Economist's View

Macroeconomic Models and Monetary Policy

Paul De Grauwe is critical of the macroeconomic models used by central banks:

Cherished myths fall victim to economic reality, by Paul De Grauwe, Commentary, Financial Times: ...But that is not the world of the macro­­economic models that are now in use in central banks. The world of these models is one of supernatural and God-like creatures for which the world has few secrets. These creatures can perfectly compute the risks they take and estimate with great precision how an oil price shock will affect their present and future production and consumption plans. They may not be able to predict each shock, but they know the probability distribution of these shocks. Thus the risk involved in financial instruments is correctly evaluated by individuals populating these models.

These superbly informed individuals want the central bank to keep prices stable so that as consumers they can optimally set their consumption plans with minimal uncertainty, and as producers they can set prices equal to marginal costs (plus a mark-up). If the central banks keep prices stable, these individuals, helped by well-functioning markets, will take care of all the rest and ensure that the outcome is the best possible one. This is a world in which free and unfettered markets are always efficient.

This is also a world where individual agents cannot make systematic mistakes. Their consumption and production plans are optimal. They will never build up unsustainable debts. In the world of these macroeconomic models financial crises should not occur. And if they do, it cannot be because of malfunctioning markets. Governments that impose silly constraints on rational individuals are messing things up, and central banks that do not keep their promises to maintain price stability are the source of macroeconomic instability. ...

There is a danger that the macro­economic models now in use in central banks operate like a Maginot line. They have been constructed in the past as part of the war against inflation. The central banks are prepared to fight the last war. But are they prepared to fight the new one against financial upheavals and recession? The macroeconomic models they have today certainly do not provide them with the right tools to be successful.

There is quite a bit of research on monetary policy that is devoted to the issues he is worried about, particularly the literature on adaptive learning. See here, and some of his publications here for and example from a European central bank. These ideas are also well-known and of considerable interest to the US Fed, e.g. one example is here, but there are many more. Some of the recent work of Chris Sims is also of interest in this regard:

...Most recently, theories that postulate deviations from the assumption of rational, computationally unconstrained agents have drawn attention. One branch of such thinking is in the behavioral economics literature (Laibson, 1997; Benabou and Tirole, 2001; Gul and Pesendorfer, 2001, e.g.), another in the learning literature (Sargent, 1993; Evans and Honkapohja, 2001, e.g.), another in the robust control literature (Giannoni, 1999; Hansen and Sargent, 2001; Onatski and Stock, 1999, e.g.).

This paper suggests yet another direction for deviation from the seamless model, based on the idea that individual people have limited capacity for processing information. That people have limited information-processing capacity should not be controversial. It accords with ordinary experience, as do the basic ideas of the behavioral, learning, and robust control literatures. The limited information-processing capacity idea is particularly appealing, though, for two reasons. It accounts for a wide range of observations with a relatively simple single mechanism. And, by exploiting ideas from the engineering theory of coding, it arrives at predictions that do not depend on the details of how information is processed.

Returning to the article above criticizing macroeconomic models, the author goes on to explain why he thinks the reliance of central banks on macroeconomic models is a problem:

This intellectual framework helps to explain the single-minded focus of many central bankers on inflation. Clearly, inflation is important and maintaining price stability is an important task of the central bank. It is not the only task, though. Financial stability is equally important. But this dimension is completely absent from the macroeconomic models now in use.

Perhaps more attention to financial market instability is warranted, there's a lot of work on that currently underway, but as this overview of the learning literature makes clear, if you drop the rational expectations assumption and assume agents must learn about their economic environment (one means of generating financial market instability), it may still be that the an aggressive response to inflation is optimal:

Expectations, Learning and Monetary Policy: An Overview of Recent Research, by George W. Evans and Seppo Honkapohja, July 16, 2008: ...contemporaneous Taylor-type interest-rate rules should respond to the inflation rate more than one for one in order to ensure determinacy and stability under learning...

So central banks' focus on inflation comes solely from examination of standard macroeconomic models.

The point is that, unlike the implication in the article, central banks are quite anxious to explore the implications of agents that are less than fully informed or fully rational, how that impacts behaviors such as risk assessment, and to examine the implications of financial market instability. They are particularly interested in how these factors impact the conduct of stabilization policy. The models aren't perfect, and standard models do miss a lot of these elements, but standard models are not all we have and central bankers are quite aware of, and actively engaged in exploring the policy implications of alternative theoretical structures that can tell us more about these issues.

Are Inflation Expectations Becoming Unglued?

This Economic Letter argues the Fed has not lost credibility as an inflation fighter. The idea is to estimate a model of expectations through 2003 or 2005, i.e. to just use data where credibility is still present, forecast inflation expectations through the end of the sample, and compare the forecast of inflation expectation to the actual value of inflation expectations (from surveys). If expectations are losing their anchor, then the predicted expected inflation rate should lie below the the actual expected inflation rate since the predicted rate will be based only upon data that came before the potential loss of credibility. I'm not sure how much weight to give this evidence since I have questions about the adequacy of the adaptive expectations model used to forecast future inflation expectations, which the authors argue is forced upon them by limited data availability:

Unanchored Expectations? Interpreting the Evidence from Inflation Surveys, by Wayne Huang and Bharat Trehan, FRBSF Economic Letter: Recent surveys have shown that households are expecting higher inflation in the future. These readings, coming at the same time as surging commodity prices, have raised concerns that inflation expectations are no longer well-anchored and that the Fed has lost credibility. Unstable expectations could stoke higher inflation and possibly lead to a return to the stagflation of the 1970s.

In this Economic Letter, we argue that focusing only on whether the level of expected inflation has gone up may not be the best strategy for determining whether there has been a loss in credibility. Instead, it may be more useful to try to determine whether there has been a change in the way households and firms perceive the inflation process (and consequently form expectations about inflation). We use two surveys of inflation expectations, one based on household respondents, and the other on professional forecasters, to examine this issue. In neither case do we find evidence suggesting that expectations have recently become unanchored, even though consumer expectations of inflation have clearly gone up.

Moral Hazard Misconception

In this debate:

Moral hazard misconception, Economist's Forum

I (mostly) side with Ricardo Caballero, as summarized here.

Infrastructure Spending and Stabilization Policy

Megan McArdle:

Infrastructure is so . . . stimulating, Megan McArdle: Mark Thoma wants us to look at spending for stimulus, instead of tax cuts:

I agree that Fed policy alone may not be enough to get the economy back on track, I've argued that for a long time. But tax cuts are not the only option for stimulating the economy, government spending can also be used, and in theory on short-run stabilization policy, a one dollar increase in government spending has a bigger impact on GDP than a one dollar tax cut. Infrastructure is an obvious target for spending, it's surely needed, but there are other areas that could use help as well.

The idea that we should use emergency infrastructure spending as a stimulus is gaining strength among liberals. ... I can certainly vouch for the fact that many areas of American infrastructure are in dire need of improvement.

However, ... I regret to report that the idea of using infrastructure spending as a stimulus is a complete fantasy. This is not your grandfather's stimulus spending. FDR could spend whacking great sums on dams and roads and rural electrification, and hope to have an immediate effect, because FDR was working on a multi-year depression, and in the pre-1960s regulatory environment.

Between the environmental impact statements, public review periods, and byzantine bidding process, the development cycle for anything more complicated than painting a bus station is now measured in decades, not years. ...

The reason we rely mostly on monetary policy and tax cuts for stimulus is that it is possible to rapidly implement whatever stimulus you decide on.  With the exception of a few transfer programs such as food stamps and unemployment insurance, which are hard to funnel very large sums of money through, there is nothing on the spending side that matches tax cuts for speed.  You could allocate the money, to be sure, but by the time it actually hit an agency and went through the bureaucratic procedures necessary to actually spend it, the window for effective stimulus would have passed.

We could improve matters by ripping out all of the procedural hurdles and community review procedures we've forced on the government, and in my opinion, that wouldn't be a bad thing.  But in my opinion, this is[n't] ... likely to be achieved...

The other thing we might consider is just not having the stimulus. It seems to me that both monetary and fiscal stimulus at this point are trying to attack supply shocks by goosing demand. America is going to have to get used to consuming less oil and less cheap foreign credit some time, and maybe the best way to do that is to let the shocks work their way through the system.

While I was thinking over a response, Free Exchange covered most of the points I wanted to make:

An Infrastructure Stimulus, Free Exchange: Mark Thoma writes ... [and] Megan McArdle responds...

One initial point is that if this slump is anything like the last one (and it probably is), then America can probably look forward to at least another year of the doldrums before regular growth conditions return. That takes a little of the need for immediacy out of the stimulus calculations.

I'd just add that if you go by the last two recessions, the recovery of employment has lagged behind the recovery in output, and may not have fully recovered at all, so from that perspective, the slowdown could be even more extended. This gives more weight to policies that have impacts over a longer time period. Back to Free Exchange:

But Ms McArdle is still right that the appropriate time-frame for an infrastructure project, from idea to ribbon cutting, is at least a decade (in America; China, I believe, is a different story). What's important to note is that there are many infrastructure projects available that are quite close to the construction stage, that have been on the books for some time and only lack final say on funding to begin. In some cases, these projects might have already been underway, had the economic slowdown and credit issues not constrained local and state budgets. It's quite possible, then, that a quick injection of federal funding for ready-to-go projects might provide the economy with a nice shot in the arm. Given the attraction of infrastructure projects as investments generally, this also reduces the economic downside to getting the timing wrong. These are, after all, things that America should be doing anyway.

The Fed Could Use Some Help

Glenn Hubbard says the Fed can't do it alone:

We're Asking Too Much of the Fed, by R. Glenn Hubbard, Commentary, WSJ: The combination of eye-popping headline inflation of 5% year over year and dramatic expansions of the Federal Reserve's lending activities to limit the credit crunch raise a key question: Are we asking too much of monetary policy?

The simple answer is yes. The expansion of the Fed's lending has been extraordinary in scale and scope. But it is not the best response to the present credit crunch, and may bring unwelcome side effects. ... moral hazard. ... ... inflationary pressures. ...surging commodity prices ... weakness in the foreign-exchange value of the dollar. ...

It is asking a lot for monetary policy alone to carry the burden of supporting aggregate demand. Fiscal policy can play a role. Congress and President Bush did pass an economic stimulus package centered on tax rebates. But clarity about a positive future for the 2001 and 2003 tax cuts which bolster collateral values -- along with a cut in corporate tax rates to promote investment -- would offer a much more potent tonic. ...

I agree that Fed policy alone may not be enough to get the economy back on track, I've argued that for a long time. But tax cuts are not the only option for stimulating the economy, government spending can also be used, and in theory on short-run stabilization policy, a one dollar increase in government spending has a bigger impact on GDP than a one dollar tax cut. Infrastructure is an obvious target for spending, it's surely needed, but there are other areas that could use help as well.

If the worry is that the spending will be permanent, Democrats can play the Republican game, but actually mean what they say. A stimulus should be temporary, so - just like the Republicans do with tax cuts - put clauses in the legislation that say the spending expires at a certain date. There will be x dollars per year for y years to do z, and that will be it. That way, there's no long-run impact on the budget (unlike the real intent of the tax-cut advocates who, once the economy gets better, will argue against reversing the stimulus measures). If the goal is to stimulate the economy, there's just no need to limit the policies under consideration to some type of tax cut.

Tim Duy: Not So Bad?

Tim Duy gives and answer to Brad DeLong's question:

Not So Bad?, by Tim Duy: Brad DeLong is puzzled. Earlier this week, defending Greenspan-era monetary policy,

Now we are not yet out of the woods. If the tide of financial distress sweeps the Fed and the Treasury away--if we find ourselves in a financial-meltdown world where unemployment or inflation kisses 10%--then I will unhappily concede, and say that Greenspanism was a mistake. But so far the real economy in which people make stuff and other people buy it has been remarkably well insulated from panic at 57th and Park and on Canary Wharf.

Today Delong adds:

I still do not understand why the real side of the economy is doing so well in relative terms. The worst financial distress since the Great Depression ought to trigger the worst downturn in demand, production, and employment since the Great Depression. It hasn't--at least not so far.

Good questions; I think economic activity has surpassed most peoples’ expectations. My answer to DeLong’s question comes in three parts:

1. The nature of the expansion defines the nature of the following contraction. The post-tech bubble expansion was anemic by most measures, and never gained much traction until the housing bubble arose. The primary channel through which housing supported the economy was via consumer spending, generating a tepid growth dynamic compared to the equipment and software investment boom of the 1990’s. The tepid upside suggests a tepid downside. I would be more worried if the chart for equipment and software:

looked like the chart for residential investment:

And given trends in new orders, I am hoping it won’t:

2. The impact of the consumer slowdown is partially offshored, a point which I think deserves greater attention. This shifts job destruction to an overseas producer. In fact, as spencer at Anger Bear shows, the recent improvement in the real trade balance has less to do with rising exports, which continue to follow recent trends, than the sharp slowdown in real import growth. Note too that exports are not falling as they were in the 2001 recession as the global economy has held up better than expected.

3. Perhaps most importantly, however, is the massive liquidity injections from the rest of the world, or what Brad Setser calls “the quiet bailout.” In the first half of this, global central banks accumulated $283.5 billion of Treasuries and Agencies, something around $1,000 per capita. This is real money – I outlined the likely implications in January. Foreign CBs are happily financing the first US stimulus package; will they be happy to finance a second? Do they have a choice? Their accumulation of Agency debt is also keeping the US mortgage market afloat. Do not underestimate the impact of these foreign capital inflows. If the rest of the world treated the US like we treated emerging Asia in 1997-1998, the US economy would experience a slowdown commensurate with the magnitude of the financial market crisis. The accumulation of US assets is also forcing an expansion of foreign CB’s balance sheets, creating global monetary stimulus that allows the rest of the world to decouple from the US economy, supporting continued US export growth (see point 2 above).

Ideally, the slowdown remains moderate, allowing for a rebalancing as we expand export and import competing industries domestically, narrowing the current account deficit and eliminating the necessity of foreign official financing. This means accepting a period of time with suboptimal domestic demand growth and structural adjustment. Excessive fiscal stimulus risks testing the willingness of foreign CBs to continue to accumulate US assets. Moreover, I believe that excessive stimulus will eventually foster a more damaging inflationary dynamic, but such a process would likely build over a long period of time – the seeds for the 1970s were planted in the 1960s.

In short: External dynamics play a significant role in explaining the relatively mild US downturn. As long as foreign CBs are willing to accumulate US debt, the US government is willing to issue debt, the Federal Reserve is willing to accommodate the debt with low interest rates, we will avoid the most dire deflationary predictions.

Should William Poole Say "I Told You So"?

Questions for William Poole:

Seven Questions: How Bad Will It Get?, Foreign Policy: When William Poole warned in 2003 that Fannie Mae and Freddie Mac lacked the capital to weather a financial storm, his advice went unheeded. Five years later, the outspoken former president of the Federal Reserve Bank of St. Louis is far too polite to say “I told you so,” but he does have a message for the Fed: Wait too long to tackle inflation, and you’ll face an even worse recession in the years to come.

Foreign Policy: What’s your diagnosis of what happened to Fannie Mae and Freddie Mac?

William Poole: First of all, they had too little capital to withstand adverse circumstances. And the adverse circumstances were the severe downturn in housing, the decline in house prices, and the rising default rate on mortgages. I don’t know of anyone who early enough was saying that there would be a major national decline in house prices, so I can’t hold them to that standard, but I can hold them to a standard of holding adequate capital to be able to withstand unforeseen circumstances. That’s what capital is for. ...

FP: Now, there has obviously been some turmoil in the banking sector. ... Analysts are wondering where the line is in terms of what banks are considered “too big to fail.” Where would you draw that line?

WP: I like the way that Greenspan used to put it and probably still does put it, that no firm should be too big to fail. Some might be too big to liquidate quickly and may require some support until they can be wound down, but there should be no firm too big to fail. We don’t know yet what the nature of the bailout of Fannie and Freddie is going to be, but I believe the plan would be to pay off at par all of the regular obligations. They are being turned into full faith and credit obligations of the United States government. ...

FP: NYU economist Nouriel Roubini, who has been sounding the alarm for quite a while, told Bloomberg News that we’re seeing the worst U.S. financial crisis since the Great Depression.

WP: I think that’s right, but let’s go back and revisit the Great Depression for a moment. ... There was a total and complete collapse of the banking system, and the economy that had functioned on credit and deposits was suddenly left to function on hand-to-hand currency. We aren’t anywhere close to that and we won’t get close to that because of ample Federal Reserve resources and also intellectual understanding that would not permit that to happen.

FP: How bad will it get, then?

WP: We are going to have failures of large numbers of firms, financial firms in particular..., failures of smaller commercial banks ... that were the most heavily involved in real estate are the ones at the greatest risk. ...

FP: Meanwhile, consumer prices are rising at their fastest rate in 17 years. Does that mean the Fed is running out of tools to keep growth going?

WP: All the financial turmoil that we’ve just been talking about—the tightening of credit...—that’s putting downward pressure on the economy, and the big increase in fuel prices is also putting downward pressure on real activity. ... There is a growing amount of unemployment in those sectors, and the Federal Reserve is trying to support economic activity by holding the federal funds rate ... at its current level. If the downturn in employment becomes much more severe, the Fed might even cut rates.

Now, to me, the inflation problem is actually part of what is depressing economic activity, because the generalized inflation that I think we have underway—although it’s not showing up in core inflation and wages just yet—is showing up in the depreciating dollar, and the depreciating dollar directly feeds through to increased energy prices and food prices. So, the depreciation itself is leading to depressed economic activity.

Moreover, if the inflation really starts to go into wages and into the core ... price indices—it will probably develop a fair amount of momentum and the Federal Reserve is not going to be able to reverse it even with a tighter monetary policy for probably a year or two, maybe even three. If the policy is too expansionary too long and we end up with a real inflation problem, all we’re doing is trading a bigger recession later for a smaller recession now.

On the too big to fail issue, I don't think it is the size of firms alone that is the problem. For example, suppose that we take a firm too big to fail and break into two smaller firms of one half the original size. If the factors that would have caused the one large firm to fail would have also caused the two smaller firms to fail, then we really haven't accomplished much, the size of the banking disaster will be the same. The problems that affected the GSEs came from factors they did not anticipate, factors that were out of their control. In such a situation, it's not clear to me that having more firms specializing in the same business is any safer than one combined firm. Maybe if there are 100 firms a few will pursue safer strategies and survive, but if we then have 97 smaller banks in trouble rather than just one large bank having problems, the scale of the problem is essentially the same and it would be harder, not easier, to take action to shore up the system since it would take 97 separate arrangements rather than just one.

For that reason, I think regulators should consider the overall size of certain classes of risky activity in addition to the size of individual firms. If a risky activity is too large a component of the financial system, and there isn't adequate backup in the event of widespread default, it doesn't matter whether problems bring down a large number of small firms or one large one, the result will be the same.

I don't mean to say that large firms shouldn't be broken up. Even with a (seemingly) well diversified portfolio, i.e. one that avoids over exposure to any particular type of risky asset, size alone could be a risk should a very large firm fail, though hopefully diversification would make failure less likely. I'm saying that breaking firms up into smaller pieces isn't enough in and of itself to reduce the risk of massive financial meltdown. We also need to worry about the overall magnitude of particular classes of risk and how concentrated those risks are within particular sectors of financial markets. If x is a big part of overall financial activity, i.e. if a bad outcome involving x could cause a financial meltdown, one firm doing nothing but risky activity x isn't much (or any) safer than ten firms doing nothing but risky activity x (scale effects could even increase the likelihood of failure).

So I think three things should come under consideration. First, the size of individual banks. Unless scale effects justify it (a natural monopoly argument, in which case it would be heavily regulated), no firm should to large enough to bring down the economy by itself in the event it fails. Second, no particular class of risky assets should be large enough to pose a threat to the financial system. Either the overall size of the asset class should be constrained, or the degree of risk should be limited. Third, the risk from particular classes of asset should not be concentrated in a small number of firms or concentrated within a particular sector if that group of firms or that sector is, collectively, too big to fail.

Social Safety Nets, Inflation Fighting, and Market Discipline

I've had some differences with Barney Frank in the past over Fed policy, but here he makes an interesting point. Why do European central banks respond more aggressively to inflation than the US central bank? Could it be the difference in social safety nets?:

Frank Says Stronger Social Safety Net Would Free Fed, by  –Michael S. Derby, Real Time Economics: There are many reasons why the Federal Reserve is boxed in on monetary policy, but Rep. Barney Frank Wednesday found a new dimension to the central bank’s dilemma. ...

Ben Bernanke and his fellow policy makers are facing a worrisome mix of tepid growth, troubled financial conditions and rising price pressures... The weak economy and market tumult call for rate cuts. But the energy-driven price gains and deteriorating expectations for future prices call for rate increases.

That’s left the Fed stuck at its current rate of 2%, very likely for an extended period. But according to Frank, if the U.S. social safety net weren’t so miserly, the Fed might actually have more room to take on inflation. ... “The relative insufficiency of our social safety net vis-a-vis what you have in Western Europe constrains monetary policy,” Frank said.

If the U.S. offered more support for the unemployed and displaced, “the Federal Reserve would then be freer…to slow down the economy in the knowledge this would not have a disproportionately negative effect” on the working population. That part of the population is already losing notable ground in economic terms, he said. ...

And, contrary to what you might hear - sometimes based upon the argument that we are not in a technical recession - "families are facing hardship":

Bernanke: Recession or Not, Families Are Hurting, by Sudeep Reddy: ...At a House hearing, Mr. Bernanke — responding to a lawmaker’s question about Americans’ economic pain ...[and] whether a recession is underway. ...

“Whether it’s a technical recession or not is not all that relevant,” Mr. Bernanke said. “It’s clearly the case that for a variety of reasons families are facing hardship.” ...Mr. Bernanke recounted the “numerous difficulties” facing the economy: “ongoing strains in financial markets, declining house prices, a softening labor market, and rising prices of oil, food, and some other commodities.” ...

As to whether this is a technical recession, “I don’t see why that makes a great deal of difference,” Mr. Bernanke said, adding that the terminology doesn’t play into the Fed’s policy decisions.

In other what are you whining about news, prices are up, and the ability of workers to buy goods and services is down:

U.S. consumer prices soared at their fastest annual pace in nearly two decades last month... Even more worrisome for policymakers than the headline inflation jump may be signs that food and energy prices are starting to filter through the broader economy, as evidenced by sharp price gains last month in housing, transportation and services. ...

The consumer price index jumped 1.1% in June..., the second-highest increase since 1982 and the highest since 2005. Excluding food and energy, it advanced 0.3%. ...

Consumer prices swelled 5% on a year-over-year basis, the highest rate since May 1991. The core CPI grew a more modest 2.4% compared to June 2007, though that's still well above the Fed's long-term goal of 1.5% to 2%. Over the past three months, core inflation rose at a 2.5% annual rate. ...

In a separate report, the Labor Department said the average weekly earnings of U.S. workers, adjusted for inflation, fell 0.9% in June, suggesting incomes aren't keeping pace with prices...

I'm not sure that I agree with Robert Reich that the episode we are currently experiencing proves that the Great Moderation was more luck than anything else, particularly that it disproves Fed policy made any difference. There is a lot of empirical evidence pointing to more aggressive inflation fighting as a key factor in the Great Moderation (e.g. Has Monetary Policy become More Effective? by Jean Boivin and Marc P. Giannoni, and On the Sources of the Great Moderation by Jordi Galí and Luca Gambetti are two recent contributions in this area), and we don't know how bad the current episode might have been had the Fed, say, followed a 1970s-type policy prescription (that is, even though we had bad luck - a large shock hit causing large effects - without moderation through Fed policy the state of the economy could have been much worse). But I do agree with his call for increased social insurance:

The End of the Great Moderation, the Bailouts of Freddie & Fannie and Wall Street, and the Tattered Safety Net for Everyone Else, by Robert Reich: As we bail out Wall Street along with Freddie and Fannie and all the top financial executives who have been pocketing tens of millions a year, yet allow millions of homeowners and jobless Americans to sink, it's worth contemplating what's happening to the American economy and to our social safety nets.

What economists have called "The Great Moderation" - a period when the business cycle evened out, and neither inflation nor recession posed much of a threat- began in the mid-1980s, and now appears to be over. It was good when it lasted. But it led the nation to think we didn't need much by way of social insurance.

No one knows for sure what caused the Great Moderation. Some had credited increased sophistication of financial markets and the wisdom of the Federal Reserve Board. Hindsight suggests it was more luck than anything else.

Well, folks, it turns out the great moderation was something of a fluke, and now tens of millions of Americans are in trouble with no safety net to help them.

That's because the apparent end of the boom and bust cycles led us to assume the economy would no longer impose huge, unexpected, and arbitrary losses on large numbers of Americans. So we basically got rid of the safety nets. We abolished welfare, let unemployment insurance wither, and paid scant attention when corporations eliminated defined-benefit pensions and cut health insurance benefits. We even stopped worrying about the safety of small investors, allowing federal deposit insurance to shrink as a proportion of total savings (witness the recent bank run in California).

But now we have to rethink safety nets. Right now, nets are being spread for the wrong people. The giants of Wall Street along with Fannie and Freddie get bailed out but there's still no relief in sight for most homeowners who can't pay their mortgages. Corporations that don't deliver on their pension obligations are helped but there's nothing for retirees and small investors whose savings are drying up because of Wall Street's decline. Small investors are losing their shirts but the Fed stands by to help the biggest.

Yet I have to believe the end of the Great Moderation will eventually result in a broader safety net. Maybe not the old forms of social insurance, but new ones like universal health insurance, earnings insurance, and savings accounts in which the dollars you put away are supplemented by government dollars.

The very rich, fattest investors, and the biggest corporations don't need safety nets. Now that the booms and busts are back, the rest of us do.

I don't advocate protecting the financial system to bailout the "very rich, fattest investors, and the biggest corporations," it's the people who would need the social safety net if the broader economy fails that are the concern. We need both enhanced social insurance and a stable financial system. For stabilizing the financial system, the trick going forward will be to develop mechanisms that are able to prevent financial meltdowns, but avoid rewarding the people who brought about the potential for collapse. I think regulation that prevents behaviors that lead to these kinds of problems is our best chance, but we can't anticipate everything possible problem that might occur and there are times when insuring against collapse requires us to hold our noses and clean things up as best we can. But that should be a last resort. As for how the social safety net fits into this, much like the ability to fight inflation, the ability to discipline market participants - to let those who made bad bets, bad decisions, etc. suffer losses or other penalties - is also enhanced when a stronger social safety net is present.

FRB SF: The Economic Outlook

John Fernald of the San Francisco Fed gives his view of the economic outlook. The bottom line?:

The relatively strong incoming data suggest that growth in the second quarter was close to trend, after two anemic quarters. Going forward, the continuing and, indeed, intensifying pressures from housing, credit markets, and commodity prices, are likely to weigh on activity for some time. However, the fiscal stimulus program should help support growth in the current quarter.

A more solid recovery should take root in 2009, reflecting some waning of the drags on the economy. In particular, housing should begin to stabilize; credit conditions should gradually ease; and energy and food prices are expected to level off. In addition, the earlier policy easing by the Federal Reserve should provide some cushion for the economy.

Here are more details. I suspect some of you will view the inflation forecast - the third graph from the bottom - with suspicion:

FedViews, by John Fernald, FRBSF: Housing and credit markets remain troubled, and commodity prices have risen further. These factors are likely to weigh on the outlook for some time. In addition, reflecting surging food and energy prices, inflation is an increasing concern.

Fannie and Freddie

Robert Reich says Fannie and Freddie are too big to be allowed to fail:

Fannie, Freddie, and the Pending Taxpayer Bailout, by Robert Reich: Fannie Mae and Freddie Mac, the two giant quasi-public housing lenders that together own or guarantee about half the $12 trillion in home loans outstanding, are heading into insolvency. No surprise. As housing prices continue to drop, more and more middle-class homeowners who got their loans from Fannie or Freddie are under water... And as the economy continues to go south, more and more of them can't meet their loan payments.

While it's true that most of their home loans were made before 2006 when lending standards were tighter, that doesn't really matter because the rip-tide of this sinking economy is now hitting a much broader group of home owners.

Fannie and Freddie may not be technically insolvent yet, but I'm betting that if their lending portfolios reflected the true market prices of their loans they would be. That's why their own investors are bailing out.

So who gets stuck with the tab? Investors in Fannie and Freddie have always believed that the loans issued by the two giants were guaranteed by the federal government but technically they aren't. The guarantee has always been assumed but has never been put into law explicitly... Yes, the companies' charters give the Treasury the authority to buy as much as $2.25 billion in each of their securities in the event of possible default, and the two companies have access to the Fed's so-called Fedwire payments system allowing them to access funding if needed. But these won't keep the two afloat for long.

As a practical matter, we're facing a Bear Stearns squared. Fannie and Freddie are way too big to fail -- especially now. There's no question the government will have to take over the companies, which means taxpayers will get stuck with the tab yet again.

Here we have another example of socialized capitalism. The executives of Fannie and Freddie have been among the best paid in all of corporate America. We're talking tens of millions a year in CEO pay alone. Fannie and Freddie are treated like giant investor-driven entities as long as they're healthy and their investors and executives are doing well. But when they start to go down the tubes they become public entities with public responsibilities, and the rest of us have to bail them out.

On the too big to fail issue, my view hasn't changed. If failure of these firms endangers the broader economy, and hence threatens to impose large costs on people who had nothing to do with creating the problems, then policymakers need to step in and do what they can to prevent a downward economic economic spiral. In addition, they need to change the rules and regulations that allowed the problem to emerge in the first place, and add new rules and regulations as needed to lower the moral hazard worries going forward.

What would you do?

Update: Big Picture adds:

The U.S. Monetary Experience of 1979-1982

This is something I want to have available here for reference, but if anyone is interested in it, so much the better. It is Bennett McCallum's account of the 1979-1982 period in monetary history from his book Monetary Economics: Theory and Policy:

1.3 The U.S. Monetary Experience of 1979-1982

Having briefly highlighted some contrasts between the pre- and post- World War II record, let us now consider a recent episode that has received considerable attention. As a result of the relatively severe inflation of the late 1970s, Volcker and other officers of the Fed became convinced during 1979 that to prevent an extremely unhealthy situation they would need to exercise tighter control over growth of the money stock than in previous years. To facilitate such control,[10] they publicly adopted on October 6, 1979, a new set of operating procedures, procedures that featured increased emphasis on a particular measure of bank reserves (i.e., nonborrowed reserves) and reduced emphasis on short-term interest rates. Their new procedures were supposed to be helpful to the Fed in achieving its targets for money supply growth-targets that it had been announcing since 1975 but failing to achieve in most years.

The practice of announcing these money supply targets, it should be explained, had been reluctantly adopted by the Fed at the insistence of the U.S. Congress.[11] As can be seen from Table 1-3, the targets were not highly precise. For the year ending with the fourth quarter of 1978, for example, the target consisted of a range of values for the money growth rate that extended from 4.0 to 6.5 percent. (The actual value turned out to be 7.2 percent in this year, as can also be seen from Table 1-3.) Given the modest degree of precision sought for, it appeared that the failure to achieve the official targets should in principle be correctible.

The new operating procedures begun in October 1979 were kept in place by the Fed until late 1982, with September 1982 usually regarded as the last month of the episode. Because so-called "monetarist" economists had for many years been recommending tighter money stock control as the best way of fighting inflation, and had often recommended operating procedures with a measure of bank reserves[12] as the key variable, this experience has frequently been termed a "monetarist experiment." Actually, for various reasons, that label is highly inappropriate.[13] But the episode did nevertheless constitute a policy experiment of a sort, and is therefore of considerable interest.

What, then, were the results of this experiment? In one respect the Fed's attempts were successful: by September 1982 the U.S. inflation rate had been reduced from around 11 or 12 percent (per year) to a magnitude in the vicinity of 4 or 5 percent. Other aspects of the outcome were not as planned, however, and were highly unpopular with the public and with most commentators. Of these undesirable side effects, four will be mentioned. First, short-term interest rates rose to levels unprecedented in U.S. history. Over the month of May 1981, for example, the 90-day Treasury bill rate averaged 16.3 percent. Second, the extent of month-to-month variability of interest rates was greater than ever before. Third, in 1981 a recession began that was the most severe since the Great Depression of the 1930s; the nation's overall unemployment rate climbed over 10 percent in the second half of 1982. So while the economy was relieved -- at least temporarily -- of the inflationary pressures that it had been experiencing for about a decade, this relief was apparently[14] obtained at the cost of an unwelcome recession and the associated loss in output.

Perhaps the most interesting aspect of the episode, however, pertains to the fourth item on our list: the Fed did not succeed in improving its record of money stock control. Instead, the realized growth rates for the years ending in the fourth quarter of 1980, 1981, and 1982 were again outside the specified target range, as indicated in Table 1-3. And monthly values of the growth rate were highly variable, as can readily be seen from Figure 1-1. This is especially striking, of course, because the special operating procedures of 1979-1982 were designed precisely for the purpose of improving money stock control so as better to achieve the monetary growth targets!

The facts that we have just reported are not a matter of dispute - students of the episode agree that inflation came down, unemployment rose, interest rates became high and variable, and money stock targets were not met. What interpretation to place on the facts is, however, another matter. To some economists they suggest that it is unwise to pursue money stock targets, in part because of the putative unreliability of money demand behavior in an economy in which new payments practices and financial assets are constantly being developed.[15] To other economists, however, the experience illustrates how poorly the Fed's procedures were designed for money stock control, and how dangerous it is to allow excessive money growth -- and the inflation that it engenders -- to become established in an economy.[16]

---

[10] According, at least, to the Fed's public statements on the subject.

[11] On this topic, see Weintraub (1978).

[12] Total reserves, however, not the nonborrowed reserves measure actually emphasized by the Fed.

[13] In particular, monetarist prescriptions have typically stressed the importance of nearly constant money growth rates and the absence of activist attempts to vary these rates countercyclically. In fact, the Fed did not abstain from activism during 1979-1982 and - as we will see shortly - money growth rates were far from constant. For an elaboration on this argument, see Friedman (1983).

[14] The word apparently is inserted because a few economists would argue that the recession of 1982-1983 was not brought about by the monetary policy under discussion. The viewpoint of such economists is discussed in section 9.7.

[15] For an expression of this view, see Blinder (1981) or Bryant (1983).

[16] These views are expressed by Brunner and Meltzer (1983) and Friedman (1983), among others.

Fed Watch: Follow the Money

Tim Duy syas if you want to understand what's going on in the economy, then "follow the money and see where it leads":

Follow the Money, by Tim Duy: My apologies to Brad Setser for borrowing the title of his blog for the evening.

I am writing tonight while on vacation at a cabin in Central Oregon. I do not have high speed internet access, reverting instead to a telephone modem. Consequently, I have left out some links that I would normally include. Not exactly my most polished piece either. And I probably shouldn’t even be working; it is just my son and me tonight, and he went to bed hours ago. A wise man would have followed and taken the rare opportunity for extended sleep, but I had some stories I just could not get out of my head, so better just to write them down.

During my brief stint at the US Treasury, an economist visiting from Australia requested an informational meeting with some Treasury staff to discuss the results of a paper he was in the process of writing. I recall this visit occurring during the height of the Asian Financial Crisis, about the time that JP Morgan issued a US recession call on the basis of an expected widening of the trade deficit. This economist, whose name I can’t recall, said that a US recession was simply not going to happen. Instead, he predicted that a wave of capital would flow out of Asia to the US, pushing down long term interest rates, which the Fed would accommodate at the short end. The end result would, he anticipated, be highly stimulative.

Not exactly conventional wisdom at the time, but needless to say, this turned out to be a remarkably accurate prediction; the capital flow into the US found traction in the already smoldering information technology sector. The rest is history, both good and bad. The lesson I took away from this episode was to drop your preconceived ideas about what you were sure would happen and just follow the money and see where it leads.

Fed Watch: Denying the Great Adjustment

Tim Duy's latest Fed Watch looks at growing international imbalances that have "US and emerging market policy makers on a collision course":

Denying the Great Adjustment, by Tim Duy: While not always the dominant force in my outlook, the external imbalance consistently lurks in the background of the US economy. I tell local audiences that the imbalance represents a very simple reality – the US consumes more than it produces, and the excessive consumption is provided by foreign producers. Eventually, maybe tomorrow, maybe years from now, those producers will desire to consume their own domestic output. At that point, US consumption and production will have to fall into line via a possibly painful restructuring. The more painful, the more policymakers will resist.

It is interesting to reference this framework in light of recent policy talk, kicked off by Federal Reserve Vice Chair Donald Kohn:

Fed Watch: This Is Not Good

Tim Duy says the Fed is in "something of an untenable position, to say the least":

This Is Not Good, by Tim Duy: Presidential candidate Barack Obama summed up the Fed’s dilemma today. From Bloomberg:

''The Fed is in a tough situation because it wants to control the inflation being caused by energy while at the same time trying to restore the economy,'' he said.

One tool, two objectives – something has got to give. The Fed is not blind to their dilemma, and today Fed Vice Chairman Donald Kohn said monetary policy has reached an impasse domestically, and implores emerging market economies to start doing the heavy lifting on inflation fighting. From the Wall Street Journal:

“The upward trend in prices of food and energy over the past several years…importantly reflects the pressures posed by rapidly growing demand in developing economies against relatively inelastic global supplies of commodities,” Kohn told a monetary conference in Frankfurt.

And “in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability,” he said.

Kohn’s analysis sounds remarkably close to my own – Dollar bloc nations are effectively tied to Fed policy, and that policy is simply too easy for the those economies. But not to easy for the US, which puts the Fed in something of an untenable position, to say the least. Kohn is making an obvious effort to shift the blame for rising commodity prices away from the Fed, because, as is well know, it is never the Fed’s fault, whatever the problem (actually, the US Treasury deserves some of the blame, for using the IMF like a club during the Asian Financial Crisis).

Kohn’s is urging the Dollar bloc nations to raise interest rates while the Fed holds steady. This appears to be at odds with dollar supportive Fedspeak, although I suspect that rhetoric is largely directed at the major currencies. Still, could the Fed really want a fresh bout of Dollar weakness? Indeed, some Asian nations are already selling dollars to support their own currencies, even before Kohn’s speech. Interestingly, I suspect this will put the Fed into another inflation bind. If the Fed is correct and the rise in commodity prices, and specifically oil, is predominately due to global demand, rather than the Dollar’s decline, then higher rates abroad could help soften the foreign currency prices of commodities. But it is not inconceivable that a fresh bout of Dollar weakness raises the dollar price of those commodities.

In other words, the US has benefited by the foreign willingness to accumulate Dollar assets; it allows the US to consume well beyond productive capacities without, until recently, inflationary consequences. If the rest of the world is implored to tighten policy and weaken the Dollar, then I suspect those positive inflation dynamics will be reversed. The Fed effectively replaces one inflation concern with another by advocating what amounts to a Dollar drop.

In any event, it is not clear that the Fed can implore enough nations to tighten rates to have a meaningful impact on global growth. As Brad Setser reminds us, Dollar policy is inconsistent – the US government wants Asian nations to accept a weaker Dollar, but not oil exporters. And massive reserve growth in China suggests that nation is not interested in accelerating the appreciation of the yuan anytime soon.

Which is something of a good thing given that while Kohn is imploring the rest of the world to tighten policy and effectively let the Dollar go, the odds of a second stimulus package are rising. Obama again:

Democratic presidential candidate Barack Obama said the U.S. will continue dealing with ''short- term pain'' from an economic slowdown and the country needs a second round of stimulus checks to spur consumer spending.

''We know that consumer confidence is at all-time lows. We have to give people some sense that they could absorb the rising costs in gas, food and medical care,'' Obama said in an interview with Bloomberg Television today in Pittsburgh.

The US needs the rest of the world to buy that debt necessary to support the stimulus. If not China and the rest of the Dollar bloc nations, then who? Is it any wonder that financial markets are in disarray? From MarketWatch:

I can't remember the last time Dow futures in freefall the way they've been today," said Dale Doelling, chief market technician at Trends In Commodities. It's "an absolute boycott by buyers in stocks and the dollar."

But "the exact opposite happened in the commodity markets. You name it, oil corn, gold bonds -- everything up, up and away," he said in emailed comments.

Also providing support for oil Thursday, Algerian Energy Minister Chakib Khelil, who serves as president of OPEC, said oil prices could jump as high as $150 to $170 dollars a barrel this summer, according to reports.

However, he thinks crude will fall short of $200 a barrel. At a meeting in Paris, Khelil said a further fall of 1% to 2% of the dollar vs. the euro could add another $8 a barrel to oil prices. He cited the weakness of the greenback as a major cause of spiking oil prices.

The failure of the FOMC to issue a more hawkish statement weighs on the Dollar and pushes commodities upward, which only adds to the misery in US equities. But if the Fed hiked rates, financial markets might implode.

This is a no win situation...which way will the Fed turn? The Fed will hold the current policy in place until policymakers becomes sufficiently distressed by the impact of energy price inflation (September, October, next year; just not August). Note that market participants are increasingly aware that the Fed’s default policy for the time being is higher inflation, as evidenced by the rise in 10 year TIPS breakeven levels to 254bp today.

In theory, the best outcome is to find is a sweet spot that allows global growth outside of the US to decelerate while avoiding a free fall in the Dollar. In the absence of such equilibrium, the US economy can hobble along only as long as the following three conditions hold:

1. The Federal Reserve can maintain easy monetary policy.

2. The US government can sustain repeated fiscal stimulus measures.

3. China and the rest of the dollar bloc continue to be willing to accumulate US assets, primarily the Treasury debt needed for fiscal stimulus.

When these conditions no longer hold – such as the Fed needs to tighten to counter energy inflation, or the demand for US debt drops sharply – then I suspect the US economic environment will shift decisively toward higher inflation or significant recession.

Or both.

Fed Watch: Cutting It Down the Middle

Tim Duy assesses today's decision from the FOMC to leave the target interest rate unchanged:

Cutting It Down the Middle, by Tim Duy: Today’s FOMC statement was largely in-line with expectations – worries were tilted toward higher inflation risks, but fell short of setting the stage for a rate hike in August. Will we see a rate hike this latter this year? I still tend toward expecting a rate hike sometime this fall, vacillating between September and October depending upon the intensity of Fedspeak, largely in response to energy/Dollar driven inflation concerns. Recent Fedspeak pulled me to the earlier date; this statement pushes me toward the later date.

Mark Thoma compares the two most recent statements side by side here. Some points of interest:

1. The Fed identifies some “firming in household spending,” which at first glance appears inconsistent with weak consumer confidence numbers. That firming, however, likely reflects the impact of tax rebates, and confidence remains low because households realize the spending boost is only temporary. Also, the Fed now acknowledges that higher energy prices weigh on real spending.

2. The language on the inflation forecast is tightened, but qualitatively similar, maintaining a benign outlook, although the Fed dropped its optimistic assessment of the direction of commodity prices.

3. The inclusion of the sentence “[a]lthough downside risks to growth remain, they appear to have diminished somewhat, and the upside risks to inflation and inflation expectations have increased,” shifts the balance of risks toward inflation, but not so much as to expect a rate hike in the near term.

4. There is no mention of the Dollar, although I suspect the minutes will reveal concern on that front.

The Fed is attempting to walk a fine line, with enough hawkish talk to keep the Dollar and oil in check, but not so much that they trigger a substantial rise in longer term rates such that they undermine the current fragile and tentative signs of economic stability. As the FOMC statement suggests, both growth and inflation prospects depend on the path of oil prices (See, for example, Dow Chemical’s second price increase in a month.), and I believe policymakers are genuinely concerned that easy US monetary policy is a contributing factor to this trend. Indeed, this is the only rational explanation for the heightened hawkishness at the Fed given the weak economy. Across the Curve succinctly notes:

FOMC Keeps Target Rate at 2%

As expected, the FOMC left the target federal funds rate unchanged:

"One of the Two Central Banks Must be Making a Mistake"

Guido Tabellini discusses difficulties faced by central banks, including the current debate over whether central banks should be more worried about inflation or about weak economic growth. He says that because the Fed or the ECB have made different choices about "the primary objective – inflation or growth," one of the two is making a mistake:

Why central banking is no longer boring, by Guido Tabellini, Vox EU: Until a year ago, central bankers could boast with satisfaction that monetary policy had become boring. A widely shared “best practice” was followed by almost all central banks. Any controversies concerned technical nuances that were really only relevant to professionals in the field. Then came the credit crisis – and all certainties went out the window. Now new dilemmas are emerging, and many central banks have embarked on different routes. Within a few years, we will know who was right and who wasn’t.

Fighting inflation or avoiding recession?

A first question: what’s the primary objective – inflation or growth? The American Federal Reserve has chosen growth. For fear of recession, it lowered the interest rate to 2% - two points below the rate of inflation. The gamble is that the cyclical slowdown will still put the brakes on price increases, despite the energy shock and agricultural prices, and even though inflation forecasts have reared their heads – above all (but not only) in the short term. Paul Volcker, the architect of disinflation in the 80s, has said that recent months remind him of the early 70s. Even then the oil shock was accompanied by a rise in agricultural prices, a weakening of the dollar, and an expansive monetary policy to counteract recession. The result was a decade of inflation.

The Bank of England made the opposite choice – it’s keeping interest rates at 5% (2 points above the inflation rate), because it wants inflation to fall towards the target of 2%, while recognising that the English economy risks winding up in recession, driven by tight credit, the drop in house prices, and the oil shock. The economic situation in England still isn’t as serious as that in America, yet the orientations of the two central banks are very different. Mervyn King, governor of the Bank of England, has emphasised that the Bank “did not fall prey to the sirens who were pressing us to cut interest rates as rapidly as some other central banks have done”.

The European Central Bank is going even further, surprising everyone with a warning that a hike in interest rates is imminent, despite the global slowdown and the ongoing credit crunch. This is remarkable, because the source of higher inflation is clearly exogenous to the Euro area and not due to domestic overheating or wage increases. By implication, the ECB welcomes a slowdown of the European economy to make sure that external inflationary pressures do not ignite a domestic wage-price spiral. The contrast with the Fed approach could not be more striking; one of the two central banks must be making a mistake.

Inflation or Unemployment?

Should the Fed be more concerned with inflation, or with weak output growth and rising unemployment? Robert Kuttner says the answer is easy, worry about output growth and employment:

My dissent on the risk of inflation, by Robert Kuttner, Commentary, Boston Globe: The Federal Reserve and the European Central Bank are both signaling a tighter money policy. The reason? Inflation...

The consensus is that combating inflation is more important than other economic goals, such as rescuing the financial system or preventing recession. Please permit me a dissent.

Unemployment went up a full half point to 5.5 percent in May, the biggest monthly jump in 22 years, and worse is forecast. Subprime fallout continues. Home foreclosures are running at 25,000 a month, and housing values are still dropping. If the economy is not quite in official recession, tight money will push it over the edge.

Consider the sources of today's inflation. The standard explanation is that inflation results when the economy overheats. Tight money helps cool it down. But today's American economy is too weak, not too strong. ...

Why the price increases? One theory is that China and India are consuming more energy and food, bidding up world prices. Another view is that Wall Street speculators ... are ... causing prices to spike.

But either way, it's not clear how higher interest rates in the United States will moderate worldwide prices of oil and food. ...

Rather, the nation needs ... to end its reliance on imported oil. It needs sensible food policies worldwide, so that the productive capacities of underperforming agricultural regions are realized. And it needs policies to restrict the purely speculative influences on commodities prices. ...

I think caution in pulling the trigger to fight inflation is in order, this doesn't look like a repeat of the wage-price inflation spiral of the 1970s, but Nouriel Roubini doesn't think it's as clear what the Fed and other central banks should do:

...central banks in many advanced and emerging economies are facing a nightmare scenario, in which they simultaneously must tighten monetary policy (to fight inflation) and ease it (to reduce the downside risks to growth)... [...full article...]

Krugman on Calvo on Commodities

In his discussion of the cause of skyrocketing commodity prices, which he attributes in large part to central bank behavior creating excessive liquidity, Guillermo Calvo said:

Absence of a substantial increase in physical commodity inventories has been mentioned as evidence of absence of speculative activity (by Martin Wolf and, more guardedly, Paul Krugman).[1] But that is not valid.

Paul Krugman replies:

Calvo on commodities: Guillermo Calvo is one of my favorite economists. But - you know there had to be a but - I just don't buy his latest missive. Still, it's important that we have this debate: something awesome is happening to oil and other commodities, and figuring out what it means is crucial.

So, a couple of points.

Calvo: "Exploding Commodity Prices, Lax Monetary Policy, and Sovereign Wealth Funds"

Guillermo Calvo argues that fundamentals, not speculation, explain rising commodity prices. He says "when analysed from the perspective of some future time, this whole episode will look very much like a bubble in the commodity market, a market mirage, even though what is behind it is a fundamental factor: lower demand for liquid assets by sovereigns like China, Chile or Dubai."

Why have sovereign wealth funds lowered their demand for liquid assets? He argues that lax Fed policy is a big part of the inducement to switch out of liquid assets, and that the commodity price explosion is "a harbinger of higher CPI inflation" in the future. However, all is not lost in the inflation battle, but the Fed needs to "seriously start worrying about inflation and stop chasing imaginary destabilising speculators":

Exploding commodity prices, lax monetary policy, and sovereign wealth funds, by Guillermo Calvo, Vox EU: Oil, metals, and now food prices are heading to the sky with a virulence that is hard to rationalise on the basis of world output growth – not even on the basis of China’s and India’s fast growth, let alone the expected global slowdown. This phenomenon has been accompanied by much higher transaction volumes in forward markets. Thus, analysts and policymakers have been quick in pointing an accusing finger at the proverbial speculator, who has even been declared persona non grata in some countries, like India, where commodity futures have been banned.

The thrust of this column is that we are not going through another self-fulfilling bubble. Today’s explosion of commodity prices is the result of a very real global financial storm associated with large excess liquidity in several non-G7 countries and nourished by low G7 central banks’ interest rates. This price explosion could be a leading indicator of future inflation driven by fundamentals.

Commodity stockpiles

Absence of a substantial increase in physical commodity inventories has been mentioned as evidence of absence of speculative activity (by Martin Wolf and, more guardedly, Paul Krugman).[1] But that is not valid. Suppose, for the sake of the argument, that the demand for commodities for current consumption or production is completely inelastic (food and oil are good examples in the short run). If speculators attempt to stockpile commodities, commodity prices will go up. And they will go up as much as necessary to discourage the speculators from adding to their stocks, that’s all. To keep matters simple, I will zero in on that special case and explain what drives speculators to stockpile so aggressively as to provoke a price explosion.

Incentives to stockpile commodities stem from the combination of low central bank interest rates (especially in the US) and the growth in sovereign wealth funds. The latter, in my view, is the crucial factor. Sovereign wealth funds have been created partly with the intent of switching the composition of government wealth from highly liquid but low-return assets to more risky but much more profitable investment projects. Thus, their attempt to get rid of excess liquidity resembles the econ 101 exercise in which the student is asked to trace the effects of a portfolio switch away from money and into capital. The answer is – of course – higher prices. I will return to that in a moment after I explain why central bank interest rates are also important.

Oil Prices, Inflation, and the Fed's Next Move

What's the Fed likely to do?:

Oil Price Realities May Soften Fed Rate Moves, by John M. Berry, Commentary, Bloomberg: ...When the cost of a barrel of crude oil touched $140 on June 16, almost double its price a year earlier, the sky may have seemed the limit.

But even with soaring rising demand in China, India and some other emerging-market countries, prices at some point must plateau, and perhaps come down. A doubling of oil prices simply has to reduce demand, which in turn will moderate the price.

So Fed officials have common sense on their side in assuming consumer prices won't increase indefinitely at a 4 percent rate, or higher, because of oil. Food prices are also playing a big role in keeping inflation high at the moment, and they too will eventually top out.

Still, Fed Chairman Ben S. Bernanke and his colleagues want to make sure food and energy inflation doesn't infect the whole U.S. price-setting process. That's why many of them are talking a tough anti-inflation game these days.

''The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations,'' Bernanke told a Boston Federal Reserve Bank conference...

Choosing the best policy course is complicated right now. ... [I]t's not as if the Fed needs to raise rates to cool off an overheated economy; far from it. Nor would food and energy prices be affected very much by higher interest rates.

The primary purpose of a rate increase now would be to reassure the public that the Fed will do whatever is needed to hold down core inflation... If that works -- if the public's expectations for inflation remain low -- then temporarily higher food and energy prices are unlikely to generate higher sustained inflation. ...

Some private economists have argued that the oil price increases of the past four years, and the more recent food price increases, indicate a sea change in U.S. inflation. There's little evidence to back that up. ...

Inflation isn't out of control in the U.S. Fed officials are determined to make sure that remains the case...

Since last summer, officials have had to concentrate on keeping the economy afloat in the face of serious financial market turmoil. The danger of a deep recession has subsided.

So now it's time for some anti-inflation insurance -- in small, moderate doses.

FRBSF: The Current Economy and the Economic Outlook

Reuven Glick of the SF Fed uses fourteen graphs to illustrate the state of the economy, and to predict where the economy might be headed next:

FedViews, by Reuven Glick, FRBSF (no permalink available): Reuven Glick, group vice president at the Federal Reserve Bank of San Francisco, states his views on the current economy and the outlook:

Alan Blinder: Two Bubbles, Two Paths

Alan Blinder says there are two types of bubbles, and the Fed should only try to prevent one of them:

Two Bubbles, Two Paths, by Alan S. Blinder, Economic Scene, NY Times: Lately more and more people have been questioning the received wisdom about what a central bank should do when confronted by an asset price bubble. That piece of wisdom ... holds that deliberate bubble-bursting is something between impossible and dangerous — and thus best avoided. Instead, ... the Fed should let bubbles burst of their own accord, and then be prepared to mop up after.

This strategy ... is designed to limit collateral damage to the rest of the financial system, and especially to the overall economy. The Fed executed such a mop-up-after strategy with great success when the tech bubble popped spectacularly in 2000. ...

In taking up these [questions about the received wisdom]..., it’s crucial to distinguish between two types of bubbles. The first, what I’ll call “bank-centered bubbles,” are speculative excesses ... principally fueled by irresponsible ... bank lending. The housing-mortgage bubble was an obvious and painful example. But in other asset bubbles, bank lending plays a minor role, or none at all. The tech-stock bubble was a dramatic example of this second type.

I would argue that the central bank’s proper role is fundamentally different in the two types of bubbles. Here’s why:

When bubbles are not based on bank lending, the Fed has no comparative advantage over other observers in distinguishing between rising fundamentals and bubbly valuations. It may see bubbles where there are none, or fail to recognize them until it’s too late...

Indeed, at the Fed, I recall Mr. Greenspan thinking that he saw a stock market bubble as early as 1995... Fortunately, he did not make the mistake of trying to burst it. ...

That’s the first problem, and it’s a huge one. Here’s the second:

Once a central bank correctly recognizes a bubble’s existence, what is it supposed to do? The Fed has no instruments aimed directly at, say, tech stocks, and practically no instruments aimed at stock prices more broadly. (Those who argued that higher margin requirements would have worked were engaged in deeply wishful thinking.)

Of course, the Fed could have raised interest rates. But why would raising the federal funds rate by, say, two to three percentage points have ended the stock market mania when investors were expecting 19 percent annual returns in the stock market? That much monetary tightening, however, might well have stopped the economy in its tracks. ...

But a bank-centered bubble is starkly different in both respects.

As long as the central bank is also a bank supervisor and a regulator, it is extraordinarily well placed to observe and understand bank lending practices — much better positioned than almost anyone else. ...

And what about instruments specifically aimed at the bubble? ...[T]he Fed’s kit bag is ... stuffed full when it comes to taking aim at bank lending practices. Escalating upward from a sternly arched eyebrow to an outright prohibition of certain types of lending — for example, subprime loans with no documentation...

Finally, regarding inflation, let’s look at the record. The core inflation rate ... was in the 2 1/2 to to 3 percent range in 1995 to 1996, when serial bubble-blowing supposedly began. It has hovered in the 2 1/4 to 2 3/4 percent range in 2007 and so far in 2008. Do you see a rising trend?

There are two main conclusions: First, when bubbles are not based on bank lending, the mop-up-after strategy still looks pretty good. When it comes to bank-centered bubbles, however, there are many more things that a central bank can and should do. But raising interest rates to burst the bubble is probably not one of them.

Fed Watch: Between a Rock and a Hard Place

What will the Fed do in coming months?:

Between a Rock and a Hard Place, by Tim Duy: Fedspeak turned decidedly hawkish this week, and market participants responded accordingly, moving up expectations for a rate hike to as early as this August. But is Federal Reserve Chairman Ben Bernanke really ready to follow through? The answer could make or break the Dollar in the coming weeks.

Recall that just last week, Bernanke sent clear signals that rising near-term inflation expectations effectively put an end to the Fed’s rate cutting. But Bernanke’s concerns were quickly overtaken by events in two separate directions at the end of the week. First, on Thursday European Central Bank President Jean-Claude Trichet surprised markets by suggesting that the ECB’s next move might be a rate increase, as early as next month. Trichet’s comments were a slap in the face to traders betting that the interest rate differential between the US and Europe would narrow; instead, it looked like the opposite would happen, and markets needed to adjust accordingly. Dollar down, oil up – neither of which the Fed wanted to see. But this was only a prelude to Friday’s debacle that followed the release of the May employment report.

Market participants were looking for a stronger employment report. Initial unemployment claims fell last week, while the ADP report suggested the private payrolls actually increased. Instead of a strong report, the BLS reported what should have been expected – a continued erosion of the labor market. On the establishment side, the nonfarm payrolls decline was largely consistent with the story told by initial claims. On the household side, the jump in the unemployment rate was shocking, but was magnified by a surge of teenagers entering the job market (presumably seeking additional gas money).

I think discounting this impact is appropriate, at least until we see the June numbers. Still, even adjusting for the teen influx, the report was undeniably weaker than most expected, and brought into question the ability of the Fed to hold rates steady this year, let alone raise them. This realization sent the Dollar into a tailspin, while oil, aided by renewed tensions in the Middle East, rocketed to a new high.

Friday’s price action likely confirmed what Fed officials only grudgingly considered up to now – that they need to take seriously the idea that US monetary policy is directly impacting commodity prices, contributing to a deterioration of US inflation expectations. Bernanke was quick to react, downplaying the employment report, claiming that the risk of a substantial downturn has dissipated over the last month, and, to top it off, claimed that policymakers would “strongly resist” any rise in inflation expectations.

But does anyone believe Bernanke can follow through on this threat? According to MarketWatch, Fedwatchers are lining up to call his bluff. Across the Curve succinctly, and colorfully, describes the situation:

I think the 2 year part of the curve is oversold. I think (I know) the economy is weak. It is an election year and the unemployment rate just jumped to 5.5 percent. The housing market is a debacle. The Fed’s favored metric the core PCE has strayed very little from the top end of its prescribed range. Hemingway and Fitzgerald are not writing novels about World War One and this is not the Weimar Republic. The credit markets are frayed frazzled and fragile. Recovery has barely begun.

And hence we see the crux of the problem for Bernanke. Deserved or not, he has a credibility problem; at this point, he is seen as simply an inflationist hell-bent on fighting the Fed’s ghosts of the Great Depression. It is just so hard to believe that he would raise rates in the current environment, regardless of inflation expectations. We could believe Trichet. We could believe former Fed Chairman Paul Volker. But Bernanke? Still, with central bankers around the globe shifting gears to tackle rising inflation (see Bloomberg and WSJ), Bernanke may not have much choice. Any hint of hesitation to follow on the Fed’s part will likely renew the attack on the Dollar and push oil prices even higher, thereby undoing the recent string of jawboning.

But hiking rates is an equally dangerous path. Most obviously, the economy is clearly in a precarious position, temporarily held together by the flow of fiscal stimulus and cheap money. Raising rates would almost certainly upset this delicate balance. Furthermore, higher rates threaten to intensify and lengthen the housing downturn; a 30-year conventional mortgage is already at 6.25%. Note also the Fed would be raising rates into what many believe will be the second wave of mortgage problems, the Alt-A and option adjustable mortgages that reset beginning in 2009. If the Fed starts raising rates meaningfully at this point, anticipate the yield curve to invert early next year, signaling a recession in 2010.

Another risk is political. Normally, I would not place much weight on the importance of an election year, but to initiate a tightening campaign with rising unemployment and stagnating real incomes gives me pause. The political response is all too predictable: Why is the Fed so eager to support Wall Street in their hour of need, but equally eager to abandon Main Street when unemployment is rising? Indeed, I would not be surprised to see some Senators start jawboning the Fed by the end of this week. With four spots on the Board open for the next Administration to place, independence of the Fed cannot be taken for granted.

Bottom Line: The Fed has no one to blame for their predicament but themselves. Bernanke & Co. cut rates too deeply, fighting a battle against deflation that never was. Now they are backed into a corner; either raise rates and risk upsetting a very fragile economy, or stay the path and risk the inflationary consequences. If the Fed is truly concerned about the Dollar and commodity prices – and their open talk about currency values implies real and serious concerns – Bernanke will have to follow through with his newfound hawkish side. The bluntness of Fedspeak looks to signal a dramatic shift in thinking on Constitution Ave., and that argues for a rate hike by September, earlier than I had previously expected, and I cannot rule out an August move. Such a move is not without considerable risk for the economy.

Real-Time Assessment of the Economy

Ben Bernanke gave a speech today at a Boston Fed conference on inflation and the Phillip's curve. Part of the speech discusses the difficulties with real-time policymaking, and those remarks are repeated below. To complement the discussion, I also included an academic paper by S. Boragan Aruoba, Francis X. Diebold, and Chiara Scotti that develops "a framework for high-frequency business conditions assessment" that is an attempt to provide a solution to this problem. The paper is, essentially, a call to action on this problem and it attempts to lead the way by providing the methodology for obtaining real time assessments of economic conditions, and by providing an illustrative example (see the graph below). This is probably geekier than I realize:

Outstanding Issues in the Analysis of Inflation, by Ben S. Bernanke, FRB: ...Forecasting and controlling inflation are, of course, central to the process of making monetary policy. In this respect, policymakers are fortunate to be able to build on an intellectual foundation provided by extensive research and practical experience. Nonetheless, much remains to be learned about both inflation forecasting and inflation control. In the spirit of this conference, my remarks this evening will highlight some key areas where additional research could help to provide a still-firmer foundation for monetary policymaking.

...I will briefly touch on four topics of particular interest for policymakers:  commodity prices and inflation, the role of labor costs in the price-setting process, issues arising from the necessity of making policy in real time, and the determinants and effects of changes in inflation expectations. ...