at the Fed’s estimate of the natural rate, inflationary pressures will soon emerge. To be sure, wage growth remains flat, but even Yellen leans toward writing that off as an expected outcome of low productivity growth:
The growth rate of output per hour worked in the business sector has averaged about 1-1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth.
When combined with stable inflation expectations, policymakers have good reason to be confident that actual inflation will soon reverse course and trend toward the Fed’s target. In such an environment, financial accommodation needs to be withdrawn pre-emptively to avoid overshooting the targets. As policymakers prefer to raise rates gradually, they are impelled to raise them early to avoid the risk of more rapid increases in the future.
The counterargument, however, is also straightforward. Labor markets remain far from healed if viewed through the eyes of Yellen in 2014: 


Low wage growth is thus consistent with the hypothesis that underemployment indicators are important measures of labor market health. The persistence of weak wage growth should leads to revised estimates of the natural rate of unemployment. After all, targeting 5 percent unemployment when the natural rate is 4 percent means denying jobs to roughly 1.5 million people. That’s no small responsibility.
Moreover, inflation continues to trend away from target. If you are uncertain of your estimate of the natural rate and inflation is moving away from target, why rush to hike rates? Even though Fed officials believe that inflation has been unduly influenced by the temporary factors of falling oil prices and a rising dollar, those factors reasserted themselves since the last FOMC meeting. And market-based measures of inflation expectations do not signal a revival of inflation anytime soon.
Recent financial turbulence also calls into doubt the wisdom of raising rates next week. To be sure, the Federal Reserve is not responsible for maintaining the value of everyone’s portfolio. But they are responsible for maintaining the financial stability necessary to sustain economic growth. Recent market activity, including a stronger dollar, wider credit spreads, and falling stocks, points toward already tighter financial conditions in the absence of a rate hike. A forward-looking central bank should be cautious of further tightening. Indeed, a forward-looking central bank would be expected to react to current signals with a delayed and shallower path of rate hikes.
Ultimately, the Fed will need to choose between one of these two arguments, and by doing so they will define a direction for policy. This will be important new information. Ultimately, we will learn who rules the roost at the FOMC – the Janet Yellen of 2013, or the Janet Yellen of 2014. Will it be the hawkish or dovish Janet Yellen that appears in the subsequent press conference? I tend to think the later will appear, but the case for the former is strong as well. In any event, the signaling information we receive next week is far more important than any 25 basis points could be.

Saturday, September 05, 2015

Fed Watch: If You Ever Wondered Whose Side The Federal Reserve Is On...

Tim Duy:

If You Ever Wondered Whose Side The Federal Reserve Is On..., by Tim Duy: Catching up with Richmond Federal Reserve Jeffrey Lacker's speech. His dismissal of low wage growth numbers:
Some argue there must be excessive slack in labor markets if wage rates are not accelerating. But real wages are tied to productivity growth, and productivity growth has been slow for several years now. Wage growth in real terms has at least kept pace with productivity increases over that time period, which is perfectly consistent with an economy from which labor market slack has largely dissipated. 
Real wage growth is consistent with productivity, thus there is no excess slack in the labor market. If you think this is some crazy hawk-talk, think again. Fed Chair Janet Yellen in July:
The growth rate of output per hour worked in the business sector has averaged about 1‑1/4 percent per year since the recession began in late 2007 and has been essentially flat over the past year. In contrast, annual productivity gains averaged 2-3/4 percent over the decade preceding the Great Recession. I mentioned earlier the sluggish pace of wage gains in recent years, and while I do think that this is evidence of some persisting labor market slack, it also may reflect, at least in part, fairly weak productivity growth.
For more than three decades, the pace of productivity growth has exceed that of real compensation:


Another view from real median weekly earnings:


Real median weekly earnings have grown 8.6% since 1985. Nonfarm output per hour is up 79% over that time. Yet the instant that there is even a glimmer of hope that labor might get an upper hand, the Federal Reserve looks to hold the line on wage growth. It still appears that the Fed's top priority is making sure the cards remain stacked against wage and salary earners.

Deflation and Money

The summary "Deflation and money" by Hiroshi Yoshikawa, Hideaki Aoyama, Yoshi Fujiwara, and Hiroshi Iyetomiof says:

Deflation and money, Vox EU: Deflation is a threat to the macroeconomy. Japan had suffered from deflation for more than a decade, and now, Europe is facing it. To combat deflation under the zero interest bound, the Bank of Japan and the European Central Bank have resorted to quantitative easing, or increasing the money supply. This column explores its effectiveness, through the application of novel methods to distinguish signals from noises.

The conclusion:

...all in all, the results we obtained have confirmed that aggregate prices significantly change, either upward or downward, as the level of real output changes. The correlation between aggregate prices and money, on the other hand, is not significant. The major factors affecting aggregate prices other than the level of real economic activity are the exchange rate and the prices of raw materials represented by the price of oil. Japan suffered from deflation for more than a decade beginning at the end of the last century. More recently, Europe faces a threat of deflation. Our analysis suggests that it is difficult to combat deflation only by expanding the money supply.