Economist's View

Bernanke's Leadership a Critical Factor for Fed Policy

I have a few comments on Bernanke's testimony this morning at CBS MoneyWatch. The bottom line:

... Battling the inclination to exit too soon is the most important challenge that the Fed faces. I think Bernanke understands this, and his leadership and ability to steer the middle away from the tendency to exit too soon will be a critical factor in the pace of the recovery.

Fed Watch: And Then There is Bernanke

Tim Duy:

And Then There is Bernanke, by Tim Duy: Lots of Fed chatter in the last week. For openers, some background from Reuters:

It decided on May 1 to keep buying at an $85 billion monthly pace, and many economists say mixed economic data warrants keeping up the purchases through year-end.

But persistent warnings from more hawkish Fed officials had fanned talk that it might start to wind back soon.

The hawkish Fed officials would be Dallas Federal Reserve President Richard Fisher, Philadelphia Federal Reserve President Charles Plosser, and Richmond Federal Reserve President Jeffrey Lacker. These are often colorful voices, but as a general rule are not voices that will hold much sway with regards to the pace of easing. What is much more important is to what extent remaining policymakers are coming along to the same view. In other words, these three can ruffle their feathers all they want, but that ruffling should not be interpreted as consensus movement within the FOMC.

For consensus movement, turn more toward New York Federal Reserve President William Dudley. Great speech today, but I will narrow my focus with a few points I think are relevant for US policy. While Dudley is clearly concerned about deflation, this is important:

Similarly, current circumstances in the two countries are different, with deflationary expectations still in the process of being dislodged in Japan. The BoJ needs to push up inflation expectations, whereas in the U.S. the current level of inflation expectations is consistent with the long-term objective of the Fed.

This speaks to his concerns - or lack thereof - about the current US inflation numbers. My sense is that he will dismiss those low numbers as long as expectations stay anchored at 2 percent. Later he says:

Let me give a few examples of how my own thinking may evolve. In terms of our asset purchase program, I believe we should be prepared to adjust the total amount of purchases to that needed to deliver a substantial improvement in the labor market outlook in the context of price stability. In doing this, we might adjust the pace of purchases up or down as the labor market and inflation outlook changes in a material way. For me, the base case forecast is not the sole consideration—how confident we are about that outcome is also important.

Here he brings inflation back as an issue in determining the pace of purchases. But then in the next paragraph:

Because the outlook is uncertain, I cannot be sure which way—up or down—the next change will be. But at some point, I expect to see sufficient evidence to make me more confident about the prospect for substantial improvement in the labor market outlook. At that time, in my view, it will be appropriate to reduce the pace at which we are adding accommodation through asset purchases. Over the coming months, how well the economy fights its way through the significant fiscal drag currently in force will be an important aspect of this judgment.

Which sounds as if inflation is not the primary determinant in the decision to taper. The labor market is the primary determinant, which might be expected if he believes that low inflation numbers are not a relevant concern in the context of stable inflation expectations. In such a context, Dudley wants to see to what extent the labor market will feel the fiscal drag. In other words, be cautious about how far the low inflation story will travel in the FOMC.

To be sure, you can point to today's speech by St. Louis Federal Reserve President James Bullard as a reason that current inflation is relevant. From Reuters:

"Inflation is pretty low in the U.S.," Bullard told reporters after delivering a lecture in Frankfurt. "I can't envision a good case to be made for tapering unless the inflation situation turns around and we are more confident than we are today that inflation is going to move back toward target," he said.

But is this the consensus view? Robin Harding of the FT smartly tweets:

Re Bullard comments, low inflation has always been the main driver of QE for him. Entirely different for Bernanke, Yellen et al.

— Robin Harding (@RobinBHarding) May 21, 2013

I think Harding is right. With inflation expectations stable, from the consensus FOMC viewpoint tapering will be much more dependent on the labor outlook than current inflation.

Other voices include Chicago Federal Reserve President Charles Evans who raises the prospect of a sharp end to quantitative easing. From Reuters:

"Another approach, which doesn't get talked about that much, we could continue to go with $85 billion a month until we decide that absolutely we've seen enough improvement, and then bring it to a quick conclusion at that time," Evans told reporters after the speech.

"That would be a program going into the fall, I would think, because you can't really have that much confidence to bring it to an end" before that, he said. "I think at the moment the key issue is whether or not it is extremely likely that this (improvement) is going to be maintained over the next few months."

That last line is important - I think it means that if the labor market continues on its current pace through the rest of spring and into the summer (again, assessing the impact of fiscal contraction), then the tapering will begin in later summer or early fall.

In contrast, Minneapolis Federal Reserve President Narayana Kocherlakota argues that policy is still too restrictive:

The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

And, at a minimum, he would not favor reducing the pace of stimulus:

...this kind of analysis suggests that, currently, the gains from tightening related to improving financial stability are both speculative and slight. In contrast, the losses from tightening—in terms of pushing employment and prices even further below the Federal Reserve’s goals—are both tangible and significant. I conclude that financial stability considerations provide little support for reducing accommodation at this time.

I don't think he would favor it in three months regardless of the labor data.

So many voices, so many views. Looking through the noise, I think there is strong interest in tapering QE now that we have a string of job reports pointing to substantial and sustainable improvement in labor markets, but, given the fiscal contraction, little willingness to pull the trigger on tapering until we see another two or three similar reports. On net, I think disinflation concerns will move to the back-burner as long as inflation expectations are stable.

Still, at the same time, the Fed wants to keep its options open, as they are very much cognizant that past efforts to pull back on easing have been premature. Hence the talk that future moves could be up or down, which is really just plain confusing because why would the Fed even begin tapering if they thought there was a reasonable chance of having to reverse course the next month? It is even more confusing given that some officials seem to care about inflation, but others labor markets. The former says more purchases, arguably the latter says less. And I am not sure they have a consensus view of what would be the pace of tapering even if they all could agree on the forecast and relevant indicators. No wonder communications is a problem. Back to Dudley:

An important challenge for us will be to think carefully about what combination of actions and communications will best ensure that when we do eventually judge that it is appropriate to begin normalizing policy, the initial tightening of financial market conditions is commensurate to what we desire. There is a risk is that market participants could overreact to any move in the process of normalization.

It seems that lacking a more clear, consistent framework for the exit from quantitative easing, the risk of miscommunication is high. Hence, we are all looking toward tomorrow's speech by Federal Reserve Chairman Ben Bernanke to provide the clarity that appears very much needed.

Fed Watch: 'Dollar Up' and 'Confidence Boom?'

Two from Tim Duy:

First, "Dollar Up":

Dollar Up, by Tim Duy: The Dollar continues to gain despite the supposed "Great Debaser" Federal Reserve Chairman Ben Bernanke bringing us multiple rounds of quantitative easing:

Just sayin....

And second, "Confidence Boom?":

Confidence Boom?, by Tim Duy: The early read on the Thomson Reuters/University of Michigan Consumer Sentiment index jumped to 83.7 in May, up from 76.4 in April. Just a quick reminder before we get too excited - sentiment has tended to be low relative to actual spending. May's sentiment bounce just returns us to trend:

Better than collapsing confidence, but by itself not pointing to an imminent acceleration in consumer spending.

'The Key Challenges Facing Central Bankers'

Narayana Kocherlakota on how he sees the balance between keeping interest rates low for an extended time period to help with the unemployment problem (the benefit) and potential financial instability that low rates bring (the cost). He doesn't give a precise statement about how he sees the tradeoff, but does seem to indicate that he sees the benefits as being much larger than the cost. He also explains how the increased demand for safe assets and the fall in supply translates into lowered aggregate demand and the need for stimulative policy from the Fed, and concludes that "Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described." I certainly agree. (This is from a Q&A at the 61st Annual Management Conference of the University of Chicago Booth School of Business.):

The Key Challenges Facing Central Bankers, by Narayana Kocherlakota, President Federal Reserve Bank of Minneapolis: Question: What are the key challenges facing central bankers around the world today?

Narayana Kocherlakota: Thanks for the question. Before answering, I should point out that my remarks today will reflect only my own views and not necessarily those of anyone else in the Federal Reserve System.

In my view, the biggest challenge for central banks—especially here in the United States—is changes in the nature of asset demand and asset supply since 2007. Those changes are shaping current monetary policy—and are likely to shape policy for some time to come.

Let me elaborate. The demand for safe financial assets has grown greatly since 2007. This increased demand stems from many sources, but I’ll mention what I see as the most obvious one. As of 2007, the United States had just gone through nearly 25 years of macroeconomic tranquility. As a consequence, relatively few people in the United States saw a severe macroeconomic shock as possible. However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Workers and businesses want to hold more safe assets as a way to self-insure against this enhanced macroeconomic risk.

At the same time, the supply of the assets perceived to be safe has shrunk over the past six years. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. They no longer think that. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. They no longer think that either.

The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. It follows that the Federal Open Market Committee (FOMC) can only meet its congressionally mandated objectives for employment and prices by taking actions that lower the real interest rate relative to its 2007 level. The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

The passage of time will ameliorate these changes in the asset market, but only gradually. Indeed, the low real yields on long-term TIPS bonds suggest to me that these changes are likely to persist over a considerable period of time—possibly the next five to 10 years. If this forecast proves true, the FOMC will only meet its congressionally mandated objectives over that long time frame by taking policy actions that ensure that the real interest rate remains unusually low.

One challenge with this kind of policy environment—and this is closely linked to the overarching theme of this panel—is that low real interest rates are often associated with financial market phenomena that signify instability. There are many examples of such phenomena, but let me focus on a particularly important one: increased asset price volatility. When the real interest rate is unusually low, investors don’t discount the future by as much. Hence, an asset’s price becomes sensitive to information about dividends or risk premiums in what might usually have seemed like the distant future. These new sources of relevant information can lead to increased volatility, in the form of unusually large upward or downward movements in asset prices.

These kinds of financial market phenomena could pose macroeconomic risks. These potentialities are best addressed, I believe, by using effective supervision and regulation of the financial sector. It is possible, though, that these tools may fail to mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy. However, it should only do so if the certain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis. Hence, the FOMC’s decision about how to react to signs of financial instability—now and in the years to come—will necessarily depend on a delicate probabilistic cost-benefit calculation.

Here’s an example of the kind of calculation that I have in mind. Last week, the Survey of Professional Forecasters reported that it saw less than one chance in 200 of the unemployment rate being higher than 9.5 percent in 2014, and an even smaller chance of the unemployment rate being that high in 2015.¹ One possible cause of this kind of a large upward movement in the unemployment rate is an untoward financial shock ultimately attributable to low real interest rates. Thus, the gain to tightening monetary policy is that the FOMC may—and I emphasize the word may—be able to reduce the already low probabilities of adverse unemployment outcomes.

Endnote

1 See the Survey of Professional Forecasters, page 14.

Fed Watch: Lumping Everything into the Wealth Effect

Another from Tim Duy:

Lumping Everything into the Wealth Effect, by Tim Duy: After posting my review of Martin Feldstein's WSJ op-ed, I waded through Dallas Federal Reserve President Richard Fisher's latest speech and found this:

The former outcome is that envisioned by the theoreticians that lead the Fed: According to this plot, by driving rates to historical lows along the entire length of the yield curve, investors will rebalance their portfolios and reach out to riskier assets, providing the financial wherewithal for businesses to increase capital expenditures and reengage workers, expand payrolls and regenerate consumption. Rising prices of bonds, stocks and other financial instruments will bolster consumer confidence. The CliffsNotes account of this play has the widely heralded “wealth effect” paving the way for economic expansion, thus saving the day.

The latter outcome posits that the wealth effect is limited, for two possible reasons. One is that our continued purchases of Treasuries are having decreasing effects on private borrowing costs, given how low long-term Treasury rates already are. Another is that the uncertainty resulting from fiscal tomfoolery is a serious obstacle to restoring full employment. Until job creators are properly incentivized by fiscal and regulatory policy to harness the cheap and abundant money we at the Fed have engineered, these funds will predominantly benefit those with the means to speculate, tilling the fields of finance for returns that are enabled by historically low rates but do not readily result in job expansion. Cheap capital inures to the benefit of the Warren Buffetts, who can discount lower hurdle rates to achieve their investors’ expectations, accumulating holdings without necessarily expanding employment or the wealth of the overall economy.

Is it just me, or is Fisher being explicitly derisive about the wealth effect? And when did we start lumping all the channels of monetary policy into the "wealth effect"? The wealth effect is but one channel of monetary policy. See something like this graphic from Frederick Mishkin's money and banking textbook:

While equity prices do operate through a number of channels, only one of those is the "wealth effect." To his credit, Fisher has a more sophisticated view of those channels than Feldstein, who appears to limit the impact of QE to the strict definition of the wealth effect:

That drives up the price of equities, leading to more consumer spending.

But even if Fisher does see the bigger picture, should he really be lumping together all the channels of monetary policy into the "wealth effect?" Doing so only feeds the bias against monetary easing by perpetuating the view it is about nothing more than creating an artificial boost of equity prices and benefiting speculators rather than stimulating the economy via a number of channels that subsequently enhance the profitability of firms and thus raises equity prices.

Of course, Fisher and Feldstein are deliberately trying to perpetuate a bias against quantitative easing. And even after all these years, I still find it odd that Fisher appears to believe his job is to undermine the institution that provides his employment.

Fed Watch: Dodged That Bullet

Tim Duy:

Dodged That Bullet, by Tim Duy: I was reading Robin Harding's take on the possible nomination of Federal Reserve Vice Chair Janet Yellen for the top job at the Fed, and a chill went down my spine when he reminded me of this:

Mr Bernanke’s own appointment in 2005 was a case in point. There were several candidates that year. According to people involved, then-President George W. Bush leaned towards Martin Feldstein, a former economic adviser to Ronald Reagan.

But fate intervened:

But Mr Feldstein was a director of the insurance company AIG, which restated five years of financial results that May after an accounting scandal. Then in October, Mr Bush ran into a huge backlash after nominating his lawyer Harriet Miers, who later withdrew, to the Supreme Court.

I think we dodged a bullet there. Indeed, it might be proof of a higher power. Martin Feldstein could have been Fed chair during the worst financial crisis since the Great Depression. Consider that in light of May 9, 2013 Wall Street Journal op-ed in which he professes that raising equity prices is the ONLY mechanism by which quantitative easing impacts the economy:

Quantitative easing, or what the Fed prefers to call long-term asset purchases, is supposed to stimulate the economy by increasing share prices, leading to higher household wealth and therefore to increased consumer spending. Fed Chairman Ben Bernanke has described this as the "portfolio-balance" effect of the Fed's purchase of long-term government securities instead of the traditional open-market operations that were restricted to buying and selling short-term government obligations.

Here's how it is supposed to work. When the Fed buys long-term government bonds and mortgage-backed securities, private investors are no longer able to buy those long-term assets. Investors who want long-term securities therefore have to buy equities. That drives up the price of equities, leading to more consumer spending.

As might be expected, Feldstein finds this channel lacking:

...Although it is impossible to know what would happen without the central bank's asset purchases, the data imply that very little increase in GDP can be attributed to the so-called portfolio-balance effect of the Fed's actions.

Even if all of the rise in the value of household equities since quantitative easing began could be attributed to the Fed policy, the implied increase in consumer spending would be quite small. According to the Federal Reserve's Flow of Funds data, the total value of household stocks and mutual funds rose by $3.6 trillion between the end of 2009 and the end of 2012. Since past experience implies that each dollar of increased wealth raises consumer spending by about four cents, the $3.6 trillion rise in the value of equities would raise the level of consumer spending by about $144 billion over three years, equivalent to an annual increase of $48 billion or 0.3% of nominal GDP.

This 0.3% overstates the potential contribution of quantitative easing to the annual growth of GDP, since some of the increase in the value of household equities resulted from new saving and the resulting portfolio investment rather than from the rise in share prices. More important, the rise in equity prices also reflected a general increase in earnings per share and an increase in investor confidence after 2009 that the economy would not slide back into recession.

Oh my. Can Feldstein really believe that only the wealth effect channel is in operation? What about other channels that could boost activity and drive the improvements in earnings and confidence? And does Bernanke believe quantitative easing has an impact only throughthe wealth effect? I don't think that is the conclusion you reach if you read his speeches. Bernanke's description of the portfolio-balance impact is a bit more sophisticated than Feldstein's interpretation. From last year's Jackson Hole speech:

One mechanism through which such purchases are believed to affect the economy is the so-called portfolio balance channel, which is based on the ideas of a number of well-known monetary economists, including James Tobin, Milton Friedman, Franco Modigliani, Karl Brunner, and Allan Meltzer. The key premise underlying this channel is that, for a variety of reasons, different classes of financial assets are not perfect substitutes in investors' portfolios....Thus, Federal Reserve purchases of mortgage-backed securities (MBS), for example, should raise the prices and lower the yields of those securities; moreover, as investors rebalance their portfolios by replacing the MBS sold to the Federal Reserve with other assets, the prices of the assets they buy should rise and their yields decline as well. Declining yields and rising asset prices ease overall financial conditions and stimulate economic activity through channels similar to those for conventional monetary policy.

Quantitative easing acts through a variety of channels - interest rate, credit, exchange rate, etc. - just like traditional interest rate policy. And other channels as well:

Large-scale asset purchases can influence financial conditions and the broader economy through other channels as well. For instance, they can signal that the central bank intends to pursue a persistently more accommodative policy stance than previously thought, thereby lowering investors' expectations for the future path of the federal funds rate and putting additional downward pressure on long-term interest rates, particularly in real terms. Such signaling can also increase household and business confidence by helping to diminish concerns about "tail" risks such as deflation. During stressful periods, asset purchases may also improve the functioning of financial markets, thereby easing credit conditions in some sectors.

So, no, Bernanke does not view quantitative easing as acting only through equity price and related wealth effects, and no, Feldstein shouldn't either. But somehow he does, or wants to trick you into believing that Bernanke's only objective is boosting equity prices. Either way, I don't think this is the intellectual approach we should be looking for in a Fed chair.

With regards to Feldstein's claim that it is impossible to know what would have happened in the absence of quantitative easing, I think Bernanke would have something like this to say:

If we are willing to take as a working assumption that the effects of easier financial conditions on the economy are similar to those observed historically, then econometric models can be used to estimate the effects of LSAPs on the economy. Model simulations conducted at the Federal Reserve generally find that the securities purchase programs have provided significant help for the economy. For example, a study using the Board's FRB/US model of the economy found that, as of 2012, the first two rounds of LSAPs may have raised the level of output by almost 3 percent and increased private payroll employment by more than 2 million jobs, relative to what otherwise would have occurred....Overall, however, a balanced reading of the evidence supports the conclusion that central bank securities purchases have provided meaningful support to the economic recovery while mitigating deflationary risks.

Yes, like it or not, quantitative easing has been a successful policy.

I understand that in the midst of the crisis there was a significant confusion about what monetary policymakers were doing and why. But we are well past that stage. We would hope that any potential Fed chair would by now have come to an understanding about what quantitative easing is and how it works. And we should be relieved that any candidate that has not made that leap did not get the pick for the top job at the Federal Reserve.

Fed Watch: Plosser on the Exit

Tim Duy:

Plosser on the Exit, by Tim Duy: As is well known, policymakers have been coalescing around a QE exit strategy for some time, since at least the March FOMC meeting. Two central issues with the exit are the timing and the communications. Officials do not want to undermine the recovery, knowing full-well that previous flirtations with exits have gone awry. At the same time, however, they fear the cost-benefit analysis may be turning against them. For some doves it is not the potential inflation cost, but the potential financial instability cost. Some policymakers want to begin tapering asset purchases at the next meeting, some are looking to the summer, and others looking to the fall.

Regarding the communications issue, policymakers seem to be taking pains to make clear that the financial markets should not overreact to any one policy move. The tapering process may be smooth, it may be choppy, it may be long, it may be short. It is contingent on the state of the economy, something inherently unknown. Mostly, they want to avoid a 1994-type of miscommunication.

Today's speech by Philadelphia Federal Reserve President Charles Plosser covers nearly all of these elements. In general, although I do not agree with his conclusions regarding timing, I think he makes a what would be viewed by some as a credible argument for tapering to begin sooner than later.

Begin with his base forecast:

My forecast of 3 percent growth should allow for continued improvements in labor market conditions, including a gradual decline in the unemployment rate, similar to the trend we have seen over the past three years, which was a 0.7- to 0.8-percentage point decline per year. Continuing at such a pace would lead to an unemployment rate close to 7 percent at the end of 2013 and a rate below 6.5 percent by the end of 2014.

Indeed, this year we have already seen the unemployment rate fall from 7.9 percent in January to 7.5 percent in April. Employers added 165,000 jobs in April, but the more positive news came in the revisions for February and March. The revised data indicate that firms added 332,000 jobs in February and 138,000 in March. The upward revisions for these two months added 114,000 jobs.

The forecast of a 6.5% unemployment rate by the end of 2014 is important. My thought is that the Fed will want to conclude asset purchases before hitting that target. Moreover, optimally they would like time so that, if necessary, the tapering can be a slow process. That argues for tapering to begin sooner than later. Indeed, Plosser would like asset purchases to end this year:

Based on the stated views of the Committee regarding the flexibility in pace of purchases, I believe that labor market conditions warrant scaling back the pace of purchases as soon as our next meeting. Moreover, unless we see a significant reversal in current trends that jeopardizes my forecast of near 7 percent unemployment rate by the end of this year, then I anticipate that we could end the program before year-end. Let's look at some of the data.

The end of the year is actually fast approaching; if you want to taper off over the course of a hand full of meetings, the calendar is driving you to begin now. Now, back to that data:

In the six months through September 2012, when the decision to initiate the latest open-ended asset purchase program was made, nonfarm payrolls had increased an average of 130,000 per month, and the unemployment rate had averaged 8.1 percent. In the most recent six months, from November 2012 through April 2013, nonfarm payrolls have increased on average 208,000 per month — a 60 percent increase — and the unemployment rate has averaged 7.7 percent. As I noted earlier, April's unemployment rate has now reached 7.5 percent.

Moreover, the average duration of unemployment has fallen, the share of long-term unemployment has dropped, and hours worked and earnings have risen. While further progress would certainly be desirable, I believe the evidence is consistent with a significantly improving labor market. Thus, it is appropriate to begin scaling back the pace of asset purchases.

At this point, I raise my hand and say "But isn't underemployment still too high and being driven by cyclical factors? Aren't you erring on the side of removing stimulus too early?" But that arguement is neither here nor there for Plosser. He has obviously decided these are second-order issues. He does deliver what (I think) is a novel argument for tapering sooner than later:

Indeed, in my view, were the FOMC to refrain from reducing the pace of its purchases in the face of this evidence of improving labor market conditions, it would undermine the credibility of the Committee's statement that the pace of purchases will respond to economic conditions. Similarly, if there were sufficient evidence that conditions in labor markets had deteriorated, I would expect the FOMC to consider increasing the pace of purchases. After all, this is the meaning of state-contingent monetary policymaking. But if we reach the point that markets only expect us to move in one direction — that is, toward more easing — and we become reluctant to dial back on purchases over concerns of disappointing or surprising markets, then we will find ourselves in a very difficult position going forward.

In short, the Fed communicated a particular strategy - one in which the pace of asset purchases would be determined by recovery in the labor market. And, by Plosser's reckoning, the 60% increase in the pace of job growth is evidence of exactly the kind of improvement the Fed was looking to achieve.

Notice that Plosser is not appealing to a fear that the Fed's credibility on inflation is at risk. Instead, not acting to slow asset purchases undermines the credibility of the Fed's communications strategy. This is an argument that might resonate with other policymakers who are already worried that financial markets will misinterpret future policy actions. I suspect Plosser knows inflation concerns are likely to fall on deaf ears. Indeed, he addresses the inflation topic earlier in the speech:

Should inflation expectations begin to fall, we might need to take action to defend our inflation goal, but at this point, I do not see inflation or deflation as a serious threat in the near term. However, I do believe that our extraordinary level of monetary accommodation will have to be scaled back, perhaps more aggressively than some think, to ensure that inflation over the medium term remains consistent with our target.

Convincing others to pull back on easing due to inflation concerns is something of a challenge when your preferred inflation measure is below target and trending down. But where that argument fails, perhaps a credibility/communications argument can succeed?

Plosser is careful to add the now required "not tightening" clause:

I want to emphasize that in this state-contingent framework, reducing the pace or even ending asset purchases need not be the start of an exit strategy or more aggressive tightening. Nor would it indicate that an increase in the policy rate was imminent. Instead, these actions would slow and then halt efforts to continuously expand the level of accommodation by increasing the size of the balance sheet. Given the improving economy, dialing back asset purchases is an appropriate response.

I imagine we will see something like this in every speech going forward. Policymakers do not want market participants to jump to conclusions on the basis of any one policy move.

Bottom Line: While the Fed is moving closer to tapering asset purchases, timing remains an issue. I think that most policymakers will not be swayed to an early end by the "Fed's inflation credibility is at risk" argument. But a subset is likely swayed by the "financial stability is at risk" argument. And another subset may be swayed by the "communications credibility is at risk argument" that is an element of Plosser's speech. In short, the majority favoring continuing asset purchases at the current pace is obviously shrinking. Hopefully this week's upcoming speech by Federal Reserve Chairman Ben Bernanke and the release of the minutes from the last FOMC meeting will help clarify how quickly that majority is loosing ground.

Cyclical and Structural Shocks Require Different Policy Reactions

Steven Pearlstein argues that The case for austerity isn’t dead yet, and that:

austerity by itself won’t solve the problem of high employment and low growth in developed economies. But neither will fiscal stimulus by itself. Neither will work unless incorporated into a program of serious and credible structural reform.

But this is incorrect, and it confuses long-run growth policy with short-run stabilization. Monetary and fiscal policy can be used to stabilize fluctuations in the economy even without reforms that could raise long-run growth (the short-run stabilization policies may help with long-run growth, e.g. by improving labor market conditions and preventing people from permanently leaving the labor force, so the policies are not fully independent, but it's important to keep them conceptually separate). As Antonio Fatás points out in a post that anticipates and counters this argument (this was written before Pearlstein's piece), the idea that monetary and fiscal policy cannot work to stabilize the economy without structural reform is wrong (especially in countries like the US):

Time travel in Euroland: Unfortunately, this is not news by now, but the president of the Euro group, Jeroen Dijsselbloem in an interview with CNBC yesterday dismissed the role that fiscal policy and monetary policy can have to address the economic crisis (emphasis is mine):

"Monetary policy can really not help us out of the crisis. It can take away the pressure, it can accommodate new growth, but what we really need in all countries is structural reforms in the first place. I'd just like to stress the point that in the policy mix of fiscal policy, monetary policy and structural reforms — I'd like the order to be exactly the other way around. Structural reforms in the first place, fiscal policy and viable targets in the mid-term for all regions in second place — and monetary policy can only accommodate domestic economic problems in the short-term."

It is not exactly clear what to make out of his statement but it seems that long-term solutions should come first before we implement those that will help us in the short term. It is surprising that even today there is such a great confusion about long-term versus cyclical problems.

This confusion comes from a basic belief that some hold that there is nothing inherently different in the dynamics of an economy when one looks at the short run and the long run. This is part of a never-ending academic debate but when it comes to policy makers and politicians it seems to be more a matter of beliefs.

What it is not always understood is that we are dealing with two separate problems and therefore we need two different set of tools or solutions to deal with them.

It is possible that irresponsible behavior, excessive spending and accumulation of debt (private or public) are the cause of the Great Recession. And if this is true, it will require future adjustments to spending plans, deleveraging, and fiscal discipline to avoid a repetition of this event in the future.

But once the crisis started we are dealing with a second problem: a recession that moves us away from full employment. This is a cyclical phenomenon that is well described in macroeconomic textbooks and to deal with it we use monetary and fiscal policy. The fact that potentially debt and excessive spending were the cause of this cyclical event does not mean that we need to deal with these imbalances now to get out of the crisis. We are dealing with two separate phenomena that are only related because one possibly led to the second one, but the dynamics associated with each of them are very different and the recipe to get out of them can be, in some cases, the opposite.

This is what we write in all macroeconomics textbooks: what works in the short run might not work in the long run. As an example, we emphasize the importance of saving in the long run to drive investment and growth. But when we talk about the short run we emphasize the importance of spending to understand fluctuations in economic activity. Excessive spending hurts growth in the long run but it is spending and demand what drives growth in the short run.

There will be a day when we will have to debate about whether the cyclical phenomenon has already been addressed because we are back to full employment and therefore all our focus should be on the long term, but it is very hard to argue that this is where Europe is today. My point is not to deny that there are many deep structural issues to be addressed among Euro countries, but to recognize that we are dealing with two set of dynamics that require different solutions and until we invent time traveling the short term still comes before the long term.

Fed Watch: What Does Japan Mean For The Rest of the World?

Tim Duy once again:

What Does Japan Mean For The Rest of the World?, by Tim Duy: Is Abenomics about boosting exports or domestic demand? I tend to agree with Lars Christensen on this issue:

There has been a lot of focus on the fact that USD/JPY has now broken above 100 and that the slide in the yen is going to have a positive impact on Japanese exports. In fact it seems like most commentators and economists think that the easing of monetary policy we have seen in Japan is about the exchange rate and the impact on Japanese “competitiveness”. I think this focus is completely wrong.

While I strongly believe that the policies being undertaken by the Bank of Japan at the moment is likely to significantly boost Japanese nominal GDP growth – and likely also real GDP in the near-term – I doubt that the main contribution to growth will come from exports. Instead I believe that we are likely to see is a boost to domestic demand and that will be the main driver of growth. Yes, we are likely to see an improvement in Japanese export growth, but it is not really the most important channel for how monetary easing works.

In my view, Abenomics has been remarkably centered on the domestic economy. The impact on the Yen is almost an afterthought, whereas in the past policymakers would have turned to intervention to directly support the economy. This looks like policymakers finally realized that such a policy approach wasn't working and they need to change gears to a frontal-assault on domestic policy levers.

That said, a side-effect of Abenomics is currency depreciation, and this will have an impact on global trade. Investment Week has an interview with hedge fund manager Hugh Hendry:

"Japan's monetary pivot towards QE will not create economic growth out of nothing. Instead it seeks to redistribute global GDP in a manner that favours Japan versus the rest of the world. This is the last thing the global economy needs right now," he said.

So what's right and what's wrong with that quote? What's right is that there will be a trade impact. A story floating around right now is that Japanese exporters are not changing prices, but instead just allowing the impact of the weaker Yen to fall straight through to the bottom line. But they will soon turn their attention to leveraging the weaker Yen to cut prices and take market share. And they have Europe in their sights. They might not be able to compete with Chinese exporters, but they can with German ones.

What's wrong, however, is that this is exactly what the global economy needs right now. If Germany and by extension Europe experiences weaker growth, European policymakers will need to respond. And they are not likely to respond by buying Yen to hold its value up. They are likely to respond by stimulating their domestic economy directly via easier monetary policy and, hopefully, easier fiscal policy.

In other words, successful domestically-orientated policy in Japan will have second-round effects that will induce further policy easing Europe. And a good kick in the pants in Europe is exactly what we need right now. Rather than thinking about Japan's policy as triggering "competitive devaluations," think of it as triggering "coordinated global easing."

What's also wrong is Hendry's usual hedge-fund bias again monetary policy. By altering expectations to lower real interest rates, Japan's monetary policy is in a sense creating economic growth out of nothing. We frequently heard that "uncertainty" was holding back the recovery, but isn't this the same thing as creating a recession out of nothing? If you can create a recession out of nothing, then why not an expansion?

FRBSF Economic Letter: Will Labor Force Participation Bounce Back?

This is related to the recent post from Gavyn Davies. Recall that he is worried about the unemployment rate giving misleading signals about the labor market. Many workers have dropped out of the labor force, and if those workers return to the labor force as the economy improves, then the measured unemployment rate will make conditions in the labor market look better than they actually are.

In this Economic Letter from the SF Fed, Leila Bengali, Mary Daly, and Rob Valletta argue that this is, in fact, something to worry about. They "find evidence, reinforcing other research, that the recent decline in participation likely has a substantial cyclical component" (i.e. their analysis concludes that exit from the labor market is temporary for a substantial number of people, and they will begin seeking work again when the economy improves):

Will Labor Force Participation Bounce Back?, by Leila Bengali, Mary Daly, and Rob Valletta, Economic Letter, FRBSF: The most recent U.S. recession and recovery have been accompanied by a sharp decline in the labor force participation rate. The largest declines have occurred in states with the largest job losses. This suggests that some of the recent drop in the national labor force participation rate could be cyclical. Past recoveries show evidence of a similar cyclical relationship between changes in employment and participation, which could portend a moderation or reversal of the participation decline as the current recovery continues.

Since the beginning of the recession in 2007, the U.S. labor force participation rate has dropped sharply. Some of this decline reflects long-term demographic trends and other factors that helped push down the participation rate before 2007. But the recent withdrawal of prime-age workers from the labor market is unprecedented and may reflect a cyclical component that could reverse as the labor market recovery solidifies. The return of these workers to the labor force would partially offset the longer-term demographic influences and potentially cause the participation rate to bounce back (Daly et al. 2012, Van Zandweghe 2012). Moreover, the increase in the number of active jobseekers in the labor force associated with higher participation could slow the decline in the unemployment rate.

Assessing the contribution of cyclical factors and the likelihood of a reversal or slower decline in labor force participation is difficult based on aggregate labor market data alone. Such data cannot perfectly distinguish between long-term trends and shorter-term cyclical factors, particularly given the severity of the labor market dislocation during the past recession. To assess the role of cyclical factors in the current recovery, we examine state-level variation in the relationship between changes in the labor force participation rate and changes in employment over several business cycles. ...

After a detailed analysis, they conclude that:

The U.S. labor force participation rate has declined sharply since 2007, intensifying a downward trend that has been evident since about 2000. Distinguishing between long-term influences on the participation rate, such as demographics, and short-term cyclical effects is important because it helps us understand and predict the future path of macroeconomic variables such as the unemployment rate. Using state-level evidence on the relationship between changes in employment and labor force participation across recessions and recoveries, we find evidence, reinforcing other research, that the recent decline in participation likely has a substantial cyclical component. States that saw larger declines in employment generally saw larger declines in participation. A similar positive relationship was evident in past recessions and recoveries. In the current recovery, it will probably take a few years before cyclical components put significant upward pressure on the participation rate because payroll employment is still well below its pre-recession peak.

Let me add, once again, that the costs of being wrong are not symmetric. If we are going to make a policy mistake, the bias ought to be toward keeping policy in place too long (and perhaps enduring a temporary bout of inflation) rather than putting the brakes on too quick (and ending up with an elevated unemployment rate and all of the short-run and long-run consequences that come with it).

Fed Watch: Fed Notes

Tim Duy:

Fed Notes, by Tim Duy: Gavyn Davies at the Financial Times questions the Federal Reserve's employment target:

On the wider issue of general monetary policy, the behaviour of inflation and unemployment remain the key drivers, and here the Fed has a headache. Its forward guidance on unemployment is in danger of giving misleading signals about the need for tightening, and it probably needs to be changed.

I agree. Davies cites research indicating that recession-driven underemployment makes the unemployment rate a poor measure of resource utilization. The policy implications:

What does this imply for policy? It implies that the Fed will have a bias to keep policy aggressively easy long after the unemployment rate has fallen below 6.5 per cent, and even after it has fallen below the estimated natural rate of 5.25 to 6 per cent, provided that the inflation threshold is still intact. This is because the reserve army of disguised unemployed people will exert a downward force on inflation which will not be correctly picked up by the official unemployment statistics.

See my related piece on structural (or lack thereof) unemployment here. Davies raises a often-forgotten point: Even though the Federal Reserve is turning its attention to ending quantitative easing, the timing of the first rate hike is most likely much farther off in the future.

A challenge for the Fed is that asset purchases are at least in part a communications device that signals commitment to a given policy path. Thus, the Federal Reserve will need to take care to avoid the impression of imminent rate hikes as they scale back asset purchases. Indeed, I thought this was the most important takeaway from Friday's Jon Hilsenrath article in the Wall Street Journal:

Officials are focusing on clarifying the strategy so markets don't overreact about their next moves.

Overreaction can come in many forms:

For example, officials want to avoid creating expectations that their retreat will be a steady, uniform process like their approach from 2003 to 2006, when they raised short-term interest rates in a series of quarter-percentage-point increments over 17 straight policy meetings...An abrupt or surprising end to it could send stocks and bonds in the other direction, but a delayed end could allow markets to overheat. And some officials feel they've ended other programs too soon and don't want to repeat the mistake.

This sounds as if Fed officials are cognizant of this from Davies:

The more precise the forward guidance given, the more the Fed exaggerates the degree of knowledge which the central bank can possibly have about its own future actions, since these actions will depend on many factors which cannot be exactly predicted in advance.

Which also speaks to the inclusion of "increase or decrease" phrase in the last FOMC minutes. Back to Hilsenrath:

The Fed said in its postmeeting statement that it was "prepared to increase or reduce the pace of its purchases" as the economic outlook evolved.

The suggestion that the Fed might boost its bond buying was a change in the policy statement that seemed to some an acknowledgment that more aid for the economy might be needed...

...But many officials believe the recovery is on track and aren't yet concerned about the inflation slowdown. Instead, the most recent statement seems more aimed at signaling the Fed's broader flexibility in managing the programs.

Bottom Line: We need to be very careful in extrapolating the implications of the next policy move to future policy moves. The Fed has only a general strategy for exit, but policymakers lack enough certainty about the future to determine the exact nature of that exit. Still, even given that uncertainty, the current state of labor force utilization and inflation suggest that while the end of QE may occur this year, the first rate hike is not likely until some point well into the future.

'The Fed Dials the Wrong Unemployment Number'

Gavyn Davies argues the Fed is targeting the wrong thing (unemployment instead of employment):

...the Fed has a headache. Its forward guidance on unemployment is in danger of giving misleading signals about the need for tightening, and it probably needs to be changed. ...

The difficulty is that unemployment is declining towards the announced threshold in part because large numbers of people have left the labour force altogether as the recession has dragged on, and this probably means that the official unemployment rate is no longer acting as a consistent measuring rod for the amount of slack in the labour market.

The upshot is that the Fed will probably want to keep short rates at zero until unemployment has dropped a long way below 6.5 per cent...

[I]t is a distortion which the Fed cannot afford to ignore. Its mandate requires that it should aim for “maximum employment”, not “minimum unemployment on the official statistics”, which is what it risks doing under its current forward guidance. ...

If the Fed is going to make a mistake -- ease too long or tighten too soon -- you can probably guess which mistake I think is worse.

'Moby Ben, or, The Washington Super-Whale'

Learn why hedge fund traders are so angry with Ben Bernanke, and why

There is a reason that the trade of shorting the bonds of a sovereign issuer of a global reserve currency in a depressed economy is called "the widowmaker".

See: Moby Ben, or, The Washington Super-Whale: Hedge Fundies, the Federal Reserve, and Bernanke-Hatred by Brad DeLong.

Fed Watch: When Will The Divergence Between PCE and CPI Matter?

Tim Duy:

When Will The Divergence Between PCE and CPI Matter?, by Tim Duy: The divergence between PCE and CPI measures of inflation remains in the headlines. Pedro da Costa at Reuters sees a test of the Fed's credibility at hand:

With the inflation rate about half of the Federal Reserve's 2.0 percent target, the central bank is facing a major test and some experts wonder whether it will eventually need to ramp up its already aggressive bond buying program.

The challenge for policymakers is that they are clearly falling short of their dual mandate and that should open the door for additional asset purchases. But, but, but...I think that additional asset purchases is just about the last thing they want to do right now. We will see if their thinking evolved much at the last FOMC meeting, but the minutes of the March meeting clearly indicate that a large contingent of FOMC members are looking to end the asset purchase program by the end of this year. Take ongoing improvements in labor markets, add in concerns about financial stability, mix in some cost-benefit analysis about the efficacy of additional QE, and top-off with a dash of improving housing markets, bake at 350 for 40 minutes, and you get monetary policymakers hesitant to push the QE lever any further.

My sense is that policymakers will thus try to find reasons to dismiss falling PCE inflation as a non-issue. From an email exchange last week, today da Costa quotes me as saying:

"The Fed may view the divergence between the two measures as indicating that worries about deflation are premature," said Tim Duy, a professor of economics at the University of Oregon. "If core CPI was trending down as well, the Fed would be more likely to conclude that their inflation forecasts should be guided lower."

And also last week, Greg Ip at the Economist had this observation:

If CPI inflation were to converge to PCE inflation, that would be a concern. Goldman expects CPI inflation to drop to 1.8% in coming years and PCE inflation to rise to 1.5%. It would be preferable for both to converge to 2%; but so long as inflation expectations remain where they are, it is of little consequence for monetary policy – and a tangible plus for incomes and spending.

Yesterday, Philadelphia Federal Reserve President Charles Plosser had this to add, via the Wall Street Journal:

As of right now, “I’m not concerned” about inflation drifting too far under the central bank’s price target of 2%, Federal Reserve Bank of Philadelphia President Charles Plosser said in response to reporter’s questions at a conference here.

Inflation expectations “look pretty well anchored,” and it’s likely that price pressures as measured by the personal consumption expenditures price index will drift back up to 2% over time and reconverge with the consumer price index, he said.

Today, Chicago Federal Reserve President Charles Evans seemed resigned to low inflation. Again, from the Wall Street Journal:

“Inflation is low, and it’s lower than our long-run objective,” Mr. Evens said in an interview on Bloomberg Television, adding that he would like to see inflation closer to 2% but expects it to stay below 2% for several more years. Inflation, he said, “can be too low” when the central bank’s objective is 2%.

Asked if low inflation should prompt a policy response from the Fed, Mr. Evans said “I think it’s way too early to think like that.” In the debate over how the Fed might exit from the asset purchase program, Mr. Evans, a voting member of the policy-setting Federal Open Market Committee, said he remains “open minded [and] I’m listening to my colleagues.”

The general story seems to be that as long as inflation expectations remain anchored, and CPI inflation does not drift much below 2%, then the Fed will resist accelerating the pace of asset purchases.

Also note that the downward inflation drift is an underlying trend, or so concludes the Federal Reserve Bank of Atlanta's macroblog. The authors use a principle component model to estimate a common trend in the price data, and get these results:

The author's note that by this measure, the decline in PCE is not as ominous as it first seems, but it is clear that inflation by either measure is missing the Fed's target and currently trending away from that target. They conclude:

Does that mean we should ignore the recent disinflation being exhibited in the core PCE inflation measure? Well, let’s put it this way: If you’re a glass-half-full sort, we’d say that the recent disinflation trend exhibited by the PCE price index doesn’t seem to be “woven” into the detailed price data, and it certainly doesn’t look like what we saw in 2010. But to you glass-half-empty types, we’d also point out that getting the inflation trend up to 2 percent is proving to be a curiously difficult task.

Indeed, very curious given that we tend to think that at a minimum the monetary authority should be able to raise inflation rates. You are left with thinking that either the Federal Reserve still had more work to do or that monetary policy can do little more at this point than put a floor under the economy. If the latter, and if you want something more, you need to turn to fiscal policy.

Bottom Line: I suspect that at this point the Fed tends to think the costs of additional action still outweigh the benefits, and thus below-target inflation only induces pressure to maintain the current pace of QE longer than they currently anticipate rather than increase the pace of purchases.

Fed Watch: 'Really? One Basis Point?' and 'Rising Structural Unemployment?"

Two from Tim Duy. Here's the first:

Really? One Basis Point?, by Tim Duy: Bloomberg has a story with an ominous opening paragraph:

Bank of Japan Governor Haruhiko Kuroda’s stimulus policies are backfiring in the housing market, where mortgage rates are rising even as the central bank floods the financial system with cash.

Lions, tigers, and bears, oh my! The next paragraph:

Fixed 35-year home-loan costs rose to 1.81 percent this month, the first increase since February and up from an all-time low of 1.8 percent in April, according to data compiled by the Japan Housing Finance Agency. Federal Reserve Chairman Ben S. Bernanke’s monetary easing almost halved 30-year U.S. mortgage rates since 2008 to 3.35 percent on May 2.

Seriously? The case against Kuroda is that after declining since February, mortgage rates climbed a whole basis point? And Kuroda is expected to accomplish in a few months what took Bernanke five years? And I thought I could be a harsh critic of central bankers!

Hopefully this is just a typo; I can't seem to locate a time series of the 35-year mortgage rate in Japan. Otherwise, one might be tempted to conclude that the reporters were biased against Abenomics.

And here's the second:

Rising Structural Unemployment?, by Tim Duy: This tweet from Andy Harless caught my eye:

HIres-to-openings ratio looking uglier & uglier bls.gov/news.release/j… Looks like rising structural unemployment

— Andy Harless (@AndyHarless) May 7, 2013

The chart:

The ratio of hires to openings fell to the low of the last cycle. Now compare the ratio to the unemployment rate:

Unemployment appears to be too high relative to the hires/openings ratio (caution is warranted, however, as the JOLTS data only extends back to 2001). One would normally associate such a low ratio with low unemployment as the number of hires would be relatively low because of the lack of available workers. In this case, however, the number of hires appears to be low despite a large pool of potential employees, consistent with the concern that available workers lack the skills firms seek. Structural unemployment, as Harless suggests.

That said, recall that Matthew O'Brien pointed us at research here and here suggesting that high unemployment is attributable not to structural factors, but instead to a bias against the long-term unemployed. O'Brien recognizes the insidious nature of this problem:

Circles don't get more vicious than this. The people who need work the most can't even get an interview, let alone a job. It's a cycle that could end with the long-term unemployed becoming unemployable. It's what economists call hysteresis, the idea being that a slump, left untreated, can make us permanently poorer by reducing our future ability to do and make things.

Bias against the long-term unemployed might explain why wage growth remains muted:

One would think that a low hires/openings ratio suggests that wage growth would be accelerating (as employers appear to face a relative shortage of workers), but that is not the case. Indeed, low wage growth is one reason to believe that excessive unemployment is cyclical in nature. How does this fit with the long-term unemployed story above? Perhaps that although firms have a bias against the long-term unemployed, those potential workers still place downward pressure on wages. The newly unemployed don't require higher wages despite demand for their skills because they know there is a large pool of people available with similar skills. If the newly unemployed demand too high wages, they may induce employers to take another look at the pool of long-term unemployed. Consequently, they do not seek higher wages.

Incidentally, this also explains the low quits rate. The consequences of becoming long-term unemployed are particularly severe, raising the expected cost of voluntarily leaving a job.

So I guess the "good" news would be this: If bias against the long-term is simply creating the illusion of structural unemployment, then we are not yet faced with the problem of hysteresis. If the pool of long-term unemployed can place downward pressure on wages, then they must have a valuable skill set. Otherwise, they would not represent a threat to the newly unemployed. Keep the demand up for employees long-enough, and firms will eventually give up their bias against the long-term unemployed (I assume this would be preferable to the alternative of prematurely escalating wages). Eventually, the pool of unemployed would decrease and then wage pressures increase.

Still, the longer we wait for this bias to diminish, the more likely it is that the unemployment does indeed become structural. Then we would expect rapidly rising wages despite elevated unemployment. Another argument for pulling on all the stimulus levers. Alas, that is not the case.

Update: And after I wrote all this, I saw this Harless tweet:

Likely part of the reason 4 low hires/opening is that most applicants r now long-term unemployed, who face a more rigorous screening process

— Andy Harless (@AndyHarless) May 8, 2013

Apparently on the same path.

Fed Watch: Consistency of the Underlying Trends

Tim Duy:

Consistency of the Underlying Trends, by Tim Duy: Calculated Risk comments on this morning's JOLTS report:

Not much changes month-to-month in this report - and the data is noisy month-to-month, but the general trend suggests a gradually improving labor market.

This observation extends far beyond just the JOLTS report to virtually the entire set of labor market data. While we often get caught up in the month-to-month gyrations of various employment reports, the underlying trend of those data have been remarkable consistent:

General, consistent improvement is evident across an array of indicators. The pace of that improvement, however, consistently falls short of what is necessary to rapidly alleviate excessively high levels of underemployment, counter demographic trends impacting labor force participation, or induce significantly higher wage growth. And you can find that generally steady pace of improvement in other indicators as well. For example:

In short, it looks as if monetary policymakers have put a bottom under the economy but are unable to accelerate the pace of recovery. Whether the lack of acceleration is attributable to shortfalls on the monetary side of policy (insufficient quantitative easing, unwillingness to allow inflation expectations to drift higher, etc) or lack of cooperation of fiscal authorities (there seems to be no reason to hasten the pace of deficit reduction) remains a matter of debate. I tend to believe that the economy needs additional monetary and fiscal support, in part because I tend to worry that we will not lift off the zero lower bound in this recovery, setting the stage for even larger policy challenges in the next recession. In any event, regardless of where you think policy should be, right now it looks to be accomplishing something of a minimum by setting a floor for activity.

What does this mean for monetary policy going forward?

First, I think we will need to keep a focus on the trend and not think policy will be swayed (in either direction) by every gyration of the data. The data is inherently noisy, and the Fed will be looking through that noise.

Second, the Fed recognizes the same underlying consistency in the data, and likely concludes that there is little they can do to accelerate that recovery without further substantive changes to policy (dramatically increase asset purchases or changing the inflation target). The costs of those policy shifts are perceived to outweigh the benefits (this is a revealed preference at this point). Hence we should not anticipate the Fed will scale up asset purchases, even though this option was on the table in the last FOMC statement. Scaling up would only happen in the event of a sharp deterioration of the forecast.

Third, they will not scale up asset purchases as long as they expect the impact of fiscal contraction to have largely passed by the end of this year.  If not for the fiscal contraction, the economy would already be accelerating at a more rapid pace, and we would probably be looking at the Fed tapering off asset purchases sooner than later.

Fourth, even if the forecast for 2014 devolves into a continuation of the slow and steady improvement of the past nearly four years (!) since the end of the recession, I doubt the Fed will accelerate the pace of asset purchases. The problem is the 6.5% unemployment threshold for considering the path of short-term interest rates. Slow and steady improvement will place that threshold in sight by the middle of next year, and the Fed will want to be done with asset purchases well before the economy hits that threshold. That helps explain why FOMC members seem to have coalesced around an expectation that they can wind down and end asset purchases by the end of this year. In short, they will be increasingly hesitant to increase asset purchases (and more anxious to begin tapering) as we move closer to the 6.5% unemployment target.

Bottom Line: Pay attention to the underlying trend, discount the month-to-month noise. The farther out we get from the recession, that noise becomes less important. That underlying trend seems to be generally consistent with the unemployment rate coming within sight of the 6.5% threshold by the middle of next year, which explains the interest in ceasing asset purchases by the end of this year. Despite talk of the ability to increase the pace of purchases, I have a hard time seeing the circumstances that would make such a dramatic shift in policy direction. Such a shift will require a substantial negative shock that stalls the pace of activity and brings the threat of deflation back to the front burner - think circumstances that threaten to take out the Fed's current floor under the economy.

Fed Watch: 14,000

Tim Duy:

14,000, by Tim Duy: Seems like just yesterday Japanese policymakers were looking to push the Nikkie to 13,000. It even seemed like a overreaching at the time. Here is Matthew Boesler at Business Insider:

The 13,000 index target implies around 17 percent upside in February and March. The pace may sound ambitious, but then again, Japan is one of the hottest momentum trades in the world right now.

Today the Nikkei pushed past 14,000:

Note too that the 10-year Japanese government bond holds well below 1 percent - fears that aggressive policy would cause rates to skyrocket are once again proved unfounded.

So far, so good for Abenomics. Now the question is will policymakers back off soon after seeing such positive results? We have seen such stop-go policy in Japan in the past when attention turns back toward the size of the deficit. Are Japanese policymakers in it for the long-haul?

Fed Watch: When Deficits Become a Problem

Tim Duy:

When Deficits Become a Problem, by Tim Duy: L. Randall Wray (ht FTAlphaville) thinks that Paul Krugman has made the leap to MMT by acknowledging the ability of the central bank to control interest rates. Wray sees that Krugman was faced with an intellectual roadblock to MMT:

The sticking point has been “crowding out”—the idea that once we get beyond the liquidity trap and return to a more “normal” ISLM world, government deficits will push up interest rates. And that will then reduce private investment, which tends to lower economic growth. Higher interest rates plus lower growth means the government’s deficit and debt ratios grow beyond “sustainable” levels.

Wray argues that ultimately the central bank does not need to fear the bond vigilantes because the Treasury need not issue long-term debt and can instead issue only short term debt. The Fed is assumed to have complete control over rates on short term debt:

But as I explained last week, the short term rate is completely within the control of the Fed....Long term rates depend on the state of liquidity preference plus expectations of future Fed policy. But in any case, the Vigilantes cannot force Treasury to issue long term debt. It can stick to the short end of the maturity structure and then pay whatever rate the Fed targets.

Actually, I would go one step further than Wray and argue that the Fed's expectations tools coupled with large-scale asset purchases allows them to influence the entire yield curve. Wray then explains that this means the danger is not the vigilantes, but the Federal Reserve:

The real danger is not that the Vigilantes go all vigilant on Uncle Sam, but rather that the Fed decides to do a Volcker (raise the overnight rate to 20%). Congress can stop that by legislating that the Fed cannot act like a Vigilante. Or, alternatively, Treasury can stay on the short end. Both of these are policy choices, completely outside the influence of Vigilantes.

Wray takes Krugman's post today as evidence that Krugman believes that crowding out is not a issue either in a liquidity trap or at potential output. The Krugman quote:

the short-term interest rate is set by the Bank of England. And the long-term rate, to a first approximation, is a weighted average of expected future short-term rates. Unless markets believe that Britain is going to default — which it isn’t, and they won’t — this is more or less an arbitrage condition that ties down the long run rate no matter what happens to confidence.

Wray's interpretation:

All he has to do is to carry that analysis beyond the current downturn. This can go on forever, of course. Keep short term interest rates low, or keep Treasury out of long maturities.

Wray seems to believe that this means Krugman has departed from his earlier story:

I could go on, but you get the point: once we’re no longer in a liquidity trap, running large deficits without access to bond markets is a recipe for very high inflation, perhaps even hyperinflation. And no amount of talk about actual financial flows, about who buys what from whom, can make that point disappear: if you’re going to finance deficits by creating monetary base, someone has to be persuaded to hold the additional base.

But I don't see anything inconsistent between the Krugman of the past and that of today. The crowding out argument is a simply a bit more nuanced than in Wray's description. Wray seems to want to overlook the inflation part of Krugman's position. Specifically that in a more "normal" ISLM world, which I would interpret as near potential output, then additional government spending would tend to increase interest rates and crowd out private spending or - and this is an important or - that the Federal Reserve could accommodate the increased government spending and hold interest rates low, but that the end result would be higher inflation.

In other words, I doubt that Krugman fears the bond vigilantes even at potential output, but that he would expect the Federal Reserve to allow interest rates to increase to prevent inflation. Presumably this crowds out private investment, and shifts the mix of demand toward the government sector.

Does this mean that additional debt lowers growth in a Rogoff/Reinhart sense? No, but it does mean that the Fed will not allow output to exceed potential due to inflation concerns. The claim that crowding out leads to lower potential growth in the long-run is generally a supply-side type story in which an excessive level of government spending reduces the rate of resource (labor/technology/capital) growth.

In short, I doubt that Krugman's acknowledgement of the Federal Reserve's control over interest rates implies that he now believes that government deficits do not matter or that he will make such an intellectual leap. Krugman appears to have always believed that the Fed can control interest rates, thus leaving the bond vigilantes impotent. And there is nothing in his blog today to suggest that he no longer believes that at some point (hopefully) inflation - and by extension, interest rates - will once again be a concern. Believe it or not, it is not logically inconsistent to believe that concerns about rising interest rates are not valid today, but might be valid at some point in the future.

Update: I see Ed Harrison is writing on Krugman and the bond vigilantes as well, and sees the difference in not the so much the outcome

Of course running enormous deficits when the economy is operating at full capacity causes inflation to go haywire. Of course it does.

But in the rhetorical approach:

The difference is he straw-manned the deficit as an exogenous policy variable in 2011 when it simply isn’t one. 

Harrison (correctly) views the deficit as largely endogenous. When the economy improves, then the deficit will dissapear (or at least be greatly reduced). So arguing about the deficit's impact on interest rates is pointless:

This could only happen if our politicians went mad and added yet more fiscal stimulus to the economy even after it was overheating.

The key point is inflation:

Wait until inflation starts to creep up. Then the bond vigilantes can get going. But this is a long way off.

Paul Krugman: Not Enough Inflation

Inflation is the wrong thing to worry about:

Not Enough Inflation, by Paul Krugman, Commentary, NY Times: Ever since the financial crisis struck, and the Federal Reserve began “printing money” in an attempt to contain the damage, there have been dire warnings about inflation...

And now, sure enough, the Fed really is worried about inflation. You see, it’s getting too low. ...

It’s not hard to see where inflation fears were coming from. In its efforts to prop up the economy, the Fed has bought more than $2 trillion of stuff — private debts, housing agency debts, government bonds. It has paid for these purchases by crediting funds to the reserves of private banks, which isn’t exactly printing money, but is close enough for government work. Here comes hyperinflation!

Or, actually, not. From the beginning, it ... should have been obvious that the financial crisis had plunged us into a “liquidity trap”... Economists who had studied such traps ... knew that some of the usual rules of economics are in abeyance as long as the trap lasts. Budget deficits, for example, don’t drive up interest rates; printing money isn’t inflationary; slashing government spending has really destructive effects on incomes and employment.

The usual suspects dismissed all this analysis; it was “liquidity claptrap,” declared Alan Reynolds of the Cato Institute. But ... the liquidity trappers seem to have been right, after all. ...

So all those inflation fears were wrong..., at this point, inflation — at barely above 1 percent by the Fed’s favored measure — is dangerously low. ...

So why is inflation falling? The answer is the economy’s persistent weakness, which keeps workers from bargaining for higher wages and forces many businesses to cut prices. And if you think about it,,,, you realize that this is a vicious circle, in which a weak economy leads to too-low inflation, which perpetuates the economy’s weakness.

And this brings us to a broader point: the utter folly of not acting to boost the economy, now.

Whenever anyone talks about the need for more stimulus, monetary and fiscal, to reduce unemployment, the response from people who imagine themselves wise is always that we should focus on the long run, not on short-run fixes. The truth, however, is that ... by letting short-run economic problems fester we’re setting ourselves up for a long-run, perhaps permanent, pattern of economic failure.

The point is that we are failing miserably in responding to our economic challenge — and we will be paying for that failure for many years to come.

Fed Watch: FOMC Leaves Policy Unchanged

Tim Duy:

FOMC Leaves Policy Unchanged, by Tim Duy: The FOMC concluded their two-day meeting by holding policy constant, as expected. The assessment of the economy was largely unchanged. From March:

Information received since the Federal Open Market Committee met in January suggests a return to moderate economic growth following a pause late last year. Labor market conditions have shown signs of improvement in recent months but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy has become somewhat more restrictive. Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Now:

Information received since the Federal Open Market Committee met in March suggests that economic activity has been expanding at a moderate pace. Labor market conditions have shown some improvement in recent months, on balance, but the unemployment rate remains elevated. Household spending and business fixed investment advanced, and the housing sector has strengthened further, but fiscal policy is restraining economic growth. Inflation has been running somewhat below the Committee's longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Notably, recent data has had little impact on the Fed's economic outlook. This includes the last employment report as well. The inclusion of the term "on balance" was clearly intended to downplay the March numbers.

My interpretation is that the Fed is attempting to move away from being pulled this way and that by the monthly fluctuations of the data and instead focus on the underlying trend; presumably, it is that trend that should be guiding policy decisions. Of course, one could argue that that underlying trend should induce them to additional action, but that is neither here nor there at this point. From their perspective, policy is appropriate given that trend. The Fed also strengthened its language on fiscal policy, but again the damage so far is not sufficient to change the course of policy. Or, probably more accurately, the damage is not so great that the Fed is willing to let Congress hit the ball into their court.

The other significant change came latter in the statement. From March:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

Now:

The Committee will closely monitor incoming information on economic and financial developments in coming months. The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability. The Committee is prepared to increase or reduce the pace of its purchases to maintain appropriate policy accommodation as the outlook for the labor market or inflation changes. In determining the size, pace, and composition of its asset purchases, the Committee will continue to take appropriate account of the likely efficacy and costs of such purchases as well as the extent of progress toward its economic objectives.

In the wake of the last meeting, comments from some Fed presidents as well as the minutes themselves seemed to imply that further expansion of the large scale asset purchase program was out of the question. Instead, it seemed the focus had firmly shifted to ending QE as soon as possible, with the end of this year as a goal. With this language shift, the FOMC pulls back on this direction, and instead makes it clear than an expansion of the program is still possible. And possible not only due to a changing employment outlook, but also due to a deteriorating inflation picture.

But isn't the inflation picture already deteriorating? Yes, the latest numbers suggest a worsening disinflation trend. The Fed, however, probably has not adjusted their forecast; they probably do not expect that substantially lower inflation is likely given that inflation expectations remain anchored and economic activity is not deteriorating. In such an environment, they likely are not all that concerned that inflation is running somewhat below target.

Moreover, the Fed has that cost-benefit analysis thing working in the background, and likely believes that any more than $85 billion a month is not likely to have large, positive marginal benefits. Not enough to justify expanding policy further for any small changes to the forecast.

Bottom Line: The urge to taper off quantitative easing has lessened since the last meeting. That pushes the beginning of the end back to the later back of the year. The door is open to additional stimulus as well, but I suspect that it would have to be driven by the employment side of the mandate. Clear evidence of a deflationary threat is likely necessary to drive action on the other side of the mandate; such a threat seems unlikely in an expanding economy.

What Comes Next for the Fed?

I have a few comments at MoneyWatch on the Fed's decision to keep policy unchanged:

What comes next for the Fed?

Fed Watch: What About Inflation?

Tim Duy:

What About Inflation?, by Tim Duy: I find Binyamin Applelbaum's Fed preview to be rather depressing and distressing. Appelbaum begins with a solid insight - reducing the unemployment rate is not the same as maximizing employment:

The Federal Reserve is making modest progress in its push to reduce the unemployment rate. But that is not the jobs goal Congress actually established for the Fed. The central bank is supposed to be maximizing employment. And on that front, it is not making progress.

Applelbaum points to the employment to population ratio as evidence that the Fed is falling short of the mandate. But are Fed officials ready to do more? No:

There is little sign, however, that Fed officials are considering an expansion of their four-year-old stimulus campaign as the Fed’s policy-making committee prepares to convene Tuesday and Wednesday in Washington.

Applelbaum notes that the recent flow of data has forced monetary policymakers to back away from talk of ending large scale assets purchases. But among the reasons to avoid expansion of the program we find this:

Another reason the Fed is not embracing new measures is that it already has tied the duration of low interest rates to the unemployment rate. The Fed said in December that it intended to hold interest rates near zero at least as long as the unemployment rate remained above 6.5 percent, provided that inflation remained under control. The theory is that the economy will get as much stimulus as it needs.

But what if the inflation rate is persistently below the target? Or, worse, trending lower? Clearly then the economy is not getting the stimulus it needs. If we are missing on both targets, then the economy needs more stimulus. And while we can debate the efficacy of monetary policy in influencing the pace of employment growth, surely monetary policy can influence the inflation rate. Correct?

The distressing part of this article is that it reads as if the Fed has given up not only on its ability to influence the pace of employment growth, but also on its ability to influence the inflation rate. Or, possibly worse, that the Fed is simply no longer concerned with the inflation rate now that the obvious threat of deflation has passed. This again feeds suspicion that the Fed's 2 percent target is really an upper bound.

Bottom Line: The Fed is supposed to have a dual mandate. Dual, as in two. Maximum employment and price stability. One would think that failing at the latter would be at least as important as failing at the former. Perhaps we are learning that the Evan's rule is flawed - it should not be about only conditions before which the Fed considers removing stimulus, but also conditions by which the Fed deliberately considers adding additional stimulus. A two-side Evan's rule is needed.

Why Do We Use Core Inflation?

Paul Krugman:

Blogging is a bit like teaching the same class year after year; inevitably there are moments when you feel exasperated at the class’s failure to grasp some point you know you explained at length — then you realize that this was last year or the year before, and it was to a different group of people.

So, I gather that the old core inflation bugaboo is rearing its head again — the complaint that it’s somehow stupid, dishonest, or worse to measure inflation without food and energy prices, often coupled with the claim that the statistics are being manipulated anyway. So, time for a refresher. ...

Hs refresher is here. Let me offer one of my own (from 2008):

Why Do We Use Core Inflation?: There is a lot of confusion over the Fed's use of core inflation as part of its policy making process. One reason for confusion is that we using a single measure to summarize three different definitions of the term "core inflation" based upon how it is used.

First, core inflation is used to forecast future inflation. For example, this recent paper uses a "bivariate integrated moving average ... model ... that fits the data on inflation very well," and finds that the long-run trend rate of inflation "is best gauged by focusing solely on prices excluding food and energy prices." That is, this paper finds that predictions of future inflation based upon core measures are more accurate than predictions based upon total inflation.

Second, we also use the core inflation rate to measure the current trend inflation rate. Because the inflation rate we observe contains both permanent and transitory components, the precise long-run inflation rate that consumers face going forward is not observed directly, it must be estimated. When food and energy are removed to obtain a core measure, the idea is to strip away the short-run movements thereby giving a better picture of the core or long-run inflation rate faced by households. I should note, however that this is not the only nor the best way to extract the trend and the Fed also looks at other measures of the trend inflation rate that have better statistical properties. Thus while the first use of core inflation was for forecasting future inflation rates, this use of core inflation attempts to find today's trend inflation rate [There is a way to combine the first and second uses into a single conceptual framework that encompasses both, but it seemed more intuitive to keep them separate. In both cases, the idea is to find the inflation rate that consumers are likely to face in the future.]

Let me emphasize one thing. If the question is "what is today's inflation rate," the total inflation rate is the best measure. It's intended to measure the cost of living and there's no reason at all to strip anything out. It's only when we ask different questions that different measures are used.

Third, and this is the function that is ignored most often in discussions of core inflation, but to me it is the most important of the three. The inflation target that best stabilizes the economy (i.e. best reduces the variation in output and employment) is a version of core inflation.

In theoretical models used to study monetary policy, the procedure for setting the policy rule is to find the monetary policy rule that maximizes household welfare (by minimizing variation in variables such as output, consumption, and employment). The rule will vary by model, but it usually involves a measure of output and a measure of prices, and those measures can be in levels, rates of change, or both depending upon the particular model being examined.

In general, a Taylor rule type framework comes out of this process ( i.e. a rule that links the federal funds rate to measures of output and prices). However, in the policy rule, the best measure of prices is usually something that looks like a core measure of inflation. Essentially, when prices are sticky, which is the most common assumption driving the interaction between policy and movements in real variables in these models, it's best to target an index that gives most of the weight to the stickiest prices (here's an explanation as to why from a post that echoes the themes here).  That is, volatile prices such as food and energy are essentially tossed out of the index used in the policy rule.

The indexes that come out of this type of theoretical exercise often includes both output and input prices, and occasionally asset prices as well. That is, a core measure of inflation composed of just output prices isn't the best thing for policymakers to target, a more general core inflation rate combining both input and output prices works better. ...

Finally, there is also a question of what we mean by inflation conceptually. Does a change in relative prices, e.g. from a large increase in energy costs, that raises the cost of living substantially count as inflation, or do we require the changes to be common across all prices as would occur when the money supply is increased? Which is better for measuring the cost of living? Which is a better target for stabilizing the economy? The answers may not be the same. For a nice discussion of this topic, see this speech given yesterday by Dennis Lockhart, President of the Atlanta Fed:

Inflation Beyond the Headlines, by Dennis P. Lockhart, President, Federal Reserve Bank of Atlanta: ...Let me begin by posing the simple question: What do we mean by "inflation"? The answer to that simple question isn't as simple as it may seem.

The popular treatment of inflation in our sound bite society risks confusing inflation with relative price movements and the cost of living. By cost of living, I'm referring to the costs you and I incur to maintain our level of consumption of various goods and services including essential items such as food, gasoline, and lodging. 

Relative price movements occur continuously in an economy as individual prices react to market forces affecting that good or service. Neither relative price movements nor sustained high living costs constitute inflation as economists commonly use the term....

And I think I'll end with this part of his remarks:

Attempts to measure the aggregate rate of price change—no matter how sophisticated—remain imperfect. As a result, when it comes to measuring inflation, judgment is needed to distinguish persistent price movements that underlie overall inflation from the relative price adjustments. Separating the inflation signal from noise involves much uncertainty—especially when making decisions in real time. Discerning accurately the underlying trend is difficult. It is essential for those of us who have responsibility for responding to these trends to use a wide variety of core measures and inflation projections to make the most informed judgment we can.

Is Quantitative Easing Becoming Quantitative Exhaustion?

This discussion of Fed policy seems like a stacked deck:

Central Banks: Is Quantitative Easing Becoming Quantitative Exhaustion?
Monday, April 29, 2013 3:30 PM - 4:30 PM

Speakers:

• James McCaughan , CEO, Principal Global Investors
• Cliff Noreen, President, Babson Capital Management LLC
• Tad Rivelle, Chief Investment Officer, Fixed Income, TCW
• Aram Shishmanian, CEO, World Gold Council
• Kevin Warsh, Distinguished Visiting Fellow, Hoover Institution; Former Member, Federal Reserve Board of Governors

Moderator: David Zervos, Chief Market Strategist, Jefferies LLC

Among the monetary measures central banks have taken to address the lingering impact of the 2008 financial rupture, keeping interest rates artificially low has been a primary aim. The term "financial repression" has become associated with that policy. Such measures were launched in the hope of not only stimulating economic activity but to ease the pressure of servicing onerous public debt. Concern is growing, however, that quantitative easing has distorted markets by interfering with the proper pricing of risk and, by extension, obscuring the true cost of capital. Our panel of experts will explore the possible effects of sustained QE and the quest for financial stability. For instance, are bubbles inflating? Will these effects be similar or will they vary from market to market? What costs will long-tem financial repression impose on the Federal Reserve and other central banks? What tools can be employed as alternatives?

It was stacked. Pretty much unanimous thumbs down on QE. Even the moderator is noting how one-sided the discussion is. It's making things worse! (e.g. QE drives up gas prices and holds back the economy). One panelist is even complaining that interest rates are too low, and no other panelist disagrees. They couldn't find anyone to defend the Fed's current policies? Someone to address all the questionable claims this panel is making? Wow. They are giving the Fed credit for stepping in saving markets when problems first hit financial markets, but seem to think we'd be better off if the Fed had done less. Sorry, but we wouldn't be. The Fed was slow to react and overly cautious at every stage of the crisis. We needed more, not less, and still do.

(Weird, the guy arguing that QE made things worse is now arguing that the recovery has been much stronger than most people are aware, e.g. unemployment not so bad as we hear...).

Anyway, think I've had enough of the Fox News version of a debate (actually, Fox would at least have an ineffective defender to tear apart). Time to move on.

[The video from each session will be posted here several hours after the session ends. I'll add the video to this (and other posts) once it appears (Update: video added).]

Fed Watch: Just a Few Weeks Makes a World of Difference

Tim Duy:

Just a Few Weeks Makes a World of Difference, by Tim Duy: The minutes of the last FOMC meeting, concluded on March 20, included this passage:

In light of the current review of benefits and costs, one member judged that the pace of purchases should ideally be slowed immediately. A few members felt that the risks and costs of purchases, along with the improved outlook since last fall, would likely make a reduction in the pace of purchases appropriate around midyear, with purchases ending later this year. Several others thought that if the outlook for labor market conditions improved as anticipated, it would probably be appropriate to slow purchases later in the year and to stop them by year-end. Two members indicated that purchases might well continue at the current pace at least through the end of the year.

The center of the FOMC appeared to be shifting toward agreement that large scale asset purchase program would likely be wrapped up by year end. Of course, they included a caveat:

It was also noted that were the outlook to deteriorate, the pace of purchases could be increased.

Since the last FOMC meeting, it has become clear that the economy continues along a suboptimal path, as illustrated by the disappointing 2.5 percent GDP growth for the first quarter; just a few weeks ago, Macroeconomic Advisors was anticipating a 3.6 percent growth rate. In addition, both employment and manufacturing reports have been less than impressive (see Calculated Risk for his take on today's Dallas Fed numbers and the implications for the ISM report). Moreover, fiscal austerity continues to bite:

The end result is that investors have concluded, rightly, that FOMC members looking forward to cutting the pace of purchases by mid-year were overly optimistic. Consequently, the 10-year yield was bid down to just 1.67 percent this afternoon, well below the 2.05 in early March.

Probably more important, at this juncture is that disinflation is again evident, with headline and core PCE up just 1.0 and 1.1 percent, respectively, compared to last year:

In an April 17 Wall Street Journal interview, St. Louis Federal Reserve President James Bullard highlighted the possibility that a deteriorating inflation trend might require additional easing. Other policymakers have joined him in this concern. From Bloomberg:

“I’d of course be giving serious thought” to additional stimulus if disinflation persists, Richmond Fed President Jeffrey Lacker, who voted against the bond program last year, said last week -- while adding he doesn’t think that will happen. The Minneapolis Fed’s Narayana Kocherlakota also said this month weaker inflation may be reason to consider more accommodation.

The important point is that low inflation prompts concern even among policymakers who think the Fed can have little impact on employment growth. For this group, high unemployment is distressing but not actionable. But low inflation is both distressing and actionable. Thus, at a minimum, the low inflation numbers should push the FOMC back to avoiding a premature end to quantitative easing. In addition, it is easy to argue that the Fed should be thinking about additional easing. Not only are they missing on the employment mandate, but increasingly it looks like they are missing on the price stability mandate as well. A policy failure all around.

Bottom Line: The FOMC statement should shift to indicate the softer economy and falling inflation numbers; I am watching for how much emphasis they place on the latter as a signal as to the likelihood of easing further in future meetings. Like most, I don't anticipate an expansion of the program at this juncture. I doubt the FOMC would see the current data as justifying a leap from thinking about ending the program to expanding the program just six weeks later. It would be interesting if Kansas City Federal Reserve President Esther George pulls her dissent. Her objection has been that the Fed's policy stance risks financial stability for little economic benefit. Pulling her dissent in response to falling inflation would signal that disinflation concerns run deep in the FOMC.

'Monetarism Falls Short'

I've was making this argument long before the crisis hit, I was among the first to say that monetary policy would not be enough to solve our problems, aggressive fiscal policy would also be needed, and nothing that's happened during the recession has changed my mind. I eventually tired of the debate and assumed everyone was tired of hearing me say we needed more fiscal stimulus -- arguing with monetarists won't change any minds anyway and policymakers weren't about to do more fiscal stimulus - - so I moved on to other things (mostly talking about the need for job creation through more aggressive policy of any type):

Monetarism Falls Short: ... Sorry, guys, but as a practical matter the Fed – while it should be doing more – can’t make up for contractionary fiscal policy in the face of a depressed economy.

Krugman is right.

'Why Gold and Bitcoin Make Lousy Money'

David Andolfatto:

Why gold and bitcoin make lousy money: A desirable property of a monetary instrument is that it holds its value over short periods of time. Most assets do not have this property: their purchasing power fluctuates greatly at very high frequency. Imagine having gone to work for gold a few weeks ago, only to see the purchasing power of your wages drop by 10% in one day. Imagine having purchased something using Bitcoin, only to watch the purchasing power of your spent Bitcoin rise by 100% the next day. It would be frustrating. 

Is it important for a monetary instrument to hold its value over long periods of time? I used to think so. But now I'm not so sure. While I do not necessarily like the idea of inflation eating away at the value of fiat money, I don't think that a low and stable inflation rate is such a big deal. Money is not meant to be a long-term store of value, after all. Once you receive your wages, you are free to purchase gold, bitcoin, or any other asset you wish. (Inflation does hurt those on fixed nominal payments, but the remedy for that is simply to index those payments to inflation. No big deal.)

I find it interesting to compare the huge price movements in gold and Bitcoin recently, especially since the physical properties of the two objects are so different. That is, gold is a solid metal, while Bitcoin is just an abstract accounting unit (like fiat money). 

But despite these physical differences, the two objects do share two important characteristics:

[1] They are (or are perceived to be) in relatively fixed supply; and
[2] The demand for these objects can fluctuate violently.

The implication of [1] and [2] is that the purchasing power (or price) of these objects can fluctuate violently and at high frequency. Given [2], the property [1], which is the property that gold standard advocates like to emphasize, results in price-level instability. In principle, these wild fluctuations in purchasing power can be mitigated by having an "elastic" money supply, managed by some (private or public) monetary institution. This latter belief is what underlies the establishment of a central bank managing a fiat money system (though there are other ways to achieve the same result). ...

The key issue for any monetary system is credibility of the agencies responsible for managing the economy's money supply in a socially responsible manner. A popular design in many countries is a politically independent central bank, mandated to achieve some measure of price-level stability. And whatever faults one might ascribe to the U.S. Federal Reserve Bank,... since the early 1980s, the Fed has at least managed to keep inflation relatively low and relatively stable. 

Our Unequal Recovery

From the WSJ:

Only Richest 7% Saw Wealth Gains From 2009 to 2011, by Neil Shah: ... From 2009 to 2011, the average wealth of America’s richest 7% — the 8 million households with a net worth north of about $800,000 — rose nearly 30% to $3.2 million from $2.5 million, according to a Pew Research Center report... By contrast, the average wealth of America’s remaining 93%, some 111 million households, actually dropped by 4% to $134,000 from $140,000. ...

The findings show that America’s economic recovery has been not just sluggish, but painfully uneven in its benefits. Rallying stock and bond markets have boosted the wealth of America’s most affluent... The upper 7% of households held 63% of the nation’s wealth at the end of 2011, up from 56% in 2009.

As the article notes, "the one-sidedness of the U.S.’s recovery ... has been supported by low-interest-rate policies from the Federal Reserve that have helped push asset prices higher."

One of the things we need to think a lot harder about is how to improve the distributional effects of monetary policy. I'd feel better about taking care of the top 7 percent if it had somehow trickled down to more jobs for struggling households, or if we had used fiscal policy to address the unemployment problem to a far greater degree than we did.

Fed Watch: Monetary Policy and Financial Stability

Tim Duy:

Monetary Policy and Financial Stability, by Tim Duy: I think it is difficult to ignore the role of asset prices in the dynamics of the past two business cycles:

If the objective of monetary policy is a combination of low inflation and unemployment, I think it is difficult to argue that the Federal Reserve pursued an overly loose policy stance in the periods of the internet and housing bubbles. Indeed, it is arguable that asset price bubbles were integral in fostering low unemployment.

With this in mind, consider this conclusion from Minneapolis Federal Reserve President Narayana Kocherlakota, speaking at the 22nd Annual Hyman P. Minsky conference:

In this way, unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity. All of these financial market outcomes are often interpreted as signifying financial market instability. And this observation brings me to a key conclusion. I’ve suggested that it is likely that, for a number of years to come, the FOMC will only achieve its dual mandate of maximum employment and price stability if it keeps real interest rates unusually low. I’ve also argued that when real interest rates are low, we are likely to see financial market outcomes that signify instability. It follows that, for a considerable period of time, the FOMC may only be to achieve its macroeconomic objectives in association with signs of instability in financial markets.

This sounds like Kocherlakota believes that it is not possible for the Federal Reserve to accomplish its dual mandate in the absence of asset bubbles, excessive credit growth, etc. This leads to issue of how should the Federal Reserve deal with such instability:

To answer this question, the Committee will need to confront an ongoing probabilistic cost-benefit calculation. On the one hand, raising the real interest rate will definitely lead to lower employment and prices. On the other hand, raising the real interest rate may reduce the risk of a financial crisis—a crisis which could give rise to a much larger fall in employment and prices. Thus, the Committee has to weigh the certainty of a costly deviation from its dual mandate objectives against the benefit of reducing the probability of an even larger deviation from those objectives.

In other words, if they raise interest rates, the will clearly deviate from their objectives, but if they don't there is only a chance of suffering a larger deviation. So they should refrain from addressing financial instability (through raising interest rates) until it is clearly evident that it poses a significant risk to the dual mandate.

But how might one measure financial instability? A new paper by Claudio Borio, Piti Disyatat, and Mikael Juselius offers a fresh look at potential output that incorporates information about the financial cycle. Note that traditional measures of potential output focus on the inflationary consequences of level of actual output. If inflation remains contained or falling, then by definition actual output is equal to or less than potential output. Borio et al, however, note that the economy may be on an unsustainable path even when inflation remains contained. Arguably, measures of potential output should incorporate information about financial factors that might signal the economy is on such a path.

Why might be expect that we might be on a unsustainable path even under conditions of low and stable inflation? The authors summarize:

There are at least four reasons for this. One is that unusually strong financial booms are likely to coincide with positive supply side shocks (eg Drehmann et al (2012))....A second reason is that the economic expansions may themselves weaken supply constraints. Prolonged and robust expansions can induce increases in the labour supply, either through higher participation rates or, more significantly, immigration....A third reason is that financial booms are often associated with a tendency for the currency to appreciate, as domestic assets become more attractive and capital flows surge. The appreciation puts downward pressure on inflation. A fourth, underappreciated, reason is that unsustainability may have to do more with the sectoral misallocation of resources than with overall capacity constraints. The sectors typically involved are especially sensitive to credit, such as real estate.

Thus, unsustainable financial booms can be especially treacherous, as it is all too easy to be lulled into a false sense of security. Economic activity appears deceptively robust. Financial and real developments mask the underlying financial vulnerabilities that eventually bring the expansion to an end...

The author's estimate what they describe as "finance neutral" output gaps via an expanded version of an H-P filter. Among their findings is that applying a Taylor rule to their output gap suggests that the Federal Funds rate was set too low during much of the 2000's, and possibly now as well. Still, the authors stop short of advocating that interest rate policy should be used to lean against financial headwinds. Tighter monetary policy might ease financial instabilities, but aggravate recovery from a balance sheet recession.

Arguably, the current environment is a case where it would be imprudent to lean against potential financial instabilities. The Federal Reserve is holding interest rates low for a protracted period and thus fueling fears they are laying the groundwork for the next financial crisis. But raising rates doesn't seem like an appropriate option considering the economy is far from fully recovered from the recession. This speaks to Kocherlakota's comment. And those of Federal Reserve Chairman Ben Bernanke as said in a recent speech:

One might argue that the right response to these risks is to tighten monetary policy, raising long-term interest rates with the aim of forestalling any undesirable buildup of risk. I hope my discussion this evening has convinced you that, at least in economic circumstances of the sort that prevail today, such an approach could be quite costly and might well be counterproductive from the standpoint of promoting financial stability. Long-term interest rates in the major industrial countries are low for good reason: Inflation is low and stable and, given expectations of weak growth, expected real short rates are low. Premature rate increases would carry a high risk of short-circuiting the recovery, possibly leading--ironically enough--to an even longer period of low long-term rates. Only a strong economy can deliver persistently high real returns to savers and investors, and the economies of the major industrial countries are still in the recovery phase.

Admitedly, this is frustrating. It is as if we we are faced with a tradeoff between economic recovery and financial stability. But this begs an even greater question. Why do we have to make this tradeoff? Why is maintaining full-employment dependent on destabilizing asset bubbles? Commenting on this speech, Ryan Avent asks if the current dynamics are a result of the Fed's never-ending pursuit of low inflation:

...one very clear implication...price stability is keeping nominal rates low and is therefore an impediment to financial and macroeconomic stability. One has to weigh costs and benefits, of course, but one cannot miss the trade-off: the more you worry about low rates the less low and stable inflation should look like a good thing...

...It is perhaps premature to declare the existence of a new monetary trilemma, that over the medium-term central banks can choose at most two of the following: low inflation, low unemployment, and financial stability. But if Mr Bernanke continues arguing this effectively in favour of higher inflation, we may need to ask why he isn't pursuing it as an explicit goal.

Has the pursuit of low inflation brought us to a point where we can maintain the Fed's dual mandate only at the presence of financial instability? That unless we allow for somewhat higher inflation, we are making a deliberate choice to follow only "inflation-neutral" measures of the output gap and ignore "finance-neutral" measures? And, importantly, might it not be the case that the costs of somewhat higher inflation are in fact less than the costs associated with the financial instabilities that seem to be part and parcel of the current low-inflation regime?

Bottom Line: If Kocherlakota is correct and monetary policy can only pursue the dual mandate in the context of financial - and, by extension - macroeconomic instability, then we really need to consider which part of the dual mandate needs to be loosened to reduce the reliance on financial instability. My fear is that if Fed policy makers were asked this question, they would unanimously answer that it is the full-employment portion of the mandate that should be jettisoned.

'The Economy Will Not Manage Itself, At Least Not In A Good Way'

Brad DeLong on the role of government in a market economy:

Economic Policy: Saturday Twentieth Century Economic History Weblogging: Note well: the economy will not manage itself, at least not in a good way.

As John Maynard Keynes shrilly stated back in 1926:

Let us clear… the ground…. It is not true that individuals possess a prescriptive 'natural liberty' in their economic activities. There is no 'compact' conferring perpetual rights on those who Have or on those who Acquire. The world is not so governed from above that private and social interest always coincide. It is not so managed here below that in practice they coincide. It is not a correct deduction from the principles of economics that enlightened self-interest always operates in the public interest. Nor is it true that self-interest generally is enlightened… individuals… promot[ing] their own ends are too ignorant or too weak to attain even these. Experience does not show that… social unit[s] are always less clear-sighted than [individuals] act[ing] separately. We [must] therefore settle… on its merits… "determin[ing] what the State ought to take upon itself to direct by the public wisdom, and what it ought to leave, with as little interference as possible, to individual exertion".

The management of economies by governments in the twentieth century was at best inept. And, as we have seen since 2007, little if anything has been durably learned about how to regulate the un-self-regulating market in order to maintain prosperity, or ensure opportunity, or produce substantial equality.

Before the start of the nineteenth century, there were markets but there was not really a market economy—and the peculiar dysfunctions that we have seen the market economy generate through its macroeconomic functioning were, if not absent, at least rare and in the background of attention. Wars, famines, government defaults were threats to life and livelihood. The idea that Alice might be poor and hungry because Bob would not buy stuff from her because Bob was unemployed because Carl wanted to deleverage because Dana was no longer a good credit risk because Alice had stopped paying rent to Dana--that and similar macroeconomic processes are a post-1800 phenomenon.

The problems of economic policy in the modern age are, speaking very broadly, threefold: first, the problem of attempts to replace the market with central planning--which is, for reasons well-outlined by the brilliant Friedrich von Hayek, a subclass of the problem of twentieth-century totalitarian tyranny--second, the problem of managing what Karl Polanyi called "fictitious commodities"; and, third, the problem of managing aggregate demand. ...[much more]...

Fed Watch: Three Parts to Macro Policy

Tim Duy:

Three Parts to Macro Policy, by Tim Duy: The G20 has accepted Japan's policy approach. From the Financial Times:

The yen fell sharply against other major currencies on Friday after the Japanese finance minister said Japan’s monetary policies had not met with resistance at the G20 group of nations in Washington.

This interpretation of the meeting helped sink the Yen to almost 100. More specifically, from the statement:

In particular, Japan’s recent policy actions are intended to stop deflation and support domestic demand.

Still, there remains a pro-austerity contingent:

Japan should define a credible medium-term fiscal plan.

I think the only credible medium-term plan for fiscal consolidation first involves higher near-term growth. More broadly than just Japan, but including Japan:

We will continue to implement ambitious structural reforms to increase our growth potential and create jobs.

How do these pieces fit together? I tend to see room for all three policy tools - monetary, fiscal, and structural - in fighting weak growth and outright recessions, although the weighting will vary according to circumstances. For instance, I don't deny the need for structural changes in the European periphery or Japan. Those changes, however, need to be cushioned with expansionary monetary and fiscal policy to yield a positive growth trajectory.

With this in mind, consider this recent post by Ed Harrison. He expands the Reinhart/Rogoff debate to current events in Japan:

This is the takeaway in Japan: stimulus without reform leads to a policy cul-de-sac. Monetary and fiscal stimulus is not a cure-all for economies or Japan would be the model and it most assuredly is not the model. If you want to use stimulus, then you need to have reform policies as well. It’s a three-pronged approach. The supply side matters. And that is the promise of Abenomics, isn’t it: fiscal and monetary stimulus as bridges to sustainable growth due to economic reform. Supposedly, this is what Abenomics is all about. And the Wall Street Journal told us yesterday that this reform, the third leg of this stool is now being put into place. Be sceptical, of course. Let’s just see what happens.

Mixing the RR debate and the Japanese and European experiences leads him to these conclusions:

Take a cue from Japan. The lesson is not to stimulate and deficit spend like mad and hope this succeeds in reflating the economy. That’s just a risk shift onto the public balance sheet. And the Japanese experience shows that people are uncomfortable with these kinds of deficits and will always work to reduce them irrespective of the consequences. You need supply side fixes too.

Take a cue from the euro zone. The lesson is also certainly not to undergo painful – and front-loaded – austerity like the euro zone. The Europeans have tied their hands with the euro. There is no currency sovereignty there and the ECB is legally forbidden to be politically aligned with any national government. The threat of insolvency is real. But Britain doesn’t have to go down this path. They have a lot more policy space. The bond vigilantes are a myth.

Read the post for more good insights.

Fed Watch: Accepting Failure

Tim Duy:

Accepting Failure, by Tim Duy: It is starting to look like European policymakers have given up trying. Bundesbank President Jens Weidmann, via the Wall Street Journal:

"Overcoming the crisis and the crisis effects will remain a challenge over the next decade," he said in an interview from his conference room at Bundesbank's headquarters overlooking Frankfurt's financial district, contrasting recent comments from European Commission President José Manuel Barroso that the worst of Europe's crisis is over.

Also from the Wall Street Journal:

An aging society and the time needed to work through its debt crisis will keep growth in Europe subdued for years to come, German Finance Minister Wolfgang Schaeuble said Friday.

“No one should expect that Europe will deliver high growth rates for years,” he said.

Apparently the new strategy is to keep expectations low. One has to imagine that given the current path of activity and the lack of fiscal support from European nations, the European Central Bank will find itself not only cutting rates but implementing its own version of quantitative easing by year end. The only other option would be to sit back and watch Europe slide from recession to depression And that does not seem like a credible policy path.

Low Real Interest Rates and Financial Market Instability

Here's the executive summary of a speech from Minneapolis Fed president Narayana Kocherlakota. He argues that "the FOMC will only be able to meet its congressionally mandated objectives ... by taking policy actions that ensure that the real interest rate remains unusually low," and that these policies will "necessarily give rise to signs of financial market instability":

Low Real Interest Rates - Executive Summary, by Narayana Kocherlakota - President Federal Reserve Bank of Minneapolis: My talk is about the decline in real—that is, net of inflation—interest rates since 2007. I begin by describing how, over the past six years, the demand for safe assets has grown, while the supply of those assets has shrunk. These changes in asset demand and asset supply imply that households and firms spend less at any level of real interest rates. It follows that the Federal Open Market Committee can only meet its congressionally mandated objectives for employment and prices by taking actions that greatly lower the real interest rate relative to its 2007 level. This is my first of three main messages: The FOMC should be thought of as having been forced to lower the real interest rate in order to respond appropriately to dramatic changes in asset market demand and supply.

I suggest that these dramatic changes in asset demand and asset supply are likely to persist over a considerable period of time—possibly the next five to 10 years. If that forecast holds true, it follows that the FOMC will only be able to meet its congressionally mandated objectives over that time frame by taking policy actions that ensure that the real interest rate remains unusually low. I point out that low real interest rates can be expected to be associated with financial market phenomena—like high asset price volatility—that are seen as signifying instability. This is my second main message: For many years to come, the FOMC will only be able to achieve its objectives by following policies that necessarily give rise to signs of financial market instability.

These financial market phenomena could pose macroeconomic risks. In my view, these potentialities are best addressed using effective supervision and regulation of the financial sector. It is possible, though, that these tools may only partly mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy. However, it should only do so if the certain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis. Hence—and this is my third main message—the FOMC’s decision about how to react to signs of financial instability will necessarily depend on a delicate probabilistic cost-benefit calculation. The Committee is in a better position to make that calculation now than it was in 2007, and continues to make progress on this dimension.

Note

* I thank Ron Feldman, David Fettig, Terry Fitzgerald and Kei-Mu Yi for many valuable comments.

Full speech: Low Real Interest Rates.

Fed Watch: Bullard Concerned About Low Inflation

Tim Duy:

Bullard Concerned About Low Inflation, by Tim Duy: St. Louis Federal Reserve President James Bullard sees inflation as a potential problem, but not in the way you might think. From the Wall Street Journal:

Federal Reserve Bank of St. Louis President James Bullard said Wednesday inflationary pressures may be growing too weakly and if they soften further, the central bank may have to boost its asset buying to bring price pressures back up to more desirable levels.

“Inflation is running very low” as measured by the personal consumption expenditures price index, the Fed’s favored inflation gauge, the policymaker said. “I’m getting concerned about that,” he said.

“If inflation [gains] continues to go down, I’d be willing to increase the pace of purchases” of bonds the Fed is now engaged in, Mr. Bullard said. “This is not what I expected, and I think inflation should be closer to the target than it is,” the official said, adding he considers it just as important to defend the Fed’s 2% inflation target from the low side, as it is to keep prices from going over 2%.

This is the problem:

With the Fed's preferred inflation target trending down, it seems a little silly to start talking about ending the asset purchase program. Indeed, as Bullard suggests, there might be room to expand it further. Note also that Bullard comes to this conclusion despite his concern that monetary policy has limited ability to create jobs, the main point of his speech. See the Wall Street Journal article cited above or Neil Irwin for more.

While everyone is busy watching the labor market for signs that the Fed can wind down asset purchases, we tend to forget that inflation should be part of the equation as well. From the most recent FOMC statement:

The Committee will continue its purchases of Treasury and agency mortgage-backed securities, and employ its other policy tools as appropriate, until the outlook for the labor market has improved substantially in a context of price stability.

The phrase "in the context of price stability" should cut both ways. The Fed might need to tighten policy even if the labor market is not improving if inflationary pressures start to emerge. But at the same time, it should also mean that the Fed may need to increase the pace of asset purchases even if the labor market is improving. That seems to be the current situation, yet we hear alot of Fedspeak suggesting a widespread inclination to end asset purchases this year regarless of the recent bout of disinflation.

That said, inflation might be set to tick up in the months ahead. From MIT's Billion Prices Project:

Not a worrisome move, but enough to suggest that Bullard's low inflation concern might be short-lived.

Bottom Line: Bullard reminds us the exit from the asset purchase program should not be simply a function of labor markets, but also a function of inflation. And the current path of inflation does not indicate that policymakers should be rushing ahead with a plan to end QE this year.

Fed Watch: Yellen and the Reach for Yield

Tim Duy:

Yellen and the Reach for Yield, by Tim Duy: Federal Reserve Vice Chair Janet Yellen, speaking at the IMF "Rethinking Macro Policy II" conference, notes that Fed policy is intended, at least in part, to increase risky-taking behavior:

Some have asked whether the extraordinary accommodation being provided in response to the financial crisis may itself tend to generate new financial stability risks. This is a very important question. To put it in context, let's remember that the Federal Reserve's policies are intended to promote a return to prudent risk-taking, reflecting a normalization of credit markets that is essential to a healthy economy.

Certainly some reflation of asset prices is helpful in healing household balance sheets and thus But she and other realize that it can go too far:

...Obviously, risk-taking can go too far. Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield. I don't see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.

It would be hard not to make this conclusion given the role of asset bubbles in the dynamics of the last two business cycles. Still, what is the right policy response? Yellen:

However, I think most central bankers view monetary policy as a blunt tool for addressing financial stability concerns and many probably share my own strong preference to rely on micro- and macroprudential supervision and regulation as the main line of defense.

The center of gravity at the Fed remains wary of using interest rates to temper suspected asset bubbles, excessive leverage, etc. They prefer the idea of using supervision and regulation. One little problem though:

The Federal Reserve has been working with a number of federal agencies and international bodies since the crisis to implement a broad range of reforms to enhance our monitoring, mitigate systemic risk, and generally improve the resilience of the financial system. Significant work will be needed to implement these reforms, and vulnerabilities still remain.

No, we don't have the tools in place. And, I would add, regulators will be continuously playing catch-up on the regulatory front. Consequently, the ball might fall in the monetary policy court:

Thus, we are prepared to use any of our many instruments as appropriate to address any stability concerns.

Which leaves me a thinking that although the Fed might not want to use monetary policy to blunt any suspected financial stability risks, they may find themselves in a place where they believe they have no other choice because alternative tools are not available.

Not an immediate issue, but one to keep an eye on. The Fed is not likely to be so dismissive of financial stability risks the next time around.

Fed Watch: Another Spring Slowdown?

Tim Duy:

Another Spring Slowdown?, by Tim Duy: While expectations for a solid first quarter GDP report are running high, the most recent data flow has been somewhat sloppy. Sloppy enough that it should raise red flags for monetary policymakers pushing to end QE by the end of this year.

In addition to the weak employment report for March, the ISM manufacturing index retreated:

In contrast, the industrial production report appeared to signal ongoing strength:

But the details suggest a loss of momentum in March aside from a temporary boost from utilities:

Manufacturing output edged down 0.1 percent in March after having risen 0.9 percent in February; the index advanced at an annual rate of 5.3 percent in the first quarter. Production at mines decreased 0.2 percent in March and edged down in the first quarter. In March, the output of utilities jumped 5.3 percent, as unusually cold weather drove up heating demand.

More disconcerting was the retail sales report, which signaled that the recent strength in consumer spending is waning:

Indeed, this is not terribly unexpected as it likely reflects the impact of higher tax this year. But it is a signal that one should be cautious before extrapolating Q1 GDP numbers. On a more positive note, housing starts were higher, with much of the improvement stemming from multifamily construction:

The solid improvement in housing starts seems at odds with waning builder confidence, but that may have more to do with supply constraints than demand. From the news release:

“Many builders are expressing frustration over being unable to respond to the rising demand for new homes due to difficulties in obtaining construction credit, overly restrictive mortgage lending rules and construction costs that are increasing at a faster pace than appraised values,” said Rick Judson, National Association of Home Builders (NAHB) Chairman and a home builder from Charlotte, N.C. “While sales conditions are generally improving, these challenges are holding back new building and job creation.”

“Supply chains for building materials, developed lots and skilled workers will take some time to re-establish themselves following the recession, and in the meantime builders are feeling squeezed by higher costs and limited availability issues,” explained NAHB Chief Economist David Crowe. “That said, builders’ outlook for the next six months has improved due to the low inventory of for-sale homes, rock bottom mortgage rates and rising consumer confidence.”

This suggests the improvement in housing demand is just beginning to have an impact on the overall economy. That impact will accelerate as supply chains rebuild over the next year.

On net, I think the data is telling us a familiar story: The positives in the US economy are difficult to ignore. Housing starts are a very good indicator of the direction of the economy, and that direction appears to be up. But it doesn't pay to get too carried away with any one quarter's worth of data. Underlying growth has been slow and steady since the end of the recession, with positive quarters offset by negative quarters. And the impact of tighter fiscal policy looks likely to produce a similar trend this year. The light at the end of the tunnel, however, is that as the fiscal effect fades toward the end of this year and into next, activity could finally see a more of the sustained improvement we have been looking for.

But, at the moment, that sustained improvement looks ephemeral. That is the message of the bond market as yields plunged back to the 1.7 percent range since the beginning of the year. And the beat-down of commodity prices indicates nervousness on the global outlook as well. If I was a monetary policymaker, I would be paying attention, especially as the inflation numbers are not telling us that imminent tightening is necessary:

Consumer price inflation (not the Fed's preferred measure) posted a -0.2 percent headline decline in March and a slight 0.1 percent core gain. Inflation? What inflation?

Some FOMC members seem to be paying attention to the change in the tone of the data. New York Federal Reserve President William Dudley noted his concerns in a speech today:

In terms of the labor market, we have seen only a moderate improvement in labor market conditions over the past six months or so. After an encouraging pick up in the pace of job creation around the turn of the year, the employment report for March showed a gain of only 88,000 jobs. While I don’t want to read too much into a single month’s data, this underscores the need to wait and see how the economy develops before declaring victory prematurely. I’d note that we saw similar slowdowns in job creation in 2011 and 2012 after pickups in the job creation rate and this, along with the large amount of fiscal restraint hitting the economy now, makes me more cautious....

...In the near term, there is considerable uncertainty about the outlook, particularly because the multiplier effects from fiscal drag and sequestration are still unclear. This uncertainty should gradually decline—for better or for worse—over the coming months, as the sequester’s impact takes hold and more economic data come in, giving us a clearer picture of the forward momentum of the economy....

...I see the current pace of asset purchases as appropriate.

At some point, I expect that I will see sufficient evidence of improved economic momentum to lead me to favor gradually dialing back the pace of asset purchases. Of course, any subsequent bad news could lead me to favor dialing them back up again.

Notice that he does not suggest, as others do, that it would be appropriate to end quantitative easing by the end of this year. Chicago Federal Reserve President Charles Evans expressed his belief that quantitative easing would stretch into 2014:

Mr. Evans told reporters after a speech in Chicago that he expected “with a high probability” that bond buying would continue into the fall. He added he “would not be surprised” if a wind-down carried over into 2014, though offered an upbeat assessment of the economy’s current trajectory and saw no immediate inflation threat.

Prior to the discussion about ending the QE this year, my outlook had been similar to Evans' - the tapering-off procees would begin late this year after the impact of fiscal contration had passed, with a likely end in the first half of 2014. But recent Fedspeak has convinced me that a sizable contingent of policymakers are looking to end QE sooner than later; I suspect that contingent has fallen back to concerns about size of the balance sheet rather than the pace of the recovery.

Bottom Line: The data flow is not as uniformly positive as it seemed just a month ago. Arguably, we are experiencing yet another spring slowdown. This should trigger some monetary policymakers to reassess their predictions that QE could be safely terminated at the end of this year. But there may be a contigent that has dug in its heels on the issue and are asking themselves "how bad does the data have to get to continue assets purchases" rather than "how good does the data need to be to end asset purchases?" Of course, ultimately the answer will depend on which of these two questions Federal Reserve Chairman Ben Bernanke is asking.

Fed Watch: When Can We All Admit the Euro is an Economic Failure?

Tim Duy:

When Can We All Admit the Euro is an Economic Failure?, by Tim Duy: The last month of data flow from Europe is nothing short of depressing. It seems that the history of the Eurocrisis can be summed up as a repeated effort to snatch failure from the jaws of defeat. The Euro and the policy framework that supports it is now clearly inconsistent with anything but sustained recession.

Consider a handful of recent reports. First, unemployment continues to reach new highs. From Bloomberg:

Unemployment in the 17-nation euro area was 12 percent in February and the January figure was revised up to the same level from 11.9 percent estimated earlier, the European Union’s statistics office in Luxembourg said today...The European Commission predicts unemployment rates of 12.2 percent this year and 12.1 percent in 2014. ECB President Mario Draghi said on March 7 that “it is of particular importance at this juncture to address the current high long-term and youth unemployment.”

I don't think that 12.2 percent forecast will hold. Greece remains a complete disaster. Via Aljazeera:

Greece's unemployment rate reached a new record of 27.2 percent in January, new data has showed, reflecting the depth of the country's recession after years of austerity imposed under its international bailout.

The latest figure rose from a revised 25.7 percent in December, the country's statistics service ELSTAT said on Thursday...Unemployment among youth aged between 15 and 24 stood at 59.3 percent in January, up from 51 percent in the same month in 2012.

Meanwhile, the Troika continues to demand further job cuts in return for a drip feed of bailouts that have arguably done little other than ensure Greece remains in recession:

An inspection team of international lenders has finished its review of Greece's reform progress, paving the way for another 10 billion euros aid payment, a source with knowledge of the talks said on Saturday....Under Greece's current bailout plan agreed in November, Athens must overall cut 150,000 public sector jobs from 2010 to 2015, about a fifth of the total, through hiring curbs, retirements and dismissals.

As a consequence, the stage is being set for another political crisis in Greece. Ekathimeri reports:

The head of the main leftist opposition SYRIZA, Alexis Tsipras, called on Saturday for the shaky coalition government to step down and pave the way for new elections, claiming that this was “the only way out” for a country seemingly condemned to endless austerity...

...“The situation has reached the absolute limit,” the leftist leader told supporters. “At this moment, there is no other way out for the country than the resignation of the government and the staging of new elections so a new administration can emerge with the mandate and support of the majority of society to implement an alternative plan to exit the crisis.” Tsipras admitted that his plan entailed risks but was preferable to “certain failure.”

Is the price of staying in the Euro finally now too high? Meanwhile, Ambrose Evans-Pritchard reminds us that both Cyprus have gone from bad to worse:

On cue, Angela Merkel's Christian Democrat base in the Bundestag has warned that there can be no increase in the EU-IMF rescue package for Cyprus.

The Cypriot people alone must carry the extra cost of up to €5.5bn beyond what was already agreed in the €17.5bn deal in March.

"Should that not be possible, the assent of the German Bundestag next week is out of the question," said Christian von Stetten, a key member of the finance committee.

And Evans-Pritchard repeats a point that cannot be repeated enough:

If the eurozone refuses to offer any further help, there must surely be a greater temptation to withdraw from the euro and default on sovereign debt in a classic restructuring deal with the IMF.

That is what the IMF is there to do. Such restructurings have been done countless times across the world over the last 50 years. It is traumatic, but countries usually recover after a couple of years.

Currency depreciation is a critical element of traditional IMF restructurings. The inability of troubled Eurozone economies to depreciate remains a key impediment to their return to growth; there is simply no cushion to offset the never-ending austerity. Speaking of never-ending austerity, Evans-Pritchard reviews the situation in Portugal:

So Cyprus is very far from being solved, and so is Portugal. A fresh Troika leak, this time to the Pink Sheet, has confirmed what anybody following Portugal already suspected. The country is stuck in a debt-compound trap. The economic slump is proving much deeper than forecast. The deficit has been rising not falling, in spite of austerity cuts.

And, increasing, it is not just periphery. From Reuters:

Manufacturing across Europe's major economies endured another month of mostly deep decline in March, dragging down even former bright spots, surveys showed on Tuesday....

Factories in Germany and Ireland, the relative stars of February's PMIs, fell back into decline last month. Everywhere else, the industrial rot extended.

Spanish manufacturing declined at its fastest pace since October, which followed news the government will revise its economic forecasts for 2013 to show a 1 percent contraction, from a 0.5 percent decline previously.

In France, factory activity retreated for a 13th month and car registrations there dived 16.4 percent in March, further underlining the malaise sweeping through the euro zone's second-biggest economy.

"The euro zone's March manufacturing PMIs ... (banishes) the recovery scenario projected by the European Central Bank further beyond the realm of likely probabilities," said Lena Komileva from G+ Economics in London.

The ongoing deterioration in Europe is evident to everyone except European policymakers. Clive Crook wonders at European Commission President Jose Barroso's outlook:

Barroso's optimism on Europe's economic recovery, if you can call it a recovery, was harder to understand. This week the IMF's Christine Lagarde talked of a three-speed world: "countries that are doing well, those that are on the mend, and those that still have some distance to travel.” (In other words, fast growth in many emerging economies, slow growth in the U.S., and no growth in Europe.) The euro area's economy is still shrinking. Yet Barroso still thinks (or says he thinks) that policy has been mostly well-judged and the union will emerge stronger from its ordeal.

He noted early on that Europe's public debts still aren't high by U.S or Japanese standards. True -- and that's the point. The EU is insisting on austerity in its weakest economies even though, in the aggregate, its fiscal problem is manageable. The failure to create effective burden-sharing arrangements -- some form of limited fiscal union to work alongside its monetary union -- has been the euro area's biggest error, not counting the creation of the euro itself. And the consequences are crushing countries such as Spain and Barroso's own Portugal.

Note that fiscal union is not the same as an austerity union. The former allows for internal transfer of the type Crook describes. The latter is simply a joint commitment to austerity. But austerity is the only policy possible within the European framework. Calculated Risk caught German Finance Minister Wolfgang Schauble wallowing in self-delusion:

"Nobody in Europe sees this contradiction between fiscal policy consolidation and growth,” Schauble said. “We have a growth-friendly process of consolidation, and we have sustainable growth, however you want to word it.”

With no depreciation for crisis-stricken economies, no fiscal stimulus, and tight credit conditions through half of Europe as banking consolidates within national boundaries, what exactly is the road forward for Europe? I just don't see it.

Bottom Line: How high does unemployment need to rise, how much output needs to be lost, how much poverty must be endured before European policymakers realize that the framework supporting the Euro politically is an economic failure?

Paul Krugman: Lust for Gold

What explains "goldbuggism"?:

Lust for Gold, by Paul Krugman, Commentary, NY Times: News flash: Recent declines in the price of gold, which is off about 17 percent from its peak, show that this price can go down as well as up. You may consider this an obvious point, but ... it has come as a rude shock to many small gold investors, who imagined that they were buying the safest of all assets.

And thereby hangs a tale. One of the central facts about modern America is that everything is political; on the right, in particular, people choose their views about everything, from environmental science to gun safety, to suit their political prejudices. And the remarkable recent rise of “goldbuggism,” in the teeth of all the evidence, shows that this politicization can influence investments as well as voting.

What do I mean by goldbuggism? Not the notion that buying gold sometimes makes sense..., gold is like a very long-term bond that’s protected from inflation...

No, being a goldbug means asserting that gold offers unique security in troubled times; it also means asserting that all would be well if we abolished the Federal Reserve and returned to the good old gold standard... And both forms of goldbuggism soared after ... the financial crisis of 2008... (although that surge has abated a bit since 2011). But why..., how can we rationalize the modern goldbug position? Basically, it depends on the claim that runaway inflation is just around the corner. ...

Conservative-minded people tend to support a gold standard — and to buy gold — because they’re very easily persuaded that “fiat money” ... created ... to stabilize the economy is really just part of the larger plot to take away their hard-earned wealth and give it to you-know-who.

But the runaway inflation that was supposed to follow reckless money-printing — inflation that the usual suspects have been declaring imminent for four years and more — keeps not happening. For a while, rising gold prices helped create some credibility for the goldbugs even as their predictions about everything else proved wrong, but now gold as an investment has turned sour, too. So will we be seeing prominent goldbugs change their views, or at least lose a lot of their followers?

I wouldn’t bet on it. In modern America, as I suggested at the beginning, everything is political; and goldbuggism, which fits so perfectly with common political prejudices, will probably continue to flourish no matter how wrong it proves.

Is the Real interest Rate Too High or Too low?

Brad DeLong, who is sitting next to me, responds to David Andolfatto/Stephen Williamson (see the post below this one):

I Believe Tyler Cowen Is Simply Wrong: Tyler Cowen:

Is this grandma’s liquidity trap?: I say no and David Andolfatto agrees: 'In grandma’s liquidity trap, the real interest rate is too high because of the zero lower bound. Steve [Williamson] argues that in our current liquidity trap, the real interest rate is too low, reflecting the huge world appetite for relatively safe assets like U.S. treasuries. If this latter view is correct, then “corrective” measures like expanding G or increasing the inflation target are not addressing the fundamental economic problem: low real interest rates as the byproduct of real economic/political/financial factors.' I remain surprised at how many policy discussions fail to draw this basic distinction."

The large demand for relatively safe assets like U.S. Treasury securities means that the interest rate consistent with full employment--the "natural" interest rate, in Wicksell's terms--is lower than normal, and the natural rate is in fact less than zero. Since the market interest rate is bounded below by the zero lower bound, the market rate is too high.

Once you distinguish--as Knut Wicksell does: this is cutting-edge economics as of 1890 after all--all of the following things are true:

• The current natural interest rate is much lower than it is normally--the natural rate is too low--and that is a problem.
• The current market interest rate is higher than the natural rate--the market rate is too high--and that is a problem.
• Increasing G--printing more Treasury bonds, selling them, and buying goods and services--(a) increases the supply of safe assets, (b) lowers the proper value of safe assets via supply and demand, thus (c ) raises the "natural" rate of interest, and (d) could fix our problems if the policy raises the natural rate of interest so much that it is no longer lower than the market rate of interest.

In general, when the market rate of interest is higher than the natural rate of interest--when ex ante saving at full employment is greater than ex ante investment--you can fix the problem and restore full employment by (i) reducing the market rate of interest via expansionary monetary policy, (ii) raising the natural rate of interest via expansionary fiscal policy, (iii) raising the natural rate of interest via summoning the Confidence Fairy, or (iv) raising the natural rate of interest via summoning the Inflation Expectations Imp. At the ZLB, (i) is out of the question, so you must have resort to one or more of (ii), (iii), and (iv)...

This is not rocket science. This is basic Geldzins und Guterpreis...

'Monetary Policy in a Liquidity Trap'

David Andolfatto argues this is not "grandma's liquidity trap":

Krugman has an interesting article today, Monetary Policy in a Liquidity Trap. I (sort of) agree with much of it. But I believe that a few comments are in order...

In grandma's liquidity trap, the real interest rate is too high because of the zero lower bound. Steve [Willaimson] argues that in our current liquidity trap, the real interest rate is too low, reflecting the huge world appetite for relatively safe assets like U.S. treasuries. 

If this latter view is correct, then "corrective" measures like expanding G or increasing the inflation target are not addressing the fundamental economic problem: low real interest rates as the byproduct of real economic/political/financial factors. 

Given these "real" problems, Steve's view is that the Fed is largely irrelevant. But he does assign hope to the Treasury: increase the supply of its securities to meet the world demand for them. I've been making similar arguments for some time now; for example, here. ...

Did the Fed Cause the housing Bubble?

According to research by Ambrogio Cesa-Bianchi and Alessandro Rebucci, the housing bubble was caused by "regulatory rather than monetary-policy failures":

Is the Federal Reserve breeding the next financial crisis?, by Ambrogio Cesa-Bianchi and Alessandro Rebucci: Many economists think that the US Federal Reserve’s loose monetary stance in the 2000s fuelled the US housing bubble. Is the Fed thus responsible for the Global Crisis? This column discusses evidence suggesting that monetary policy was, in fact, not to blame. Rather, it was the absence of an effective regulatory function that created the mess we’re in now. It is not fair to blame the Great Recession only on the Fed’s monetary-policy stance nor is the Fed now breeding the next US financial crisis. ...

In the context of our model and according to this evidence, regulatory rather than monetary-policy failures are largely to blame for the occurrence and the severity of the Great Recession. Only by assuming that the Fed was the sole institutional guardian of financial stability, or at least the main one, is it possible to contend that monetary policy is to blame for the 2007-09 financial crisis and the ensuing Great Recession. ...

Fed Watch: FOMC Minutes Signal End to QE

One more from Tim Duy:

FOMC Minutes Signal End to QE, by Tim Duy: I usually enjoy the day FOMC minutes are released. It is one of the few releases those of us on the West Coast can read at the same time as everyone else without having to get up in what seems like the middle of the night. So I experienced a mix of surprise and disappointment when I arrived at the office and learned that everyone else had already read the release.

As is now well known, the minutes were inadvertently released early. Robin Harding tells the story:

According to two sources in Congress, the accidental release came from Brian Gross, a special assistant to the Board of Governors who works on government relations...

...“A Fed staffer inadvertently sent an email with the minutes to a group of contacts,” said the Fed. “That group of people was mostly Congressional staffers and trade association members in Washington.”

The distribution list, thought to contain about 100 people, is one that the Fed regularly uses to send out releases.

Sounds like an honest mistake - yes, not all mistakes are of the Zero Hedge "it must be a conspiracy" variety. It happens. In any event, the minutes gave a clear indication that FOMC members were leaning toward pulling the plug on asset purchases by the end of this year (emphasis added):

..Members stressed that any changes to the purchase program should be conditional on continuing assessments both of labor market and inflation developments and of the efficacy and costs of asset purchases. In light of the current review of benefits and costs, one member judged that the pace of purchases should ideally be slowed immediately. A few members felt that the risks and costs of purchases, along with the improved outlook since last fall, would likely make a reduction in the pace of purchases appropriate around midyear, with purchases ending later this year. Several others thought that if the outlook for labor market conditions improved as anticipated, it would probably be appropriate to slow purchases later in the year and to stop them by year-end. Two members indicated that purchases might well continue at the current pace at least through the end of the year. It was also noted that were the outlook to deteriorate, the pace of purchases could be increased....

It seems the center of gravity at the FOMC has shifted toward contentment with the current pace of progress in the labor markets. This seems somewhat odd to me; it is as if they were more interested in putting a floor under the recovery rather than trying to accelerate the pace of activity. The desire to pull the plug on the program as soon as possible also seems odd considering that the majority of policy makers find it to be effective:

In their discussion of this topic, meeting participants generally judged the macroeconomic benefits of the current purchase program to outweigh the likely costs and risks, but they agreed that an ongoing assessment of the benefits and costs was necessary. Pointing to academic and Federal Reserve staff research, most participants saw asset purchases as having a meaningful effect in easing financial conditions and so supporting economic growth. Some expressed the view that these effects had likely been stronger during the Federal Reserve's initial large-scale asset purchases because that program also helped support market functioning during the financial crisis. Other participants, however, saw little evidence that the efficacy of asset purchases had declined over time, and a couple of these suggested that the effectiveness of purchases might even have increased more recently, as the easing of credit constraints allowed more borrowers to take advantage of lower interest rates. One participant emphasized the role of recent asset purchases in keeping inflation from declining further below the Committee's longer-run goal. A few participants felt that MBS purchases provided more support to the economy than purchases of longer-term Treasury securities because they stimulated the housing sector directly; however, a few preferred to focus any purchases in the Treasury market to avoid allocating credit to a specific sector of the economy.

Surely this suggests that some positive fraction of the current activity is attributable to quantitative easing and thus we can expect that some of that activity to fade when the program is brought to an end. Thus even if the economy accelerates further over the course of this year, ending QE will take some wind out of its sails. And taking the wind out of the sails means risking not achieving escape velocity with respect to the zero bound. They might not believe they are actually removing accommodation when QE ends, but they will not be adding to that accommodation. And the first derivative must be important, otherwise there is no point in discussing changing the pace of asset purchases.

I am heartened a bit to see this:

It was noted that, in addition to the standard channels through which monetary policy affects the economy, asset purchases could help signal the Committee's commitment to accommodative monetary policy, thereby making the forward guidance about the federal funds rate more effective.

I have long believed that the Fed failed to appreciate the signalling component of quantitative easing. Indeed, I could be convinced it was the most effective channel of transmission. I am glad to see that policymakers are starting to see that as well.

Bottom Line: The Fed seems content with the current pace of activity. Content enough to believe they can pull the plug on quantitative easing this year. I remain concerned that ending QE will slow forward momentum, thus the Fed is running the risk that they the economy will not achieve sufficient velocity to escape the zero bound. The actual timing is still data dependent, but I am wondering if we should change our framework from "how good does the data need to be end QE" to "how bad does the data need to be to continue QE?"

Fed Watch: Handicapping Labor Data

Tim Duy:

Handicapping Labor Data, by Tim Duy: We know the Fed intends to taper off quantitative easing. We know the timing is dependent on progress in achieving a stronger and sustainable recovery in the labor market. Courtesy of San Francisco President John Williams, we have also know the time they expect to be confident of that recovery - this summer, which could be as early as the June FOMC meeting. Thus June is the earliest we could expect the Fed will begin scaling back the pace of asset purchases, with the expectation that quantitative easing will draw to a close by the end of this year.

June is earlier than I had anticipated. I had expected the Fed would want to be confident that the economy would not experience one of its Spring/Summer swoons. One would think fiscal tightening this year would magnify that concern. Via Bloomberg:

“We could very well in the summertime start seeing the effects of the fiscal tax increase and spending cut slow us down again,” said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington and a former Fed economist.

Moreover, given that inflation remains under the 2 percent target and it is likely that significant slack in the labor market will remain deep into 2014, there does not appear to be any need to rush into scaling back quantitative easing. Considering data lags, it would seem prudent for the Fed to wait until the fall or even winter before easing back on purchases.

To be sure, policymakers would probably argue that they could revert to a more aggressive pace of purchases should the data turn south. But even so, that is not likely the desired path. I don't think they would want to increase the pace of purchases just two months after a decrease. I would expect they would want to be sure that they did not have to reverse course.

But that does not seem to be the case. Instead, it is evident that FOMC members anticipate ending asset purchases this year. This I find somewhat puzzling, as they seem to have reached a consensus that they need to be scaling back the asset purchase program on the basis of their own forecast, but that forecast itself anticipates that unemployment - what Vice Chair Janet Yellen described as the “the best single indicator of current labour market conditions”- will remains unacceptably high in the 6.8 to 7.3% range at the end of 2014. Indeed, arguably the Fed has fallen back into the trap of placing an implicit calendar date for the end of quantitative easing, rather than leaving the timing data dependent. It seems they want to end the program by the end of 2013, and are desperately hoping the data cooperates.

Assuming their intention is to end the program this year, to what extent will they color the data in such a way as to ensure it cooperates? For instance, it seems evident that the March employment report should call into question plans to slow the pace of quantitative this summer. Again, from Bloomberg:

“There’s a very strong message to the Fed here, which is that it’s too early to even think about exiting from easy policy,” said Ethan Harris, co-head of global economics research at Bank of America Corp. in New York. “This report suggests that they’re missing on both of their mandates: Inflation is too low and the labor market is too weak.”

This should be correct. The sub-100k nonfarm gain should raise red flags about the strength and sustainability of the labor market improvement. If the Fed holds true to the assertion that policy is data dependent, this should be correct as well:

“It helps that we’ve removed one source of uncertainty which is, how will the Fed react?” said Julia Coronado, chief economist for North America at BNP Paribas in New York. “Instead of asking how bad things need to get for the Fed to do more, it’s how good do they need to be before they stop helping.”

But at the same time, I am watching for signals that policymakers downplay this report or any other similarly weak reports. And lo and behold, today John Williams has an interview with the Wall Street Journal:

The economy could be on a strong enough footing by the second half of the year for the Federal Reserve to begin winding down its bond-buying programs, John Williams, president of the Federal Reserve Bank of San Francisco, said in an interview with The Wall Street Journal.

Mr. Williams said this has long been his view and a disappointing jobs report Friday wouldn’t alter his thinking too much. The Labor Department said Friday that employers added just 88,000 jobs in March, after expanding by more than 200,000 in three of the previous four months.

“We just have to get away from overreacting to one piece of data,” he said.

To be sure, the usual caveat is included:

Of course, his forecast is conditional on how the economy actually performs. “We just have to keep watching all of the economic indicators,” he said.

But how closely is the Fed watching the indicators? Or have they already effectively made a decision on the timing of QE's demise? Be wary that the minutes will have a hawkish tone.

Of course, continue to watch for data that support the case for easing as early as June. With that in mind, February JOLTS report was released this morning. An update of the Yellen charts:

Although the JOLTS data is of second-order importance, notice that the quits rate was revised up for January, a signal that existing employees are more confident of labor market prospects. Put it in the "stronger and sustainable" category.

Bottom Line: I had expected that the data flow would argue for the Fed to postpone tapering off QE purchases until late this year. The Fed seems to have a different view, thinking that the data flow argues for ending QE by the end of this year. My expectation is that the Fed is being overly optimistic and will find that summer is too early to being tapering off QE. That seems to be the message from the bond market as well; yields aren't exactly soaring. But the ease by which SF Fed President John Williams is willing to dismiss the most recent jobs report suggests data may be less important than we have been led to believe.

Solow: Has Financialization Gone Too Far?

Robert Solow has an essay that begins with lots of praise for Ben Bernanke:

How to Save American Finance from Itself: Has financialization gone too far?, by Robert Solow, TNR: Central banking is not rocket science, but neither is it a trivial pursuit. ... Running a central bank is in one way a little bit like flying a plane or sailing a boat: much of the time standard responses and small adjustments will do just fine, but every so often a situation arises in which fundamental understanding, knowledge of history, and good judgment can make the difference between riding out the storm and crashing. There was no such person in charge in 1929, and the result was disaster. There was one in 2008.

In his earlier scholarly life, Ben Bernanke, the chairman of the Federal Reserve Board, had been a careful student of the general interaction between the financial system and the real economy and especially of its working out in the Great Depression of the 1930s. So he had done his homework. His decisive and innovative actions at the Fed saved our economy from free fall with a possibly catastrophic end. ...

He goes on to review a book of four lectures Ben Bernanke gave on the role of the Fed:

In March 2012, George Washington University invited Bernanke to give four lectures as part of a course devoted to the role of the Federal Reserve in the economy. The lectures are now reproduced in book form, apparently from lightly edited transcripts. Each lecture ends with half a dozen questions from anonymous “students” and Bernanke’s answers. Some of the questions are smart, some less so, in which case Bernanke exhibits the professorial skill of seamlessly answering a slightly different question. ...

The lectures are consistently lucid and informal—maybe a little too anecdotal, but illustrated with many clear and informative slides—and above all intelligent and interesting. There are no revelations or recantations; even if Bernanke had any in mind, this would not be the place for them. A short book such as this has no room for a play-by-play account of the crisis. But it would be difficult to find a better short and not very technical account of what went wrong, and of how the Fed (and the Treasury) managed to keep it from getting much worse. ...

He then goes through a long, detailed discussion of the issues Bernanke addresses in these lectures, but I want to pick it up again near the end:

Bernanke's ... preferred answer is better and more system-oriented regulation. One has to ask then why regulation failed to see the crisis of 2007–2008 coming and take action to head it off. Bernanke suggests that regulators were lulled into inattention by the so-called Great Moderation...

For safeguarding financial stability in the future, Bernanke seems to count heavily on the provision in Dodd-Frank that establishes a committee of regulators charged with keeping an eye on “systemically important” financial institutions, whatever they look like, in order to warn them away from dangerously risky behavior and/or impose extra capital requirements. We will have to see how that works out...

He touches on it only obliquely in these lectures, but Bernanke has lingering worries that the size, the complexity, and the interconnectedness of today’s financial system strain the capacity of even improved risk-management techniques to protect the system against its inherent vulnerabilities. ...

All of which leads to a broader issue... Any complicated economy needs a complicated financial system: to allocate dispersed capital to dispersed productive uses, to provide liquidity, to do maturity and risk transformation, and to produce market evaluations of uncertain prospects. If these functions are not performed adequately, the economy cannot produce and grow with anything like efficiency. Granted all that, however, the suspicion persists that financialization has gone too far.

What would that mean? It would mean that the last x percent of financial activity absorbs more resources (especially intellectual resources) and creates more potential instability than its additional efficiency-benefits can justify. This charmingly subversive suggestion is easy to make, but it is extremely difficult to validate. Yes, it is hard to imagine that the Hedge Fund Operator of the Year does anything that is remotely socially useful enough to justify the enormous (and lightly taxed) compensation that results; but that is not really an argument. Much more significant is the fact that the bulk of incremental financial activity is trading, and trading, while it may provide a little useful public information about market opinion, is largely a way to transfer wealth from those with inferior information and calculation ability to those with more. There is no enhancement of economic efficiency to speak of. This is, you might say, the $64 trillion question. Maybe I shouldn’t wish it on Ben Bernanke. 

Given his worries about financial stability, I have to wonder if the praise for Bernanke shouldn't be a bit more qualified. I agree that the Fed did a pretty good job responding the the recession. It could have done better -- it was frequently too late and too timid, especially during the first few years -- but it also could have done a whole lot worse. But what we don't yet know is how well we have been insulated from future shocks. Is Bernanke's view correct about what is needed on the regulatory front, and has it been implemented? In my view, significant vulnerabilities remain within the shadow banking system (and I'm far from alone). If that's true and we do have another crisis down the road, then the effusive praise for Bernanke will diminish much as happened with Greenspan (anointed as the best Fed Chair ever only to have housing bubble crash dramatically change the view of his record). As Robert Solow says about Bernanke's views on safeguarding financial stability in the future, "We will have to see how that works out.

'Let the Punishment Fit the Crime of the Recession'

We are, as they say, live:

Let the Punishment Fit the Crime of the Recession, by Mark Thoma: As Paul Krugman observed recently,  “the urge to see depression as a necessary and somehow even desirable punishment for past sins, while inveighing against any attempt to mitigate suffering — is as strong as ever.”  Many of those who see our economic problems in these terms believe the sin we committed is too much debt fueled consumption and government spending. According to this view punishments such as austerity and high levels of unemployment provide a moral lesson that helps to prevent us from making the same mistakes again.

This is bad economics and it has the moral lesson all wrong. ...

Macroeconomic Policy and Economic Stability - Adair Turner Keynote at INET

Adair Turner calls for "overt monetary finance":

Fed Watch: Labor Market Hits Air Pocket

Tim Duy:

Labor Market Hits Air Pocket, by Tim Duy: My first thought on the employment report is that, at its core, it was more of the same. For the last two years, nonfarm payrolls growth has shifted between promising and disappointing on the drop of a hat. Underneath the drama, the labor market continues to grind forward at a suboptimal pace - a pace that allows for a slow decline in the unemployment rate, but also suggests more policy action is necessary.

My second thought is that San Fransisco Federal Reserve President John WIlliams was likely far too optimistic in his assessment that the Fed could begin tapering off QE as early as this summer. That is only three months away, and I have trouble seeing how policymakers could be sufficiently confident in the pace and sustainability of the recovery to justify taking their foot off the gas after just three more months of data.

Headline nonfarm payrolls gained by just 88k, with a 95k in the private sector offset by a 7k loss on the public side of the ledger. To be sure, some of the sting was eased by upward revisions to the previous two months, but I think that is cold comfort at this point. Instead, anyway you slice it this report does not signal that momentum is building in the labor market. Notice that the twelve-month average is slowing declining, and stands at 159k/month, down from 202k/month last March:

Arguably, momentum has faded over the past year. Put in context of the Yellen batch of indicators, there is little reason to believe that the Fed should shift policy gears anytime soon [click on charts to enlarge]:

Other indicators were generally consistent with the tenor of the headline establishment number:

Wages, the labor force participation rate, and the employment to population ratio all slipped. On a positive note, aggregate weekly (private sector) hours gained, consistent with what I believe is a more steady underlying improvement in the labor market than suggested by the month-to-month volatility of the headline numbers. There was little evidence of an acceleration in the pace of improvement in measures of underemployment:

Underemployment measures suggest substantial slack in labor markets - plenty of slack to justify ongoing QE at the current pace for most of the year at least, even if the next six reports showed nonfarm payroll growth of 200k+. It makes me wonder what Williams was thinking pushing for the end of QE to begin this summer. Are FOMC members more eager to pull the plug on QE than public statements would suggest? Have they been spending too much time with their European counterparts? Something to mull over.

In any event, bond markets continue to suggest that any Fed officials who want to pull the plug on QE this summer are getting ahead of themselves. The 10-year Treasury yield fell to 1.69% this morning - not exactly a ringing endorsement of the pace of recovery.

Bottom Line: Another in a long line of employment reports that suggests the much hoped-for acceleration in job growth remains out of reach. Nothing to suggest the Federal Reserve needs to slow the pace of asset purchases in the near future. Williams' expectation that tapering off of purchases as early as this summer remains puzzling.

Fed Watch: Initial Jobless Claims Spiked Last Week

Tim Duy:

Initial jobless claims spiked last week, by Tim Duy: Initial jobless claims spiked last week:

As Calculated Risk notes, this could reflect the impact of the sequester. We might also be repeating the pattern of the last two years in which claims decline and then disappoint by plateauing for six months. If that is the case, then we should expect to see less improvement in nonfarm payrolls in the months ahead. If so, San Francisco Federal Reserve President would probably need to push back his expectation that large scale asset purchases are tapered off beginning this summer. Note too that 10-year Treasury rates slipped another three basis points this morning to 1.78 percent. Bond markets do not seem to be signaling that the economy is accelerating at a pace sufficient to justify the Fed taking their foot off the gas this summer.

Fed Watch: Hawkish Dove

Tim Duy:

Hawkish Dove, by Tim Duy: The generally dovish San Francisco Federal Reserve President John Williams sounded relatively hawkish in today's speech. The money quote:

I expect that continued asset purchases will be appropriate well into the second half of this year. In making this assessment, I don’t have a specific unemployment or job-gain threshold in mind for cutting back or ending these purchases. Instead, I’m looking for convincing evidence of sustained, ongoing improvement in the labor market and economy. The latest economic news has been encouraging. But it will take more solid evidence to convince me that it’s time to trim our asset purchases. An important rule in both forecasting and policymaking is not to overreact to what may turn out to be just a blip in the data. But, assuming my economic forecast holds true, I expect we will meet the test for substantial improvement in the outlook for the labor market by this summer. If that happens, we could start tapering our purchases then. If all goes as hoped, we could end the purchase program sometime late this year.

Based on William's current forecast, he expects the Fed will begin tapering off asset purchases this summer, perhaps the June FOMC meeting. He is apparently more optimistic than me, as this puts him at least three months ahead of my expectations - I had not anticipated slowing the pace of purchases until late in the year. Of course, the reality will be data dependent, with the next three employment reports being particularly important. As a recap, three of the last four reports have shown nonfarm payroll growth at or above 200k:

Will Friday's March release make it four for five? Mixed signals from labor market indicators to date make it a tough call. While the downward trend in initial unemployment claims is generally supportive of a solid report, the numbers popped in the second and third weeks of March:

Could the recent increase be the first signs of fiscal contraction working through the economy, or just noise? We get another release tomorrow. The employment number in the ISM manufacturing report was stronger, while the corresponding number from the nonmanufacturing counterpart was weaker. And the ADP release came in below expectations at a 158k gain in private sector jobs, suggesting a weaker report. Altogether, I would tend to expect a number on the low side of the current expectation of 192k gain, but don't see a lot to swing me dramatically away from that number - a number that is more consistent with William's story than not.

That said, I am cautious about extrapolating too much of the recent momentum forward. To be sure, the first quarter is shaping up to be better than the Fed anticipated, with Macroeconomic Advisors tracking forecast showing 3.6% growth. This could be giving Fed officials hope that this year's fiscal contraction is a nonevent. I am not yet convinced that we have dodged that bullet; rumor has it that sales-tax states had a weak March, possibly a delayed reaction to the end of the payroll tax credit. But more important is that the bond market is certainly not acting as if the economy is performing well enough to justify a shift in Fed policy. Notice that today the 10-year yield slumped to 1.81%, a low for the year. It seems as if bond market participants have become less confident of the recovery during the first quarter, even as Williams has become more confident.

Bottom Line: Williams placed a marker for the date that the Fed begins its exit from quantitative easing - summer, assuming that his current forecast holds. I am not so sure the bond market agrees with that assessment.

'Olivier Blanchard’s Five Lessons for Economists From the Financial Crisis'

Long, long travel day today (and not sure if I'll have an internet connection), so -- for now -- a few quick ones (between here and today's links). First, Brad Delong sends us to David Wessel, who sends us to Olivier Blanchard (I've shortened the five points):

Olivier Blanchard’s Five Lessons for Economists From the Financial Crisis: ...Here are Mr. Blanchard's five lessons in his own words, lightly edited by The Wall Street Journal’s David Wessel:

1. Humility is in order: The Great Moderation ... convinced too many of us that the large-economy crisis -­ a financial crisis, a banking crisis ­- was a thing of the past. It wasn’t going to happen again... My generation ... knew how to do things better, not only in economics but in other fields as well. What we have learned is that's not true. History repeats itself. We should have known.

2. The financial system matters — a lot: It’s not the first time that we¹re confronted with ... “unknown unknowns”... There is another example in macro-economics: The oil shocks of the 1970s... It took a few years, more than a few years, for economists to understand what was going on. After a few years, we concluded that we could think of the oil shock as yet another macroeconomic shock. We did not need to understand the plumbing. We didn’t need to understand the details of the oil market. ...

This is different. What we have learned about the financial system is that the problem is in the plumbing and that we have to understand the plumbing..., it's very clear that the details of the plumbing matter.

3. Interconnectedness matters: This crisis started in the U.S. and across the ocean in a matter of days and weeks. Each crisis, even in small islands, potentially has effects on the rest of the world. The complexity of the cross border claims by creditors and by debtors clearly is something that many of us had not fully realized..., which countries are safe havens, and when and why? Understanding this has become absolutely essential. What happens in one part of the world cannot be ignored by the rest of the world. ...

It’s also true on the trade side. ... One absolutely striking fact of the crisis is the collapse of trade in 2009. Output went down. Trade collapsed. Countries which felt they were not terribly exposed through trade turned out to be enormously exposed.

4. We don’t know if macro-prudential tools work: It’s very clear that the traditional monetary and fiscal tools are just not good enough to deal with the very specific problems in the financial system. This has led to the development of macro-prudential tools... [Macroprudential tools allow a central bank to restrain lending in specific sectors without raising interest rates for the whole economy, such as increasing the minimum down payment required to get a mortgage, which reduces the loan-to-value ratio.] ... If there is a problem somewhere you can target the tool at the problem and not use the policy interest rate, which basically is kind of an atomic bomb without any precision.

The big question here is: How reliable are these tools? How much can they be used? The answer ... is this: They work but they don’t work great. People and institutions find ways around them. In the process of reducing the problem somewhere you tend to create distortions elsewhere.

5. Central bank independence wasn’t designed for what central banks are now asked to do: ... One of the major achievements of the last 20 years is that most central banks have become independent of elected governments. Independence was given because the mandate and the tools were very clear. The mandate was primarily inflation... The tool was some short-term interest rate that could be used by the central bank to try to achieve the inflation target. In this case, you can give some independence to the institution in charge of this because the objective is perfectly well defined, and everybody can basically observe how well the central bank does.

If you think now of central banks as having a much larger set of responsibilities and a much larger set of tools, then the issue of central bank independence becomes much more difficult. Do you actually want to give the central bank the independence to choose loan-to-value ratios without any supervision from the political process. Isn’t this going to lead to a democratic deficit in a way in which the central bank becomes too powerful? I'm sure there are ways out. Perhaps there could be independence with respect to some dimensions of monetary policy -­ the traditional ones — and some supervision for the rest or some interaction with a political process.