At MoneyWatch, my reaction to Federal Reserve Bank of New York President Dudley Calls for the Fed to Take Action Against Bubbles:
[Boarding time -- going here -- guess that's the end of airport blogging for now.]
At MoneyWatch, my reaction to Federal Reserve Bank of New York President Dudley Calls for the Fed to Take Action Against Bubbles:
[Boarding time -- going here -- guess that's the end of airport blogging for now.]
[From the airport...] Ben Bernanke is worried about entitlement programs:
Bernanke on Deficits: In Long Run, We’re All on Social Security, Medicare, RTE: This morning Jon Hilsenrath noted the Fed Chairman Ben Bernanke was likely to highlight the importance of deficit reduction in a series of speeches. The following is an excerpt on the issue from the chairman’s remarks in Dallas today:
The economist John Maynard Keynes said that in the long run, we are all dead. If he were around today he might say that, in the long run, we are all on Social Security and Medicare. That brings me to two interrelated economic challenges our nation faces: meeting the economic needs of an aging population and regaining fiscal sustainability. The U.S. population will change significantly in coming decades with the combined effect of the decline in fertility rates following the baby boom and increasing longevity. As our population ages, the ratio of working-age Americans to older Americans will fall, which could hold back the long-run prospects for living standards in our country. The aging of the population also will have a major impact on the federal budget, most dramatically on the Social Security and Medicare programs, particularly if the cost of health care continues to rise at its historical rate. Thus, we must begin now to prepare for this coming demographic transition.The economist Herb Stein once famously said, “If something cannot go on forever, it will stop.” That adage certainly applies to our nation’s fiscal situation. Inevitably, addressing the fiscal challenges posed by an aging population will require a willingness to make difficult choices. The arithmetic is, unfortunately, quite clear. To avoid large and unsustainable budget deficits, the nation will ultimately have to choose among higher taxes, modifications to entitlement programs such as Social Security and Medicare, less spending on everything else from education to defense, or some combination of the above. These choices are difficult, and it always seems easier to put them off–until the day they cannot be put off any more. But unless we as a nation demonstrate a strong commitment to fiscal responsibility, in the longer run we will have neither financial stability nor healthy economic growth.Today the economy continues to operate well below its potential, which implies that a sharp near-term reduction in our fiscal deficit is probably neither practical nor advisable. However, nothing prevents us from beginning now to develop a credible plan for meeting our long-run fiscal challenges. Indeed, a credible plan that demonstrated a commitment to achieving long-run fiscal sustainability could lead to lower interest rates and more rapid growth in the near term.Our economic challenges, both near term and longer term, are daunting indeed. Nonetheless, I remain optimistic that they can be met. ...
The CBO has argued persuasively (scroll down) that demographics is not the main problem:
In addition, Social Security can be fixed relatively easy. It is health care costs rising independent of the aging of the population that must be addressed.
But there may be a solution:
Delayed retirement among Americans may bolster future of Social Security and Medicare, EurekAlert: An unprecedented upturn in the number of older Americans who delay retirement is likely to continue and even accelerate over the next two decades, a trend that should help ease the financial challenges facing both Social Security and Medicare, according to a new RAND Corporation study.
While government projections suggest the number of older Americans who remain employed is likely to plateau over the coming decade, RAND researchers say a more likely scenario is that the increase in delaying retirement that began in the late 1990s is likely to gain speed.
Because the trend holds broad benefits for the nation, lawmakers may want to consider reforms that would dismantle barriers that discourage some older people from remaining employed and even consider changes that would encourage employers to hire older workers. ...
In a report published in the Journal of Economic Perspectives, RAND researchers examine a wide array of evidence that suggests that delayed retirement or partial retirement are likely to increase...
A principal reason why retirement rates have dropped is because of an evolution in the skill composition of the nation's workforce, according to the study. As American workers have gained more education, they have achieved jobs that are more fulfilling, they face fewer physical demands in the workplace and they are paid more for their efforts.
Adding to this phenomenon is the rise in the number of dual-earner families. Since couples tend to retire together and men often are older than their spouse, men may stay in the work force longer to accommodate their wives' work lives, according to the study.
While there have been several changes made to Social Security that encourage people to work longer, researchers say those changes appear to be a secondary force behind the trend observed thus far. ...
Additional incentives are on the horizon that may fuel the future growth of the number of older Americans delaying retirement.
Changes to Social Security that delay full benefits from age 65 to age 67 will not be fully in force until 2022, and there have been discussions about further extending the threshold as well. In addition, as labor force participation among younger women has risen over time, women have become increasingly likely to qualify for Social Security benefits on their own work record. As a result, women now more than ever face direct incentives to extend their work lives in order to qualify for higher benefits.
In addition, as people live longer more Americans may need to extend their work lives to accumulate wealth to provide for their needs during old age.
Researchers say that lawmakers may want to consider policies that would further aid older Americans who want to delay retirement. Such measures include eliminating measures in some pension plans that penalize recipients who continue working and improving the public's understanding of retirement and pension rules. ...
Though they downplay it a bit, bad economic policy that creates lots of uncertainty -- something Congress is expert at -- extends their working lives. That's not a recommendation, just an observation.
The fiscal policy response to the crisis has been disappointing. Monetary policy loses its effectiveness in a recession. There are some things monetary policy can do -- important things such as injecting liquidity into fearful, frozen financial markets to prevent a complete meltdown of the system. But when it comes to providing a big shock to aggregate demand sufficient to turn the economy around and propel it back toward full employment, monetary policy alone isn't enough. It's true that monetary policy can lower real interest rates -- even at the zero bound for the federal funds rate, it's still possible to use quantitative easing to nudge long-term interest rates downward -- the problem is that all this does is create an incentive for more investment and consumption (mainly of durables), there is nothing to guarantee that people will actually respond. My reading of the evidence is that to the extent that households and businesses do respond to lower real interest rates during a recession by consuming or investing more, the response is not very strong.
Because monetary policy loses effectiveness in a deep recession -- something I've been teaching for decades -- I was among the first to call for aggressive fiscal policy. Fiscal policy creates demand directly, it does not rely upon incentives and the hope that people will respond to them. When the crisis hit, we needed fiscal policy right away. Given the lags between changes in policy and actual effects on the economy, which were known to be lengthy, and given that monetary policy was not going to be enough, there was no time to "wait and see" (as many people I respect were calling for). But the reality is that fiscal policy didn't get put into place until much, much later, far too late to stop the worst of the downturn (and it wasn't big enough anyway). The way too slow policy process, and the way too small policy that came out of it, was frustrating to watch.
I think we'd be much better off today if we'd done what is necessary right away instead of hoping and hoping that things weren't going to be so bad, and that we could escape the need for an aggressive policy intervention. This crisis has taught me that policy of that magnitude is nearly impossible to put in place based upon what looks to be happening, i.e. before the recession actually occurs. There must be clear evidence that a severe recession is actually underway before policy will be considered. Unfortunately, by that time it's too late to prevent the worst part of the downturn.
Now that we are hitting the other side, I'm feeling frustrated again with the lack of action from policymakers. I expect the recovery to proceed at a snail's pace, labor markets in particular. If employment rebounds quickly, great, but that's not what I think is going to happen, and that's not what the evidence suggests. If the recovery is going to be slow, then it's not too late to provide more help. Instead of getting back to full employment by, say, 2013, we could get there sooner if we act now. I'm not the greatest artist in the world, but I even drew a picture:
Why settle for the blue line recovery when the green line is possible? Frustration over the fact that we seem to be headed on the blue-line trajectory explains why I've been reluctant to highlight what little good news there has been about labor markets recently. I don't want to jump on the "things are getting better" bandwagon when there is still more that policymakers can do to help, and when there are still considerable uncertainties about the strength of the budding recovery.
But, as I said at the beginning, even though it's not too late for more help to make a difference, it's not going to happen. Now that the recovery seems to have started and the budding optimism is apparent, we will turn our attention elsewhere, to financial reform, to global warming, and to other issues. We'll forget about all the people who could have been working, but instead have to hope Congress doesn't cut off their unemployment insurance before they can find a job.
I'll still complain -- there's no reason to let policymakers off the hook -- but it's time to give up the hope that anything more will be done to help the unemployed find jobs.
Let me start with this:
Inflation Fears Cut Two Ways at the Fed, by Jon Hilsenrath, WSJ: The Federal Reserve's decisions to keep interest rates near zero and to flood the financial system with credit are sparking fears of an eventual outbreak of inflation.
But inside the Fed, an influential band of policy makers is fretting over the opposite: that the already-low rate of inflation is slowing further.
The presidents of the New York and San Francisco regional Fed banks, William Dudley and Janet Yellen, see the abating inflation rate as convincing evidence the economy still is burdened by excess capacity and needs to be sustained by the Fed.
Others, led by Philadelphia Fed President Charles Plosser, argue that current inflation measures are distorted by an epic decline in housing costs and could mask a buildup of inflationary pressures. ... Recent developments have given the inflation-rate-is-dropping camp an upper hand. ...
The opposing camp believes the combination of low rates and more than $1 trillion the Fed has pumped into the financial system is a formula for inflation down the road. "As the economy improves and as lending picks up, the longer-term challenge we face will not be worrying about inflation being too low," Mr. Plosser said in an interview. "The risk is really to the upside of inflation over the next two to three years."
This camp focuses less on the amount of slack in the economy ... and more on the risk that consumers and businesses will anticipate inflation and act accordingly. At the Fed's mid-March meeting, Thomas Hoenig, president of the Kansas City Fed, argued for an increase in short-term interest rates "soon" to "lower the risks of...an increase in long-run inflation expectations." ...
Mr. Plosser also argues that the recent decline in the inflation rate is a mirage, greatly influenced by an unusual decline in housing costs, which are heavily weighted in many price indexes. ...
Researchers at the San Francisco and New York Fed are scheduled to release a retort to this argument Monday that shows that among 50 different categories of consumer spending—from computers to hotels to jewelry—inflation rates have slowed over the past 18 months from the earlier trend. ...
"The trimmed mean PCE inflation rate is an alternative measure of core inflation in the price index for Personal Consumption Expenditures"
In the short-run, i.e. right now, disinflation/deflation is the worry. In the longer run, we should be concerned about inflation, but not at the expense of killing the recovery that appears to be at the beginning stages. I believe the Fed can unwind the stimulus measures when the time comes without a serious inflation problem, and that moving against inflation too soon would be a big mistake (in fact, if anything, right now we could use more stimulus from the Fed).
Here is the report from the SF and NY Feds:
The Housing Drag on Core Inflation, by Bart Hobijn, Stefano Eusepi, and Andrea Tambalotti, FRBSF Economic Letter: Some analysts have raised the question of whether the unprecedented declines in house values, which have been the hallmark of the recent recession, might be artificially dampening core inflation readings. However, a close examination of recent inflation data shows that the weakness in housing costs is representative of a broad pattern of subdued price increases across most consumption goods and services and is not distorting the broad downward trend in core inflation measures.
Measures of consumer prices such as the consumer price index (CPI) and the personal consumption expenditures price index (PCEPI) are closely watched by the Federal Reserve. The focus in this Letter is on the core PCEPI. This index covers consumer expenditures, excluding food and energy, which are used to calculate gross domestic product. The core PCEPI is one of four macroeconomic variables featured in the Summary of Economic Projections published by the Federal Open Market Committee, the Fed’s monetary policymaking body, four times a year.
Core PCEPI inflation has shown a clear downward trend since mid-2008. Declines in house prices have contributed to that trend. However, it is important to realize that house price declines themselves do not directly show up in measured inflation. This is because the price of a house not only reflects the cost of living in it, but also the returns on investment in the house as an asset. The PCEPI aims to capture the cost of living in a house and to filter out changes in house prices due to changes in their returns as investment assets. For renters, the result is that the housing part of the PCEPI is measured by the change in the monthly expense for living in a house or apartment, that is, their rent. For people who own their living space, such rental payments do not occur and thus cannot be directly measured. Instead, the Bureau of Labor Statistics collects data on rents that people pay for comparable living units. These data are then used to estimate the rent that people who own their homes would pay if they were renting their dwellings. McCarthy and Peach (2010) describe the statistical methods used for this purpose in detail. The resulting imputed rent level is known as owners’ equivalent rent and is used in the core PCEPI to measure the cost of housing for homeowners.
Thus, the price of housing in the core PCEPI is made up of both rents and owners’ equivalent rents. The expenditures on these two categories add up to 18% of total consumer spending covered by the core PCEPI.
Core inflation with and without housing
One way to consider the effect of the price of housing on core inflation is to calculate a core PCEPI that excludes housing. This is done in Figure 1, which contains three time series. The first is 12-month growth in the core PCEPI. The second is a comparable measure of inflation for the housing component of the core PCEPI. The final time series is a core PCEPI that excludes housing expenditures.
Core PCE inflation with and without housing
January 2005 through February 2010
Source: Bureau of Economic Analysis, authors' calculations.
Three things stand out in this figure. First, the standard core inflation measure shows substantial disinflationary pressures at work. Twelve-month annualized core PCEPI inflation has come down from 2.7% in August 2008, immediately before the financial crisis reached a crescendo, to 1.3% in February 2010. Core inflation dipped even deeper during the midst of the crisis, when plummeting demand for consumer goods, especially such consumer durables as cars, electronic goods, and furniture, led retailers to lower prices drastically to get rid of excess inventories. This is the source of the September 2009 trough in 12-month core inflation. Twelve-month core inflation briefly increased at the end of 2009, and has since resumed its downward course. This indicates that the upward move of core inflation late in 2009 was temporary and that the disinflationary trend that started in the fall of 2008 continues.
Second, part of the drop in measured core inflation is undoubtedly due to the deceleration in the price of housing. The declines in housing inflation have been more profound than in core inflation. The 12-month percentage change in rents and owners’ equivalent rents has come down from 4.5% in February 2007, at the height of the housing bubble, to 0.3% in February 2010. This decline in the rate of housing price increases reflects reduced upward pressure on rents, which in turn is due to historically high vacancy rates for rental properties. Because house price inflation is now below core inflation, it drags down the overall level of core inflation.
Third, it turns out that this drag is rather small. The decrease in housing inflation only accounts for a small part of the overall disinflationary pressure on core PCEPI. This can be seen by comparing the core inflation rate with the PCEPI inflation rate that excludes housing, shown in Figure 1. The core PCEPI inflation measure without housing displays a very similar trend to core inflation. From July 2008 to February 2010, it has fallen from 2.6% to 1.6%. Just like core PCEPI inflation, 12-month core inflation without housing temporarily increased after the trough in September 2009 and has started to come down again in recent months. The current difference of 0.2 percentage point between core PCEPI inflation and core PCEPI without housing is not large by historical standards.
Consequently, the evidence in Figure 1 offers little cause for concern that the recent behavior of core inflation might be a misleading signal of the underlying inflation trend. Instead, Figure 1 reveals that, no matter whether housing is included or not, core inflation exhibits a noticeable disinflationary tendency since August 2008. This is not only true for the core PCEPI, but also for core CPI, which is not shown here. For core CPI, the difference between the index with and without the two PCEPI housing components, rent and owners’ equivalent rent, is slightly larger due to the higher weight of these in the CPI.
Disinflation beyond housing
Figure 2 provides more direct evidence in support of the view that the weakness in housing inflation is not an outlier to be discounted, but rather a reflection of a widespread deceleration in inflation during the acute phase of the recession. The figure compares the annualized inflation rates of about 50 goods and services that make up core personal consumption expenditures before and after August 2008.
Annualized inflation in core PCE components before and after August 2008
Source: Bureau of Economic Analysis, authors' calculations.
Notes: Comparison periods are January 2005 to August 2008 and August 2008 to February 2010.
In the figure, each circle corresponds to a particular category of consumer spending, and the size of the circle reflects the expenditure share of that category. Circles below the dashed line correspond to spending categories for which the average annualized rate of inflation has decreased in the past 1½ years compared to the prior 3½ years. The majority of circles lie below the dashed line, confirming that disinflation has been a widespread phenomenon in the recent period. Moreover, the large red circle that represents housing sits more or less at the center of the picture, close to many other large expenditure categories. This is evidence that the deceleration in housing inflation over the past 1½ years was not an outlier, but rather a fairly typical reflection of broad-based deceleration in core inflation.
Some individual spending categories are worth pointing out. Used and new motor vehicles have been among the goods with the highest acceleration in prices. However, this acceleration was partly due to government support of the vehicle market through the cash-for-clunkers program. With the expiration of the program, it is unlikely that car prices will continue to rise at the same rates.
Public transportation, including airfares, has experienced severe disinflation. Fares have fallen in response to a decline in demand for air transportation and the fall in oil prices since the summer of 2008. The latter is not surprising in light of the evidence in Hobijn (2008) that transportation services have the highest oil share of any category in the core PCEPI.
Several categories with the largest declines in inflation are luxury goods, such as jewelry, luggage, and multimedia equipment. Another group with declining inflation can be classified as highly discretionary spending items, such as hotel accommodations. This suggests that disinflation in these categories in large part reflects very low demand for these goods and services.
Weakness in the housing market has reduced the inflation rate of the housing components of core inflation. Yet, this very substantial decline in the rate of housing inflation has not been isolated. Rather, it is indicative of a much wider decrease in inflationary pressures observed since the peak of the financial crisis. Even if we take housing out of core PCEPI, inflation has come down substantially over the past 1½ years. As a consequence, there is little reason to reduce the emphasis on core inflation as the main gauge of underlying price pressures in the economy. Recent core inflation trends reflect substantial and widespread disinflationary pressures, which, as Liu and Rudebusch (2010) point out, is likely due to a large amount of slack in the economy.
Right now, with labor markets struggling just to tread water, inflation is not the problem we should be most worried about.
I'm encouraged that at least one Federal Reserve policymaker (though not a voting member of the FOMC) is linking increases in the target federal funds rate, i.e. moving away from a zero interest rate policy, to improvements in the labor market. However, if expected inflation begins increasing, all bets are off.
That's the part that concerns me. How quickly will policymakers abandon efforts to stimulate employment by maintaining a zero interest rate policy if they start to get worried about inflation? What, exactly, is the tradeoff here? Will any sign of inflation whatsoever cause policymakers to panic and start aggressively raising interest rates even if unemployment remains elevated, or will concerns over employment cause them to be patient and accept some inflation in the short-run? Again, it's encouraging that employment concerns are coming to the forefront of the policy decision, but will those concerns carry sufficient weight if there are signs that inflation expectations are increasing? I'm worried that they won't:
Prospects for Sustained Recovery and Employment Gains, by Dennis P. Lockhart, President and Chief Executive Officer, Federal Reserve Bank of Atlanta: After the deepest and longest recession in the past half century ... the U.S. economy is now in recovery. Today I want to discuss the prospects that the recovery ... is sustainable—and the implications ... for perhaps the most vexing current problem coming out of the recession: unemployment. ...
The economy remains in a transitional phase from a period that depended on support of public sector programs to a period of resumed growth based on private spending. For the recovery to be sustained, we need consumers to consume and businesses to spend on inventory, investment goods, and human resources. Economic forecasts hinge on how formidable those positive forces will be and on the strength of countervailing headwinds.
Views about the economic outlook fall roughly into two narratives. The more optimistic scenario is a V-shaped bounce back from severe recession. ... By contrast, the second scenario is a relatively modest recovery, with slow reduction of unemployment. ... In ... Atlanta..., our outlook is closer to the second narrative.
Perspective on labor markets
As already suggested, an implication of this slow recovery scenario is the very gradual decline of today's unacceptably high rate of unemployment. ... Today, the rate stands at 9.7 percent, down from a high of more than 10 percent in October.
I view unemployment as a daunting economic challenge—and very likely a dominant political issue—of the period ahead. ... Today, there are about 130 million payroll jobs in the United States, and that number is about 8.4 million lower than at the beginning of the recession. ...
About 15 million people in the United States are unemployed. ... Also, underemployment is prevalent. The underemployed include both discouraged workers... as well as individuals who are working part-time but want to work full-time. The unemployment rate that combines the fully unemployed and underemployed workers is about 17 percent.
Another indication of underemployment is reduced hours of work. Average hours of work per week are still well below prerecession levels...
Despite the weak state of labor markets, there are signs that the worst may be behind us. The rate of job loss is slowing. The rate of decline in payroll employment has been close to zero in the last couple of months. Also, while initial and continuing unemployment claims are at historically high levels, both have fallen.
Another bright spot is temporary employment. The temporary services sector shed more than 800,000 jobs during the recession but has seen a notable increase since last fall. This improvement is noteworthy as temporary employment is often viewed as a leading indicator.
The normal state of affairs in the country's labor market is a dynamic mix of separations from employment and new job creation. There are two causes of separations—layoffs and voluntarily quitting a job, or so-called quits. ... Today's slow pace of employment gains is due more to the slow pace of job creation, not the high rate of layoffs.
Job gains, as conventionally understood, require two things: a vacancy and a worker able to fill that vacancy. For most of 2009, vacancies were relatively flat while unemployment continued to rise. This condition suggests the existence of what labor economists call "match inefficiencies."
There are two key types of match inefficiency. One is geographic mismatch. In 2008, the percentage of individuals living in a county or state different than the previous year was the lowest recorded in more than 50 years of data. People may be reluctant to relocate for a new job if the value of their house has declined. In addition, many who would like to move are under water in their mortgage or can't sell their homes.
The second inefficiency is skills mismatch. In simple terms, the skills people have don't match the jobs available. Coming out of this recession there may be a more or less permanent change in the composition of jobs. Skill mismatches require new training, and there is evidence that adult education institutions have responded to this need. For instance, officials at Miami-Dade College in Florida, which is the largest college in the country and a grantor of associate and vocational degrees, told us they have recently seen a strong increase in enrollment, especially of men in their 20s.
This evidence of retooling is encouraging, but, to be realistic, structural adjustment takes time. ...
All things considered, labor market trends appear to be headed in the right direction. But it's quite possible the recovery could be well advanced before any significant reduction of unemployment materializes. It's also quite possible circumstances justifying the start of a cycle of policy tightening will develop well before the unemployment rate has found a satisfactory level. ... So let me now comment on how I'm thinking about the relationship between the Fed's employment mandate and monetary policy.
Implications for monetary policy
As you know, monetary policy is highly accommodative. And I think this stance is appropriate at present. I continue to support ... a low federal funds rate target for an extended period. ... As long as inflation remains subdued and inflation expectations anchored, a key factor for me is improvement of employment markets.
Going forward, I will be looking for signs that employment gains are likely to repeat and accumulate and, once achieved, are likely to be durable.
What might such signs be? One indication would be that the process of job creation is improving. In January, we saw a sizable increase of job openings, according to the BLS. I'm looking for that to become a trend. A second sign would be a decline in the measured rate of underemployment. And the third sign would be a string of employment gains large enough to appreciably move the unemployment rate down over time.
There are hopeful, if tentative, signs of improvement in employment markets. We have a long way to go, and for that reason I believe it is premature to assume an imminent reversal of the Fed's accommodative policy. But you can interpret the fact that I am here discussing the conditions under which such a reversal will be appropriate as an indication of my conviction that we are, finally, moving in the right direction.
Despite all the worries about inflation, the latest release of the Dallas Fed's Trimmed mean PCE inflation calculations (a measure of the core rate of inflation) indicates that inflation is still headed downward:
"The trimmed mean PCE inflation rate is an alternative measure of core inflation in the price index for Personal Consumption Expenditures"
Here are the recent data for the 12-month inflation rate (3/29 release):
Target the Cause Not the Symptom, by David Beckworth: Olivier Blanchard of the IMF recently made the case for monetary policy targeting a 4% inflation target instead of the standard 2% target. His main argument for doing so is that it would make the zero bound on the policy interest rate less of an issue. Here is how the Wall Street Journal summarized his view:At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.
There was a lot of push back on this argument in the blogosphere from folks like Ryan Avent, Mark Thoma, and David Altig who countered that (1) the zero bound isn't really a constraint for monetary policy, (2) higher inflation will lead to increased relative price distortions, and (3) there is mixed evidence and thus less certainty on the benefits of higher inflation. While all of these points are valid, I think there is a more fundamental problem with Blanchard's view: inflation targeting at any rate is merely responding to the symptom not the underlying causes--shocks to aggregate demand (AD) and shocks to aggregate supply (AS)--of macroeconomic volatility. This is problematic because monetary policy can only meaningfully counter AD shocks and therefore, it must be able to discern which shock is driving inflation. Inflation, however, can be hard to interpret. For example, if there is a sudden burst of inflation is it due to a positive aggregate demand shock (e.g. sudden, unsustainable increase in household spending) or a negative aggregate supply shock (e.g. temporary spike in oil prices)? In the former case inflation targeting would act appropriately by reigning in excess spending while in the latter case inflation targeting would only make matters worse by further restricting economic activity. Rather than targeting inflation, then, monetary policy should directly target the underlying source of macroeconomic volatility over which it has real influence, AD. Doing so would have gone a long way in making the U.S. economy during the 2000s more stable, a point I have made repeatedly during this crisis.
The importance of targeting AD can easily be illustrated using an AD-AS model. Here I use the AD-AS model developed by Tyler Cowen and Alex Tabarrok in their new macroeconomic textbook. Their version of the AD-AS model places growth rates on the two axis rather than levels. Below is the model in equilibrium with an AD growth rate of 5% that can be split up into an inflation rate of 2% and a real growth rate of 3%. (Click on figure to enlarge.)
Now consider four shocks to the economy when monetary policy is solely targeting an inflation rate of 2%. First, let see what happens when there is a positive AD shock driven by say expansionary fiscal policy (click on figure to enlarge):
The positive AD shock pushes the economy beyond full employment, increases inflation to 3%, and real growth jumps to 4%. AD is now growing at an accelerated rate of 7%. Fed officials seeing the higher inflation tighten monetary policy to get back to 2% inflation and in so doing push the economy back to full employment. Here the 2% inflation target worked just fine and effectively served to stabilize AD at 5% growth.
Now consider a negative AD shock caused by say a sudden collapse in economy certainty (Click on figure to enlarge).
Joseph Gagnon has been frustrated with those of us who have not fully embraced further action by the Fed to lower long-term interest rates. Here's his description of some new research on this issue:
Monetary Policy Can Do More, by Joseph Gagnon, Peterson Institute for International Economics: A new study in which I participated has been posted on the website of the Federal Reserve Bank of New York. It documents how the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. The study reinforces an argument I have previously made: that the Federal Reserve and other central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero. (For the wonkish, the effect appears to work though the term premium rather than through expectations of future short-term interest rates.)
The reduction in long-term interest rates applies not only to Treasury securities, but also to mortgages and corporate bonds. Households buying and refinancing their homes took out mortgages worth over $2 trillion in 2009 and they will save about $11 billion in interest payments each year because of the lower interest rates. With interest rates remaining low for new borrowers in 2010, these benefits will continue to grow and will help to support consumer spending and economic recovery. Thanks to the low interest rate environment, corporate bond issuance (net of redemptions) reached a record $381 billion in 2009, helping to finance a turnaround in capital spending late last year that exceeded most private forecasts.
With unemployment projected to remain far above most estimates of its equilibrium for the next few years and with core inflation having fallen to 1 percent over the past 6 months, the US economy clearly needs more of this medicine. As I argued last December, the Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt.
Does additional Fed action mean that inflation is going to come roaring back? Not unless the Fed forgets everything it learned from the 1970s. But right now, inflation is below the Fed’s target of 2 percent and heading lower. The immediate problem is deflation. As Japan shows, acting too weakly against deflation is a serious error. Yes, the Fed may have to reverse course in a couple years, but that would be better than facing a decade of excess unemployment and entrenched deflation.
I have been working on a write-up of how the crisis will affect monetary and fiscal policy in the future based upon my discussion at the Kaufman Center's recent Economic Bloggers' Forum. Here's the draft version of what I wrote on this issue:
Quantitative Easing: Whether or not the Fed embraces more aggressive quantitative easing the next time a crisis hits depends critically upon how gracefully the Fed can exit from the policies implemented during this crisis. If, as I believe, the Fed can exit without an outbreak of inflation, then one conclusion that will most likely be drawn is that the Fed was way too timid with its quantitative easing policy. However, if inflation does turn out to be a problem, it will call the whole policy procedure used during the crisis into question.
I was among the people who (probably) had too much fear of inflation and hence was unwilling to fully embrace more aggressive policy (though I did give lukewarm support). The Fed's credibility is shaky, and I was worried that if there was an inflation problem, it would further undermine the Fed's credibility and cause Congress to take more control over monetary policy, something I thing would be a big mistake and lead to worse policy outcomes in future recessions. I was also skeptical that a fall in long-term real interest rates would induce much in the way of new investment and the consumption of durables due to poor economic conditions, so the benefits of the policy seemed small relative to the potential costs. As I said above, right now I don't expect inflation to be a problem, but the Fed's exit is just beginning, so we will have to wait and see.
In a speech today, Ben Bernanke says the financial system is far from the "competitive ideal," and that the too-big-to-fail problem is the primary cause of the "insidious barriers to competition" and "competitive inequities" that currently exist in these markets.
One thing I'd add is that there is reason to be concerned about the size of these firms over and above the too-big-to-fail problem, i.e. for traditional reasons involving the exercise of market power. Bernanke says that:
our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope
But I'd like to have more precise information about how large these firms need to be until the economies of scope and scale begin bottoming out. If it's so large that firms can gain a substantial market share by moving down the cost curve, then regulators need to ensure that firms do not exploit their market power:
...Toward a More Competitive, Efficient, and Innovative Financial System The United States has a financial system that is remarkably multifaceted and diverse. Some countries rely heavily on a few large banks to provide credit and financial services; our system, in contrast, includes financial institutions of all sizes, with a wide range of charters and missions. We also rely more than any other country on an array of specialized financial markets to allocate credit and help diversify risks. Our system is complex, but I think that for the most part its variety is an important strength. We have many, many ways to connect borrowers and savers in the United States, and directing saving to the most productive channels is an essential prerequisite to a successful economy.
That said, for the financial system to do its job well, it must be an impartial and efficient arbiter of credit flows. In a market economy, that result is best achieved through open competition on a level playing field, a framework that provides choices to consumers and borrowers and gives the most innovative and efficient firms the chance to succeed and grow. Unfortunately, our financial system today falls substantially short of that competitive ideal.
Among the most serious and most insidious barriers to competition in financial services is the too-big-to-fail problem. Like all of you, I remember well the frightening weeks in the fall of 2008, when the failure or near-failure of several large, complex, and interconnected firms shook the financial markets and our economy to their foundations. ... It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.
The costs to all of us of having firms deemed too big to fail were stunningly evident during the days in which the financial system teetered near collapse. But the existence of too-big-to-fail firms also imposes heavy costs on our financial system even in more placid times. Perhaps most important, if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm's business model, its management, and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.
Having institutions that are too big to fail also creates competitive inequities that may prevent our most productive and innovative firms from prospering. In an environment of fair competition, smaller firms should have a chance to outperform larger companies. By the same token, firms that do not make the grade should exit, freeing up resources for other uses. Our economy is not static, and our banking system should not be static either.
In short, to have a competitive, vital, and innovative financial system in which market discipline encourages efficiency and controls risk, including risks to the system as a whole, we have to end the too-big-to-fail problem once and for all. But how can that be done? Some proposals have been made to limit the scope and activities of financial institutions, and I think a number of those ideas are worth careful consideration. Certainly, supervisors should be empowered to limit the involvement of firms in inappropriately risky activities. But even if such proposals are implemented, our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope. The unavoidable challenge is to make sure that size, complexity, and interconnectedness do not insulate such firms from market discipline, potentially making them ticking time bombs inside our financial system.
To address the too-big-to-fail problem, the Federal Reserve favors a three-part approach.
I have a quick reaction to the Press Release from today's FOMC meeting at MoneyWatch:
Larry Meyer on Janet Yellen's nomination as Vice Chair of the Federal Reserve Board:
Meyer on Yellen as Fed Vice Chair: "The best possible choice", by Larry Meyer, MacroAdvisors: President Obama is reported to soon announce his decision to nominate Janet Yellen as Vice Chair of the Federal Reserve Board... My reaction to the President's choice: an enthusiastic Hurray! ... I am biased. Janet is one of my favorite people, a good friend, a former colleague (both at the Board and briefly at Macroeconomic Advisers) ... I want to say a few ... words about ... how her appointment could affect monetary policy decisions. ...
Many in the markets ... will be interested in only one question: How will the nomination affect monetary policy decisions, specifically the timing of exit from the current near-zero rate? Janet Yellen is today, certainly, among the doves on the Committee. I will be posting a commentary soon ... where I explain what makes one a hawk or a dove ... and whether it matters. The conclusion is that it does not matter... The reason is, as said to me by a member of the Board: "The Chairman owns the room." When the Chairman wants to move away from the near-zero funds rate, the Committee will do so. Until that time, he will always enter the room with at least eight votes in his pocket and with assurance that there will be several more each time. As Vice Chair, Janet can never vote against the Chairman. She can never take a substantially different view than the Chairman around the table. This is the etiquette of being a Vice Chair... It goes with the territory. You don't take this position if you cannot abide by this rule. Fortunately, this won't be a problem for Janet. First, she holds views that are not very different than the Chairman's. Second, she has utmost confidence in his judgment, and the feeling is mutual. She will, almost alone on the FOMC, continue to have the opportunity to help shape that judgment. Janet surely appreciates ... that the only way she can affect the policy decision is to convince the Chairman to alter his recommendation to the Committee is to reach him before the meeting. What we can say for sure is that Janet will surely help the Chairman make the best decision, even in those occasions when he ends up disagreeing with her.
The final question is whether Janet is really a dove. Let me tell you a story. Janet and I held very similar views when we were colleagues on the Committee, despite the fact that I was immediately viewed as a hawk and she was already viewed as a dove. (I thought of myself at the time as being a "hawkish dove.") In any case, when it comes to ensuring price stability and maintaining well-anchored inflation expectations, there are no doves on the Committee. Before the September 1996 FOMC meeting, Janet and I went to see the Chairman to talk about the policy decision at that meeting and at following meetings. This was the only time I ever visited the Chairman (at my initiative) to talk about monetary policy, before or after a meeting. Janet and I were both worried about inflation, even though it was very well contained at the time. We told the Chairman that we loved him but could not remain at his side much longer if he continued, as he had been doing for some time, to push the next tightening action into the next meeting, and then not follow through. He listened, more or less patiently. I recall, though this may have not been the case, that he just smiled and didn't say a word. After an awkward silence, we said our good-byes. Needless to say, we didn't win this argument. Yet, we never dissented. That is another matter of etiquette for the entire Board, at least since when I was there: The Board is a team, always votes as a block, and, therefore, always supports the Chairman.
Yes, Janet is a dove today. But this is so principally because she passionately believes in the dual mandate (price stability and full employment). ... Given the Fed's mandate, and because she expects the unemployment rate to be very elevated for a long time and inflation to be very low for quite some time, she wants to make a "late" exit from the near-zero rate policy. How could you not be a dove under these circumstances? Certainly I would be a dove if I were on the Committee today. But Janet would quickly switch camps, unquestionably along with all her dove colleagues, if the outlook or her forecast changed such that a serious threat to price stability emerged. There simply are no doves at central banks under these circumstances, and certainly not on the FOMC.
In any case, the minute she was nominated to the Committee she became a centrist. Now, more than ever, she will be side-to-side with the Chairman, who, by definition, is always the center of the Committee. ...
Update: On another topic, in September 2005 post, she was not a fan of Fed intervention to pop bubbles:
Presentation to the members of Parliament at the Conference on US Monetary Policy, by Janet L. Yellen, President, FRBSF: ... I want to focus my remarks today on another longer-term issue, namely, the housing market ... The question is: ...Is there a house-price "bubble" that might collapse, and if so, what would that mean for the U.S. economy? To answer this question, let me begin by clarifying what I mean by the term "bubble." A bubble does not just mean that prices are rising rapidly—it's more complicated than that. Instead, a bubble means that the price of an asset—in this case, housing—is significantly higher than its fundamental value.
One common way of thinking about housing's fundamental value is to consider the ratio of housing prices to rents. ... Currently, the ratio for the U.S. is higher than at any time since data became available in 1970 ... Higher than normal ratios do not necessarily prove that there's a house-price bubble. House prices could be high for some good, fundamental reasons. ... Probably the most obvious candidate for a fundamental factor ... is low mortgage interest rates. ... While the fundamentals I've mentioned do play a role, the consensus seems to be that much of the unusually high price-to-rent ratio for housing remains unexplained. Moreover, with controversy over exactly why long-term interest rates have remained so low, we can't rule out the possibility that they would rise to a more normal relationship with short-term rates, and this obviously might take some of the "oomph" out of the housing market. So, while I'm certainly not predicting anything about future house price movements, I think it's obvious that the housing sector represents a risk to the U.S. outlook.
This brings me to the debate about how monetary policy should react to unusually high prices of houses—or other assets, for that matter. ... As a starting point, the issue is not whether policy should react at all; I believe there is quite general agreement that policy should be calibrated to the wealth effects of house prices on output and inflation. The debate lies in determining when, if ever, policy should be focused on deflating the asset price bubble itself. In my view, the ... decision to deflate an asset price bubble rests on positive answers to three questions. First, if the bubble were to collapse on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble?
My answers to these questions in the shortest possible form are, "no," "no," and "no." ... In answer to the first question on the size of the effect, it could be large enough to feel like a good-sized bump in the road, but the economy would likely to be able to absorb the shock... In answer to the second question on timing, the spending slowdown that would ensue is likely to kick in gradually... That would give the Fed time to cushion the impact with an easier policy. In answer to the third question on whether monetary policy is the best tool to deflate a house-price bubble, ... For one thing, no one can predict exactly how much tightening would be needed, or by exactly how much the bubble should be reduced. Beyond that, a tighter policy to deflate a housing bubble could impose substantial costs on other sectors of the economy that would lead to equally unwelcome imbalances. Finally, it's possible that other strategies, such as tighter supervision or changes in financial regulation, would not only be more tailored to the problem, but also less costly to the economy. Taking all of these points into consideration, it seems that the arguments against trying to deflate a bubble outweigh those in favor of it. ... But let me stress that the debate surrounding these issues is still very much alive.
By June 2009, her views had evolved:
Panel discussion for the Federal Reserve Board Journal of Money, Credit, and Banking conference on "Financial Markets and Monetary Policy," by Janet Yellen, President FRBSF: My second point concerns asset prices. The role of the house price bubble in precipitating the current financial crisis places new urgency on a long-standing question: Should central banks attempt to deflate asset price bubbles before they grow large enough to cause big problems? Until recently, most central bankers would have said monetary policy should respond to an asset price only to the extent that it will affect the future path of output and inflation. In essence, if you believe that financial markets work well most of the time, then you would be highly reluctant to target asset prices, let alone pop asset price bubbles. But, as I have discussed, we have vivid proof that markets sometimes don't work, and that the unwinding of a bubble can dramatically harm economic performance and threaten financial stability.
Four main issues define this debate... First, some question whether bubbles even exist. They argue that asset prices reflect the collective wisdom of traders in organized markets who best understand the fundamental factors underlying asset prices. It seems to me that this argument is difficult to defend in light of the poor decisions and widespread dysfunction we have seen in many markets during the current turmoil.
Second, it's an open question whether policymakers can identify bubbles in time to act effectively...
Third, even if we can identify bubbles as they happen, using monetary policy to address them will reduce our ability to attain other goals, so it makes sense for monetary policy to intervene only if the fallout is likely to be quite severe and difficult to deal with after the fact. ... By their nature, credit booms are especially prone to generating powerful adverse feedback loops between financial markets and real economic activity.4 If all asset bubbles are not created equal, policymakers could decide to intervene in those cases that seem especially dangerous.
Fourth, if a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy.5 However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets.6 Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.
Certainly there are pitfalls to trying to deflate bubbles. At the same time, policymakers often must act on the basis of incomplete knowledge, and it is now patently obvious that not dealing with some bubbles can have grave consequences. I would not advocate making it a regular practice to lean against asset price bubbles. But, in my view, recent painful experience strengthens the case for using such policies, especially when a credit boom is the driving factor.
Having made the same points, I have no choice but to agree:
Fed Vacancies and the Monetary Challenge, by Alan S. Blinder, Commentary, WSJ: ...Federal Reserve Vice Chairman Donald Kohn's recent announcement that he will retire in June will bring the Federal Reserve Board down to four members—unless the Obama administration gets some new members in place by then. Recent history is not propitious. While the law states that the board has seven governors, vacancies have become the norm in recent decades. ... Let's hope Mr. Obama breaks that pattern—soon.
Why? Because ... Chairman Ben Bernanke and his four (soon to be three) colleagues, along with the presidents of the 12 district Reserve Banks, face two enormously complex and consequential sets of decisions. One has to do with the Fed's exit from its hyper-expansionary monetary policies—a process that is just beginning. The other pertains to the post-crisis regulatory system—provided Congress keeps the Fed in that business.
Each of these two areas is replete with hazards and numerous questions... And in each, mistakes can be quite consequential. As the Fed grapples with its many difficult decisions..., it would be nice if the estimable Mr. Bernanke were supported by a full, talented team. ...
That said, the Fed is formulating exit plans... Doing so adroitly will require both consummate technical skills and good seat-of-the-pants judgments. Yet, remarkably, once Vice Chairman Kohn retires, the Federal Reserve Board will be down to just one ... trained economist. That member, of course, is a very talented guy named Bernanke. But not even Derek Jeter carries the Yankees alone.
So it is imperative that President Obama appoint two distinguished and knowledgeable economists to the board as soon as possible. Such talent is often found in academia..., but that is not the only source. In selecting nominees, the president should be mindful ... that ... the Federal Open Market Committee ... is, on average, pretty hawkish. Mr. Obama will, I believe, want to create more balance.
The Fed's second big task will be creating and adapting to the new financial regulatory system. The ... Fed must be prepared for either of two challenging contingencies. If a major financial-reform bill passes, the Fed will likely have to reorganize itself and, in concert with other agencies, write scores of rules and regulations to implement the new regulatory framework. The other possibility is that no legislation passes. Since maintaining the regulatory status quo ante is unthinkable, the Fed and other agencies would then have to think through and promulgate dozens of regulatory changes that fall within their existing authority...
In either case, the Fed has a major regulatory job ahead of it. Economics will be useful here, too. But ... economists who would be most helpful on monetary policy will probably have little expertise on financial regulation. So President Obama would be wise to use one of his three nominations for someone deeply experienced in banking or financial regulation. Having three vacancies ... gives the president the luxury of being able to hire a diversified portfolio of talented people.
One last but important point: Confirmations of Federal Reserve governors have not traditionally been political events. ... Fed nominees are rarely highly political people. That's a tradition that both parties should cherish and nurture. ... Senate Republicans should refrain from turning his nominations into a political circus. Well, a man can hope, can't he?
It looks like there may finally be some action on this issue:
Report: Yellen to Fed vice-chair, by Tracy Alloway, FT Alphaville: Janet Yellen, president of the Federal Reserve Bank San Francisco, has been chosen by US president Barack Obama to replace Donald Kohn as vice chairman of the central bank, Bloomberg reports, citing two people with knowledge of nomination process. The selection is “pending completion of vetting by the Obama administration,” Bloomberg said.
Brad DeLong says "A very good person for the job. Not, however, a good move as far as strengthening the FOMC is concerned..." I also think Yellen is a very good choice, and if the new president at the SF Fed is chosen wisely, the FOMC will be improved over its present composition.
The administration has not taken full advantage of the opportunity to shape monetary policy during the crisis.
Should the Fed have done more to combat the unemployment problem? In examining the costs and benefits of further easing, I have made almost all of the arguments against further easing by the Fed made below, i.e. that further easing by the Fed may not have much additional effect on long-term real interest rates, that even if rates could be brought down, consumers and businesses would be unlikely to respond by increasing investment and the consumption of durables -- firms already have considerable idle capacity, so why build more, and consumers are pessimistic about their futures, so why buy on credit -- and that there is an inflation risk from further easing.
One additional argument against more aggressive action by the Fed is that there is considerable uncertainty about the effects of further easing because they do not yet have "a robust suite of formal models to reliably calibrate interventions of this sort." But as with climate change, uncertainty does not necessarily translate into inaction. If the uncertainty includes much worse outcomes for employment than expected, and if the costs we attach to that outcome are very large, then uncertainty may prompt more aggressive rather than less aggressive intervention.
Yet another argument concerns the degree to which current productivity changes are permanent of temporary and how that translates into the degree of slack in labor markets. However, on this point I agree that "the sheer magnitude of unemployment today is so large that there is little doubt in my mind that there is considerable slack in the economy." Thus, however this debate comes out, it does not much change the degree and urgency of the unemployment problem.
In the end it comes down to the relative weights placed on the cost of inflation and the cost of unemployment, and I don't think policymakers are placing enough weight on the unemployment term (particularly given the uncertainty about the speed of recovery).
The Fed has the ability to help -- something needs to be done -- and a responsibility to help to the unemployed. The Fed is not alone in not doing enough, fiscal policymakers bear even more responsibility for failing to act aggressively, but that doesn't excuse the Fed's less than full bore attack on the unemployment problem.
This is the last part of a speech given today from Charlie Evans, President of the Chicago Fed, along with a graph from the speech showing the severity of the long-term unemployment problem:
Labor Markets and Monetary Policy, by Charles Evans, President, Chicago Fed: ...Productivity and resource slack The other side of an economy experiencing growing output but low labor utilization is high productivity growth. Indeed, productivity has been quite strong of late, particularly over the past three quarters. This is often the case in the early stages of a recovery, as firms first meet higher demand for their products and services without expanding their work force.
A key question today is the degree to which the recent productivity surge reflects a temporary cyclical development or a more enduring increase in the level or trend rate of productivity. If the gains are predominantly driven by intense cost cutting, then they may be unsustainable once demand revives more persistently. In this case, we would expect hiring to pick up quickly as the economic expansion takes hold. However, if the level or trend in productivity has risen due to technological or other improvements, then higher average productivity gains will continue. In this case, the implications for hiring are not clear. Higher levels of productivity will show through in both higher potential and actual output for the economy, and so need not necessarily come at the cost of lower labor input.
The relative importance of these factors also has consequences for our assessment of the degree to which resource slack exists in the economy. Since a higher level or trend of productivity implies a higher path for potential output, a given level of actual GDP would also be associated with a greater degree of economic slack. That is, the good news on productivity, if sustained, suggests that as of today we have a larger output gap to fill In contrast, some are skeptical that the economy really is operating far below sustainable levels. They argue that much of the drop in output during the recession was the result of a permanent reduction in the economy’s productive capacity, perhaps because certain financial market practices that had for a time enabled additional investments have now been discredited. According to this view, the strong productivity growth of recent quarters only goes a fraction of the way toward offsetting this decline in the level of potential output.
Of course, the unemployment rate gives us another way to infer the degree of slack in the economy. My earlier discussion of the sharp rise in unemployment duration and decline in labor force attachment may lead one to think that slack is even greater than what is implied by the unemployment rate itself.
However, it is possible that longer durations and lower labor force attachment could reflect broader structural changes in the economy, such as a mismatch between the skills of the unemployed and those demanded by employers. There may also be other impediments that currently prevent workers from shifting to the industries or locations where jobs are available. Under these scenarios, labor market slack might actually be lower than what one might infer from the unemployment rate alone.
I have just given you 2 minutes of classic two-handed economist speak. In the final analysis, however, the sheer magnitude of unemployment today is so large that there is little doubt in my mind that there is considerable slack in the economy. Incorporating alternative views about productivity and labor market behavior do not alter this general conclusion. The debate really boils down to whether the amount of slack in the economy is large or is extremely large.
Should the Fed have done more?
Given this large degree of slack, there is a legitimate question of whether monetary policy could, and more fundamentally should, have done more to combat the deterioration in labor markets. As we all know, a lot was done. As the crisis arose, we first used our traditional tools, substantially cutting the federal funds rate and lending to banks through our discount window. As we neared a zero funds rate, we turned to nontraditional tools to clear up the choke points, providing liquidity directly to nonbank financial institutions and supporting a number of short-term credit markets. Finally, we reduced long-term interest rates further by purchasing additional medium- and long-term Treasury bonds, mortgage-backed securities, and the debt of government-sponsored enterprises.
These nontraditional actions helped us avoid what easily could have been an even more severe economic contraction. But the unemployment rate still hit 10 percent this fall.
Had we done more, the most plausible action would have been to expand our Large Scale Asset Purchases (LSAP) program. Precisely quantifying the effect this would have had is difficult. A good place to start, though, is to look at the recent empirical evidence. When significant new asset purchases were announced, our big, fluid financial markets built that information immediately into asset prices. For example, right after the March 2009 Treasury purchase announcement, ten-year Treasury yields fell about 50 basis points. Comparable declines occurred in Option Adjusted Spreads (OAS) on the announcement of agency mortgage-backed securities (MBS) purchases in November 2008. It might be reasonable to infer that say, doubling the size of the LSAPs might have doubled this impact on rates.
However, I would attach more than the usual amount of uncertainty to such an inference. Part of my hesitation reflects our lack of understanding about the interactions between nontraditional monetary policy, interest rates, and economic activity. While research efforts at the Federal Reserve and elsewhere to assess the effects of nonstandard monetary policy have been ramped up considerably, to date we do not have a robust suite of formal models to reliably calibrate interventions of this sort.
Moreover, there are reasons to expect that the impact of recent nontraditional policy actions might not have scaled up so simply. We initially responded to the financial crisis with our highest-value tool—a reduction in the funds rate—and then moved to our best alternative policies as interest rates approached zero. Finally, we turned to the LSAPs, which were designed to further lower long-term interest rates and thus stimulate demand for interest-sensitive spending, such as business fixed investment, housing, and durables goods expenditures. But the influence of lower rates on private sector decision-making may have reached the point of second-order importance relative to the countervailing forces of the housing overhang, business and household caution, and considerably tighter lending standards.
Moreover, although it is impossible to quantify, a portion of the impact of our nontraditional actions may have come simply from boosting confidence. In those very dark times, I believe households, businesses, and financial markets were reassured that policymakers were acting in a decisive manner. Further asset purchases would not have had an additional effect of this kind.
In addition, on a practical level, the portfolio of future purchases likely would have looked different and therefore their overall effectiveness might have deviated from our recent experience. The Fed’s typical monthly purchases of new issuance MBS were so large that it left very little floating supply for private investors. This could have forced a larger LSAP program to concentrate more heavily in Treasuries or existing MBS. Though the empirical evidence is limited, these assets likely are less close substitutes than new MBS for many of the instruments used to finance spending on new capital goods, housing, and consumer durables. Consequently, the effect of their purchase on economic activity may be less.
Finally, we must also keep in mind that more monetary stimulus also has costs. These could be considerable at higher LSAP levels. Many are already worried about the inflation implications of the Fed’s expanded balance sheet and the associated large increase in the monetary base. Currently, most of the increase in the monetary base is sitting idly in bank reserves—and because banks are not lending those reserves, they are not generating spending pressure. But leaving the current highly accommodative monetary policy in place for too long would eventually fuel inflationary pressures. Likewise, if the monetary base was expanded much beyond where we are today, the risk that such pressures would build as the economy recovers would be significantly increased. Furthermore, policymakers already face the task of unwinding a sizable balance sheet at the appropriate time and pace. Substantially increasing the size of asset purchases could have further complicated the exit process down the road.
That said, changes in economic conditions could alter the cost–benefit calculus with regard to the LSAP. Hopefully the recovery will progress without any serious bumps in the road and the inflation outlook will remain benign. But, as we have repeatedly indicated in the FOMC statements, the Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. ...
My attention this morning was drawn to the inflation numbers in the January Personal Income and Spending release, specifically the recent downward trend in core PCE inflation:
Coupled with a sizable output gap that yields very high human cost in the form of high rates of labor underutilization - and forecasts that such underutilization will persist for years - would lead one to believe that policymakers still have work left ahead of them. Policymakers, however, do not appear to agree, and instead focus on the fact that output is growing again, even if the 5.9% pace in the final quarter of last year was inflated by inventory correction. Indeed, with the recovery taking hold, there is no imperative for more action. Fiscal policy looks hamstrung by deficit concerns, while monetary policy is poised to turn contractionary as asset purchase programs are wound down. To be sure, few expect the Fed to start raising the Federal Funds rate in the near term. But the Fed is throwing up its hands on unemployment, effectively saying they have done all they can do. Dallas Federal Reserve President Richard Fischer, via the Wall Street Journal:
But the Fed has space to maintain its current policies. “Inflation is not the issue,” given that it is so low right now, Fisher said. “The real issue right now is how patient the people can be, how patient the Congress can be with regard to this slow healing of the employment situation. It’s going to be a slow path.”
True, inflation is not an issue, so there is no rush to tighten policy. But is it too early to dismiss deflation, or at least consider that persistently low inflation demands additional monetary firepower, not less? Fed officials look increasingly poised to dismiss the central deflationary pressure, the cost of housing. This first jumped out in the minutes of the January 2010 FOMC meeting:
One participant noted that core inflation had been held down in recent quarters by unusually slow increases in the price index for shelter, and that the recent behavior of core inflation might be a misleading signal of the underlying inflation trend.
Is it smart to ignore roughly a quarter of the CPI? Laurel Graefe of the Atlanta Fed responded on macroblog:
However, once we've opened the door for pruning sectors that have displayed unusual price behavior in recent months, we can find a slew of outlying components to pare.
The Cleveland Fed uses a more methodical approach to exclude the CPI components that show the most extreme price changes each month. Their calculations show a more subdued underlying inflation environment, with median and trimmed mean CPI hovering around 1 percent for the past several months (chart 3). I'm not endorsing this method as a perfect estimation of “true” underlying inflation, but it does provide an example of indiscriminately trimming the outliers to see what's beneath.
Today we learned that Philadelphia President Charles Plosser was likely the dismissive participant:
I’m not as worried about deflation particularly. We’ve had a huge shock in housing. If you look at the components in CPI, a lot of the softness in the CPI is coming from the huge decline in rents and housing prices and housing costs. We want to be careful not to necessarily just count on certain relative prices to keep inflation in line.
Would he be as dismissive if only "certain relative prices" were keeping inflation high? I think not. Is it just Plosser? I found it interesting that Fed Chairman Ben Bernanke drew attention to the price of shelter in his semiannual trek to Capitol Hill:
Increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation likely will be subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most markets, and sharp increases in productivity have further reduced producers' unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, reflecting high vacancy rates. In addition, according to most measures, longer-term inflation expectations have remained relatively stable.
Note that it is not just low inflation that needs to be explained away. From the minutes:
Though participants agreed there was considerable slack in resource utilization, their judgments about the degree of slack varied. The several extensions of emergency unemployment insurance benefits appeared to have raised the measured unemployment rate, relative to levels recorded in past downturns, by encouraging some who have lost their jobs to remain in the labor force. If that effect were large--some estimates suggested it could account for 1 percentage point or more of the increase in the unemployment rate during this recession--then the reported unemployment rate might be overstating the amount of slack in resource utilization relative to past periods of high unemployment. Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, could reduce the economy's potential output, at least temporarily; historical experience following large adverse financial shocks suggests such an effect. On the other hand, if recent productivity gains were to be sustained, as some business contacts indicated they would be, potential output currently could be higher than standard measures suggested, and the high level of the unemployment rate could be a more accurate indication of slack in resource utilization than usual measures of the output gap.
Some at the FOMC appear ready to dismiss high unemployment rates on the basis that extended unemployment benefits are pulling people into the labor force. But wouldn't that simply be the same thing as saying that we are underestimating underemployment? If we label a person as discouraged rather than unemployed is there really less slack in the economy? It seems that Fed officials actively looking to avoid the inconvenient truth that inflation remains well below target while unemployment remains high even as their attention shifts to weaning the economy from their balance sheet.
Interesting that we should be debating the necessity of raising inflation targets when we can't even get the Fed to direct policy at the target we already have. But I suspect the Fed believes that doing anything more would be the equivalent of raising inflation expectations, a bridge they are not ready to cross. Policymakers are likely to view inflation as a greater concern that the zero bound. David Altig argues a similar point:
To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous....
...my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.
I am not quite so sanguine. While David is correct, the Fed did find ways to maneuver around the zero bound constraint this time, I am more concerned with the next recession than this one. Recent history suggests that each recession necessitates lower interest rates than the last. I would prefer to pull the economy up to a point where we had some distance from the zero bound such that we did not have revert back to managing economic activity via ballooning the balance sheet. And while the balance sheet proved to be an effective tool for defrosting frozen financial markets, would it be as effective if the next time around the problem was simply too little demand in the presence of functioning financial markets? I would rather not endure the experiment.
Moreover, years of watching the Japan experience has left me leery of ignoring the dangers of persistently low inflation. From Bloomberg:
Japan’s consumer prices fell for an 11th month in January, putting renewed pressure on policy makers to eradicate deflation that hampers the recovery.
Prices excluding fresh food slid 1.3 percent from a year earlier, the same pace as December, the statistics bureau said today in Tokyo. The figure matched the median estimate of 29 economists surveyed by Bloomberg News.
Bank of Japan Deputy Governor Hirohide Yamaguchi said this week that prices may not be improving as quickly as he had expected. Finance Minister Naoto Kan today reiterated that the central bank should help the government beat deflation.
An interesting conundrum in Japan. A central bank so afraid of its independence - note the clear pressure from the Ministry of Finance - that it will not aggressively combat deflation, combined with fiscal authorities concerned about the deficit:
Bank of Japan Deputy Governor Hirohide Yamaguchi said yesterday that investors are closely monitoring fiscal policies as “Japan’s fiscal balance is in a very severe state.”
“It’s key that the nation recover its fiscal balance and exercise fiscal discipline,” Yamaguchi told reporters in Kagoshima, southern Japan. “Financial markets are always watching what the government is doing on these fronts.”
The fiscal authorities in Japan need to spend more money, and the monetary authorities need to print more money. One would think an obvious policy solution was at hand.
The US is not Japan. The US has that persistent current account deficit, for example. But we increasingly share some striking similarities. Dual equity and property bubbles. Zero interest rate monetary policy. Deficit concerns. Indeed, I would prefer to take more aggressive action to ensure that we do not share more similarities in the future. But like in Japan, US policymakers have reached the limit of their perceived abilities. Hopefully the similarities will end there.
I have to go teach my classes, but in case you want to talk about Ben Bernanke's testimony before the House Financial Services Committee today, here are a few links (there's not much discussion of the testimony on blogs yet -- I won't be able to update this, so please feel free to add additional links in comments):
I have argued many times that the Fed should have two roles. It should conduct monetary policy, and it should be the primary regulator of the financial system. However, not everyone agrees. When I was at the What's Wrong with Modern Macro Conference in Munich recently, I met Hans Gersbach -- we were on a panel together -- and he passes along his argument that monetary policy and banking regulation should be conducted by separate bodies:
Double targeting for Central Banks with two instruments: Interest rates and aggregate bank equity, by Hans Gersbach, Vox EU: The current crisis has placed a fundamental question at the centre of policy discussion: “Should monetary policy and banking regulation be conducted separately?” Opinions differ – see Adrian and Shin (2009), Goodhart (2008), and De Larosière et al. (2009).
- Brunnermeier et al. (2009) argue that central banks should be tasked with macroprudential regulation.
- De Grauwe (2007) argues that central banks should be responsible for the supervision of all institutions involved in the business of creating credit and liquidity.
- Linking both policy areas directly, however, might endanger the exceptional success of many central banks in creating low and stable inflation of the kind observable during the last two decades (Gerlach et al. (2009)).
There is thus a pressing need to clarify the objectives and instruments of central banks and banking supervisory authorities, and also to inquire how they should ideally interact. Here I present a new framework aimed at such a clarification.
The Fed's recent decision to increase the discount rate does not signal an intent to tighten policy:
The Fed's discount rate hike, econbrowser: The Federal Reserve Board announced on Thursday that it is raising the interest rate at which banks borrow from the Fed's discount window to 0.75%, a 25-basis-point increase, and intends to return discount lending primarily to the traditional overnight loans. "The rate hike cycle begins," declared 24/7 Wall St...
But I don't believe that's what the discount rate hike means at all. The Fed sometimes has used discount rate changes as a signal of its intentions for interest rates more broadly. But the Fed press release accompanying the move stated flatly that's not the case this time...
The same message was emphatically repeated in statements by Fed Governor Elizabeth Duke and Federal Reserve Bank of New York President William Dudley. Maybe you have a theory that the way the Fed communicates that it intends to raise rates is by denying that it intends to raise rates. If so, I can't help you. ...
The Wall Street Editorial page was upset because the move didn't signal an intent to begin raising interest rates sooner rather than later. The editorial page gang would also like to balance the budget beginning right now with spending cuts "to demonstrate that those who can be trusted with small things—cutting back what can be removed now—can be trusted with larger things." It's all part of their quest to repeat the 1937-38 experience.
At my blog at CBS MoneyWatch:
Here's something I wrote for Free Exchange's Round Table in response to a proposal from Daniel Gros and Thomas Mayer to create a European Monetary Fund:
David Altig, research director at the Atlanta Fed and someone I've found to be very much worth listening to (even if I don't always agree), has a dissenting view on adopting a 4% inflation target in order to give central banks more room to maneuver in times of crisis:
Do we need to rethink macroeconomic policy?, by David Altig: The aftermath of a crisis is always fertile ground for big thoughts. Big thinking is exactly what we get from Olivier Blanchard (the International Monetary Fund's director of research) and his colleagues Giovanni Dell'Aricca and Paolo Mauro, in their new overview of the financial crisis and what it means for how we think about and, more importantly, practice macroeconomic policy. Titled, appropriately enough, "Rethinking Macroeconomic Policy," one of the more provocative parts of their analysis was highlighted in the Wall Street Journal:
"Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.
"At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further."
Paul Krugman approves, as does Ken Houghton at Angry Bear, who concludes with this comment:
"None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation."
I suppose that the modifier "major" provides something of an escape clause, but as a general proposition there is at least some evidence that 2% is preferable to 4%. From the IMF itself, for example, there is this…
"The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust..."
… which confirms the results of an earlier IMF study:
"Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…"
To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:
"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "
So, the issue comes down to whether the uncertain costs of raising the average inflation rate is justified by the goal of avoiding the zero bound. At Free Exchange, the blog of The Economist, there is some skepticism:
"… the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years."There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out."
Those are good arguments in my view, but my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.
The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?
In fact, Blanchard and company acknowledge that…
"It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap."
… but follow up with this:
"But it is clear that the zero nominal interest rate bound has proven costly."
Clear? Proven? I don't see it, and the IMF authors, in my view, explain why the zero bound problem was of limited relevance in the recent crisis:
"Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy." (I added the emphasis.)
The highlighted passage, of course, does not say "the policy rate is no longer a necessary instrument," and I certainly cannot prove that the trajectory of the economy in 2009 wouldn't have been better if only we had another 100 to 200 basis points in the tool kit. But color me a skeptic, and put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.
I'm not yet on the 4% bandwagon, but I haven't ruled it out either. I'm still considering arguments on both sides of the issue. I do agree, however, with this point from Free Exchange. It's something I've worried about as well:
On the other hand, a higher inflation rate brings with it its own difficulties. Chief among these, according to Mssrs Billi and Kahn, are relative-price distortions. Not all prices inflate at the same rate, and so inflation generates some relative-price distortions which lead to resource misallocation. The higher the inflation rate, the greater these distortions (you can see a helpful discussion of these issues by James Hamilton here). After reviewing the costs and benefits, Mssrs Billi and Kahn conclude that a target just below 2% is optimal.
But the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.
Just to be clear, the relative price of good A to good B is PA/PB. If there is inflation and one of the two prices is stickier than the other, then the two prices will change at different rates in response to inflation. This pushes relative prices away from their fundamental values, and this in turn distorts resource flows (which leads to losses and unemployment as resources are subsequently reallocated). The higher the inflation rate, the faster these prices become distorted and the higher the subsequent costs. This is not the only cost of inflation, but on this basis alone it's likely that at some point the costs of inflation will exceed the benefits. The hard question is where the breakpoint is (partly because we don't have good estimates of either the costs or the benefits, so it's possible to support most any position by picking and choosing among the empirical studies). I'd be very uncomfortable with a rate over 4%, 4% itself seems a bit high, but 3% isn't so hard to accept.
On the benefits, I agree with David, it's not that clear that the zero bound was the main impediment to policy action. This was a case where fear not high interest rates was the main factor causing investment to fall, and starting from a higher inflation rate target doesn't change that. Reducing fear means reducing risk, and that required the Fed to use other innovative policies rather than the standard interest rate policies that work during normal times. Fed purchases of toxic assets removes risk from the marketplace, various policies that amount to insurance policies on financial investments reduce fear, and so on -- these were the policies that made the most difference in terms of getting money flowing through these markets once again.
Maybe a higher inflation target will help. As I said my mind is open. People I respect greatly are on both sides of this issue -- there is no clear answer as to whether this would help -- and for me that is the problem. If I was more certain about the benefits, and less fearful of the costs, supporting a higher inflation target would be an easy call. But until the benefits are established more firmly than they are presently, I find it hard to support this without hedging on the recomendation.
Here's an explanation of the Fed's exit strategy, including why the Fed is planning to raise the interest rate it pays on reserves rather than the more traditional strategy of using open market operations to control the federal funds rate:
Devil's Advocate, by Tim Duy: Commentators, including myself, have been critical of a Federal Reserve policy stance that appears to place uncertain inflation concerns ahead of a very real unemployment problem. Playing devil's advocate, one can argue that Federal Reserve members are showing remarkable patience in keeping interest rates at rock bottom levels. Even more remarkable is that there is not a greater push to aggressively contract the balance sheet to a more traditional state. Central bankers are simply a very conservative lot, and the Fed is operating at the boundary of what many policymakers can stomach. Indeed, recent data must be somewhat disconcerting, with the US economy under the influence of an inventory correction that is having a very real positive impact on the manufacturing sector. And if the January employment report yields a substantial increase in nonfarm payrolls - something not out of the question in the wake of 5.7% growth in the fourth quarter of last year - policymakers may start to think that the balance of risks are turning rapidly toward inflation. Remember, the chief obstacle to tighter policy is the forecast of persistently high unemployment. Data flow that runs contrary to that expectation will raise fears among some policymakers that they are already dangerously behind the curve.
It is hard not to flag the flow of manufacturing data as a warning that a V-shaped recovery is at hand. The ISM manufacturing report was solid across the board as firms are caught in the midst of a traditional inventory correction. Particularly disconcerting to Fed officials will be the price data, with 44% of firms reporting higher prices, while only 4% seeing declines. No commodities were reported down in price. This follows a strong showing in manufacturing orders for December, with a clear upward trend established in the data:
Furthermore, highlights of the GDP report included a gain in equipment and software spending in addition to a positive contribution from net exports. Sustained improvement in the latter would be a very significant development, helping the US adjust to a less consumer-dependent economy and providing a basis for additional investment in export oriented and import competing industries. I have, however, been somewhat skeptical that US authorities would actually challenge the fundamentally currency "misalignments" that help perpetuate the still significant trade imbalance. President Obama's SOTU address, however, and its pledge to pursue export led growth looks to have lit a fire under policymakers. Perhaps the external sector will be a sustained source of growth. That said, talk is cheap - this Administration is not known for policy follow-through.
To be sure, I would be amiss if I did not identify less strong data. The ISM nonmanufacturing report was weaker than hoped for, throwing cold water on the notion that inventory correction is spreading more broadly into the service sector. Initial unemployment claims have backed up in recent weeks, a reminder of the still precarious state of the labor market. Auto sales slipped a notch, suggesting that the road to sustained improvement remains elusive. Finally, while retails sales posted solid gains in January, we really wouldn't have expected much else given the decline at this time last year. Overall, while none of this data is particularly strong, I would not describe it as particularly weak, nor should it alter the perception the economy is on a sustained upward trend.
But what is the pace of that trend? We always come back to this question, because it is the key to policy evaluation. If the pace is sufficiently high, then we would expect unemployment to come down quickly, and the Fed would be behind the curve, in which case the Treasury market will be in a world of pain. The expected path of activity, however, remains such that unemployment rates will come down gradually, thus alleviating the danger of a rapid reversal of monetary. What kind of growth would we need to send the Fed scrambling for the exits? On this issue, Brad DeLong provides some guidance by depicting the path of unemployment beginning in 1982 - the so-called "Morning in America" - versus the actual beginning in 2009 and the Administration projection for 2010 and beyond:
A good opportunity to look at real final sales - GDP excluding inventory changes - during the mid 80's:
As can be seen, the underlying rate of growth enjoyed a sustained surge from 4Q82 onward - an average of 5.4% growth through 1984. That is the kind of growth needed to drive down unemployment rates quickly. In contrast, real final sales climbed just 2.2% in 4Q09. We need to see sustained growth at more than twice that rate to bring unemployment quickly down to acceptable levels. But there is simply no faith that such a feat can be achieved. Most doubt there is sufficient pent up demand in the consumer to do the job, while Calculated Risk has repeatedly stated the case against a quick rebound in housing. With fiscal stimulus set to slow, that leaves investment and the external sector to big up the slack - neither of which packs the weight of the consumer. Consequently, the Fed can hold policy steady on the back of the current forecast, which lacks the post-1982 surge. But given the amount of cash sloshing around in the banking system, they will be sweating out the data, more concerned about the upside risk than the downside. In their defense, arguably the rapid and tepid recovery scenarios are observationally equivalent in the inventory correction phase of the recovery.
Bottom Line: An improvement in labor markets would not be unexpected given the GDP surge at the end of 2009. But sustainability is the key, and sustainability requires 4Q09 GDP numbers in the absences of inventory effects. Few forecasts are looking for such growth, certainly not yet at the Fed. Indeed, the recent travails of the stock market and sustained sub-4% level on 10 year Treasuries argues against such growth as well. Interestingly, at this juncture, I place more weight on the upside risk than the downside, although I suspect that is a factor of my relatively low expectations than any real optimism on my part. I don't see an actual return to recession short of another negative demand shock, but I am expecting the economy to settle into an anemic pace of growth. In this environment, I don't see how the Fed is interested in substantially tightening policy - but I can see how some policymakers could perceive that their hand was forced if they see a string of upside surprises in growth indicators, especially if the January read on employment is better than anticipated. Still, I think only clear evidence that a 1983 recovery is emerging would prompt a sudden policy shift at the Fed.
Chris Sims talks about difficulties of policy at the zero lower bound (wonkish). In particular, he discusses the difficulty of credible commitment to higher future inflation that is necessary in most New Keynesian models, the difficulty in achieving fiscal and monetary policy coordination, and the problems that may arise when the central bank takes quasi-fiscal actions:
Commentary on Policy at the Zero Lower Bound, by Christopher A. Sims, Princeton University, CEPS Working Paper No. 201, January 2010: I. ROBUST IMPLICATIONS OF CONVENTIONAL NEW KEYNESIAN MODELS FOR POLICY AT THE ZERO LOWER BOUND Monetary policy has been thought of, at least for several decades up until the fall of 2008, as interest rate policy. Certainly New Keynesian policy models treat it this way. At the zero lower bound (ZLB), the interest rate is stuck, so long as policy makers would like to be taking a more stimulative stance. This would seem on the face of it to imply that monetary policy is paralyzed. New Keynesian models like those in this volume generally agree that monetary policy can be effective, though, if policy can take the form of credible commitments to future interest rate paths. This optimistic conclusion was developed by Christiano, Motto, and Rostagno (2004), Eggertsson and Woodford (2003), and Eggertsson (2008), and emerges in this volume’s papers as well.
But the conclusion is less optimistic than it looks. In models, it is easy to specify an announced future policy stance and assume the public believes the announcement. In practice, there is inevitably uncertainty about exactly how firm are commitments to future policy, even if the future policy is announced in detail. The uncertainty implies volatility, as newly arriving information shifts the public’s perception of how easy it will be to deliver on the commitment.
Central banks in most developed countries have succeeded in convincing the public that they are committed to maintaining low and stable inflation. But this credibility has built up over decades as the central banks have acted to deliver on their commitment. In the presence of a binding ZLB, the result from the models is that the central bank ought to commit to expansionary future policy. A bank that has built up inflation-fighting credibility may find this is a liability if it tries to convince the public that it is temporarily committed to increasing the inflation rate.
Announcements about future policy at a time when the short rates that ordinarily are seen as set by the central bank are stuck at zero are particularly subject to doubt, just because they are accompanied by no current action.
Mortgage Choice and the Pricing of Fixed-Rate and Adjustable-Rate Mortgages, by John Krainer, Economic Letter, FRBSF: In the United States throughout 2009, the share of adjustable-rate mortgages among total mortgage originations was very low, apparently reflecting the attractive pricing of fixed-rate mortgages relative to ARMs. Government policy could have changed the relative attractiveness of the fixed-rate mortgages and ARMs, thereby shifting the market share of these two housing finance instruments.
One of the notable features of the current U.S. mortgage market is the predominance of fixed-rate mortgages. The interest rate differential between fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs) has fallen from a recent high of about 2.5 percentage points in the summer of 2004 to about 0.5 percentage point at the end of 2009. These changes in the interest rate differential have coincided with the collapse of mortgage securitizations other than those mediated by government-sponsored enterprises (GSEs), including Fannie Mae, Freddie Mac, and Ginnie Mae (see Krainer 2009). In addition, the Federal Reserve began large-scale purchases of GSE mortgage-backed securities (MBS) starting in January 2009, adding significant secondary market demand for fixed-rate mortgages. The Fed's purchase program has not included MBS containing ARMs.
This Economic Letter reviews some of the factors determining consumer mortgage choices. It shows that ARM share has declined in ways that parallel the behavior of several key mortgage market interest rates. These developments have coincided with, among other things, Fed intervention in the market through large-scale MBS purchases. Thus, the Fed program, while supporting the functioning of the residential mortgage market overall, could have affected the composition of the mortgage market. To help understand this dynamic, this Letter estimates what the ARM share might have been under alternative scenarios in which fixed mortgage rates were higher, which would likely have been the case if the Fed had not been intervening in the market to the extent that it did. ... [continue reading]
Here's my reaction to the vote to reconfirm Ben Bernanke as Fed Chair:
Tim Duy reacts to today's FOMC meeting:
Dissent, by Tim Duy: The FOMC statement contained a mini-bombshell, the dissent of Kansas City Fed President Thomas Hoenig. I am skeptical, however, that this dissent is a significant shift in the policy environment. Instead, I view the statement as taking another baby step forward to a normalization of monetary policy now that the financial crisis has eased and that the economic environment has firmed. Many policymakers will simply find themselves increasingly uncomfortable holding rates at rock bottom levels while sitting on a bloated balance sheet -- regardless of the unemployment rate. Short of a significant reversal of recent economic gains, I would be hard pressed to see the Fed back away from a policy stance that is growing tighter, albeit slowly tighter.
The opening sentence of the statement maintains the position that the economy continues to strengthen while labor markets firm. Some may be surprised about the latter point given the disappointing December employment report. The Fed, however, will be expecting the road to sustained improvement to be bumpy; one month will not significantly impact their outlook given the sharp decline in the pace of job losses in the second half of 2009. The trend is clear. The Fed also upgraded slightly its assessment of business spending, consistent with data such as new orders for capital goods.
The opening paragraph, however, omitted mention of the housing market improvements as noted in the December statement. Are they less confident of a sustained rebound given the drop off that followed this summer's tax credit induced boom? Or do they just want to avoid mention of housing given that they intend to halt stimulus for that sector? In my opinion, of all the Fed interventions over the past year, the decision to acquire $1.25 trillion of mortgage securities is the most politically risky; more on that later.
There's always room for more debate on Ben Bernanke's reconfirmation:
The Quarrel Over Bernanke, Room for Debate: The Senate is expected to vote this week on whether to confirm Ben Bernanke to a second term as the Federal Reserve chairman. Though it appears that he will overcome a filibuster threat, opposition to Mr. Bernanke has grown, along with worsening jobs numbers and public anger over the Fed’s failure to regulate banks before the financial crisis. His Democratic and Republican opponents have criticized him as the architect of the Wall Street bailout and being out of touch with the woes of Main Street.
How much is Mr. Bernanke to blame for the regulatory failures, the weak recovery and high unemployment numbers? Could a new Fed chairman make a difference?
Paul Krugman's view on Ben Bernanke's reconfirmation as Fed Chair:
The Bernanke Conundrum, by Paul Krugman, Commentary, NY Times: A Republican won in Massachusetts — and suddenly it’s not clear whether the Senate will confirm Ben Bernanke for a second term as Federal Reserve chairman. That’s not as strange as it sounds: Washington has suddenly noticed public rage over economic policies that bailed out big banks but failed to create jobs. And Mr. Bernanke has become a symbol of those policies.
Where do I stand? I deeply admire Mr. Bernanke, both as an economist and for his response to the financial crisis. ... Yet his critics have a strong case. In the end, I favor his reappointment, but only because rejecting him could make the Fed’s policies worse...
Mr. Bernanke is a superb research economist..., his academic expertise and his policy role meshed perfectly, as he used aggressive, unorthodox tactics to head off a second Great Depression.
Unfortunately, that’s not the whole story. Before the crisis struck, Mr. Bernanke was very much a conventional, mainstream Fed official, sharing fully in the institution’s complacency. Worse, after the acute phase of the crisis ended he slipped right back into that mainstream. Once again, the Fed is dangerously complacent...
Consider two issues: financial reform and unemployment.
Back in July, Mr. Bernanke spoke out against ... the creation of a new consumer financial protection agency. He urged Congress to maintain the current situation, in which protection of consumers from unfair financial practices is the Fed’s responsibility.
But here’s the thing: During the run-up to the crisis, as financial abuses proliferated, the Fed did nothing. In particular, it ignored warnings about subprime lending. So it was striking that ... Mr. Bernanke ... gave no reason to believe that the Fed would behave differently in the future. ... As I said, the Fed has returned to a dangerous complacency.
And then there’s unemployment. The economy may not have collapsed, but it’s in terrible shape... Nor does Mr. Bernanke expect any quick improvement... So what does he propose doing...?
Nothing. Mr. Bernanke has offered no hint that he feels the need to adopt policies that might bring unemployment down faster. ... It’s harsh but true to say that he’s acting as if it’s Mission Accomplished now that the big banks have been rescued.
What happened...? My sense is that Mr. Bernanke, like so many people who work closely with the financial sector, has ended up seeing the world through bankers’ eyes. ... Given that, why not reject Mr. Bernanke? There are other people with the intellectual heft and policy savvy to take on his role: ...possible choices would be ... Alan Blinder ... and Janet Yellen...
But — and here comes my defense of a Bernanke reappointment — any good alternative ... would face a bruising fight in the Senate. And choosing a bad alternative would have truly dire consequences for the economy.
Furthermore, policy decisions at the Fed are made by committee vote. And while Mr. Bernanke seems insufficiently concerned about unemployment..., many of his colleagues are worse. Replacing him with someone less established, with less ability to sway the internal discussion, could end up strengthening the hands of the inflation hawks and doing even more damage to job creation.
That’s not a ringing endorsement, but it’s the best I can do.
If Mr. Bernanke is reappointed, he and his colleagues need to realize that what they consider a policy success is actually a policy failure. We have avoided a second Great Depression, but we are facing mass unemployment — unemployment that will blight the lives of millions of Americans — for years to come. And it’s the Fed’s responsibility to do all it can to end that blight.
I don't disagree at all with the pressure on the Fed to do more, unemployment is a big problem and I'm ready to give further easing a try (particularly since Congress has dropped the ball on additional fiscal policy to help with job creation). But I see this more as a disagreement over what type of monetary policy is best for unemployment now and in the future than I do as Bernanke taking the side of bankers over the unemployed.
I think a lot of apparently mysterious things about Ben Bernanke’s career can be solved if you just assume that Ben Bernanke is doing things that a conservative Republican would do because he is a conservative Republican. For example, remember when conservative Republican George W Bush was president and made Ben Bernanke chairman of the Council of Economic Advisors? And remember when Bush put Ben Bernanke in charge of the Fed? ... If it looks like a duck and quacks like a duck, then it’s probably a duck. ...
I note that liberals, in their condescension toward conservatives, sometimes wind up tying themselves into knots about guys like Bernanke. Bernanke is very smart and incredibly accomplished. Many smart liberals think conservatives are dumb. So if Bernanke is so smart, it must be that he’s not really a conservative! But no. Smart conservatives are a very real phenomenon. And in politics the general idea is to give positions of authority to well-qualified people who share your political objectives.
Liberals think Bernanke can't be conservative because he's smart? Let me suggest that the support for Bernanke among some liberals is not the result of unfounded prejudice that only Matt Yglesias is free of, it instead results, at least in part, from the opinions of people who have spend a lot of time with him.
What do those people think, people who have had plenty of time to observe how he walks and talks, and whether he quacks Republican?:
Fed Official Moves Up and Into Politics, by Edmund L. Andrews, New York Times: For years, some of his closest friends did not know that Ben S. Bernanke was a Republican. It is not that Mr. Bernanke has been shy about his views. As an economist at Princeton, he broke new ground on the causes of the Depression. And as a governor on the Federal Reserve Board since 2002, he spoke bluntly about weakness in the job market, the dangers of deflation, the impact of higher oil prices and the need for the Fed to reduce uncertainty by being more open. ... But now Mr. Bernanke ... is moving directly into the political arena, taking over next week as chairman of President Bush's Council of Economic Advisers. He is also on the short list of potential candidates to succeed Alan Greenspan as chairman of the Federal Reserve. The two jobs are related, if only because Mr. Bush will be looking to name a new Fed chairman that he knows well and trusts. Two other possible candidates to succeed Mr. Greenspan, who has been atop the Fed for nearly 18 years, are also former council chairmen: Martin Feldstein, who served under President Reagan; and R. Glenn Hubbard, who worked for President Bush from 2001 to 2003.
Mr. Bernanke built a sterling reputation while at Princeton, and has won widespread praise for his cogent analyses while at the Fed. But he has studiously avoided partisan political issues, at least in public. He has said little about issues at the top of Mr. Bush's agenda,... and his economic writing betrays few hints of political ideology. "If you read anything he's written, you can't figure out which political party he's associated with," said Mark L. Gertler, a professor of economics at New York University who has written more than a dozen papers with Mr. Bernanke. Mr. Gertler, who said he did not know his close friend's political affiliation until relatively recently, added: "He's not ideological. I could imagine Ben working with economists in the Clinton administration." Alan S. Blinder, a longtime colleague at Princeton who has advised numerous Democratic presidential candidates, also said he had worked alongside Mr. Bernanke for years without having any sense of his political views. "We wrote articles together and sat at the same lunch table thousands of times before I knew he was a Republican," Mr. Blinder recalled. ... Mr. Bernanke enjoys enormous credibility among economists in academia as well as on Wall Street..."I think Wall Street would be more comfortable with Bernanke as Fed chairman, if only because he isn't viewed as being ideological," said William C. Dudley, chief United States economist at Goldman, Sachs. The disadvantage is that Mr. Bernanke may not be able to build up close ties in the White House, where Mr. Bush's inner circle places high priority on personal loyalty and passionate support for the White House's policy goals. ...
There is this:
People who know Mr. Bernanke say he is entirely comfortable in supporting President Bush's economic policies. He has expressed little worry about the current budget deficit,... and he has supported Mr. Bush's call to overhaul Social Security. ...
I don't like the Social Security statement either, but in general I don't think we can explain Bernanke's monetary policy stance by blaming it on his being a conservative republican.
Does it even make sense to say Bernanke's economic policies have been ideologically conservative?
This charge that Bernanke is ideologically motivated is all about the fact that Bernanke has not gone above and beyond the massive bailout of the financial system that has distressed conservatives and endorsed aggressive quantitative easing. The idea is that quantitative easing - the purchase of long-term securities by the government - will bring down long-term real interest rates, which is then supposed to spur investment (despite the recession), which then in turn will increase employment (with a considerable lag). Despite the massive intervention that the Fed has undertaken so far - one that has not pleased conservatives at all - the fact that Bernanke won't take policy as far as some, but by no means all on the left think, causes him to suddenly be tagged with the ideological conservative label to explain this resistance?
Sorry, but it just doesn't fit. If you want conservative, listen to someone like John Taylor who would likely already be raising interest rates and winding down asset purchase programs. Listen to someone like former Federal Reserve Bank of St. Louis President William Poole who would have likely let the too big to fail banks fail, Main Street be damned, and elevated inflation over all other goals. Ideological conservatives in general, and the inflation hawks among them in particular, do not approve of what Bernanke has done. Go ahead and criticize Bernanke for his policies, I think there is a genuine debate about quantitative easing that we can have, and it could be that not moving more aggressively is, in fact, a mistake, but don't blame it on his politics.
If you disagree with current policy, if you think it should be taken further, then explain why (and Matt Yglesias has done some of that). But don't take the lazy way out and simply tag Bernanke with an ideological conservative label that doesn't fit, and then use it to explain his policies. If we really had an ideological conservative as Fed Chair, there would be no need to wonder about the underlying politics, there would be no "probably a duck" about it, those policies would likely mean much worse conditions in labor markets right now. I think more could be done to help labor markets with both monetary and fiscal policy (though I should add that I think fiscal policy is a much more effective means of increasing employment, and I'm skeptical about the degree to which quantitative easing would actually work). But I don't believe that the barrier to pursuing these policies is Ben Bernanke's conservative ideology. It's his economics, and he has done far more than most in his career to have those views respected even when you disagree with his conclusions.
Update: Let me add one other thing. The other charge leveled against Bernanke is that his own work supports quantitative easing, yet he resists this policy, so it must be that his political ideology is in the way. Conservatives tried this with Christina Romer and her work on fiscal policy, but she made it clear that she was well aware what her own work said, that her position was fully supported by and consistent with her economics, and she swatted that charge way rather easily.
Bernanke also understands and is well aware of his own work, and of course he knows it better than anyone else, the charge against him is that he is abandoning his own research to serve conservative ideological principles. But the simpler explanation, the one that is actually supported by his past and all the testimonial above about his lack of political passion, is that it is his economics - which has been updated as the crisis evolves and he learns more - that is driving his policy choices. And his economics is not particularly conservative, it's fully consistent with the work that appears in mainstream journals. Again, that's not to say that there is no dispute here, different assumptions lead to different conclusions and there is plenty of room to argue over the best policy. But I just can't agree with the charge that he has abandoned his own research to pursue an ideological course.
Update: On a related note, from Paul Krugman:
Know Your Feds, by Paul Krugman: I’m hearing a lot from people who want Paul Volcker as Fed chair. (Consider the joke about exemplifying too big to fail as having been made). There really is nobody with his stature (literally, as it happens) and moral authority. And he’s a powerful advocate of financial reform.
You should know, however, is that Volcker is usually a hard-money guy. I haven’t had an opportunity to ask him, but my guess is that he’s suspicious of quantitative easing, and would be more likely to side with the Fed’s inflation hawks than with those of us who think the Fed should expand its balance sheet, target higher inflation, and in general do whatever it takes to bootstrap ourselves out of the liquidity trap.
This isn’t a simple question of good versus evil. There are substantive policy disputes, and some very good people are, in my view, on the wrong side of some issues.
I didn't want to be right about this (video from 12/17/2009):
From Market Talk:
...It seems hard to believe that Congress would not approve the President’s choice for the Federal Reserve, but the uncertainty of it is hanging in the air, after the confirmation vote was delayed to next week. Some time next week. The Fed chairman’s term expires Sunday.
Let’s just say it wouldn’t exactly send the right message to the rest of the world, and the bond market especially, should Congress vote Bernanke out. You have to expect a good amount of this is just posturing, something Congress does better than any other group on the planet. But, you know, wars tend to start with a single, errant shot.
The latest spanner in the works came from Nevada’s Harry Reid, who said he’s still undecided about how to vote. Reid happens to be the Senate’s Democratic leader, so his voice carries some amount of water. The odds are still that he gets reappointed — a senior Senate Republican aide said it’s not an issue as at least four GOPers intend to vote for him — but even the fact that it’s being discussed just a week before his term ends should give you some indication of just how unsettled things are these days....
What a great time to give financial markets a big dose of uncertainty along with the potential shock of replacing the Fed chair.
Update: What happens if he is not reappointed before his term ends on 1/31/2010?:
The chairman and vice chairman of the FOMC are chosen separately from the main Board of Governors. At the first meeting of the year, the committee members vote for the two positions. The chairman of the Board is usually named chairman of the committee and the president of the New York Fed is traditionally the vice chairman. At next week’s meeting, the FOMC is expected to vote for Bernanke and William Dudley of the New York Fed to take those positions for 2010. Though Bernanke’s term as chairman of the Fed’s Board is up on Jan. 31, he retains his position as Fed governor and remains on the FOMC. As long as he stays on the Board of Governors, he can lead the rate-setting committee.
But things won’t be as stable at the Board of Governors. When Bernanke’s term expires on Jan. 31, Vice Chairman Donald Kohn is set to become acting chairman. Kohn remains in that position until Bernanke or another nominee is confirmed.
Update: Brad DeLong:
Don't Block Ben!, by Brad DeLong: I wish Boxer and Feingold had not done this:
Patrick Yoest and Luca di Leo: Boxer, Feingold Come Out Against Fed Chairman Bernanke - WSJ.com: Ben Bernanke faced ebbing support for a second term as Federal Reserve chairman as more senators adopted a populist, antibank stance even as the White House launched a public push to defend his candidacy. The erosion of support crossed party lines. Two Democratic senators facing re-election in November, Barbara Boxer of California and Russ Feingold of Wisconsin, on Friday joined two Democrats and an independent who previously announced their opposition. Ten Republicans say they, too, will oppose Mr. Bernanke.
Alarmed that there might not be the 60 votes in the Senate needed to extend Mr. Bernanke's term beyond its Jan. 31 expiration, the White House entered the fray publicly for the first time, with officials trying to win support among Democratic senators...
First, a correction to the story: it's not 60 votes, it's 51--for there are many more people who want to be on record as opposing Bernanke than who actually want the Federal Reserve to be headless on February 1.
Second, I think Boxer and Feingold have fallen into a trap. If Bernanke's nomination fails, it will be because of a combination of left Democrats and right Republicans. Why would right Republicans vote against the nomination of a Republican-appointed hard-money Republican? So that they can then vote against financial regulatory reform without taking political damage. "You are too friendly to the banks!" their opponents will say. And they will respond: "Oh yeah? Your president wanted bank-friendly Ben Bernanke to stay at the head of the Fed. AND WE BLOCKED HIM!!"
Boxer and Feingold, it seems to me, are enabling the future Republican ability to block financial reform without taking political damage from it.
So I find myself thinking about last August, and the Bernanke renomination:
Bernanke's Reappointment: David Wessel
Obama to Reappoint Fed Chairman Ben Bernanke - WSJ.com: President Barack Obama will announce Tuesday that he is nominating Ben Bernanke for a second four-year term as chairman of the Federal Reserve, White House Chief of Staff Rahm Emanuel said...
I think Bernanke is one of the best in the world for this job--I cannot think of anyone clearly better. He has made only one big mistake--buckling under to pressure from all those yelling at him for enabling moral hazard and not finding a way to takeover Lehman Brothers, and he is not going to make the same mistake again...
I am surprised that he is being reappointed. I would have thought that the combination of people angry because he has given too much public money to the banks and people angry because he didn't stop the recession would together make him damaged and that Obama would want to bring in a fresh face--never mind that Bernanke had no way to try to lessen the recession save by policy steps that inevitably involve giving money to the banks. It shows, I think, a seriousness about getting the policies right--or as close to right as we can--that I like to see in a president...
Update: See also Why Bernanke should be reconfirmed, by Jim Hamilton.
Update: Support from a staunch libertarian.
John Taylor answers a few of my questions in one part of an interview at Big Think (transcript and video of entire interview, video broken into parts). My biggest disagreement with his answers comes when he says it's time to start "letting interest rates rise appropriately and reducing the amount of quantitative easing," a theme that appears repeatedly in his answers to my questions and to those submitted by others. It's far too early for that, and if anything the Fed should be doing more to combat the slow recovery of labor markets. Where we agree the most is when he says the most important unresolved questions in monetary economics are about the connections between the financial sector and monetary policy. [As a lead-in, Dean Baker asks the first question below, and my questions follow. Questions were emailed in advance of the interview.]:
...Question: Would you advocate an aggressive strategy of
John Taylor: Well, the question is; given that the Taylor Rule has large negative interest rates right now, would I want more quantitative easing? First of all, I don't think the Taylor Rule does show a large negative interest rates right now. That's kind of a myth. The Taylor Rule is pretty simple. It just says, the interest rate should equal 1 1/2 times the inflation rate, plus 1/2 time the GDP gap, plus 1. Well, if you plug in reasonable estimates for what inflation is and what the GDP gap is, I get a number that’s pretty close to zero. Not minus four, minus five, not numbers like that. So, in fact I would say the amount of quantitative easing could be reduced right now. I hope it is reduced in a gradual way. Some of the mortgage purchases I think could be slowed down and then actually reversed.
So, the question is a good one, and I'm glad it was asked because there is a lot I think, of misinformation out there about what the Taylor Rule says. The Taylor Rule is very simple, as I just mentioned. You can say it in a sentence and you plug in the numbers, you don't get minus five, minus six percent. You get something much closer to zero where the interest rate is now. Now, that of course has implications going down the road because it says, to the extent that real GDP picks up; I hope it does, or if inflation picks up; hope it doesn't. But if either of those occur, then you'd have to see interest rates starting to move above the zero to 25 basis point range. And if we don't then we're going to be back in the same kind of situation we were in 2002 through 2004, and that of course could begin to induce bubbles and we certainly don't want that to happen.
Question: Would quantitative easing speed the recovery?
John Taylor: No. I don't think quantitative easing at this point would effectively smooth the recovery. I think right now, based on historical experience, the interest rate is about where it is, it's not that we don't need a lot of quantitative easing. We've had some and I think the job of the Fed now is to bring it back. They're talking about doing that, which is good. But I think, for me, the most important thing now for policy to have a good recovery is to reduce this tremendous amount of uncertainty that exists with both monetary policy and fiscal policy and the uncertainty for monetary policy is, we don't know how rapidly the quantitative easing will be reversed. We don't know what's going to happen with interest rates. There is a lot of questions there. So I’d say, get back to the things that were working during the great moderation period, the '80's and '90's primarily, and that means letting interest rates rise appropriately and reducing the amount of quantitative easing; getting back to where it was through most of policy of the '80's and '90's.
Question: What is the most important unresolved question in monetary economics?
John Taylor: I think the most important unresolved question of monetary economics is the interaction between the financial sector and monetary policy. There's been lots of thinking about it over the years, some of it actually done here at Stanford, e.g. Gurley and Shaw. A lot of it done by Tobin at Yale, Ben Bernanke has done some of it. But I think the most promising part is the combination of the newest work on pricing of bonds and securities. A lot of it's done by [people who] combine that with monetary policy so that you have a sense of what's going to happen to longer term rates when the short rate is reduced. What's going to happen to credit flows and how much are credit flows going to impact the economy?
This crisis has been very clear in demonstrating that more work on the connection between the financial economics and monetary policy is needed. In fact, there's still a lot of questions out there in policy about whether the financial markets performed well, or not. It seems to me, if you look at them, they absorbed a tremendous shock from policies. It's effectively a panic induced by some ad hoc policy changes and they responded quickly and they responded in a way which has been smooth, as the markets themselves. The institutions, the financial institutions of course, have been in great difficulty, but the markets themselves have worked well.
So, to me, where we should focus our attention really is this connection between the financial markets, including the financial institutions and the monetary policy itself.
Question: How important is Fed independence?
John Taylor: I think we need to have both independence and accountability. They go together. It's not one or the other. So, in answer to the question, how important is Fed independence? I say it is very important, but it needs to be matched with accountability.
A lot of the concerns that you're seeing in the Congress, in the country about the Fed; the Ron Paul bill, I think that's a reaction to what looks like a very interventionist action by the Federal Reserve. Not a lot of descriptions of how it actually occurred, there's no reports on what's called a Section 13-3 Intervention. Section 13-3 of the Federal Reserve Act which allows for such actions, but there’s very little reporting on how it actually took place.
So, I think the best thing the Fed can do to get back some of its independence, and quite frankly, I think it's lost a little bit in this crisis. The best thing it can do is be very accountable about some of the interventions in Section 13-3, that's where most of the transparency concerns exist at this point, and then of course to emphasize that the policy that has worked most well was the policy of the '80's and '90's and when we got off track on that, things deteriorated.
I think that some recognition of interest rates being so low for so long in the '02 to '04 period by the leadership would be very important. It’s discussed in the Fed system, is discussed by other central banks, it's discussed quite widely, but some recognition of that seems to me would be important in terms of bringing back some of the independence that the Fed lost.
So, I think that independence, just to summarize, is really important, it's essential, we've seen evidence over time about how it is. But it has to be matched with a strong sense of accountability to the Congress and to the American people of what the Fed is actually doing. ...
I agree with Brad DeLong:
Stimulus Too Small, by Brad DeLong, WSJ: Fourteen months ago, just after Barack Hussein Obama's election, most of us would have bet that the U.S. unemployment rate today would be something like 7.5%, that it would be heading down, and that the economy would be growing at about 4% per year. ... Well, we have been unlucky. Unemployment is ... not 7.5% but 10%. More important, perhaps, is that the expectation is for 3% real GDP growth in 2010.
That leaves us with two major questions: First, why has the outcome thus far been so much worse than what pretty much everyone expected in the late fall of 2008? And second, why is the forecast ... for growth so much slower than our previous experience with recovery from a deep recession in 1983-84?
I attribute the differences to four factors:
First, the financial collapse of late 2008 did much more damage than we realized... The shock now looks to have been about twice as great as the consensus in the fall of 2008 thought. ...
And that leads us to Factor No. 2. The Obama administration envisioned a $1 trillion short-term deficit-spending..., had the administration known how big the problem would turn out to be, it would have sought a $2 trillion stimulus. And what did we get once Congress got through with it? A $600 billion stimulus—about one-third of what we needed.
Making matters worse: The stimulus was not terribly well targeted. In an attempt to attract Republican votes, roughly two-fifths of it was tax cuts. Such temporary cuts are ineffective... (It also failed to win any extra votes.) Roughly two-fifths ... was infrastructure and other ... direct federal spending. But it is hard to boost federal spending quickly without wasting money, and those projects that are shovel-ready are not terribly labor intensive.
Meanwhile, the most-effective stimulus would have been aid to the states... But senators don't want to hand out money to governors; the governors then tend to run against the senators and take their jobs away.
This problem with both the quantity and quality of the stimulus is tied up with the third factor: that the Obama administration declared victory on fiscal policy with the American Recovery and Reinvestment Act ... and then went home.
There was no intensive lobbying for a bigger program,... no attempts to expand the stimulus programs... The background chatter is that trying for more deficit spending would have been fruitless, given the broken Senate...That background chatter is probably right. But ... there is still the Federal Reserve. And that's where the fourth factor comes in.
It is true that as far as normal monetary policy is concerned, the Federal Reserve was tapped out... But there is more in the way of extraordinary monetary policy that could have been attempted in 2009—including inflation-targeting announcements, the taking of additional risky assets out of the pool to be held by the private sector, larger operations on the long end of the yield curve.
And I must confess that what the Federal Reserve thought and did in 2009 remains largely a mystery to me.
Ben Bernanke tries to overcome some of the Fed's negative publicity:
Bernanke Invites GAO to Audit AIG Bailout, by Sudeep Reddy: In a bid to soften congressional criticism, Federal Reserve Chairman Ben Bernanke on Monday invited the Government Accountability Office to audit the central bank’s involvement in the U.S. rescue of American International Group Inc. In a letter to Acting Comptroller General Gene Dodaro, Bernanke said the Fed would provide “all records and personnel necessary” for the auditing arm of Congress to review the rescue. ...
The invitation from Bernanke does not change existing policies about congressional reviews of the Fed. The GAO already has authority to review the central bank’s involvement in the AIG bailout, along with other company-specific rescues by the Fed and Treasury Department. ...
Most people won't realize Bernanke is asking for something the GAO could have done on its own (though perhaps with less cooperation), e.g. the LA Times does not even mention this, so the politics work in the Fed's favor. And it does send the message that the Fed doesn't think it has anything to hide.
Tim Duy looks at the Fed's likely interest rate and balance sheet actions in the months ahead:
It's Not About Interest Rates Yet, by Tim Duy: Incoming data continue to support expectations that the Federal Reserve will hold rates at rock bottom levels for the foreseeable future - likely into 2011. But interest rates should not be the focus of policy analysts. The Fed will manipulate policy via the balance sheet long before they fall back to the interest rate tool. The question is whether or not the slow growth environment is sufficient to persuade the Fed to hold the balance sheet steady or even expand the balance sheet beyond current expectations. And there always remains the third option, favored by a minority of policymakers - withdraw the stimulus now that growth has reemerged. At this point, I suspect the Fed will stick with the hold steady option.
One of the key elements of the slow growth story was the inability and unwillingness of households to revert to past spending habits. The critical parts of the story are that savings rates would rise as household struggled to rebuild tattered balance sheets and that credits would become dearer. These stories are playing out in the data:
Yet the trend of consumer spending has undoubtedly been upward since June, as has been the trend of overall economic activity. Cyclically, the economy is on an upswing, surprising many who believed the apocalypse was at hand. But fears of a consumer apocalypse were always overblown; the change need only be moderate to have a large impact on the overall economic environment. It is not necessary that consumers crawl into their basements, curled into a fetal position hugging a bar of gold in one arm and a loaded shotgun in the other, to dramatically alter the role of households in the economy. Consider, for instance the path of retail sales excluding gasoline:
The November-December average monthly growth trend is 0.032% (note: log difference approximation), while the July-December trend is 0.03% and averages out the distortion caused by the "Cash for Clunkers" program. In either case, the spending trend is below the prerecession trend in sales growth. What are the takeaways from such an analysis?
Andy Harless says that, in the future, the Fed should target a higher level of inflation to give it more room to maneuver in a crisis:
Inflation Targets and Financial Crises, by Andy Harless: There are basically four ways to deal with the possibility of severe financial crises. First, you can just cross your fingers, hope such crises don’t happen very often, and live with the consequences when they do. Second, you can publicly insure and regulate your economy heavily in an attempt to minimize the risk and severity of such crises. Third, you can have your central bank monitor the fragility of general financial conditions and “take away the punch bowl” when it thinks conditions are in danger of becoming too fragile. Fourth, you can have your central bank target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate.
I know you are tired of hearing me make this point, and that many of you disagree, but maybe you'll be convinced by Paul Volcker? Should the fire code designers, inspectors, and enforcers be part of the fire department, or housed in a separate, independent agency? Does, for example, the knowledge inspectors gain about the risks of fire in various buildings along with knowledge about the nature of those risks (e.g. of spreading to particular adjacent buildings) help firefighters plan a more effective response if a fire does break out? Conversely, does the knowledge that firefighters have help the inspectors to know what to regulate and what to look for during inspections? Are there economies of scale from consolidation, e.g. if we want experts on how fires spread from building to building present among both inspectors and firefighters, is it most efficient and effective to concentrate this expertise in a single agency?:
Volcker Stands Up for Fed Role in Financial Oversight, Reuters: The Federal Reserve must have a “strong voice and authority” on regulatory matters, Paul Volcker ... said on Thursday. Mr. Volcker, a former Federal Reserve chairman, told a lunch meeting at the Economic Club of New York that he had been “particularly disturbed” by proposals to strip the Fed of its supervisory and regulatory responsibilities. “What seems to me beyond dispute, given recent events, is that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined,” said Mr. Volcker...
What are the actual arguments for this?:
The Public Policy Case for a Role for the Federal Reserve in Bank Supervision and Regulation, by Ben Bernanke: Like many other central banks around the world, the Federal Reserve participates with other agencies in supervising and regulating the banking system. The Federal Reserve’s involvement in supervision and regulation confers two broad sets of benefits to the country.
In response to the question of whether the Fed's low interest rate policy is responsible for the bubble, most respondents point instead to regulatory failures of one type or another. Ben Bernake has also made this argument. However, I don't think it was one or the other, I think it was both. That is, first you need something to fuel the fire, and low interest rates provided fuel by injecting liquidity into the system. And second, you need a failure of those responsible for preventing fires from starting along with a failure to have systems in place to limit the damage if they do start.
Bank regulators didn't have the systems in place to prevent bubbles, they didn't see the bubble developing until it was too late to prevent major damage, and the systems needed to limit the damage were inadequate, e.g. there were insufficient limits on leverage and other protections in the system. By analogy, the Fire Department's inspections were inadequate and there was much more fire risk than anyone thought, they didn't notice the fire until it was already out of control (even though Dean Baker and others had tried to alert them), when they did notice and respond they were initially confused and didn't have the tools they needed to fight the fire or prevent it from spreading, and they hadn't thought to require protections such as automatic sprinkler systems that might have limited the damage.
What fueled the housing bubble? There were three main sources of the liquidity that inflated the bubble. First, the Fed's (and other central banks') low interest policy added cash to the financial system, second, the high savings in Asia, particularly China, along with cash accumulations within oil producing nations, and third, some of the cash was generated endogenously within the system (e.g. by increasing leverage or by diverting other investments into housing and mortgage markets).
Once the fuel was present, something had to allow the bubble to inflate and then do widespread damage, and that's where the regulatory failure comes in. But I don't think the regulatory failure matters much without a large amount of liquidity within the system, and I don't think the large amount of cash in the system is problematic without the regulatory failures.
I've been making this argument for some time, so is there any support for the idea that bubbles are fueled by excessive liquidity? In the video embedded below of Nobel prize winning economist Vernon Smith that posted today at Big Think, he notes that in the experiments he has conducted that reproduce bubbles in the lab, the existence and size of bubbles depends critically upon the amount of "cash slopping around in the system."
In the video, he also notes that if you ask a different question, why was this bubble so devastating as compared to the dot.com bubble even though the initial losses were smaller -- $10 trillion in 2001 compared to $3 trillion in the housing bubble collapse -- you get a different answer: a failure of regulation. Here, he points to a failure to impose sufficient margin requirements as the key difference between the two episodes (I agree that leverage should be limited through margin requirements, and this would have helped to contain the damage, but I would have focused on the markets for complex financial assets rather than down payments on homes).
So I think the bubble itself was driven by "cash slopping around in the system" that originated from several sources, the Fed being one, and the regulatory failures (such as failing to provide sufficient transparency so that the smoke from the fire could be spotted in time, and failing to limit leverage) allowed the fire to spread rapidly and do major damage.
We're beginning to hear hawkish talk from some members of the Federal Reserve:
The 2010 Outlook and the Path Back to Stability, by Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City: ...Policy Challenges Ahead As I have indicated, a key contributor to the economic recovery is the extraordinary fiscal and monetary stimulus provided by governments and central banks around the world. In the U.S., we have seen the largest fiscal stimulus in history...
While these policy actions have been instrumental in helping to stabilize the economy and financial system, they must be unwound in a deliberate fashion as conditions improve. Otherwise, we risk undermining the very economic performance we hope to achieve. In the case of fiscal policy, the ballooning federal deficit must be controlled and reduced. ...
As the private sector recovers, increasing demand to finance both public and private debt will likely place upward pressure on interest rates. Eventually, there will be pressure put on the Federal Reserve to keep interest rates artificially low as a means of providing the financing. The dire consequences of such action are well documented in history: In its worst cases, it is a recipe for hyperinflation.
Addressing the deficit will be made all the more complicated by the fact that many of the stimulus programs are scheduled to wind down in 2011 at the very time the Bush administration tax cuts are also scheduled to expire. It will be an extremely abrupt shift in fiscal policy from stimulus to restraint that will cause the economy to weaken. Addressing the deficit under these types of circumstances will be controversial and desperately unpopular. ...
In the case of monetary policy, the challenges are no less daunting. The Federal Reserve must curtail its emergency credit and financial market support programs, raise the federal funds rate target from zero back to a more normal level, probably between 3.5 and 4.5 percent, and restore its balance sheet to pre-crisis size and configuration. ... However, normalizing monetary policy and the Federal Reserve’s balance sheet will be a ... contentious undertaking, and there are differing views regarding when this process should begin, how fast it should proceed, and what form it should take.
One view is that the Federal Reserve should delay interest rate normalization until there is more certainty that the economy and financial markets have completely recovered from this crisis. At that time, the accommodation can begin to be removed. Those who hold this view believe that high unemployment and low inflationary pressures due to excess capacity create considerable economic downside risks if the Federal Reserve removes stimulus. Their biggest fear is of the “double-dip” recession. In their minds, these immediate risks continue to outweigh concerns about long-term economic performance.
This is an appealing argument. The recovery is in its early stage, and weak data continue to emerge in some reports. State and local governments remain under severe fiscal pressures despite considerable federal assistance. Business investment spending for nonresidential construction and equipment remains weak. Additionally, those parts of the country heavily exposed to the subprime lending bust and to the auto industry remain depressed. Also, there is no denying the fact that despite improvements, labor markets and parts of our financial system remain under stress. Thus, while the economic and financial recovery is gaining traction, risks and uncertainty remain major deterrents to removing the stimulus.
Unfortunately, mixed data are a part of all recoveries. And, while there is considerable uncertainty about the outlook, the balance of evidence suggests that the recovery is gaining momentum. In these circumstances, I believe the process of returning policy to a more balanced weighing of short-run and longer-run economic and financial goals should occur sooner rather than later. ...
As I have already said today, experience has shown that, despite good intentions, maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations, more volatile and higher long-run inflation, and more unemployment — not today, perhaps, but in the medium- and longer-run. ...
Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis. ...
St. Louis Fed chief James Bullard said the U.S. jobless rate will start to fall soon and played down price pressures facing the United States in the near term, saying that the Fed's moves to pump liquidity into the economy were not an inflationary concern.
As noted above, there are two risks, one is high unemployment and the other is high inflation. However, the costs associated with high unemployment are larger than the costs of high inflation (Hoenig' mention of hyperinflation is merely to scare people, that's not going to happen). So preventing high unemployment should be the primary concern of policymakers. The Fed should not be in any hurry to tighten monetary policy, and if anything, it should drag its feet.
[Here's a bit more on the relationship between unemployment and the Fed's target interest rate in the aftermath of recessions. One more note. While I haven't been strongly in favor of further aggressive quantitative easing from the Fed due to pessimism that such policies would work (though I haven't strongly opposed such action either), that is different from being worried that the present policy will cause inflation problems. I don't think it will and I certainly don't think that the economy is anywhere near the point where we need to start worrying about tightening policy. Finally, I wonder what the correlation is between being hawkish about inflation and being hawkish about the deficit. I'd guess it's relatively high.]
In August 2005 at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo., Raghuram Rajan presented a paper filled with caution. Answering the question “Has Financial Development Made the World Riskier?” the University of Chicago economist observed that financial innovation had delivered unquestioned benefits, but also had produced undeniable risks.
“It is possible these developments may create … a greater (albeit still small) probability of a catastrophic meltdown,” he told the assembled central bankers and academics. “If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions.”
It was a discordant note at a forum celebrating Alan Greenspan’s tenure as Fed chairman; many deemed his conclusions “misguided.” But history, of course, proved that Rajan’s analysis was dead on. ...
Here is a blunt assessment of the Jackson Hole episode.
Here are a few sections from the (much longer) interview:
... Doubts about Diminishing Risk
[Ron] Feldman: In a prominent Jackson Hole paper,2 you talked about some of the technologies of banking that people thought were going to distribute risk widely and therefore diversify it, making the financial system and financial institutions less risky. It was less clear to you that risk reduction was actually occurring. Could you talk about how you came to that view and how important you think that was in the current crisis?
[Raghuram] Rajan: One of the things I was asked to do was to look at the development of the financial sector, and I have great admiration for some of the things that have happened. There have been good things in the financial sector which have helped us. But to some extent there was a feeling that when you distribute risk, you’ve reduced the risk of the banking system.
My thought was, what business are the banks in? They’re not in the business of being plain-vanilla entities, because they can’t make any money that way. They are in the business of managing and warehousing risk. So if it becomes easier to lay off a certain kind of risk, the bank better be taking other kinds of risk if it wants to be profitable. And if the vanilla risk is going off your books, presumably the risks that you’re taking on are a little more complex, a little harder to manage.
That was the logic which led me to argue ... that distance-to-default measures didn’t look like they were coming down despite all this talk about securitization and shifting risk off bank books. That struck me as consistent with my view that maybe the risks that banks were taking on were more complicated. Whether they were excessive or not, I couldn’t tell.
Also, as I saw the mood, I became worried. Having studied past financial crises, I knew that it’s at the point when people say, “There’s no problem,” that in fact all the problems are building up. So that was just another indicator that we should be worried.
I should add that while I thought we could have a crisis, I never thought that we’d come to the current pass. However, I did argue that it could be a liquidity crisis..., and even though banks in the past had been the safe haven, they could be at the center of this problem.
So, one strand of my argument was based on the business of banks, but the second strand was to think about the incentive structure of the financial system and say that while we have moved to a compensation structure that penalized obvious risk, risk that you could see and measure, that may have made employees focus on risks that could not be measured. An example of that is “tail risk,” because you can’t measure it until it shows up, and it shows up very infrequently. So part of the reason I was worried was that people were taking more tail risk; an insurance company writing credit default swaps was just one example of that.
It didn’t require genius at that point to look around and say the insurance companies were writing these credit default swaps as if there was no chance on earth that they would ever be asked to pay up, so they were really taking on tail risk without any thought for the future. AIG should not have been such a surprise to the Fed.
Feldman: Ex post it was clear to everyone that the incentives were aligned so that firms were taking on risk that people didn’t understand, but at the time there was push-back to what you were saying. ...
Rajan: There were two reasons for the push-back. One was just the venue. This conference was almost a Festschrift [farewell tribute] to Greenspan, and it seemed to some—though it wasn’t intended as such—that I was raining on the parade. This was his farewell, and I was talking about problems that had arisen during his tenure.
But the bigger issue was the collective sense that the private sector could take care of itself, and if not, the Fed would be able to clean up. We had been through two downturns: the 1998 emerging market crisis and the 2000-2001 dot-com bust, and we had understood the tools that were required. In 1998, it was a short reduction in interest rates, not a dramatic one. In 2000-2001, it was a dramatic reduction. And these “successes” led to a feeling that “the Fed can take care of it.”
You know the argument: Typically, the private sector will have the right incentives. Why would they blow themselves up? Regulators aren’t that capable: They’re less well-paid and less informed than the private sector, so what can they do? And finally, if worse comes to worst, the Fed will pick up the pieces.
I think there are three things wrong with this argument, one for each of those elements. Private sector—yes, it can take care of itself, but its incentives may not be in the public interest; may not even be in the corporate interest if corporate governance is problematic. So the trader could fail the corporation, could also fail society. That’s one problem.
Second, the public sector has different incentives from the private sector, and that’s a strength of the public sector. When we’re talking about regulators, because they’re not motivated in the same way as the private sector, they can stand back and say, “Well, I don’t fully understand the risks you’re taking, but you are taking lots of risk—stop.” So I think we’ve made too little of the incentive structure of regulators which should be different, can be different, which gives them a role in this, rather than saying they’re incompetent and they can’t do it. I think they can.
But the third aspect was that I think we overestimated the ability of monetary policy to pull us out of a serious credit problem. The previous problems we had dealt with in the U.S. were not credit problems. They were standard, plain-vanilla recessions. The bank system was still active, so monetary policy wasn’t pushing on a string: The Fed brought down interest rates, and things did come back up.
When credit problems arose—and real estate was central to credit problems because of the real estate securities which ended up on bank balance sheets—then the banks were incapable of being part of the transmission process, and now monetary policy lost a lot of traction, so it wasn’t simply a matter of cutting interest rates and seeing everything come back.
Feldman: People might have thought after the banking crisis of the 1980s and early 1990s—which did not have the same macroeconomic effect as this crisis—that they could respond effectively.
Rajan: Exactly. I guess we didn’t see anything as big, as deep in the recent past. And there was a certain amount of hubris that we could deal with this.
Why was the Crisis so Severe?
Feldman: Why do you think this financial crisis was more severe? There are lots of potential explanations. Some observers point to the failure of credit rating agencies; others point to flawed incentives in compensation and to the creation of new financial products as examples. If you had to list the two or three things that you think really underlie why there was so much risk-taking, why more risk-taking than people thought, what’s the deep answer for that?
Rajan: You can go right to the meta-political level, but let me leave that aside for now. If you hone down on the banking sector itself, I think it was a situation where it was extremely competitive. Every bank was looking for the edge. And the typical place to find the edge is in places where there are implicit guarantees. ...
I think the most damaging statement the Fed could have made was the famous Greenspan doctrine: “We can’t stop the bubble on the way up, but we can pick up the pieces on the way down.” That to my mind made the situation completely asymmetric. It said: “Nobody is going to stop you as asset prices are being inflated. But a crash is going to affect all of you, so we’ll be in there. By no means go and do something foolish on your own, because we’re not going to help you then. But if you do something foolish collectively, the Fed will bail you out.”...
People were acting as if liquidity would be plentiful all the time. And my sense of what the Fed does, in part, by reducing interest rates considerably is help liquidity, and so there was a sense that, well, we can take all the liquidity risk we want, and it won’t be a problem. Of course, it turned out that not just interest rates mattered; the quantity of available liquidity or credit also mattered at this point. And that was the danger. ...
Corruption, Ideology, Hubris, or Incompetence?
Feldman: One thing you haven’t mentioned as a proximate cause is issues around “crony capitalism.” Some seem to argue that banks were allowed to grow large and complex because they were run by friends or colleagues of people who were in power. And for similar reasons, these firms got bailed out—because they had colleagues and friends in “high places.” Given that you’ve thought a lot about that in your own writing, given that you were at the IMF [International Monetary Fund] where you had the ability to look across countries where it is an issue, how important would you say crony capitalism is in the U.S. context in the current crisis?
Rajan: Let me put it this way. There is always some amount of regulatory capture. The people the regulators interact with are people they get to know. They see the world from their perspective, and, you know, they want to make sure they’re in their good books. And so it’s not surprising that across the world, you have a certain amount of the regulators acting in the interest of, and fighting for, the regulated.
Beyond that: Is there naked corruption, or less naked corruption? “If you do my work for me as a regulator, then you can come and join me as a senior official in my firm, and I’ll pay you back at that point.” I’m sure there were stray instances of that, but that to my mind, wouldn’t be the number one reason for this crisis.
I think I would put more weight on a sense of market infallibility which pervaded the economics profession, not just regulators. ... I think across the field of economics, we stopped worrying about the details in industrial countries because we said, by and large, things get taken care of. Yes, there is the occasional corporate fraud or misaligned incentives, but those are aberrations rather than a systemic problem. So I think this view, that you couldn’t have a large systemic problem, this was the problem.
Overlaid on this was the view that regulation was less and less important. We put excessive weight on the private sector getting it right on their own without understanding that the private sector can also break down—the board may not know what management is doing, management may not know what the traders are doing, so that process can break down. But even if everybody is working in the interests of the corporation, the corporation may not be acting in the interests of the system. We’ve seen all these things happen. So the regulatory system had a role to play, and it did not play that as much as it should have. ...
I’m positive that there were situations that we will discover in hindsight where excessive influence was used. There’s cronyism. In a crisis like this, it’s hard to escape it. But I’m less convinced that systematic cronyism was the reason for this. I think ideology was part of the reason we went wrong, as also was the hubris built up over decades of fairly strong growth and deregulation. ...
I guess I’m paraphrasing Churchill, but my tendency is not to attribute to malevolence what can be more easily attributed to incompetence. I think there are a fair number of situations where things didn’t work out as advertised.
Feldman: But you’re talking about more than incompetence, right? You’re talking about the incentive structures within firms that would lead people to act as if they were incompetent.
Rajan: I’d even go one step further and say you don’t have to offer an explanation that relies on evil people or corrupt people. The entire crisis can be explained in terms of people who were doing the right things for their own organizations. You can even argue that it was not that they were misdirected by their own distorted compensation structures; they thought they were doing the right thing for their organization. But when you added it all up, it didn’t add up to doing good for society. And that’s where we have the problems. ...
The Economics Profession
Feldman: We just talked about the economics profession and what has worked well or hasn’t worked well. There’s been a lot of discussion about saltwater and freshwater schools in economics recently.4 I think you have an interesting background to talk about that since you’re at the [freshwater] University of Chicago business school and you’ve done a lot of work about financial systems, but you got your Ph.D. at [saltwater] MIT. Do you have a view about what the economics profession didn’t do well? And what the economics profession ought to be focused on going forward?
Rajan: I have a take on this, yes. But first, one has to remember that the saltwater economists, so to speak, were crowing victory in 1969. You see quotes from Paul Samuelson and Bob Solow [at MIT] saying essentially that the business cycle is dead; we have learned how to deal with it. And we know what happened after that.
I think there is a problem with economics when it thinks it has solved all the traditional problems. That’s when economics slaps you in the face and says, “Not so fast!” The reason rational expectations in macroeconomics and efficient markets in finance are under attack now is not so much because people can tie specific failings to these theories but because they’re the dominant part of the economics or finance profession right now. So I think debate has gone a little off track, in the sense of saying, “You were responsible.”
Would any of the neo-Keynesians have done any better? There were many of them in the Clinton administration where some of this stuff built up. Would anybody pin all this on the Bush administration only? No, it’s a systemic problem. So, I think the debate about “economics is to blame.” well, yes, it is to blame to the extent that it didn’t pick up on some of what happened. But this crisis is problematic for all broad areas of macroeconomics or even of finance.
It is clear that there are many areas of economics that have studied the problems we saw in this crisis. For example, the banking and corporate finance guys have looked at agency problems, looked at banking crises, etc. The behavioral theorists have inefficient markets and irrational markets. So, again, the profession as a whole, I don’t think, deserves blame. It has been studying some of these things.
The central question is why certain areas of economics, particularly macroeconomics, abstracted from the plumbing, which turned out to be the problem here. My sense is that that abstraction was not unwarranted given the experience of the last 25 to 30 years. You didn’t have to look at the plumbing. You didn’t have to look at credit. Monetary economists thought credit growth was not an issue that they should be thinking about. Interest rates and inflation were basically what they should be focusing on. The details of exactly how the transmission took place were well established, and we thought they would not get interrupted. Well, we’ve discovered they can get interrupted.
The natural reaction is now to write models which have the details of the plumbing, and you see more of that happening. So I think what the macroeconomists did was not because they were in the pay of the financial sector or consultants of whatever [laughter], as some have said. But I think it was that that was a useful abstraction given what we knew, and it’s no longer an abstraction that we can ever undertake now. ...
This is from Roger Farmer's "Farewell to the natural rate: Why unemployment persists." He argues that "the relationship between unemployment and inflation is more complicated than that suggested by simple new-Keynesian models that incorporate a “natural rate” of unemployment." Why is this important?:
...In two forthcoming books,... I provide a theory that explains these data. I argue that there is no natural rate of unemployment and that the economy can come to rest in a stationary equilibrium at any point on the Beveridge curve. Which equilibrium persists, is decided by the confidence of households and firms that pins down asset values as reflected in housing wealth and the value of the stock market.
When households feel wealthy, that belief is self-fulfilling. Consumers spend a lot, firms hire workers, and the economy comes to rest at a point on the Beveridge curve with low unemployment and high vacancies. When the values of houses, factories, and machines fall, households spend less, firms lay off workers, and the economy comes to rest at a point on the Beveridge curve with high unemployment and low vacancies. Both situations – and anything in between – are zero-profit equilibria. ...
Most policymakers subscribe to the theory of the existence of a natural rate of unemployment. The data suggest that this theory is unconfirmed at best. To make the theory consistent with data, one must posit that the natural rate changes between recessions in unpredictable ways. This version of natural rate theory is difficult or impossible to refute. It is religion, not science.
For more than fifty years policy makers have been trying to hit two targets, unemployment and inflation, with one instrument, the interest rate. Recently, central bankers have discovered a second instrument – quantitative easing. I believe that quantitative easing works by influencing the value of real assets as reflected in housing wealth and the stock market and that it was successfully deployed by central banks in 2009 to maintain aggregate demand. In my two forthcoming books, I argue that quantitative easing should permanently enter the lexicon of central banking as a second instrument of monetary policy and that it will prove to be a more effective and flexible tool than fiscal policy for restoring and maintaining full employment.
I seem to be the only skeptic about the ability of quantitative easing to have a substantial impact on unemployment.
Out of the Gate with a Bang, by Tim Duy: If you were looking for a final, cataclysmic collapse of the US economy, you remain disappointed. To be sure, the fallout from the financial crisis is severe, with the palpable wreckage evident in the bottom line, a rate of underemployment at 17.2%. Yet even the most diehard pessimist could not fail to recognize the numerous signs of a cyclical turning point in the second half of 2009. And those signs continued into the new year with today's ISM release. The bulls had reason to run with these numbers; the near term outlook appears baked in the cake. Yet the near term is not an interesting question, in my opinion. The interesting question is what will emerge in the second half of the year. Is the first half a head fake? And, more importantly, where will incoming data lead policymakers, particularly at the Fed? My expectation remains that the Fed will wait until the medium term uncertainty is lifted before raising interest rates, which would be well into the back half of this year if not into 2011. But that might not be the ball to watch; policymakers probably worry about the size of the balance sheet more than the level of interest rates. The near term risk is that stronger than expected growth in the first half would tempt the Fed to withdraw that liquidity before the recovery became fully entrenched.
The ISM manufacturing numbers for December stoked a fire on Wall Street Monday morning, with the better than expected headline number bolstered by strong gains in new orders, the lifeblood of future factory production. Moreover, the employment numbers moved higher, which, coupled with steady declines in initial unemployment claims, points toward actual - gasp - job growth as early as the first quarter. Industrial production gained a solid 0.8% in November, returning to something resembling a "V" shaped recovery in the making after a flat reading in October. Similarly, core manufacturing orders continued their upward trend that same month. Inventory to sales ratios continue to fall, arguing for continued restocking support. And consumer spending continues to edge forward despite declining consumer credit and rising saving rates, a dynamic that will be increasingly supported by firming job markets. What's not to like? No wonder then that Treasury markets have sold off modestly, the 10 year bond heading toward the 4% mark.
Indeed, using the typical post war recession as a guide, one would think the pessimists would by now have folded their cards, leaving that smoky back room of despair for the clear air and bright sunshine that mark the beginning of a new day. But alas, the fear remains that there is no longer such a thing as a "typical" post war recession. The recovery appears inexorably linked to a host of stimulus measures that reach into virtually every strand of the fabric that is the US economy. And therein lies the uncertainty - few are confident that the economy can stand on its own. And the hypothesis that it can has not been tested. The Fed continues to expand its holding of mortgage securities, still looking toward March as the end date for that program. The positive growth impulse from fiscal stimulus will continue through the first half of this year. Support for housing comes via many channels - and despite rising existing home sales and price stabilization, no one believes the housing market remains anything but broken. Moreover, it is difficult to forget that solid US growth of the past decade and earlier was dependent on asset bubbles to fuel consumer spending. No such convenient asset bubble is on the horizon at the moment.
Where does the economy stand when the support for housing is withdrawn, when fiscal stimulus runs its course, when the inventory correction process is complete?
Did the Fed Cause the Recession?, by Mark Thoma: I have been more defensive of the Fed's actions both before and after the crisis started than most, and I want to talk about why recent criticism of Bernanke and the Fed for their failure to use regulatory intervention to stop the housing bubble is correct, but perhaps directed at the wrong target. ...[...continue reading...]...
There's a pretty good chance that the next few economic reports will make it appear that the economy is improving, but those reports may not be as positive as they seem on the surface. Will policymakers "misinterpret the news and repeat the mistakes of 1937?":
That 1937 Feeling, by Paul Krugman, Commentary, NY Times: Here’s what’s coming in economic news: The next employment report could show the economy adding jobs for the first time in two years. The next G.D.P. report is likely to show solid growth in late 2009. There will be lots of bullish commentary — and the calls we’re already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder.
But if those calls are heeded, we’ll be repeating the great mistake of 1937, when the Fed and the Roosevelt administration decided that the Great Depression was over, that it was time for the economy to throw away its crutches. Spending was cut back, monetary policy was tightened — and the economy promptly plunged back into the depths. ...
As you read the economic news, it will be important to remember, first of all, that blips — occasional good numbers, signifying nothing — are common even when the economy is ... in a prolonged slump. ...
Such blips are often ... statistical illusions. But ... they’re usually caused by an “inventory bounce.” When the economy slumps, companies typically find themselves with ... excess inventories, [and] they slash production; once the excess has been disposed of, they raise production again, which shows up as a burst of growth in G.D.P. Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long-term investment, pick up.
Which brings us to the still grim fundamentals of the economic situation. During the good years of the last decade,... growth was driven by a housing boom and a consumer spending surge. Neither is coming back. ...
What’s left? A boom in business investment would be really helpful... But it’s hard to see where such a boom would come from: industry is awash in excess capacity, and commercial rents are plunging in the face of a huge oversupply of office space.
Can exports come to the rescue? For a while, a falling U.S. trade deficit helped cushion the economic slump. But the deficit is widening again, in part because China and other surplus countries are refusing to let their currencies adjust.
So the odds are that any good economic news ... will be a blip, not an indication that we’re on our way to sustained recovery. But will policy makers misinterpret the news and repeat the mistakes of 1937? Actually, they already are.
The Obama fiscal stimulus plan is expected to have its peak effect ... around the middle of this year, then start fading out. That’s far too early: why withdraw support in the face of continuing mass unemployment? Congress should have enacted a second round of stimulus months ago... But nothing was done — and the illusory good numbers we’re about to see will probably head off any further possibility of action.
Meanwhile, all the talk at the Fed is about the need for an “exit strategy” from its efforts to support the economy. One of those efforts, purchases of long-term U.S. government debt, has already come to an end. It’s widely expected that another, purchases of mortgage-backed securities, will end in a few months. This amounts to a monetary tightening, even if the Fed doesn’t raise interest rates directly — and there’s a lot of pressure on Mr. Bernanke to do that too.
Will the Fed realize, before it’s too late, that the job of fighting the slump isn’t finished? Will Congress do the same? If they don’t, 2010 will be a year that began in false economic hope and ended in grief.
Will the crisis teach economists not to be overconfident about their abilities?
My answer is here.
Why Christmas Eve?, by Tim Duy: One would think that policymakers would treat the day before Christmas as sacrosanct, if not for the sake of their employees, but to avoid the endless conspiracy theories that naturally arise when you partake in activities that look like they are intended to fly under the radar. Has US Treasury Secretary Timothy Geithner learned nothing in his long tenure serving Goldman Sachs the people of the United States of America? Ignoring the wisdom of the ages, Geithner made what appears to be unlimited funds available to Freddie Mac and Fannie Mae on the day when most of the nation is more concerned about getting presents under the tree (myself personally content that I can squeeze yet another year of magic under the Santa Claus myth) than the policy machinations of Washington.
But do we really care? Is this really a new news, or just a matter of questionable timing? Would the same announcement today have raised the ire of the blogoshpere?
To get at this issue, we should back up to a New York Times article a few weeks back (hat tip to Dean Baker):
Fannie Mae and Freddie Mac, which buy and resell mortgages, have used $112 billion — including $15 billion for Fannie in November — of a total $400 billion pledge from the Treasury. Now, according to people close to the talks, officials are discussing the possibility of increasing that commitment, possibly to $400 billion for each company, by year-end, after which the Treasury would need Congressional approval to extend it. Company and government officials declined to comment.
Apparently this little item was lost in the Christmas rush - seriously, could this even compare to the endless fascination with the status of holiday sales? The point is that hanging in the background was the likelihood that Mae and Mac were expecting some very, very bad fourth quarter numbers. Indeed, despite the massive efforts to support the housing market, Fannie Mae reported today that serious delinquencies continue to climb at an alarming rate. So, at second glance, Treasury's Christmas Eve announcement looks somewhat less disconcerting. The timing questionable, but the outcome expected. But why the essentially unlimited access to funds? I think this is pretty straightforward - Geithner simply lifted illusion (delusion?) that the GSEs were anything less than backed by the full faith and credit of the Uncle Sam. Seriously, at this juncture who believes that GSE debt is any different than Treasury debt? Or that the US will not pump in any amount of dollars necessary to keep the GSEs afloat?
That said, the Treasury's press release was bereft of explanatory information, giving rise to a host of theories as chronicled by Calculated Risk. In my mind, the most appealing of these explanations (other than that stated above) is the supposed intention to use the GSEs to absorb dysfunctional mortgages in an effort to revive floundering modification programs. Why? Because, as structured, modifications just simply don’t work in aggregate. I have thought this from day one of the modification story. And, frankly, I don’t think I am particularly insightful on this point. Seems obvious. Suppose homeowner A is underwater on a mortgage costing $4,000 a month for a property that now has a rental equivalent of $2,000. How exactly does it help that homeowner to "modify" their mortgage to $3,000 a month? They are still underwater, and they will likely have to sacrifice any potential gains (10-20 years down the road!). The modification leaves you with the choice of being a virtual renter for $3,000 a month or an actual renter for $2,000 a month. Moreover, what truly is better for the economy? To free up $2,000 in the household's monthly budget via a balance sheet restructuring, or to weigh down the household balance sheet with an impossible debt burden?
The Wall Street Journal recently printed a front page article on this topic that I thought was spot on:
The excess capacity series (red line) peaked in June of this year, and has been moving downward ever since. If the pattern in the two most recent recessions holds, those in 1990-91 and 2001, the peak in the unemployment rate will come between 16 and 19 months after the peak in excess capacity, i.e. around a year from today (though prior to 1990 the peaks were coincident).
The most recent data on the unemployment rate showed a downward tick from 10.2 percent to 10.0 percent, so perhaps unemployment has already peaked and the lag will be shorter this time. But perhaps not. As an inspection of the unemployment series in the graph shows, the unemployment rate bounces around even when it is trending upward or downward. So it's hard to tell from one month's data whether the downward tick in the unemployment rate is temporary and unemployment still has a ways to go before peaking (as in the last two recessions), or a sign that a turning point has been reached and things are getting better (which would represent a reversion to the more coincident movement in the two series observed before 1990).
Note, however, that in the 2001 recession, unemployment fell briefly just after excess capacity peaked, but then resumed its upward movement for several more months before reaching a turning point 19 months after the turning point in excess capacity. Thus, while the recent downward tick in the unemployment rate is good news, certainly better than an uptick, we should be prepared for the possibility that the pattern in the last recession might repeat itself and unemployment will head back upward for several more months before it reaches its peak. I hope that doesn't happen, the sooner unemployment returns to normal the better, but we need to be better prepared than we are for the very real possibility that unemployment will continue to trend upward. I'd like to see more done on both the monetary and fiscal policy fronts as a preemptive measure, we can always ease off if things turn our better than expected, but at the very least we need to resist calls from the deficit and inflation hawks to begin pulling back and continue the programs that are already in place.
[Question: What happened from mid 1997 through the beginning of 1999 that caused the two series to move in opposite directions and separate?]
Update: Paul Krugman follows up here.
I have been more skeptical than most about the ability of quantitative easing to stimulate output and employment, so I thought I'd counter that with this explanation of how QE works, what might go wrong, and some of the evidence in its favor.
[My doubts come on two fronts. The first is the ability of QE to affect long-term real rates, and the evidence is somewhat favorable on this point, though not 100 percent compelling. It does seem that the Fed can lower long-term real rates, mortgage rates in particular, though why we want to stimulate investment in new housing in the aftermath of an housing bubble is a question we might want to ask.
My second objection is related to this - even if we do lower long-run real mortgage rates, will that stimulate new investment in housing given the inventory problem that already exists, and given the condition of the economy? I'm doubtful, and that doubt extends generally. The mechanism described below relies upon lower real interest rates stimulating new investment, but even if long-term rates fall across the board, will firms be inclined to go out and buy new factories and equipment when so much of what they have is sitting idle?
Fiscal policy can put these resources to work directly, but monetary policy must induce firms to invest (or induce households to purchase housing and durables), and in a recession that may be hard to do. That's why I've emphasized fiscal policy, and that is what my objection is mostly about. The focus on the Fed has made it appear that monetary rather than fiscal policy is our best bet at this point. Monetary policy might be able to help for the reasons explained below, so I have no objection to trying, but fiscal policy needs to take the lead.
I should acknowledge that it may not be politically possible at this point to do more on the fiscal policy front, and the 3.5 percent growth rate for third quarter GDP that turned out to be a false signal didn't help at all (note, however, that the Fed is equally unlikely to respond to calls for it to do more). But there did seem to be momentum building toward providing more help through fiscal policy -- there was even a jobs summit -- however the talk about fiscal policy suddenly ended as people turned their guns on the Fed. While that may have been needed to get the Fed thinking harder about what more it can do, we should have also kept up the pressure on fiscal authorities. That fiscal authorities have been let off the hook is disappointing]:
Conducting Monetary Policy when Interest Rates Are Near Zero, by Charles T. Carlstrom and Andrea Pescatori, Economic Commentary, FRB Cleveland: This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes how monetary policy might be conducted in such a situation. We argue that avoiding expectations of deflation is key and that the monetary authority needs to demonstrate an unequivocal commitment to preventing deflation. We also argue that price-level targeting might be a good device for communicating such a commitment.
While business cycles are inevitable, there is quite broad agreement among economists and policymakers that monetary policy can and should be used to damp fluctuations in economic activity. But some fluctuations can occur in an unusual economic environment in which the traditional tools of monetary policy become useless. When short-term interest rates are at or near zero, for example, monetary policy cannot be implemented in the usual way—by adjusting these short-term interest rates. If policymakers want to lower rates in such an environment, they must look for alternative ways of conducting policy. With the federal funds rate hovering just above zero since December 2008, the current U.S. economic situation is a case in point. To conduct monetary policy under these conditions, the Federal Reserve has had to turn to a new strategy and new tools.
Some economists have pointed to another problem that an environment of near-zero interest rates could pose for monetary policy. They suggest that the inability to lower interest rates could allow a sudden and unexpected fall in the demand for goods and services to push the economy into a deflationary spiral, a situation in which falling prices and falling output feed upon each other. The fear is that a negative demand shock that pushes down prices (in short, a deflationary shock) could further decrease output, thereby accentuating the deflationary process. This additional deflation will then lead to further output decline. Paul Krugman, the economist and New York Times columnist, has dubbed this downward spiral a “black hole,” from where there is no return.1
This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes some of the ways in which monetary policy might be conducted in this situation. We conclude by emphasizing that to be effective in an environment of zero short-term nominal interest rates, monetary policy needs to be unequivocally committed to avoiding expectations of deflation. We also argue that price-level targeting might be a good device for communicating such a commitment. While this policy prescription follows from the assumption that the zero interest rate bound is a consequence of a negative demand shock hitting the economy, it is worth stressing that falling prices can also be the consequence of a supply shock, namely particularly high productivity growth (not a bad thing!). This would clearly call for different policy actions than the ones described here.
Many of you will likely disagree with this: