Category Archive for: Monetary Policy [Return to Main]

Friday, May 18, 2012

Fed Watch: Closer to Colliding

Tim Duy:

Closer to Colliding, by Tim Duy: Each passing day brings the runaways trains closer to collision.  

The European strategy to scare the Greek people into voting for pro-austerity parties was always risky. My tendency is to think it will drive voters in the other direction, this is especially the case if voters come to believe they hold the real leverage. And that is exactly the strategy that is emerging. From the Wall Street Journal:

The head of Greece's radical left party says there is little chance Europe will cut off funding to the country and if it does, Greece will repudiate its debts, throwing down a gauntlet that could increase tensions between Greece's recalcitrant politicians and frustrated European creditors...

..."Our first choice is to convince our European partners that, in their own interest, financing must not be stopped," Mr. Tsipras said in an interview with The Wall Street Journal. "If we can't convince them—because we don't have the intention to take unilateral action—but if they proceed with unilateral action on their side, in other words they cut off our funding, then we will be forced to stop paying our creditors, to go to a suspension in payments to our creditors."

Europe and the Greece are locked in a battle of mutually assured financial destruction. Nor can European leaders afford to take Tsipras' threats lightly:

According to recent opinion polls, Mr. Tsipras' party is poised to win the most votes in repeat elections next month, bettering its surprise second-place finish in an inconclusive May 6 vote that left no party or coalition with enough seats in Parliament to form a government. With Mr. Tsipras poised to win pole position in the coming vote, it raises the risk that Greece will soon face a showdown with its European creditors over the contentious austerity program that Athens must implement in order to receive fresh aid.

If Europe caves and gives in to Greek demands, however, a new set of challenges to the austerity agenda will arise. How long would it be before the people of Spain or Italy or Portugal or Ireland realize that they too have much more leverage than they ever imagined. Can the Troika cave to Greece while remaining credible with other troubled economies?  I doubt it - which I think increases the risk that the core of Europe will believe it necessary to create a moral hazard example out of Greece.  

Of course, this worked so well with Lehman Brothers. We will just foget about that little detail for the moment.

Thursday, May 17, 2012

"Is Inflation Targeting Really Dead?"

David Altig argues that flexible inflation targeting "is far from dead":

Is inflation targeting really dead?, by David Altig: Harvard's Jeffrey Frankel (hat tip, Mark Thoma) is the latest econ-blogger to cast an admiring gaze in the direction of nominal gross domestic product (GDP) targeting. Frankel's post is titled "The Death of Inflation Targeting," and the demise apparently includes the notion of "flexible targeting." The obituary is somewhat ironic in that at least some of us believe that the U.S. central bank has recently taken a big step in the direction of institutionalizing flexible inflation targeting. Frankel, nonetheless, makes a case for nominal GDP targeting:

"One candidate to succeed IT [inflation targeting] as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980's, since it did not share the latter's vulnerability to so-called velocity shocks.

"Nominal GDP targeting was not adopted then, but now it is back. Its fans point out that, unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand—the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway."

That's certainly true, but a nominal GDP target is consistent with a stable inflation or price-level objective only if potential GDP growth is itself stable. Perhaps the argument is that plausible variations in potential GDP are not large enough or persistent enough to be of much concern. But that notion just begs the core question of whether the current output gap is big or small. At least for me, uncertainty about where GDP is relative to its potential remains the key to whether policy should be more or less aggressive.

In another recent blog item (also with a pointer from Mark Thoma), Simon Wren-Lewis offers the opinion that acknowledging uncertainty about size of the output gap actually argues in favor of being "less cautious" about taking an aggressive policy course. The basic idea is familiar. It is a simple matter to raise rates should the Fed overestimate the magnitude of the output gap. But with the short-term policy rates already at zero, it is not so easy to go in the opposite direction should we underestimate the gap.

No argument there. As I pointed out in a May 3 macroblog item, Atlanta Fed President Dennis Lockhart has said the same thing. But, as I argued in that post, this point of view is only half the story. Though I agree that the costs are asymmetric with respect to the downside with respect to the FOMC's employment and growth mandate, they look to me to be asymmetric to the upside with respect to the price stability mandate. And I view with some suspicion the claim that we know how to easily manage policy that turns out to be too aggressive after the fact.

My issues are not merely academic. In an important paper published a decade ago, Anasthsios Orphanides made this assertion:

"Despite the best of intentions, the activist management of the economy during the 1960s and 1970s did not deliver the desired macroeconomic outcomes. Following a brief period of success in achieving reasonable price stability with full employment, starting with the end of 1965 and continuing through the 1970s, the small upward drift in prices that so concerned Burns several years earlier gave way to the Great Inflation. Amazingly, during much of this period, specifically from February 1970 to January 1977, Arthur Burns, who so opposed policies fostering inflation, served as Chairman of the Federal Reserve. How then is this macroeconomic policy failure to be explained? And how can such failures be avoided in the future?...

"The likely policy lapse leading to the Great Inflation …can be simply identified. It was due to the overconfidence with which policymakers believed they could ascertain in real-time the current state of the economy relative to its potential. The willingness to recognize the limitations of our knowledge and lower our stabilization objectives accordingly would be essential if we are to avert such policy disasters in the future."

With this historical observation in hand, it seems a short leap to turn Wren-Lewis's thought experiment on its head. Arguably, the last several years have demonstrated that nonconventional policy actions have been quite successful at short-circuiting the disinflationary spirals that pose the central downside risk when interest rates are near zero. (If you can tolerate a little math, a good exposition of both theory and evidence is provided by Roger Farmer.)

On the opposite side of the ledger, we know little about the conditions that would cause the Fed to lose credibility with respect to its commitment to its inflation goals, and very little about the triggers that would cause inflation expectations to become unanchored. Thus, I think it not difficult to construct a plausible argument about the risks of being wrong about the output gap that is exact opposite of the Wren-Lewis conclusion.

I end up about where I did in my previous post. Flexible inflation targeting, implemented in such a way that the 2 percent long-run inflation target rate exerts an observable gravitational pull over the medium term, feels about right to me. Despite what Frankel seems to believe, I think that idea is far from dead.

Break Them Up

This was unexpected:

Federal Reserve Bank of St. Louis President James Bullard said Thursday that banks deemed “too big to fail” should be split up. “We do not need these companies to be as big as they are,” Bullard said. His remarks come a week after J.P. Morgan Chase & Co. disclosed a $2 billion trading loss. “We should say we want smaller institutions so that they can safely fail if they need to fail,” he said...

I don't like excessively large banks because of the economic and political power that they have. For me, that is the main reason to break them up (especially since I have yet to see convincing evidence that we need banks this large in order to exploit economies of scope and scale).

But when it comes to stabilizing the financial system, it's not so clear. If we break a big bank into smaller banks, and a systemic shock hits that threatens to cause all of the small banks to fail, it may be harder to shore up the system and prevent a domino-style collapse than it would be if there was just one large bank to deal with. The Great Depression, for example, was characterized by the failure of many, many smaller banks rather than the toppling of a few large, systemically important institutions.

But that is not an insurmountable problem. A coordinated policy across the smaller banks can be equivalent to policy at a single, large institution, and we simply have to be ready to implement the appropriate policies when trouble threatens. So although it may be somewhat easier to deal with one bank rather than, say, 10 or 20, that's not a reason to allow banks to be so large. So I'm glad to see Bullard's comments.

However, Tim Duy is less pleased with his views on inflation:

Don't Let the Data Get in the Way of Your Story, by Tim Duy: St. Louis Federal Reserve President James Bullard:

The main risk lies in potentially overcommitting to the ultra-easy monetary policy, reigniting the global inflation debacle of the 1970s.

Ten-year inflation expectations via the Cleveland Federal Reserve:


Bullard is obviously a Serious Central Banker, because Serious Central Bankers only see inflation everywhere.

Undue fear of inflation generally among FOMC memebers is holding policy back. There are those who favor more aggressive policy, but not enough to make a difference.

Are You Feeling Lucky?

Give all the uncertainties about Europe, and additional worries about other things such as oil prices, if we could buy insurance against future economic problems, now would be a good time to do it.

Oh wait, we can. That insurance is called monetary and fiscal policy. Like all insurance it does come with some cost, and yes -- again like all insurance -- there's a chance we won't need it. But if we bet against the car wreck and it happens anyway -- and the odds of collateral damage from a wreck in Europe are high right now -- we'll be sorry.

Keep in mind, too, that some forms of insurance don't have to be very costly. In fact, in some cases the benefits could outweigh the costs even if Europe, oil prices, etc. do not turn out to be problems. What I have in mind is infrastructure spending. Infrastructure spending gives us the extra demand we need to provide insurance against a shock to demand from Europe, etc. And we could use the extra demand in any case given the high level of unemployment right now, so there are benefits even if the insurance is not needed. Thus, there are benefits on the demand side no mater what happens.

But infrastructure spending also has important supply side effects. Improved infrastructure would enhance future growth (and the additional jobs the spending would generate would help to prevent permanent losses to the economy associated with long-term unemployment). The higher growth alone yields benefits to the economy that exceed the cost of the investment (costs that are extraordinarily low due to rock bottom interest rates), and when the deamnd side/insurance benefits are added in, it seems to be a no-brainer. Unfortunatley, there are far too many "no brainers' in Congress right now to allow such sensible policy to go forward.

Wednesday, May 16, 2012

Frankel: The Death of Inflation Targeting

Jeffrey Frankel says inflation targeting is falling out of favor, but it's not clear what will replace it:

The Death of Inflation Targeting, by Jeffrey Frankel, Commentary, Project Syndicate: It is with regret that we announce the death of inflation targeting. The monetary-policy regime, known as IT to friends, evidently passed away in September 2008. The lack of an official announcement until now attests to the esteem in which it was held, its usefulness as an ornament of credibility for central banks, and fears that there might be no good candidates to succeed it as the preferred anchor for monetary policy. ...
Regardless of the form it took, IT began to receive some heavy blows a few years ago... Perhaps the biggest setback hit in September 2008, when it became clear that central banks that had been relying on IT had not paid enough attention to asset-price bubbles. ... [A]nother major setback was inappropriate responses to supply shocks and terms-of-trade shocks. ... CPI targeting ... tells the central bank to tighten policy in response to an increase in the world price of imported commodities – exactly the opposite of accommodating the adverse shift in the terms of trade. ...
One candidate to succeed IT as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980’s, since it did not share the latter’s vulnerability to so-called velocity shocks.
Nominal GDP targeting ..., unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand – the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway.
A dark-horse candidate is product-price targeting, which would focus on stabilizing an index of producer prices... Unlike IT, it would not dictate a perverse response to terms-of-trade shocks.
Supporters of both nominal GDP targeting and product-price targeting claim that IT sometimes gave the public the misleading impression that it would stabilize the cost of living, even in the face of supply shocks or terms-of trade-shocks, over which it had no control. ...

Fed Watch: FOMC Minutes

Tim Duy:

FOMC Minutes, by Tim Duy: The FOMC minutes are released tomorrow. Calculated Risk gives us the Goldman Sachs preview:

We expect that the April FOMC minutes ... will include a discussion of possible easing options. ... The first set of options center around the Fed's balance sheet, and we think that the discussion might include the benefits of mortgage purchases, the potential for more “twisting,” and the pros and cons of sterilized asset purchases.

I understand where this comes from - Operation Twist is coming to an end next month, and the two-day meeting in April seems like a natural chance to discuss future options. That said, I am drawn to the minimal interest in this topic in March:

The Committee also stated that it is prepared to adjust the size and composition of its securities holdings as appropriate to promote a stronger economic recovery in a context of price stability. A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

Given the last FOMC statement, it doesn't look like the Fed's baseline outlook shifted much between then and the April meeting. And I don't see Federal Reserve Chairman Ben Bernanke's press conference or the most recent Fedspeak as being particularly supportive of additional action. Which leads me to believe that even if the Fed discussed some hypothetical easing options, they will downplay this as conditional on a marked deterioration in economic conditions. I don't think we are there yet. I just don't see much support for additional easing at this point, albeit plenty of support to not tighten either. That said, I would expect market participants to seize upon even the slightest hint of QE3 given the fragility that is currently driven by Europe.

Tuesday, May 15, 2012

"The Austrian Analysis of the Great Depression and the Recent Recession are Wrong"

Bruce Bartlett:

What Rule Should the Fed Follow?, by Bruce Bartlett, Commentary, NY Times: ...[T]he “Austrian” theory of the Great Depression ... says that even though there was no inflation during the 1920s, somehow or other inflation nevertheless caused the Great Depression. According to ... the Austrian school ... there was actually some sort of double-secret inflation because the money supply increased. They believe the same thing is happening right now.
When the Austrian theory was first put forward, conservative economists were keen to refute the widespread view that capitalism itself had caused the Great Depression and that the cure was full-bore socialism. The Austrians ... and others, were desperate to show that government was responsible...
Although the Austrian theory was initially viewed sympathetically by conservative economists..., it was abandoned when it became clear that there is no Austrian cure for depressions; the only course ... is to suck it up, let unemployment rise, and purge the mal-investment no matter how painful. Anything ... whatsoever the government does to ... counteract the economic downturn ... is inherently counterproductive...
In the 1960s, conservative economists adopted a different view. The government error was ... responding inappropriately to a garden-variety recession that began in August 1929. ... This “monetarist” theory of ... Milton Friedman and Anna Schwartz ... argued that if the Fed had acted as a lender of last resort, as it was created to do, it could have stopped the Great Depression in its tracks...
The monetarist theory was a far more attractive explanation for the Great Depression that also blamed government. It was largely adopted by conservatives except for a few Austrian holdouts... One attraction of the monetarist theory is that it allows for government action to respond to economic downturns, as opposed to the Austrian do-nothing policy.
When economic downturns arise, monetarists say the Fed should respond by expanding the money supply, not through an expansionary fiscal policy, as Keynesian economics recommends. ...
In the years since, however, the monetarist theory has lost favor among conservatives. They now assert, along with the Austrians, that the only “cure” for recessions is not to sow their seeds in the first place. Those seeds, all conservatives now agree, are sown primarily by the Fed, especially by holding interest rates “too low.”
Thus almost all conservatives, including many regional Federal Reserve bank presidents, believe the Fed should raise interest rates soon to prevent a reemergence of inflation, another boom and, inevitably, another bust that may be even worse than the one we have yet to emerge from. ...
The Austrian analysis of the Great Depression and the recent recession are wrong, I think. Unfortunately, that will not deter the conservatives.

David Glasner comments:

All in all, a worthwhile and enlightening discussion, but I couldn’t help wondering . . . whatever happened to Hawtrey and Cassel?

And Paul Krugman has argued the monetarist view has been tested in this recession (and in Japan), and failed.

...whatt Friedman ... argued was that the Fed could easily have prevented the Great Depression with policy activism; if only it had acted to prevent a big fall in broad monetary aggregates all would have been well. Since the big decline in M2 took place despite rising monetary base, however, this would have required that the Fed “print” lots of money.
This claim now looks wrong. Even big expansions in the monetary base, whether in Japan after 2000 or here after 2008, do little if the economy is up against the zero lower bound. The Fed could and should do more — but it’s a much harder job than Friedman and Schwartz suggested.
Beyond that, however, Friedman in his role as political advocate committed a serious sin; he consistently misrepresented his own economic work. What he had really shown, or thought he had shown, was that the Fed could have prevented the Depression; but he transmuted this into a claim that the Fed caused the Depression.
And this debased and misleading version is what has filtered down to the likes of Ron Paul, who then use it to argue against the very activism Friedman was really advocating.
Bad Milton, bad.

Wednesday, May 09, 2012

Fed Watch: On Negative Interest Rates

Tim Duy:

On Negative Interest Rates, by Tim Duy: Scott Sumner writes:

I don’t think Keynesians should be arguing that lower real interest rates are the key to recovery. A bold and credible monetary stimulus that was expected to produce much faster NGDP growth might well raise long term risk-free interest rates.

This point doesn't get explained well - and I probably won't do any better, but I will give it a try anyway. A simple way to think about this is the basic IS-LM story (without wanting to get into a big debate about the efficacy of IS-LM):


In this version, the IS curve has shifted so far to the left that it intersects with the LM curve at the horizontal section - the zero bound problem. If I set i equal to the nominal interest rate and assume positive inflation, this translates to a negative real rate. Full employment, however, is only consistent with a nominal interest rate below zero, which implies a lower real interest rate as well. Given the zero bound on nominal rates, Keynesians (using the term loosely; labels can get sloppy), turn their attention to reducing the real interest rate.

Given the zero bound, we talk about ways to shift the IS curve to the right. Usually, these discussions take on two forms. The first is fiscal policy via deficit spending, which I am very confident will do the trick, but I am also very confident it really doesn't "fix" the economy. The instant you back off the fiscal accelerator, the economy falters. In my mind, fiscal policy is undoubtedly necessary in the near-term as a stop-gap measure, but in the long-term is leading the US down the Japanese path of endless deficit spending.

The second policy response is monetary, typically raising inflation expectations. This in turn lowers real interest rates - and this is the important part - at all nominal interest rates. This, like fiscal policy, induces a rightward shift in the IS curve:


At the zero bound, higher inflation expectations lowers the real interest rate, hence the Keynesian preoccupation. But I think the key here is the rightward shift of the IS curve past the zero bound "kink" at which point nominal and real rates begin to rise and we lift off the zero bound. We can talk about different mechanisms to accomplish this, but moving sustainably beyond that kink should be the ultimate policy goal.

Thus, ultimately I think you can have a focus on negative real interest rates as a stop on the path to Sumner's desired outcome. And I completely agree with Sumner (and I think I am paraphrasing him correctly here) in that the failure of interest rates both real and nominal to rise represents an absolute, unmitigated, unacceptable, and quite frankly irresponsible failure on the part of the Federal Reserve:



One would think the Fed would sit up and take notice that the US government sold 10 year debt at a record low interest rate today as a sign that they need to do more, not less. Notice also the failure of either real or nominal rates to get a boost after Operation Twist. This is evidence of the pointlessness of that effort. For all the grief I have given St. Louis Federal Reserve President James Bullard, he certainly had it right last year when he said:

A strategy aimed at lowering longer-term borrowing costs, sometimes referred to as a twist operation, would help drive down longer-term borrowing costs for businesses, economists say.

But James Bullard, president of the St. Louis Fed, said the effectiveness of such a strategy is questionable.

"A twist operation would not have very much effect," Bullard told Reuters Insider in an interview. "It's been analyzed many times, and the general tenor of that analysis is that it did not have very much effect."

Finally, notice that I also put the variable "confidence" into the specification for the IS curve. Here I am offering another mechanism by which we can think that QE has an impact by signaling that policymakers have an intention and a desire to maintain the pre-recession path of nominal spending (here I am paraphrasing Brad DeLong). The failure to maintain that path has undermined confidence in that agents now have less certainty in the future path of income. If policymakers let the path of nominal spending shift downward once, why should we not expect them to do it again?

Bottom Line: I don't think what Sumner describes as a Keynesian focus on negative real interest rates is inconsistent with his views on what should happen in the presence of a credible monetary policy committed to actually lifting us off the zero bound.

"Central Banks Should Do Much More"

In the Financial Times, Roger Farmer notes a close association between Fed policy and stock market values:

[1] Is the date at which QE1 began, [2] Is the date at which the Fed started to buy mortgage backed securities, [3] Is the date at which QE1 ended, and [4] Is the date of the Jackson Hole conference at which the Fed announced that it would begin QE2.

How can central banks use this information? He says the stock market crash *caused* the Great Recession. Thus, if the Fed can raise stock market values, and the graph above suggests it can, it will turn the economy around and reduce unemployment:

The stock market crash of 2008 caused the Great Recession. If this relation is truly causal, then central banks can do a great deal to alleviate persistent unemployment. ...
The chart shows that when the Fed began to purchase mortgage backed securities in March of 2009, the stock market began to rally. When QE1 ended a year later, the market tanked and equities did not recover until the Fed saw the error of its ways. When the Fed announced the beginning of QE2, at the Jackson Hole conference in April of 2010, there was a third turning point in the market and the beginning of a new bull market.
The coincidence of these market turning points with the beginning and ending of Fed asset purchase programs is not accidental.  The Fed moves markets!
So what! Who cares if a bunch of Wall Street investors make money? ... There is a connection between the stock market and the welfare of the average citizen... When the stock market plummets, so do the prospects of the average worker.

In the paper he cites as making the case that the relationship is causal, i.e. that stock market values cause unemployment (the argument is theoretical), he says:

I realize that correlation is not causation and these graphs do not prove that the stock market crash caused the Great Depression. However, they do suggest to me that a theory that does make that causal link deserves further consideration.

The paper includes the following graphs:

Figure 1: Unemployment and the Stock Market During the Great Depression

Figure 2: Unemployment and the Stock Market over the Last DecadeFarmer4

I am not yet fully convinced that causality runs from stock values to unemployment, it seems more likely that economic conditions cause both. However, I agree that central banks should do more, and this is evidence that the case for doing more can be derived from more than one theoretical construct, i.e. that it is relatively robust.

Tuesday, May 08, 2012

Inflation Can Help to Stimulate a Depressed Economy

If inflation begins to increase before the economy has fully recovered, the Fed shouldn't panic:

Federal Reserve Policy: Exceptions Improve the Rule: At some point during the recovery, the Fed may face an important decision. If the inflation rate begins to rise above the Fed’s 2% target and the unemployment rate is still relatively high, will the Fed be willing to leave interest rates low and tolerate a temporary increase in the inflation rate?
Probably not. Even though higher inflation can help to stimulate a depressed economy, Ben Bernanke, Chairman of the Federal Reserve, is not in favor of allowing higher inflation because it could undermine the Fed’s “hard-won inflation credibility.” And recent Fed communications seem to be setting the stage for the Fed to abandon its commitment to keep interest rates low through the end of 2014. This adds to the likelihood that the Fed will raise interest rates quickly if inflation begins increasing above the 2% target even if the economy has not yet fully recovered.
As I’ll explain in a moment, that’s the wrong thing to do. But first, why does the Fed put so much value on its credibility? ...[continue reading]...

Friday, May 04, 2012

Symmetric Goals, Asymmetric Risks

David Altig:

Symmetric goals, asymmetric risks, by David Altig: Mark Thoma has been hanging out with my boss or at least was at the same conference, where Thoma had a chance to try out his reporter chops:

"I just got out of a press conference with Dennis Lockhart (Atlanta Fed president) and Charles Evans (Chicago Fed president). I can't say there was any real news, but I did manage to ask a question... I asked whether the 2% inflation target was truly symmetric."

Thoma got an answer, though seemingly not one that left him totally convinced:

"Both insisted that the target is symmetric. However, Lockhart said that we know much more about the effects of inflation than deflation, and that preventing deflation was therefore job number one (which doesn't really answer the question). He didn't explain what he is so afraid of if inflation goes up...
"Evans, while explicitly agreeing the target was symmetric, made comments that indicated that it may not be. He said the Fed has not done a very good job of communicating its tolerance around the 2 percent target, both up and down, and they need to improve. But if the target is really symmetric, simply saying that (along with the tolerable range) is all that is required. Talking separately about tolerance for over and under-shooting isn't needed."

Evans' and Lockhart's statements stand on their own, but we've collected some information via the Atlanta Fed's Business Inflation Expectations survey that helps me think about the Thoma question. The chart below plots the answers, collected in the January and April surveys, to the following query: "Projecting ahead, to the best of your ability, please assign a percent likelihood to the following changes to unit costs per year over the next five to 10 years."

Distribution of Respondent Expectations for Unit Costs

The question focuses on unit labor costs in order to elicit responses about what businesses may actually be planning for, as opposed to their guesses about a more abstract concept of overall inflation. The question focuses on expectations five to ten years into the future because the inflation goal of the Federal Open Market Committee (FOMC) is explicitly a long-run objective.

The obvious pattern in these survey responses is their asymmetry to the upside. The most probable outcome, according to the respondents, is that long-term costs will rise in a range that includes the FOMC's long-run inflation objective. But they also put an almost 50 percent probability on annual outcomes higher than 3 percent. Less than 20 percent probability is placed on costs rising at rates of less than 1 percent.

This picture is one of asymmetric risks to the inflation outlook, and as such it is an important element in thinking through policy choices. Symmetry in the sense of having an equal distaste for misses on either side of an objective does not necessarily imply symmetry with respect to the risks of meeting that objective.

To begin with, the Fed does have a dual mandate. Disinflation or, in the extreme, deflation has the potential to be problematic for growth and employment when interest rates are very low. The reason, if you buy the analysis, is that, with no room for rates to move lower, a decline in inflation raises the real cost of borrowing. A higher cost of borrowing restrains spending, creating an additional drag on economic activity in already tough circumstances.

The reverse argument has, of course, been made for temporarily tolerating inflation that is somewhat higher than the long-run objective. But even if you aren't quite sold on the wisdom of that approach—and I'll get to that in a bit—it is clear that, with policy rates near zero, misses to the downside on inflation bring risks to the Fed's growth mandate that are not implied by misses to the upside. Hence President Lockhart's comment regarding the importance of preventing deflation.

So why not respond to this asymmetric risk to growth by taking a chance on higher inflation? That question takes us back to the chart above. Taken at face value, the probabilities reported by our survey respondents suggest that the FOMC has been pretty successful in convincing folks that very low rates of inflation or deflation will not be allowed to set in. Perhaps this conviction is not surprising given the relatively aggressive responses of the committee to the disinflation scares of 2003 and 2010.

But the response to asymmetric risks to growth at low inflation rates may have had the effect of inducing asymmetric risks to the upside with respect to Fed's price stability mandate. Again taken at face value, the results of our business inflation expectations survey definitely imply a one-sided bet by businesses on how the FOMC might miss on its inflation objective. That could well explain why one would be so concerned if inflation rises. Just as there are asymmetric risks associated with below-objective inflation when it comes to the Fed's growth and employment mandate, there are asymmetric risks associated with above-objective inflation when it comes to the price stability mandate.

Thursday, May 03, 2012

"Gauging the Benefits, Costs, and Sustainability of U.S. Stimulus"

[Another travel day, and then hopefully back to normal tomorrow.]

Did the stimulus work? According to a collaboration between Fitch Ratings and Oxford economics, the answer is yes:

Government stimulus moves may have ended recession, by Jim Puzzanghera, Los Angeles Times: Without the unprecedented stimulus actions by the federal government triggered by the 2008 financial crisis, the Great Recession might still be going on, according to a study by Fitch Ratings. ...
The boost from those policies helped the nation's gross domestic product increase 3% in 2010 and 1.7% last year; absent the stimulus, the U.S. "might still be mired in a recession," according to the study, done in conjunction with Oxford Economics.
The U.S. economy would have seen little or no growth the last two years without the policies, the report says, and those actions appear "to have significantly softened the severity of the decline" in GDP in the year immediately after the recession ended in mid-2009.
Though the Fed's monetary policy actions were helpful, fiscal stimulus by Congress and the White House "had the strongest positive impact on consumption during the recent recovery," the study found.

This is a graph from the Fitch report (which I got by email, available here with registration):


From the Fitch summary of the report:

Stimulative Policies Driving Recovery: To better understand the future sustainability of the current U.S. economic recovery, Fitch Ratings and Oxford Economics have collaborated to analyze how much of the U.S.’s postcrisis economic growth is attributable to policy actions by the federal government and the Federal Reserve. Oxford Economics’ Global Economic Model (GEM) suggests that the U.S. policy response to the recession increased aggregate GDP by more than 4% two and three years after the trough of the last crisis than otherwise would have been the case (see graph...). These policies helped to support GDP growth of 3.0% in 2010 and 1.7% in 2011, implying that the U.S. might still be mired in a recession absent this stimulus. ...
Credit Implications: The current level of uncertainty associated with the future growth trajectory of the U.S. economy increases risk in general. This uncertainty, in turn, has the potential to affect the creditworthiness and credit ratings of all U.S. sectors, including corporates, municipal finance, and structured finance. A scenario of lower U.S. growth could also have global rating implications, particularly on foreign firms that rely on the U.S. as an export market. Until it becomes clearer that the economy can continue to grow sustainably without the support of stimulative policies, Fitch anticipates limited future rating upgrades within the sectors most closely tied to the U.S. economy.

Tuesday, May 01, 2012

Please Sirs, May We Have Some More?

Nobel Prize winner Robert Engle says more inflation would help:

New York University professor Robert Engle said policy makers should consider allowing slightly higher inflation as a way to spur the U.S. economy, joining fellow Nobel Prize winner Paul Krugman who says it could reduce unemployment.

“A little bit of inflation would do a whole lot of good for the U.S. economy, would certainly do a lot of good for the housing market,” Engle, who won the Nobel Prize in economics in 2003...

Is the Fed's Inflation Target Symmetric?

I just got out of a press conference with Dennis Lockhart (Atlanta Fed president) and Charles Evans (Chicago Fed president). I can't say there was any real news, but I did manage to ask a question. After forgetting to introduce myself, and the organization I write for like everyone else did, I asked whether the 2% inflation target was truly symmetric. I noted that the projections from members of the FOMC looked more like a ceiling than a central point, and that the comments made by Dennis Lockhart in the previous session made me wonder if, in fact, he thought there were asymmetric costs to over and under-shooting. I also asked Lockhart in particular what he is so afraid of if the inflation rate goes up temporarily.

Both insisted that the target is symmetric. However, Lockhart said that we know much more about the effects of inflatio0n than deflation, and that preventing deflation was therefore job number one (which doesn't really answer the question). He didn't explain what he is so afraid of if inflation goes up, and I didn't have enough experience to realize I should follow up. Wish I had (I'll bea t the Atlanta Fed in two weeks, so maybe I'll get another chance)

Evans, while explicitly agreeing the target was symmetric, made comments that indicated that it may not be. He said the Fed has not done a very good job of communicating its tolerance around the 2 percent target, both up and down, and they need to improve. But if the target is really symmetric, simply saying that (along with the tolerable range) is all that is required. Talking separately about tolerance for over and under-shooting isn't needed.

Finally, in the session prior to the press conference featuring Evans and Lockhart (among others), Evans seemed to endorse NGDP targeting. He didn't use those words exactly, but toward the end of the session he did talk about the advantages that come with this approach to monetary policy. I took it as an endorsement, though he might object to characterizing it that way. I think he's around today, and if I see him again, I will ask directly. (However, before the press conference started we were chatting and I told him I had just tweeted "Evans just endorsed NGDP targeting." He didn't object, so make of that what you will).

Friday, April 27, 2012

"NGDP Targeting: Some Questions"

David Andolfatto has some questions for supporters of NGDP targeting (David's request to point him in the direction of past defenses of NGDP targeting reminds me of this from David Beckworth responding to some questions I posed in a post that explained why Bernanke and Mishkin do not think that targeting nominal GDP growth is better than targeting inflation. However, as I recently noted in a post highlighting the close connection between NGDP and inflation targeting, I've learned some things since then and one or two of the questions would differ today):

NGDP Targeting: Some Questions, Macromania: Let me start by saying that the idea of a NGDP target does not sound outlandish to me. But I feel the same way about price-level and inflation targeting. The first order of business for a central bank is, in my view, is to provide a credible nominal anchor. Probably not  much disagreement about this out there.

Proponents of NGDP targeting, however, like Scott Sumner and David Beckworth, for example, seem to believe very strongly in the vast superiority of a NGDP target--not just as a policy that would mitigate the effects of future business cycles--but also as a policy that should be adopted right now by the Fed to cure (what they and many others perceive to be) an ongoing "aggregate demand deficiency." 

What I am curious about is not that they believe this, but how strongly they believe in it. I respect both of these writers a lot, so naturally I am led to ask myself how they came to hold such a strong belief in the matter. What is the theoretical underpinning for NGDP targeting? And what is the empirical evidence that leads them to believe that an NGDP target right now is a cure for whatever ails us right now? 

One way to seek answers to these questions is to spend hours perusing their past blog posts. I'm sure they must have answered these questions somewhere. But I figure it will be more efficient for me to just state my questions and have them (or somebody else) point me in the right direction for answers.

First, let us consider the (or a) theoretical justification for NGDP targeting in general. Actually, David was kind enough to point me a nice paper on the subject: Monetary Policy, Financial Stability, and the Distribution of Risk (Evan F. Koenig). Here is the abstract:

In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal-income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.

Alright, fine. The argument hinges on the existence of nominal debt obligations. Well, not just debt that is stated in nominal terms, but debt that is fixed in nominal terms (renegotiation is ruled out). This is, of course, a story that goes back at least to Irving Fisher (1933): The Debt-Deflation Theory of Great Depressions.

I've always like the Fisher story. And it obviously has an element of truth to it. But admitting this is different than asserting that the mechanism is quantitatively important, especially for generating decade-long recessionary episodes.

First of all, as I alluded to above, people can and do renegotiate the terms of nominal debt obligations if things get too far out of whack. True, renegotiation (including outright default) is costly and imperfect, but it happens nevertheless. And to the extent it does, nominal debt is not as "fixed" as some make it out to be. It would be good to know how much renegotiation does or does not happen out there.

Second, even if renegotiation is quantitatively unimportant, we should consider the dynamics of debt creation and retirement. At any point in time there is an outstanding stock of nominal debt, with terms negotiated in the past on the basis of future price level paths (among other things, of course). We should also keep in mind that new debt agreements are being formed, and old agreements are being retired continuously throughout time. How big are these flows relative to the outstanding stock of debt?

I think the answer to the previous question is important for understanding how long the real effects of a "negative price-level shock" can be expected to last. If "debt turnover" is high, then such a shock cannot reasonably be expected to generate a decade of subnormal economic performance.

We are presently more than 3 years out from the sharp decline in the price-level that occurred in the fall of 2008. How much new nominal debt has been issued since then--debt that would have presumably been negotiated with expectations of a new price-level path? Does anybody know?  In particular, if one is advocating a return to the old price-level path right now, what does this mean for the creditors who have extended loans over the past 3 years? Should we care? Why or why not?

I have not even touched upon the practical feasibility of NGDP targeting--I'll save this for another day. But for now, I'd like to know the answers to my questions above. Who knows, I too may become one of the faithful! 

A good weekend to all. 

Fed Watch: Bernanke's Shift

Tim Duy:

Bernanke's Shift, by Tim Duy: There has been a fierce counterattack to Federal Reserve Chairman Ben Bernanke's assertion that he is indeed the same Professor Bernanke that advised the Bank of Japan a decade ago. See, for example, Brad DeLong, David Beckworth, and Ryan Avent. DeLong identifies this 1999 Bernanke quote:

[Si]nce 1991 inflation has exceeded 1% only twice... the slow or even negative rate of price increase points strongly to a diagnosis of aggregate demand deficiency…. [C]ountries that currently target inflation… have tended to set their goals for inflation in the 2-3% range, with the floor of the range as important a constraint as the ceiling….

and concludes that Bernanke previously believed the inflation target should be between 2 and 3 percent, with 2 percent being a floor. One could infer, then, that Bernake at one point believed in a symmetric objective around 2.5 percent, with a hard floor and ceiling on 50bp of either side of that objective. Now the Fed has sanctified a 2 percent target.

This shift is important and evident in the path of inflation, and was my point in this post. Prior to the recession, headline PCE inflation was running about 2.4 percent a year. Now the trend is a smidgen above 2 percent:


DeLong, in another post, does a similar picture using core-CPI. I have tended to shift to headline number number because that is the Fed's stated target and there is widespread misunderstanding about the relevance of core-inflation in the policymaking process. Indeed, the belief that policymakers are somehow misleading the public about the true path of inflation runs deep in the Fed itself. Note that Beckworth takes a different direction, focusing on the path of nominal demand rather than inflation and reaches a similar conclusion - the we are witnessing an attack of the body snatchers.

I think we can conclude, by Bernanke's statement's in the past and the actual path of inflation now, that Bernanke has embraced the recession as yet another exercise in opportunitistic disinflation in which the Fed can knock another 40bp off the expected rate of inflation.

The story gets more interesting. In his press conference, Bernanke says:

So it's not a ceiling, it's a symmetric objective and we tend to bring inflation close to 2 percent. And in particular, if inflation were to jump for whatever reason and we don't have, obviously, don't have perfect control of inflation, we'll try to return inflation to 2 percent at a pace which takes into account the situation with respect to unemployment.

Avent rightly calls foul on this claim:

Perhaps more telling, the Fed gives a range for projected inflation over the next three years with 2% as the upper extent. If the Fed does indeed have a symmetric approach to the target, as Mr Bernanke asserted yesterday, one would expect 2% to be at the middle of the range, not the top. This is particularly damning as the Fed's estimate of the natural rate of unemployment doesn't appear at all in the projected unemployment-rate range over the next three years; the closest the Fed comes to meeting that side of the mandate is in 2014, when the bottom end of the projected unemployment-rate range gets within 0.7 percentage points of the top end of the natural-rate range.

Bernanke is clearly misleading us when he claims the target is symmetric as the Fed's own projections clearly treat the target as a hard ceiling. The next words out of Bernanke's mouth are also telling:

The risk of higher inflation, you say 2-1/2 percent, well, 2-1/2 percent expected change might involve a distribution of outcomes. Some of which might be much higher than 2-1/2 percent.

This was the topic my post earlier this week. Monetary policy is not neutral with regards to the distribution of income and wealth. The Fed does not want inflation to exceed the 2 percent inflation target as that will result in a new distribution. The subsequent alterations to the outcomes will not be symmetric; some will gain more than 2.5 percent, some will lose more.

Note - and I think this is important - when Bernanke's Fed took the opportunity to shift down the path of inflation by sanctifying the 2 percent target, they were comfortable with the subsequent shift in the distribution of outcomes. And consider that shift. At a time when households were overwhelmed with excessive debt, the Fed deliberately chose to increase the real burden of the debt by changing the inflation trajectory.

Why one would use a balance sheet recession to shift downward the path of prices is certainly something of a mystery. But it does imply that the Fed wanted to induce a new distibution of outcomes, even knowing that the beneficiaries would not be households.

Bottom Line: Bernanke is being disingenous in his defence. Despite his claims that his earlier views only applied to deflation, his writings still appear at odds with his willingness to embrace a new price and aggregate demand paths. Moreover, the Fed's own forecasts clearly do not support his contention that the target is symmetric, but indeed a hard ceiling. The Fed must also know that the by reducing the path of inflation they have knowing altered the distribution of outcomes in a way that is likely to slow the pace of recovery. Finally, with inflation near 2 percent, I suspect the bar toward another round of QE is higher than many believe.

GDP Growth Could be Higher

GDP growth for the first quarter, as noted in the post below this one, is estimated to be 2.2%. That is not as high as it needs to be to recover in a decent amount of time, and one of the problems is that government spending has declined during the recession. This has been driven largely by cuts at the state and local level, and it is holding back GDP growth.

I probably should have used the mediocre growth in the first quarter to call, yet again for more aggressive monetary and fiscal policy -- fiscal policy in particular. What are we thinking making cuts like this as the economy is trying to recover from such a severe recession? But what's the use? Policymakers have made it very clear they are unwilling to do more to try to help the unemployed. In fact, many policymakers would like to do less and it's only because of gridlock on Congress, and gridlock on the Fed's monetary policy committee that the cuts (austerity) haven't been worse, and interest rates are still low.

So I probably should have noted the need for more aggressive policy, but thought, why bother? I suppose there's value in pointing out the failure, but at this point that shouldn't be news.

Wednesday, April 25, 2012

Fed Policy Remains on Hold

My reaction to the Fed's Press Release from its monetary policy meeting that ended today.

Fed Policy Remains on Hold: (MoneyWatch) COMMENTARY The Federal Reserve just concluded a two-day meeting to decide what's next for monetary policy, and as was widely expected the Federal Reserve decided to keep policy on hold. Interest rates are still expected to remain extraordinarily low through late 2014, and there is no change in the Fed's other programs intended to stimulate the economy such as its program "to extend the average maturity of its holdings of securities" and reinvest principle as the assets mature.

The question is whether this is the correct policy. Presently, the Fed is missing its employment target, and it is also below its declared inflation target of 2 percent. As the statement says, "the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate." So there is no risk of overshooting the inflation target according to the Fed, only a risk of undershooting it.

If that's true, if the Fed is likely to undershoot both of its targets -- the committee believes that in the worst case it will only hit its inflation target, not exceed it -- then why not pursue more aggressive policy?

The answer, despite what the press release says about low inflation risks, is fear of inflation. In particular, it is the fear that inflation expectations will become unmoored. The Fed believes that expectations of inflation are largely self-fulfilling. If people expect prices to go up, they will take actions such as demanding wage increases that will make that happen, and the expectation will be validated. Then, as inflation begins rising, that can then lead to further increases in expected inflation which will also be self-fulfilling, and an upward spiral is set in motion.

Is this fear realistic? Some of us, myself included, think the Fed should overshoot the inflation target in the short-run since that would stimulate the economy, then bring inflation back to target once the economy nears full employment. But the Fed seems unwilling to tolerate even the possibility that inflation might cross the 2 percent threshold.

I think the Fed should have more faith in itself. It is still paralyzed by the 1970s when the self-fulfilling inflation expectations scenario above played out to the detriment of the economy. But the inflation didn't just happen without the central banks participation, policy mistakes had a lot to do with the outcome. Does the central bank think it has learned nothing? Would it really stand by and watch inflation rates go into the double digits without taking corrective action?

If inflation expectations begin to rise, and there's no sign of that presently, the Fed has the tools to bring them back down again if it has the will to use them. Is that the problem? Is the Fed worried that it won't have the courage to bring down inflation if it is called for (which would likely slow the economy)? If the unemployment rate is still relatively high and inflation begins accelerating, would the Fed be unwilling to try to fix the problem?

If unemployment is still too high, there's no reason to fix the problem. That's the policy that is called for. The important question is what happens as we approach full employment, and I have little doubt that the Fed will take appropriate action in such a case. I just wish the Fed had more faith in itself. If it did -- if it was absolutely clear that the appropriate action will be taken as the economy reaches full employment -- then long-term expectations would not be a problem.

Monday, April 23, 2012

Fed Watch: Distributional Impacts of Monetary Policy

Tim Duy:

Distributional Impacts of Monetary Policy, by Tim Duy: Dean Baker, responding to this Wall Street Journal article, sees an opportunity to make us aware on the distributional impacts of monetary choices. Specifically, Baker responds to the claim that inflation erodes earnings:

Actually, most wages follow in step with inflation, although some workers do see declines in real wages when inflation rises.

People seem to forget the connection between inflation and wages. A sustained increase in inflation needs to be accompanied by a matching increase in wages, otherwise higher inflation would simply undermine real purchasing power, leading to slower growth and a subsequent decline in the inflation rate. To be sure, as Baker notes, while on average higher inflation is matched with higher nominal wages, it does not affect all workers equally - workers with less bargaining power could see their real wages decline even if average real wages hold constant.

Baker identifies this basic chart (I replaced CPI with PCE inflation) to support his argument (click on figures for larger versions):

Notice that Baker correctly shifts from real wages to the broader measure of real compensation. He says:

These series give the basic story, although they are not perfect for reasons that you do not want to hear about. If you can see a negative relationship (i.e. higher inflation leads to lower real wage growth) you have better eyesight than me.

In fact, the correlation between these two series is 0.36. In other words, there is a weak positive relationship between inflation and real compensation - although I would be wary about calling it a causal relationship, and instead only point out that although it is often claimed that inflation erodes real wages, this is not obvious. What is more evident, and causally related, is the link between productivity and real compensation:

The correlation is 0.75, and the story is a familiar one - we expect that higher productivity growth results in higher real wage growth. That said, a careful eye will notice that the growth rates are not identical, yielding this well-known result:

Certainly since the 1980s, the gap between output and real compensation is rising. Another version of this issue is that labor's share of income has been falling since 1980. What is of course curious is that this occurs despite the sustained period of disinflation. Those who claim that inflation erodes real wage growth seem to miss that the period since 1980 has seen real compensation growth slow to a pace below productivity growth despite falling inflation. This issue is taken up by Steve Randy Waldman at interfluidity with a thought provoking post:

An increase in unit labor costs can mean one of two things. It can reflect an increase in the price level — inflation — or it can reflect an increase in labor’s share of output. The Federal Reserve is properly in the business of restraining the price level. It has no business whatsoever tilting the scales in the division of income between labor and capital.

Yet throughout the Great Moderation, increases in unit labor costs were the standard alarm bell cited by Fed policy makers as an event that would call for more restrictive policy. And all through the Great Moderation, except for a brief surge during the tech boom, labor’s share of output was in secular decline...

...even if the Fed didn’t “cause” the decline in labor’s share, Great Moderation monetary policy made it very difficult for labor’s share to grow...

...Since the early 1990s, all actors in the US political system have understood that policies that increase unit labor costs risk a response by the “inflation fighting” central bank, whose “credibility” was swaggeringly defined as a willingness to provoke recession rather than risk inflation. In this environment, the decline of labor unions and their shift in focus from wage growth to working conditions was understandable...

Waldman is saying that the Federal Reserve is at least complicit in allowing the competition between capital and labor to be tilted toward capital (not sure this should be a surprise - I don't see a revolving door between the Federal Reserve and the AFL-CIO). In other words, monetary policy has a direct impact on the distribution of income. It's not just simply raising and lowering interest rates to affect the level of output - it has an impact on how the subsequent output is split up. Waldman offers some policy advice:

All of this is one more reason to prefer the NGDP path target promoted by Scott Sumner and his merry Market Monetarists. It might prove difficult in practice to target inflation without paying some especial attention to wage growth. But a central bank can target the path of aggregate expenditure without playing favorites about who pays what to whom. Simple neutrality by the central bank in the contest between capital and labor would be a huge improvement over the status quo.

Note that even if the central bank is no longer playing "favorites", monetary policy would still have a distributional impact. For example, reverting to the pre-recession path of nominal spending would likely entail a temporarily higher rate of inflation than currently expected. And higher than expected inflation will indeed create some winners and losers:

However, the biggest losers are creditors who are almost by definition wealthy, since people owe them money. If a creditor has lent out $100 million at 2 percent interest (e.g. buying a 10-year U.S. or German government bond) and the inflation rate rises from 2 percent to 4 percent, this creditor has lost an amount equal to 100 percent of his expected income or 2 percent of his wealth. This is a far larger loss than any worker could experience as a result of this increase in the inflation rate.

Who would be the winners?

Also, most workers are debtors to some extent. They are likely to have mortgage debt, credit care debt, student loan debt and or car debt. A higher rate of inflation means that they can repay this debt in money that is worth less than the money they borrowed.

And once again, we get to the same place - changing monetary policy at this juncture would likely have significant impacts on the distribution of income and wealth. And an unwillingness to alter this current distribution is likely another reason we would not expect the Federal Reserve to change their basic policy framework away from the current 2 percent inflation target regime.

Friday, April 20, 2012

"Plutocrats and Printing Presses"

Paul Krugman:

Plutocrats and Printing Presses, by Paul Krugman: These past few years have been lean times in many respects — but they’ve been boom years for agonizingly dumb, pound-your-head-on-the-table economic fallacies. The latest fad — illustrated by this piece in today’s WSJ — is that expansionary monetary policy is a giveaway to banks and plutocrats generally. Indeed, that WSJ screed actually claims that the whole 1 versus 99 thing should really be about reining in or maybe abolishing the Fed. And unfortunately, some good people, like Daron Agemoglu and Simon Johnson, have bought into at least some version of this story.
What’s wrong with the idea that running the printing presses is a giveaway to plutocrats? Let me count the ways.
First, as Joe Wiesenthal and Mike Konczal both point out,... quantitative easing isn’t being imposed on an unwitting populace by financiers and rentiers; it’s being undertaken, to the extent that it is, over howls of protest from the financial industry. ...
Beyond that, let’s talk about the economics. The naive (or deliberately misleading) version of Fed policy is the claim that Ben Bernanke is “giving money” to the banks. What it actually does, of course, is buy stuff, usually short-term government debt but nowadays sometimes other stuff. It’s not a gift.
To claim that it’s effectively a gift you have to claim that the prices the Fed is paying are artificially high, or equivalently that interest rates are being pushed artificially low. And you do in fact see assertions to that effect all the time. But if you think about it for even a minute, that claim is truly bizarre.
I mean, what is the un-artificial, or if you prefer, “natural” rate of interest? As it turns out,... the natural rate of interest is the rate that would lead to stable inflation at more or less full employment.
And we have low inflation with high unemployment, strongly suggesting that the natural rate of interest is below current levels... Fed policy isn’t some kind of giveway to the banks, it’s just an effort to give the economy what it needs.
Furthermore, Fed efforts to do this probably tend on average to hurt, not help, bankers. Banks are largely in the business of borrowing short and lending long; anything that compresses the spread between short rates and long rates is likely to be bad for their profits. And the things the Fed is trying to do are in fact largely about compressing that spread...
Finally, how is expansionary monetary policy supposed to hurt the 99 percent? Think of all the people living on fixed incomes, we’re told. But who are these people? ... The typical retired American these days relies largely on Social Security — which is indexed against inflation. ...
No, the real victims of expansionary monetary policies are the very people who the current mythology says are pushing these policies. And that, I guess, explains why we’re hearing the opposite. It’s George Orwell’s world, and we’re just living in it.

We shouldn't let fiscal policymakers -- who have their own set of "agonizingly dumb, pound-your-head-on-the-table economic fallacies" to support inaction -- off the hook either.

Monday, April 16, 2012

Fed Watch: On Labels

Tim Duy:

On Labels, by Tim Duy: I generally follow the convention of referring to monetary policymakers as "hawks" or "doves." But what really do these terms mean? Are they appropriate or meaningful distinctions? On this topic, Cleveland Federal Reserve President Sandra Pinalto says:

I’ve been part of the Federal Reserve for a long time, more than 28 years. Those labels actually came into play when there wasn’t agreement around an inflation objective. There were some members of the Committee who felt a higher rate of inflation was appropriate. Those individuals were dubbed doves. And there were some that felt that we needed a lower rate of inflation. In fact, one of my predecessors, Lee Hoskins, was focused on achieving zero inflation. And he was considered a hawk.

We now have agreement and a statement by the Committee that 2 percent is the appropriate level of inflation. So I don’t think the titles of hawks and doves are useful when the Committee has stated that we have a 2 percent inflation goal.

If there are titles that people want to use, I would like to be labeled someone who is open-minded. Or someone who is pragmatic...

Pinalto's point is that now that the FOMC has settled in on a 2% inflation target, there is no distinction between hawks and doves. Is this true?

I see her point, but would offer some caveats. First is that perhaps we could consider the entire FOMC as hawks relative to a more dovish policy such as a 4% inflation target. Second is that Chicago Federal Reserve President Charles Evans has supported aggressive policy even if inflation rose as high as 3%. this would seem to be a contradiction to Pianlto's claim that there are no hawks or doves; Evans certainly appears to be a dove relative to the 2% inflation target.

Also, the 2% target is not written in law. Will this become a litmus test in Senate confirmation hearings for Federal Reserve governors? The lack of distinction between hawks and doves might simply be a transitory affair if future policymakers have different views - or the economy necessitates different views.

These issues aside, I still think Pinalto's point is well taken. So how should we use the terms "hawks" and "doves" at a time when most policymakers have coalesced around the same target? I tend to think of the distinction in terms of the policymaker's inflation forecast. A hawk is a policymaker who perceives a greater upside risk to the inflation forecast and thus anticipates policy will turn tighter sooner than later. On the other side, doves tend to see less upside risk to the inflation forecast, or even downside risk, and thus do not anticipate a tighter policy in the near term. (Of course, you could argue that labels are not necessary to begin with, which may be true, but I think will ultimately occur as a means of identifying the different positions of policymakers).

To be sure, these are state contingent labels. Deeper into a tightening cycle, a hawk would be a policymaker more inclined toward further rate hikes, a dove less inclined. And during an easing cycle, a dove would be inclined to cuts rates sooner and perhaps more deeply. But in either case, the distinction between a dove and a hawk is the relative timing and or pace of policy changes necessary to achieve the 2% inflation target.

Bottom Line: The hawks/doves distinction has lost some of its original interpretation as the Fed settles in on a 2% target. That said, policymakers still have different interpretations of the appropriate policy path given their economic forecast, and those interpretations can separate policymakers into camps that can still be labeled (for ease of exposition rather than a normative judgement) as generally hawks or doves. In general terms then, a hawk sees current policy as more likely to be too loose than too tight, a dove sees vice-versa, thus imparting some information about the relative views on policy direction. But Pinalto's final point also defines what we really want in a policymaker - an open-mind, rather than one entrenched in a particular vision of the economy regardless of the realities of the data. A policymaker who might be a hawk or a dove as circumstances change.

Sunday, April 15, 2012

"The ECB’s Lethal Inhibition"

Barry Eichengreen:

The ECB’s Lethal Inhibition, by Barry Eichengreen, Commentary, Project Syndicate: Last December, with Europe’s financial system on the brink of disaster, the European Central Bank stunned the markets with an unprecedented intervention... The ECB’s surprise liquidity operation put the continent’s crisis on hold. But now, just fourth months later, matters are again coming to a head. The big southern European countries, Spain and Italy, battered by austerity, are spiraling into recession. ... So, will it be once more into the breach for the ECB?
The hurdles to further monetary-policy action are high, but they are largely self-imposed. At its most recent policy meeting, the ECB left its policy rate unchanged, citing inflation half a percentage point above the official 2% target. ...
A second argument against further monetary-policy action is that it should be considered only as a reward for budgetary austerity and structural reform, areas in which politicians continue to underperform. ...
With governments hesitating to do their part, the ECB is reluctant to support them. In its view, rewarding them with monetary stimulus ... only relieves the pressure on national officials to do what is necessary.
If this is the ECB’s thinking, then it is playing a dangerous game. Without spending and growth, there can be no solution to Europe’s problems. Absent private spending, budget cuts will only depress tax revenues, requiring additional budget cuts, without end. There will be no economic growth at the end of the tunnel, and political support for structural reforms will continue to dissipate.
The ECB is preoccupied by moral-hazard risk... But it should also worry about meltdown risk... The ECB will object, not without reason, that ... a ... cut in policy rates or “quantitative easing” by another name will do nothing to enhance the troubled southern European economies’ competitiveness.
True enough. But, without economic growth, the political will to take hard measures at the national level is unlikely to be forthcoming. ...

Saturday, April 14, 2012

Fed Watch: A Reason for Pride?

The second of two posts from Tim Duy:

A Reason for Pride?, by Tim Duy: Via Bloomberg:

European Central Bank Executive Board member Joerg Asmussen said the bank could start to raise interest rates to curb inflation if the economy picks up.

“The ECB will act when needed,” Asmussen said in a speech in Berlin today. “Like last spring when the economic outlook had improved and we started carefully raising interest rates.” Still, inflation remains “in check” and will drop below the ECB’s 2 percent limit next year, he said.

I am not exactly sure that the ECB's rate hikes last year are something to be proud of, nor would I describe the action as careful. Those rate hikes arguably accelerated and deepened the European debt crisis, which necessitated a policy reversal in the fall and the massive ballooning of the ECB balance sheet. One would think that the "careful" policy would have been to have not raised interest rates, thus lessening the degree of financial stress and perhaps avoiding subsequent large scale intervention. Moreover, one has to question the success of any policy that helped trigger this unfortunate unemployment path:


Europe: Where central bankers just think different.

Fed Watch: Maddening Monetary Policy Making

The first of two posts from Tim Duy:

Maddening Monetary Policy Making, by Tim Duy: Ryan Avent directs us to David Beckwork and the following excerpt from Federal Reserve Governor Janet Yellen's recent speech:

Importantly, resource utilization rates have been so low since late 2008 that a variety of simple rules have been calling for a federal funds rate substantially below zero, which of course is not possible. Consequently, the actual setting of the target funds rate has been persistently tighter than such rules would have recommended. The FOMC's unconventional policy actions--including our large-scale asset purchase programs--have surely helped fill this "policy gap" but, in my judgment, have not entirely compensated for the zero-bound constraint on conventional policy. In effect, there has been a significant shortfall in the overall amount of monetary policy stimulus since early 2009 relative to the prescriptions of the simple rules that I've described {italics added}.

The "in my judgement" clause is important. Not only do the simply rules say more easing is needed, but she agrees with that position. Beckworth sees hope in this paragraph:

Finally, a prominent Fed official acknowledges what Market Monetarists have been saying for some time: over the past 3 years the Fed has failed to adequately ease monetary policy and thus has passively tightened.

Avent sees another opportunity to urge for additional stimulus:

One wants to scream, try overshooting for once. Try overshooting for once! Try it! Try pushing inflation up above 2% for a while and see if you can't generate enough growth to soak up some slack in the economy, thereby greatly reducing the risk that any little headwind that comes along knocks the economy back below stall speed. Try it! There is no way that a year of 3% inflation is bad enough to justify this pitiful hiccuping recovery. Try overshooting!

I find myself just plain frustrated, especially if you read further. Yellen later says:

Risk-management considerations strengthen the case for maintaining a highly accommodative policy stance longer than might otherwise be considered appropriate. In particular, the FOMC has considerable latitude to withdraw policy accommodation if the economic recovery were to proceed much faster than expected or if inflation were to come in higher.

So far so good...plenty of room to keep the monetary spigots open. But it begs the question of why shouldn't the Fed be doing more right now if Yellen thinks there remains a policy gap and risk-management considerations give the go-ahead for more policy? Then comes the pivot:

The current economic outlook is associated with significant risks in both directions.

Ugh. After arguing for more stimulus, Yellen follows up with the fair and balanced approach to economic forecasting:

In particular, we know that recoveries from financial crises are commonly prolonged, and I remain concerned that the headwinds that have been restraining the recovery could lead to a longer period of sluggish growth and high unemployment than is embodied in the consensus forecasts...Potential upside surprises to the outlook include the possibility that the recovery has greater underlying momentum than is incorporated in consensus forecasts.

She concludes with:

In summary, I expect the economic recovery to continue--indeed, to strengthen somewhat over time. Even so, over the next several years, I anticipate that we will fall far short in achieving our maximum employment objective, and I expect inflation to remain at or below the FOMC's longer-run goal of 2 percent. A range of considerations, including those relating to uncertainty and asymmetric risks, must inform one's judgment on the appropriate stance of policy. As I explained, a variety of analytical tools, including optimal control techniques and simple policy rules, can serve as useful benchmarks. Based on such analysis, I consider a highly accommodative policy stance to be appropriate in present circumstances. But considerable uncertainty surrounds the outlook, and I remain prepared to adjust my policy views in response to incoming information. In particular, further easing actions could be warranted if the recovery proceeds at a slower-than-expected pace, while a significant acceleration in the pace of recovery could call for an earlier beginning to the process of policy firming than the FOMC currently anticipates.

Yellen lays out the case for additional stimulus, making clear that the Fed is falling short in efforts to compensate for the zero bound, and then, almost inexplicably, concludes that the current policy stance is appropriate and should only be altered on the basis of incoming data. How this conclusion follows from her analysis of the situation is beyond me. After all, if you believe that the Fed is falling short of its mark, why don't you explicitly call on the Fed to do more now? Why do we need to wait for evidence of slower-than-expected growth when you have already acknowledged general disappointment with the state of the economy as well as policy?

Say what you will about the likes of Minneapolis Federal Reserve President Narayana Kocherlakota. I might not agree with his view of the economy, but at least he is willing to push a policy position that is consistent with that view. From his most recent speech:

My own belief is that we will need to initiate our somewhat lengthy exit strategy sometime in the next six to nine months or so, and that conditions will warrant raising rates sometime in 2013 or, possibly, late 2012.

Kocherlakota sees tightening sooner than later as the natural extension of his economic forecast, and he says so. The natural extension of Yellen's view is to push for additional easing now, but she just can't bring herself to say it. What is holding her back? My guess: Yellen might want to ease further, but knows Federal Reserve Chairman Ben Bernanke won't push for it, and thus she doesn't want to send an erroneous signal about the direction of monetary policy.

Bottom Line: I admit that I am a little frustrated with the doves among Federal Reserve policymakers, as they appear to believe that additional easing is appropriate, but they just can't bring themselves to actually say so. Instead, they tend to fall back on simply justifying the current policy stance. Why? Possibly because they are good soldiers following Bernanke's lead.

Thursday, April 12, 2012

Brad DeLong: Department of "Huh?!"

SharkBrad DeLong responds to Luigi Zingales

Glad to see some strong pushback on this (see here too):

Department of "Huh?!": Luigi Zingales Edition, by Brad DeLong: Luigi Zingales:

End Double Mandate to Save Fed’s Independence: As justices have weighed in on questions that were traditionally the province of elected officials -- such as abortion rights -- political institutions have fought back by making ideological orthodoxy a requirement for a Supreme Court appointment. What’s worse is that a similar dynamic is now occurring at… the Federal Reserve Board….

It is common to blame conservatives for this gridlock. That amounts to confusing cause and effect. The truth is that the visceral anti-Fed position of many Republicans is simply a political reaction to the interventionism of the central bank, which in the last decade has overstepped its boundaries…. The protracted low interest-rate policy [that started in 2001-2003] is a tax on savers that wasn’t voted by Congress…

But the Federal Reserve did not do anything over 2001-2003. It did not expand its balance sheet, increasing its supply of liquid liabilities that investors could hold as assets, and thus lower the market equilibrium return paid to savers. The market did that.

It is true that the Federal Reserve did not intervene in the market to peg the return to saving at a value that Luigi Zingales thinks is just. (Had it done so, it would in all likelihood have sent the economy into a recession in 2004.) But a failure of a government to intervene in a market and peg a market price at a level that some pressure group thinks it deserves is not a "tax".

He continues:

The “put options” offered to Bear Stearns Cos… were subsidies…

But Bear Stearns was not offered a put option. Bear Stearns was forced into liquidation over a weekend at a price of $2/share (then raised to $10/share). The market the previous Friday had guessed that it would be taken over at a price of $60/share. You can't call a Federal Reserve intervention that leaves a bank's shareholders $50/share poorer than they had thought they were the previous Friday a "subsidy'.

The “put options” offered to… Citigroup Inc. were subsidies… never approved by the political process…

But it was approved by the political process.

That was the whole point of the TARP debates and votes in the fall of 2008--that the lender-of-last-resort activities being undertaken at the end of the George W. Bush administration have the explicit backing of Congress and the President, rather than just being done on the Federal Reserve's say-so.

And when Zingales claims:

all these interventions were well intentioned and some were beneficial…. But so are many of the Chinese leaders’ decisions; that doesn’t make them legitimate in a democratic system…

Is he claiming that the Federal Reserve Act does not say what it says? Is he claiming that Congress did not pass and President George W. Bush did not sign the TARP? He seems to be claiming at least one of those. But neither is true.

The simple fact is that the Federal Reserve is and has been trying as best it can to do its job of maintaining a steady flow of aggregate demand to create a stable economic environment... The simple fact is that Republican politicians appear not to like the Federal Reserve to do its job right now: they appear to want ... to further shrink aggregate demand and raise unemployment--to put the economy further in the tank, in the hope that that will win them more seats in November 2012.

Maybe those playing for Team Republican are doing so in the hope that they will then be able to alter Republican Party policies to make them less destructive. But in the meanwhile they should admit--at least to themselves--what the aims and goals of their political masters are.

Are the Hawks Correct about the Fall in Productive Capacity?

There is a growing contingent at the Fed advocating interest rate increases sooner rather than later. I continue to think that is a mistake.

The reasoning from those who think it's time to begin reducing monetary stimulus is that the natural rate of output -- the full employment level of output -- has fallen so much that even though the recovery to date has been slow, nevertheless we are nearing potential output. Thus, any further push to increase output further could be highly inflationary.

Why do I think this is incorrect? I believe there are several types of shocks that can hit the economy. There are both permanent and temporary shocks to aggregate demand, and there are both permanent and temporary shocks to aggregate supply. As I explained here, analysts who conclude we are almost back to potential output may very well be confusing permanent and temporary shocks to aggregate supply.

As Charlie Plosser explained to me recently, it is difficult to sort aggregate demand and aggregate supply shocks. Aggregate demand shocks can produce supply shocks, and supply shocks can have an effect on demand. The explanation I was given by Plosser was, I think, intended to convince me that what look like aggregate demand shocks are actually the result of supply shocks. However, I think the explanation works better in the other direction. For example, repeating a previous argument:

When there as a large AD shock in the form of a change in preferences, say that people no longer like good A as it has gone out of fashion and have now decided B is the must have good, then there will be high unemployment in industry A and excess demand for labor and other resources in industry B. As workers and resources leave industry A, our productive capacity falls and it stays lower until the workers and other resources eventually find their way into industry B. When this process is complete, productive capacity returns to where it was before, or perhaps goes even higher. Thus, there is a short-run cycle in productive capacity that mirrors the business cycle.
Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, close factories, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.
The point is that there can be short-run cyclical AS effects, and failing to account for these can lead to policy errors.

So it may be true that productive capacity has fallen, but I beleive the fall is largely temporary, not permanent. (To be clear, I think there is a permanent component, but it is nowhere near as large as the inflation hawks are assuming -- i.e. the full employment target, once temporary effects have been cleared out of the way, is higher than the estimates that are behind the hawkery. Essentially, what I am arguing is that the temporary supply shocks are, in part, a function of AD shocks, but the effect of the AD shocks on AS wanes over time.)

If this is correct, policymakers should not be concluding that the shocks are permanent, throwing up their hands, and saying there is nothing more we can do. Instead, if, as I believe, much of the fall in productive capacity is temporary, then the job of policymakers is to make sure that employment recovers as fast as the temporary supply shocks wane. That won't be easy, employment so far has been very slow to recover and if that continues it's entirely possible that productive capacity will recover faster than employment. If policymakers try to freeze employment at a level that is too high out of misguided worries about inflation, then they will hold back the recovery and make this problem worse. That's the opposite of what they should be doing.

I could be wrong, which is what I'd like the hawks to consider. That is, what are the costs of being wrong versus the costs of being correct? My view is that the costs of doing too much -- the inflation cost -- is much lower than the costs of doing too little, i.e. the costs of higher than necessary unemployment (though see David Altig). I'm aware that we differ on this point, those in favor of relatively immediate interest rate increases see the costs of inflation as very high and it's this point that I hope will generate further discussion. In reality, how high are the costs of a temporary bout of inflation -- I have faith that the Fed won't allow an increase in inflation to become a permanent problem -- and are they so high that they justify erring on the side of doing too little rather than too much? I don't think they are, but am willing to listen to other views.

Wednesday, April 11, 2012

Monetary Policy: More or Less?

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

I would say that it would be appropriate to change the Fed’s current forward guidance to the public about the future course of interest rates. Currently, the FOMC statement reads that the Committee believes that conditions will warrant extraordinarily low interest rates through late 2014. My own belief is that we will need to initiate our somewhat lengthy exit strategy sometime in the next six to nine months or so, and that conditions will warrant raising rates sometime in 2013 or, possibly, late 2012.

But I hope that John Williams, and others with similar views, carry the day:

Let me summarize where the Fed stands in terms of achieving its congressionally mandated goals. We are far below maximum employment and are likely to remain there for some time. The housing bust and financial crisis set in motion an extraordinarily harsh recession, which has held down consumer, businesses, and government spending. By contrast, inflation is contained and may even fall next year below our 2% target.
Under these circumstances, it’s essential that we keep strong monetary stimulus in place. The recovery has been sluggish nationwide... High unemployment, restrained demand, and idle production capacity are national in scope. These are just the sorts of problems monetary policy can address. ...

The hawks will keep pushing to tighten sooner rather than later, so let's hope those who want to do more, or at least not do less, can at least produce the gridlock needed to keep current policy in palce.

Friday, April 06, 2012

Fed Watch: Labor Market Softens in March

Tim Duy:

Labor Market Softens in March, by Tim Duy: If the employment report falls on a holiday weekend, does it make a sound? Yes it does, at least when it comes in far below expectations, with 120k nonfarm payroll gain compared to a consensus of 205k. Treasury yields collapsed on the news, and are now once again hovering around 2 percent on the ten-year bond. In my opinion, this is yet another data point that confirms what has become my baseline view of this recovery - neither an optimist nor a pessimist should one be. The economy is grinding away at rate close to its potential growth rate, perhaps a little above. Certainly not a disaster in terms of expecting another recession, but also certainly also not a success story.
First off, should we be terribly concerned with the headline NFP number in and of itself? No. There is a lot of variance in the month to month changes:


Reading too much into a single data point is simply a dangerous game. During the first quarter of 2012, the average gain was 211k a month. Part of the story is likely that warmer weather boosted the numbers in January and February, and there was some give-back in March - though note again the variance of this number. You almost always need some story to explain the month to month deviations from the trend. The question is whether or not this one data point should deter you from believing the trend is intact. My view is that it should not. That said, if you thought the last two reports were really indicative of the underlying trend, I would say that that was overly optimistic. Slow and steady, slow and steady.
On the surface, some good news in that the unemployment rate continued to decline:


Still, the improvement was driven by a decline in the labor force, which fell by more than the decline in the number of unemployed. I tend to think Fed hawks will fixated on the decline in the unemployment rate itself rather than the underlying reason for the declines. One way to "solve" the unemployment problem is to drive people from the labor force, let their skills deteriorate, and ensure that a cyclical problem becomes a structural one. In other words, the view of St. Louis Federal Reserve President that the economy is operating near potential is almost certain to become a self-fulfilling prophesy given the unwillingness of the Fed to implement a more aggressive policy stance.
Support for the "structural not cyclical" view will be found in the persistence of long-term unemployment:


That said, if we were truly operating near potential, one would not expect the wages of those employed to continue to stagnate:


True enough, average hourly wages increased a nickel in March, but note that this was offset by a decline in hours so that average weekly wages fell. On net, not much help to support still weak disposable personal income growth:


For further evidence that the economy remains well below trend, note the ongoing high levels of those employed part-time for economic reasons:


An improvement, to be sure, but still a long way to go before the labor market is normalized.

As far as other views, a couple caught my eye this morning. The first was from spencer at Angry Bear:

The index of hours worked has been raising a red flag about the numerous other signs of stronger employment and an acceleration of economic growth. They are not showing the recent improvement that other employment data have been reporting Recently, unit labor cost has been rising faster than prices, implying margin pressure and very weak profits. To sustain profits growth, firms have to reestablish stronger productivity growth. The weakness in March employment is a strong indicator that business is trying to rebuild productivity growth and profits growth.

This bodes poorly for the sustainability of the recent upward trend in equities. Another issue is what does this mean for monetary policy? I think Ryan Avent (via Brad DeLong as the Economist server appears to be down at the moment) captures the general spirit:

This report will be widely analysed within the context of this year's political elections, despite the fact that the single most important influence on employment growth now and over the next four years will be the stance of monetary policy. As this report is consistent with recent Federal Reserve forecasts, indicating that the Federal Open Market Committee is satisfied with present employment trends, policy is unlikely to change in reaction to anything released today

The data is sufficiently disappointing as to not alter the view of the doves, and notably Federal Reserve Chairman Ben Bernanke, that there is no need to tighten policy in the near future, leaving the 2014 timing intact. Thinking about the trends as noted above, there is no reason on the basis of this report to believe that a significant deterioration in the outlook has or is about to occur, and thus no reason to expect this will nudge the FOMC toward another round of QE. This I find unfortunate because, as I noted earlier, the longer the Fed continues to operate policy along the post-recession growth trend the more likely it is that this will indeed become the new trend for potential output.

Bottom Line: A disappointing jobs report for those who expected the US economy was about to rocket forward, but one consistent with the slow and steady trend into which the US economy appears to have settled. And no reason to change the basic outlook for monetary policy - the Fed is on hold until the data breaks cleanly one direction or the other.

Jobs Report Shows Weakness. Will Policymakers Respond?

Here's my reaction to the jobs report:

Jobs Report Show Weakness. Will Policymakers Respond? (CBS MoneyWatch) COMMENTARY The Employment Report for March was weaker than many analysts expected. The unemployment rate fell slightly from 8.3 percent to 8.2 percent, and on the surface that seems like good news. But the 120,000 jobs created during the month was barely enough to keep up with population growth, the labor force participation rate actually fell from 63.9 percent to 63.8 percent, and the employment to population ratio also fell from 58.6 to 58.5 percent. Thus, the fall in unemployment reflects fewer people searching for jobs more than an uptick in job creation.

This is just one month's worth of data, and monthly data can be noisy so it's not time to panic yet. The recovery could pick up steam again next month. But the possibility that it won't pick up, e.g. because unseasonably good weather distorted the numbers for the last few months, has to be taken seriously by policymakers. ...[continue reading]...

Paul Krugman: Not Enough Inflation

The unemployed need more help from the Fed:

Not Enough Inflation, by Paul Krugman, Commentary, NY Times: A few days ago, Alan Greenspan ... spoke out in defense of his successor. Attacks on Ben Bernanke by Republicans, he told The Financial Times, are “wholly inappropriate and destructive.” He’s right...
But why are the attacks on Mr. Bernanke so destructive? ... The attackers want the Fed to slam on the brakes when it should be stepping on the gas... Fundamentally, the right wants the Fed to obsess over inflation, when the truth is that we’d be better off if the Fed paid ... more attention to unemployment. ...
O.K.,... let me take this in stages. First, about inflation obsession: For at least three years, right-wing economists, pundits and politicians have been warning that runaway inflation is just around the corner, and they keep being wrong. ... At this point, inflation is ... a bit below the Fed’s self-declared target of 2 percent.
Now, the Fed has, by law, a dual mandate: It’s supposed to be concerned with full employment as well as price stability. And while we more or less have price stability by the Fed’s definition, we’re nowhere near full employment. So this says that the Fed is doing too little, not too much. ...
To be sure, more aggressive Fed policies to fight unemployment might lead to inflation above that 2 percent target. But remember that dual mandate: If the Fed refuses to take even the slightest risk on the inflation front, despite a disastrous performance on the employment front, it’s violating its own charter. And, beyond that,... a rise in inflation to 3 percent or even 4 percent ... would almost surely help the economy. ...
Which brings me back to those Republican attacks and their chilling effect on policy.
True, Mr. Bernanke likes to insist that he and his colleagues aren’t affected by politics. But that claim is hard to square with the Fed’s actions, or rather lack of action. As many observers have noted, the Fed’s own forecasts indicate that ... it still expects low inflation and high unemployment for years to come. Given that prospect, more of the “quantitative easing” ... should be a no-brainer. Yet the recently released minutes from a March 13 meeting show a Fed inclined to do nothing unless things take a turn for the worse.
So what’s going on? I think that Fed officials, whether they admit it to themselves or not, are feeling intimidated — and that American workers are paying the price for their timidity.

Thursday, April 05, 2012

Feldstein v. Lazear


Feldstein v. Lazear on the Size of the Output Gap , econospeak: Martin Feldstein is worried that the Federal Reserve will not reverse its increase in the monetary base even as we approach full employment:

Here is what worries me... If the unemployment rate is still very high when product markets begin to tighten, the US Congress will want the Fed to allow more rapid growth in order to bring it down, despite the resulting risk to inflation. The Fed is technically accountable to Congress, which could apply pressure on the Fed by threatening to reduce its independence. So inflation is a risk, even if it is not inevitable. The large volume of reserves ... makes that risk greater. It will take skill – as well as political courage – for the Fed to avoid the rise in inflation that the existing liquidity has created.

Dr. Feldstein is implicitly saying that the GDP gap is not as large as what Ed Lazear wants us to believe:

During the postwar period up to the current recession (1947-2007), the average annual growth rate for the U.S. was 3.4%. The last three decades have experienced somewhat slower growth than the earlier periods, but even in the period 1977-2007, the average growth rate was 3%. According to the National Bureau of Economic Research, the recovery began in the second half of 2009. Since that time, the economy has grown at 2.4%, below our long-term trend by either measure. At this point, the economy is 12% smaller than it would have been had we stayed on trend growth since 2007. ...

Lazear wants us to believe that the economy could have continued to grow by 3.4% per year since 2007QIV... In other words, Lazear wants us to believe that the current GDP gap is 12%. ...

Republicans are simultaneously pushing two themes. One theme is that current Federal Reserve policy is endangering an inflationary spiral, which seems to be the concern of Dr. Feldstein. The other theme is that the Obama Administration is somehow making the recession worse, which Dr. Lazear was so happy to echo. Funny thing – these two themes appear to be contradictory.

Andy Harless on Twitter:

Feldstein says inflation is a "risk." I would express the same point by saying that there is "some hope" for inflation. Not much, though.

Andy will be disappointed to hear that James Bullard is also convinced that the gap is smaller than most people believe, and that the Fed's commitment to keep interest rates low through the end of 2014 is harming the economy:

Concerning the FOMC’s communications tool, the “late 2014” language describing the length of the near-zero rate policy may be counterproductive, he said.  “The Committee’s practice of including distant dates in the statement sends an unwarranted pessimistic signal concerning the future of the U.S. economy.”

Regarding the output gap and housing markets, “the U.S. output gap may be smaller than typical estimates suggest,” Bullard said, adding that typical estimates count the “housing bubble” as part of the normal level of output.  However, he said, “It is neither feasible nor desirable to attempt to re-inflate the U.S. housing bubble of the mid-2000s.”

At least he's not calling for interest rates to go up --- at least not yet:

Federal Reserve Bank of St. Louis President James Bullard ... said that brighter prospects for the U.S. economy provide the Federal Open Market Committee (FOMC) with the opportunity to pause in its aggressive easing campaign.  “An appropriate approach at this juncture may be to continue to pause to assess developments in the economy,” he stated.

But he seems to be setting the stage to call for the Fed to abandon its interest rate commitment, e.g. statements such as "low interest rates hurt savers" (see here on this point).

I think that would be a mistake. How much uncertainty does Bullard have around his estimate of potential output? If it's not a substantial amount, it ought to be and the best policy in the face of such uncertainty is to lean against the more costly outcome (it also seems to me that he has chosen a forecast with one-sided errors -- it's unlikely that potential output is much lower than his current estimate, but it couldbe much higher). As I've been stressing recently (along with Stevenson and Wolfers, DeLong, and others), since high unemployment is far more costly than a temporary bout of inflation, policy ought to be directed primarily at the unemployment problem. If and when there are signs that inflation is increasing, and that labor markets are close to full recovery, then the Fed can start laying the groundwork for interest rate increases prior to 2014. But any talk of easing off its commitment before then and the loss of credibility that comes with it would be, to echo Bullard's term, counterproductive.

Tuesday, April 03, 2012

Fed Watch: Fed Minutes Confirm Policy on Hold

Tim Duy:

Fed Minutes Confirm Policy on Hold, by Tim Duy: The minutes of the most recent Federal Reserve meeting were not exactly what one would call a page turner. Much of the contents had already been covered in recent speeches to varying degrees, culminating with an unexpectedly sanguine view of the economy:

With respect to the economic outlook, participants generally saw the intermeeting news as suggesting that economic growth over coming quarters would continue to be moderate and that the unemployment rate would decline gradually toward levels that the Committee judges to be consistent with its dual mandate. While a few participants indicated that their expectations for real GDP growth for 2012 had risen somewhat, most participants did not interpret the recent economic and financial information as pointing to a material revision to the outlook for 2013 and 2014.

The recent flow of data has done little to alter the Fed's basic outlook that the recovery will continue to grind along at a pace slower than hoped for but fast enough such that no additional easing is required. And on the prices side of the equation, inflation expectations remain anchored, and any pass-through from higher oil and gas prices will be temporary. As expected, some participants were concerned about inflation prospects:

One participant pointed to inflation readings and a high rate of long-duration unemployment as signs that the current level of output may be much closer to potential than had been thought, and a few others cited a weaker path of potential output as a characteristic of the present expansion.

These concerns, however, were largely dismissed by the rest of the committee:

However, a number of participants judged that the labor market currently featured substantial slack. In support of that view, various indicators were cited, including aggregate hours, which during the recession had exhibited a decline that was particularly severe by historical standards and remained well below the series' pre-recession peak; the high number of persons working part time for economic reasons; and low ratios of job openings to unemployment and of employment to population.

Not to be deterred so easily, the hawks come back later with:

A couple of participants noted that recent readings on unit labor costs had shown a larger increase than earlier...

That picture looks like this:


Heaven forbid we allow any catch-up in unit labor costs. In any event, I would be cautious about reading too much into the most recent data given weak wage growth:


Which is the same conclusion other the participates in the meeting:

...but other participants pointed to other measures of labor compensation that continued to show modest increases.

The hawks do make one last effort:

Other participants, however, were worried that inflation pressures could increase as the expansion continued; these participants argued that, particularly in light of the recent rise in oil and gasoline prices, maintaining the current highly accommodative stance of monetary policy over the medium run could erode the stability of inflation expectations and risk higher inflation.

This despite the experience of last year where the same arguments were made and ultimately proved wrong.

Finally, if you were looking for signs that another round of QE, your hopes were dashed:

A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

A half-hearted call for additional easing at best. The Fed is simply not inclined to overshoot. As Mark Thoma points outs, the best we get is a signal that the Fed is not ready to pull the trigger on tighter policy.

Bottom Line: The Fed remains in a holding pattern; more QE is dependent upon a meaningful deterioration in the outlook and/or a flattening out of the unemployment rate. Otherwise, it remains a debate about when the first tightening will occur, and for the moment that event is still far in the future.

Fed Meeting Minutes Blunt Hopes for QE3

Here's a quick reaction to today's release of the Fed's minutes from its March 13 rate setting meeting:

Fed Meeting Minutes Squash Hopes for QE3

As I told the editor, beyond the headline that there was little to suggest that the Fed will provide more stimulus, there wasn't much to say but I said it anyway. There was also a discussion of potential output that I failed to note, i.e. whether the unemployment problem is cyclical or structural, but the fact that "a number of participants judged that the labor market currently featured substantial slack" indicates that the many Fed members believe that cyclical fluctuation, i.e. lack of demand, is an important component of the unemployment problem (which points to more aggressive policy, or at the very least a continuation of present policy). 

"U.S. Economy Needs Stimulus, Not Soothsayers"

I have argued many, many times that policy mistakes are asymmetric, mostly to no avail, so it's nice to see Justin Wolfers and Betsey Stevenson emphasizing the point that the costs of doing too little are larger than the costs of doing too much, and what this implies for policy:

U.S. Economy Needs Stimulus, Not Soothsayers, By Betsey Stevenson and Justin Wolfers: Here’s something you don’t often hear an economist admit: We have very little idea where the economy will be next year. ...Why? Data are imperfect. Theories are coarse. Models oversimplify. The economy is constantly evolving and can’t be subjected to controlled experiments. Economic cycles are infrequent, so our understanding of them necessarily proceeds very slowly. 
None of these drawbacks, though, is fatal to the enterprise. ... Consider the current economic-policy debate. Most forecasters suggest that as the recovery slowly grinds on, unemployment will fall to about 7.5 percent by the end of 2013, from the current 8.3 percent. While this isn’t great progress, it is fast enough that some have argued against further stimulus.
We know, though, that the consensus forecast is highly likely to be wrong. Unemployment could fall to 6.5 percent, or rise to 8.5 percent. Each of these possibilities needs to be considered, and weighed according to its potential benefit or harm.
If unemployment falls to 6.5 percent, there’s no overwhelming reason for concern. ... By contrast, the longer-run consequences could be dreadful, if we find ourselves with 8.5 percent unemployment fully six years after the recession began. ...
In other words, the cost of too little growth far outweighs the cost of too much. If we readily bear the burden of carrying an umbrella when there’s a reasonable chance of getting wet, we should certainly be willing to stimulate the economy when there’s a reasonable risk that doing nothing could yield a jobless generation.

Monday, April 02, 2012

No Sign of an Inflation Problem

Via the Dallas Fed, once the volatile prices have been stripped out there's no evidence of inflation. If anything, inflation has been falling in recent months (before objecting that these measures do not capture actual changes in the cost of living for households, please see here):

Trimmed Mean PCE Inflation Rate, FRB Dallas: February 2012 The trimmed mean PCE inflation rate is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). ...
The trimmed mean PCE inflation rate for February was an annualized 1.4 percent. According to the BEA, the overall PCE inflation rate for February was 3.8 percent, annualized, while the inflation rate for PCE excluding food and energy was 1.6 percent.
The tables below present data on the trimmed mean PCE inflation rate and, for comparison, the overall PCE inflation and the inflation rate for PCE excluding food and energy. The tables give annualized one-month, six-month and 12-month inflation rates.
One-month PCE inflation, annual rate

PCE excluding food & energy
Trimmed mean PCE


Six-month PCE inflation, annual rate

PCE excluding food & energy
Trimmed mean PCE


12-month PCE inflation

PCE excluding food & energy
Trimmed mean PCE
NOTE: These data are subject to revision ...

James Bullard is trying to make the case that domestic inflation depends upon the global output gap, and that gap looks inflationary, but I just don't see evidence for an emerging inflation problem in the tables. For the last four months or so, inflation has been stable or falling depending on the measure you choose, and that's not what you'd expect if there was increasing price pressure due to either global or domestic forces.

Sunday, April 01, 2012

Real-Time Economic Analysis

When Narayana Kocherlakota gave this speech based on this paper, a paper that uses a very simply model that is essentially an IS curve analysis, the economists who believe strongly in the science of monetary policy were appalled. How could Narayana have crossed over to the dark side?

I defended him, and it leads me into a broader discussion of the problems of doing what I've called "real-time economic analysis." Let me start with something I wrote about this awhile back:

Economic research is largely backward looking. After the fact – when all of the data has been collected and the revisions to the data are complete – economists examine data on, say, a financial crisis, and then figure out what caused the economy to become so sick. Once the cause has been determined, which may involve the construction of new theoretical frameworks, they tell us how to avoid it happening again, i.e. the particular set of policies that would have prevented or attenuated the damage.
But the internet and blogs are changing what we do, and to some extent we now act like emergency room physicians rather than pathologists who have the time to carefully examine data from tests, etc., determine what went wrong, and then recommend how to avoid problems in the future. When the financial crisis hit so unexpectedly, it was like a patient showed up at the emergency room very sick and in need of immediate diagnosis and care. We had to reach into our bag of macroeconomic models, choose the one that was correct for this question, and then use it to both diagnose the problems and prescribe policies to fix them. There was no time for a careful retrospective analysis that patiently determined the cause and then went to work on the potential policy responses.
That turned out to be much harder than expected. Our models and cures are not designed for that type of use. What data should we look at to make an immediate diagnosis? What tests should we conduct to give us data on what is wrong with the economy? If we aren’t sure what the cause is but immediate action is needed to save the economy from getting very sick, what is the equivalent of using broad spectrum antibiotics and other drugs to attack unknown problems? The development of blogs puts economists in real-time contact with the public, press, and policymakers, and when a crisis hits, traffic spikes as people come looking for answers.
Blogs are a start to solving the problem of real-time analysis, but we need to do a much better job than we are doing now at providing immediate answers when they are needed. If Lehman is failing and the financial sector is going down with it, or if Europe is in trouble, we need to know what to do right now. It won’t help to figure that out months from now and then publish the findings in a journal article. That means the discipline has to adjust from being backward looking pathologists with plenty of time to determine causes and cures to an emergency room mode where we can offer immediate advice. Blogs are an integral part of that process.

Policymakers at the Federal Reserve face this problem continuously. They must confront changes in the data that aren't always well understood in near real time, and make policy decisions every few weeks. If pre-existing models apply to the problem at hand, great, it can be used to guide policy decisions. But what should policymakers do when they are faced with an important decision about how to react to a large shock, and they reach into their black bag of models and none of them seem to fit?

One approach is what Paul Krugman does so well, something Narayana Kocherlakota seems to also be doing. Reach for simple models that get to the heart of the problem and hence offer guidance about what to do next. These models are not intended to explain the world generally, they are not "science" in that respect, they are intended to shine a light and provide guidance on a very narrow issue. It takes considerable skill to do this since, as I argued yesterday, it requires the practitioner to thoroughly understand the pitfalls of the simple approach, the ways in which it could go wrong.

So I think Narayana and others are correct to reach for simple models for guidance when they are faced with a decision that existing models do not address very well and there's not time to build a full-blown model of the problem.

My call to those who object that this approach is not "science," those who look down their noses at people like Krugman and Kocherlakota when they adopt this approach, is this. What is the scientific way to diagnose the economy is real-time, and confront unknown or uncertain pathologies? As I noted in another essay that discusses this problem, doctors have tests that can be done very quickly to provide a diagnosis, and they can they use broad-spectrum drugs and other approaches to try to heal the patient when the tests point to unknown causes.

What tests should we do that are quick and informative? There are lots of data, but what should we be examining to try to diagnose problems effectively before they get really bad? If we detect a problem, and don't fully understand it, what's the most robust way to attack it? What policies tend to work on a broad variety of underlying causes? Are there tests that can guide us to the correct robust policy?

My reaction when the crisis hit, and ever since, was to recommend a "portfolio of policies."  People who say only monetary policy will work, or only fiscal policy will work, blah, blah, blah are talking with more confidence than was justified by the models they are using. I decided early on that I really didn't know for sure which macroeconomic model was best. I had my preferences, strong preferences, but I couldn't say for sure that the model I preferred was correct. And it didn't really apply very well to the financial crisis in any case.

So, I thought, why not do what a doctor would do and give a broad spectrum drug that tends to work no matter the cause. There is the danger of side effects. If we aren't sure about which policy will work and we give full doses of both monetary and fiscal policy only to have them both work, the side effect of inflation could occur as the economy heals. But to me the side effect was far less worrisome than the disease itself, and in any case the side effect could be controlled by backing off the dosage once the patient was up and about once again. But what are the optimal weights for monetary and fiscal policy in such a situation? What else ought to be in the portfolio of policies (e.g. policies that can help even if the problem is structural rather than cyclical). What guidance can we give policymakers?

Those who believe in the science of monetary policy can sneer at the Krugman/Kocherlakota approach all they want, but there's a real (time) problem to be solved here and we could use their help. As I said above this is an area where the Fed has considerable experience, real-time analysis is a large part of what they do, and my push for Federal Reserve banks to interact more through blogs is partly for this reason. Hearing how Federal Reserve policymakers approach these problems would be useful.

But it would also be useful if the profession more generally would get aboard and help us understand how to better solve the difficult questions that arise when decisions must be made based upon only a partial understanding of the problem that is affecting the economy. In the long-run it's still important to build new, full blown models that can explain the problem and provide guidance. Macroeconomists are certainly doing that presently as they try to provide better models of how a breakdown in financial intermediation can impact the real economy than we had before, and so on. But work on how to better conduct real-time analysis is not getting as much attention, and that's something that needs to change.

Friday, March 30, 2012

"Are Unemployed Construction Workers Really Doing Better?"

I've been trying to get the Federal Reserve banks to engage more with the public through blogs, with economics bloggers in particular. We'll see how that goes, but it's encouraging to see that they are starting to converse and debate among themselves:

Are unemployed construction workers really doing better?, Pedro Silos and Lei Feng, macroblog: Two New York Fed economists, Richard Crump and Ayşegül Şahin, writing in Liberty Street Economics, have shared some interesting findings regarding developments in the labor market during the ongoing recovery. Their conclusion is that unemployed construction workers, according to several indicators, seem to be doing better than workers who lost jobs in other sectors. ...
These facts, according to the authors, provide support to the hypothesis that problems in the labor market cannot be blamed on the degree of mismatch between displaced construction workers and job vacancies in other sectors.
In this post, we present an alternative view of the fate of unemployed construction workers...

Hope to see more of this.

Fed Watch: Inflation: Still Nothing to See Here

Tim Duy:

Inflation: Still Nothing to See Here, By Tim Duy: The Februrary Personal Income and Outlays report came out this morning, and with it a fresh read on the Federal Reserve's preferred inflation measure, the PCE price index. On a year-over-year basis, headline inflation is trending down to the 2% target, while core is settling in just below that target.  


As a reminder, the Fed targets headline over the longer run, but watches core as a signal to where headline is headed.  Headline is trending down to core, as expected. The Fed was right to dismiss last year's energy-induced headline increase as a temporary phenomenon. Is there any near term trends to be concerned about? The three-month core trend edged down a notch to just above 2%:


Still less than the rise experienced in the first part of 2011.  What about the path of prices? Still tracking along a trend below that of prior to the recession:


Opportunistic disinflation at work.
Bottom Line:  Inflation remains contained - by itself, price trends provide no reason for the Fed to turn hawkish. Moreover, there is nothing here to stop Federal Reserve Chairman Ben Bernanke from easing policy should the US recovery falter.

Thursday, March 29, 2012

DeLong: The Shadow of Depression

Flight delay, so one more -- Brad DeLong:

The Shadow of Depression, by Brad DeLong, Commentary, Project Syndicate: Four times in the past century, a large chunk of the industrial world has fallen into deep and long depressions characterized by persistent high unemployment: the United States in the 1930’s, industrialized Western Europe in the 1930’s, Western Europe again in the 1980’s, and Japan in the 1990’s. Two of these downturns – Western Europe in the 1980’s and Japan in the 1990’s – cast a long and dark shadow on future economic performance.
In both cases, if either Europe or Japan returned – or, indeed, ever returns – to something like the pre-downturn trend of economic growth, it took (or will take) decades. In a third case, Europe at the end of the 1930’s, we do not know what would have happened had Europe not become a battlefield following Nazi Germany’s invasion of Poland.
In only one instance was the long-run growth trend left undisturbed: US production and employment after World War II were not significantly affected by the macroeconomic impact of the Great Depression. Of course, in the absence of mobilization for WWII, it is possible and even likely that the Great Depression would have cast a shadow on post-1940 US economic growth. That is certainly how things looked, with high levels of structural unemployment and a below-trend capital stock, at the end of the 1930’s, before mobilization and the European and Pacific wars began in earnest. ...[continue reading]...

Wednesday, March 28, 2012

"The Close Connection Between Nominal-GDP Targeting and the Taylor Rule"

From the Dallas Fed:

All in the Family: The Close Connection Between Nominal-GDP Targeting and the Taylor Rule, by Evan F. Koenig: Abstract: The classic Taylor rule for adjusting the stance of monetary policy is formally a special case of nominal- gross-domestic-product (GDP) targeting. Suitably implemented, moreover, nominal-GDP targeting satisfies the definition of a "flexible inflation targeting" policy rule. However, nominal-GDP targeting would require more discipline from policymakers than some analysts think is realistic.

I've been asking this for some time now, but I viewed nominal GDP targeting as a special case of the Taylor rule (when the coefficients are set just right), but it's the other way around -- the Taylor rule is the special case:

Note that the Taylor rule is a special case of nominal-GDP targeting... The chief difference between the two policy approaches is that under nominal-GDP targeting, policymakers look at a longer history of price changes than they do under the Taylor rule when deciding on the appropriate policy setting. Secondarily, the estimate of potential output that enters the nominal-GDP-targeting rule is less sensitive to short-term supply shocks than is the estimate that enters the Taylor rule.

The last point about temporary supply shocks is important as I tried to emphasize here (the post talks about why policymakers should not respond to temporary supply shocks under a Taylor rule, I didn't mention nominal GDP targeting as a solution).


One might think that nominal-GDP targeting's ability to work around the zero-bound constraint would appeal to monetary policy doves and that its tighter control of inflation expectations would appeal to monetary policy hawks. Why hasn't nominal-GDP targeting received more widespread support? The main issue is credibility.[14] Some analysts are concerned that future FOMCs may fail to follow through on promises of accommodation, while others fear that future FOMCs may back away from nominal-GDP targeting should it call for tighter policy than the current approach. To the extent that the public shares the former concern, an announced shift to nominal-GDP targeting would do little to accelerate the economy's recovery. To the extent that the public shares the latter concern, an announced shift to nominal-GDP targeting might be seen as a relaxation of the Federal Reserve's commitment to price stability rather than an enhancement to that commitment.


Tuesday, March 27, 2012

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

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

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

I wrote this before Bernanke's speech on the labor market on Monday. He says, echoing the topic of the column:

Is the current high level of long-term unemployment primarily the result of cyclical factors, such as insufficient aggregate demand, or of structural changes, such as a worsening mismatch between workers' skills and employers' requirements? ... I will argue today that ... the continued weakness in aggregate demand is likely the predominant factor.

So maybe the structural impediment, inflation hawk types at the Fed will be vanquished after all. We shall see. [See Tim Duy's comments on as well.]

Fed Watch: Bernanke, Bullard, and QE3

Tim Duy:

Bernanke, Bullard, and QE3, by Tim Duy: This morning Federal Reserve Chairman Ben Bernanke gave a speech that apparently was identified as proof that QE3 is still in the cards. He argues that while labor markets have shown improvement in recent months, conditions are far from normal. Moreover, he sees the problem of long-term unemployment as largely structural, and delivers what many believed to be the money quote:

I will argue today that, while both cyclical and structural forces have doubtless contributed to the increase in long-term unemployment, the continued weakness in aggregate demand is likely the predominant factor. Consequently, the Federal Reserve's accommodative monetary policies, by providing support for demand and for the recovery, should help, over time, to reduce long-term unemployment as well.

In my opinion, to interpret this as a call for additional quantitative easing is a bit of a stretch. It sounds like simply a confirmation that Bernanke believes the current policy stance is appropriate and that the existence of long-term unemployment should not be viewed as a reason to believe that we are closing in on a resource constraint that would necessitate a tightening of the policy stance. I was drawn to a much more nuanced section:

However, to the extent that the decline in the unemployment rate since last summer has brought unemployment back more into line with the level of aggregate demand, then further significant improvements in unemployment will likely require faster economic growth than we experienced during the past year. It will be especially important to evaluate incoming information to assess whether the recovery is picking up as improvements in the labor market feed through to consumer and business confidence; or, conversely, whether the headwinds that have impeded the recovery to date continue to restrain the pace at which the labor market and economic activity normalize.

In essence, Bernanke suggests that the recent rapid improvements in unemployment reflect largely a reversal of out-sized deterioration experienced during the recession. As such, we should not expect a slower pace of improvement given current growth forecasts. Under such conditions, I believe, Bernanke would push for another round of QE - although it stills begs the question of why he doesn't push for more now given the existing forecasts. But he hasn't, so we can only infer that he thinks the costs of additional easing outweigh the benefits.

He leaves open the possibility, however, that labor markets will continue to improve at the recent pace, in which I think QE3 is off the table. And that is where Federal Reserve President James Bullard steps in to the picture. He said pretty much the same thing in a CNBC interview:

"I think QE3 would require the economy to deteriorate somewhat from where it is right now," Bullard said. "The basic story on the U.S. economy is that we've had good news over the last six months or so, especially compared to the recession scenario that was being painted in the August-September time period of last year."

That said, this is somewhat softer language than he used in a speech last week:

But now, with the Committee on pause, it may be a good time to take stock of whether we may be at a turning point. Many of the further policy actions the Committee might consider at this juncture would have effects extending out for several years. As the U.S. economy continues to rebound and repair, those policy actions may create an overcommitment to ultra-easy monetary policy. The ultra-easy policy has been appropriate until now, but it will not always be appropriate.

The FOMC has often been criticized historically for overstaying policy stances that might have made sense at one juncture but are no longer appropriate as macroeconomic conditions change. This occurs in part because of the lags in the effects of policy, the difficulty in interpreting real-time data, much of which is subsequently revised, and the sheer uncertainty of macroeconomic developments. With numerous monetary policy actions still on the table, and others still affecting the economy with a lag, it may be especially difficult to remove policy accommodation at the appropriate pace and at the appropriate time. One may want to approach such a situation with caution.

This seems to suggest he is in fact entertaining the possibility that the turning point for policy will occur sooner than expected. My view is that the crux of any disagreement between Bullard and Bernanke is the timing of any tightening. Both would push for additional easing should conditions deteriorate. But Bernanke is willing to leave existing policy in place for well into the future, whereas Bullard is looking forward to pulling the trigger on tighter policy sooner than later.

This, by the way, is a debate Bernanke would win in the absence of clear indications that tightening is necessary.

Incredibly, in his CNBC interview, Bullard strays into the world of Japanese monetary policy:

"I think one of the biggest mistakes is continue to throw us much more in the way of monetary injections into the economy and with that, you get a much higher increase in commodity prices and potentially produce less global consumption across the world, which slows economic activity down," Bullard said. "I'm afraid that's the real danger just now - that we've maintained too loose of a policy right across the global economy and what results is inflation and reduction in real spending power."

I get this, I really do. But I have come to the conclusion that the Federal Reserve should not consider the reaction functions of other central banks when setting policy. Simply put, this is not the Fed's problem. To the extent that other nations import the Fed's monetary policy, they do so by choice. Bullard continues:

Bullard says he would like to see the Federal Reserve resume a "more normal monetary policy as soon as possible" because it has detrimental effects on the economy.

"It (the policy) punishes savers, for instance, in the economy, it does send a pessimistic signal about the economy and I think that can hurt investment prospects in the U.S.," Bullard said. "But we need to provide the right amount of support for the recovery as we do that, and we need to keep an eye on inflation."

Concerns that like the commodity price issue seem to mimic those of Bank of Japan Governor Masaaki Shirakawa. And we all know what about the wisdom of BoJ monetary policy.

Bottom Line: I do not think Bernanke's speech is a signal that QE3 is guaranteed. But it is a signal that QE3 is definitely not off the table. It is entirely data dependent. The current flow of data does not support additional action. I don't think it would take much of a deterioration to prompt additional action, so if you have a bearish view of the US economy, expect QE3. But if you have a bullish view, don't expect a rapid policy reversal. Bernanke isn't ready to go there.

Monday, March 26, 2012

Fed Watch: Lessons From Japan?

Tim Duy:

Lessons From Japan?, by Tim Duy: Via Mark Thoma, Robin Harding at the FT Money Supply blog reports on a speech given by Bank of Japan Governor Masaaki Shirakawa. The speech reportedly details the problems that emerge from aggressive monetary policy. I cannot find a link to the speech itself, but luckily the FT quotes key sections.

The first concern is two-fold:

Mr Shirakawa’s first point is that loose monetary policy mitigates the pain as households repair their balance sheets, but reduces their incentive to do so quickly, not just for the private sector but for governments as well. However, he also suggests that the effectiveness of loose policy may fall over time as households that weren’t damaged by the crisis bring forward such spending as they want to.

The first sentence sounds like a rehashing of the "liquidationist" approach. We should let the economy collapse rather than provide support during balance sheet adjustment. The second part suggests that there is only so much spending that can be brought forward via low interest rates. But I think this is not really a novel idea, as we pretty much know that the effectiveness of monetary policy fades at the zero bound:


In this case, I drew the LM curve as a (dotted) horizontal line at a positive zero interest rate, suggesting an economy at the zero nominal bound with deflation. Yes, the effectiveness of low interest rates waned as the zero bound was a approached. At this point, if the BoJ wanted to induce additional spending, they would need to make a credible commitment to a higher inflation target. In other words, the effectiveness of monetary policy did not fade unexpectedly - it is exactly what you would expect given the zero bound problem.

The second concern is that a low interest rate environment is hurting potential growth. This time, Shirakawa:

“If low interest rates induce investment projects that are only profitable at such interest rate levels, this could have an adverse impact on productivity and growth potential of the economy by making resource allocation inefficient. While central banks have typically conducted monetary policy by treating a potential growth rate as exogenously given, when the economy is under prolonged shocks arising from balance-sheet repair, we may have to take into account the risk that a continuation of low interest rates will affect the productivity of the overall economy and lower the potential growth rate endogenously.”

I don't think this makes any sense at all (neither does Harding). I could see a problem if low productivity projects are funded instead of high productivity projects, but presumably the latter would still be funded first in any event. In other words, I don't see that the low interest rate environment by itself would alter the composition of investment. And if we cut off funding for the less productive investments, the capital stock would grow more slowly, and that would certainly reduce potential growth. And note that this is separate from the worry that government investment is displacing private investment. Government investment is compensating for the lack of private investment. If anything, Japan needs lower real interest rates to support higher levels of private investment to lessen its dependence on fiscal deficits. And that too is another result of the zero bound problem.

The third concern is aptly handled by Harding:

Point three is the more standard argument that flattening the yield curve too far for too long will undermine the profitability of the financial sector.

Again, while I am sympathetic to the financial market consequences of low interest rate environments, the central bank is really just following the economy down. In the absence of sufficient economic activity to pull longer term rates up, if the Bank of Japan raised rates they would simply be inverting the yield curve - and I don't see that as positive for the financial sector.

The final concern is almost laughable:

“Even though such a rise in commodity prices is affected by globally accommodative monetary conditions, individual central banks recognise that the fluctuation in commodity prices is an exogenous supply shock and focus on core inflation rates which exclude the prices of energy-related items and food. The resulting reluctance of individual central banks to counter rising commodity prices, when aggregated globally, could further boost these prices. From a global perspective, such a situation represents nothing more than a case where a hypothetical “World Central Bank” fails to satisfy the Taylor principle, which ensures the stability of global headline inflation. While it is understandable that the central banks would pursue the stability of their own economies in the conduct of monetary policy, it is increasingly important to take into account the international spillovers and feedback effects on their own economies.”

First, Shirakawa is making the error of thinking the Federal Reserve targets core inflation. They do not, and they have made that clear. They target headline inflation, but use core-inflation as a guide as to the direction of headline inflation. Shirakawa implies that while core-inflation is tame, headline is running wild - and that simply is not true:


The path of headline inflation is actually on a lower trend compared to before the recession. Moreover, please explain how headline inflation is causing such a problem for the Bank of Japan:


Finally, as Harding notes, if you don't like US monetary policy, don't import it.
Bottom Line: I would be cautious about taking lessons from Shirakawa. The concerns about the low interest rate environment beg the still unanswered question: What is the alternative for monetary policy? To hike short term interest rates? It sounds like Shirakawas "concerns" are more excuses for an ongoing monetary policy failure on the part of the Bank of Japan.

Thursday, March 22, 2012

"The Macroeconomic Effects of FOMC Forward Guidance"

I've been trying to figure out whether the Fed's declaration that it would maintain exceptionally low rates through late 2014 represents a conditional or unconditional statement. That is, if the economy improves faster than expected, will the Fed raise rates prior to that time? Or will it honor this as a firm commitment that is independent of the actual evolution of the economy?

The statement clearly leaves wiggle room -- if the Fed wants out of the commitment the language is there. But I have the impression that the public views it as a firm, unconditional commitment and if the Fed backs away it will be seem as breaking a promise (i.e. lose credibility).

Apparently, I'm not the only one who is unsure about this. This is from Jeffrey R. Campbell, Charles L. Evans, Jonas D.M. Fisher, and Alejandro Justiniano (Charles Evans is the president of the Chicago Fed). They look at the effectiveness and viability of the two types of forward guidance, and conclude that a firm commitment with an escape clause specified as a specific rule (e.g. won't raise rates until until unemployment falls below 7% or inflation expectation rise above 3%) can work well:

Macroeconomic Effects of FOMC Forward Guidance, by Jeffrey R. Campbell, Charles L. Evans, Jonas D.M. Fisher, and Alejandro Justiniano, March 14, 2012, Conference Draft: 1 Introduction Since the onset of the financial crisis, Great Recession and modest recovery, the Federal Reserve has employed new language and tools to communicate the likely nature of future monetary policy accommodation. The most prominent developments have manifested themselves in the formal statement that follows each meeting of the Federal Open Market Committee (FOMC). In December 2008 it said "the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time." In March 2009, when the first round of large scale purchases of Treasury securities was announced, "extended period" replaced "some time." In the face of a modest recovery, the August 2011 FOMC statement gave specificity to "extended period" by anticipating exceptionally low rates "at least as long as mid-2013." The January 2012 FOMC statement lengthened the anticipated period of exceptionally low rates even further to "late 2014." These communications are referred to as forward guidance.
The nature of this most recent forward guidance is the subject of substantial debate. Is "late 2014" an unconditional promise to keep the funds rate at the zero lower bound (ZLB) beyond the time policy would normally involve raising the federal funds rate? ... Alternatively, is "late 2014" simply conditional guidance based upon the sluggish economic activity and low inflation expected through this period? ...
Our paper sheds light on these issues and the potential role of forward guidance in the current policy environment. Motivated by the competing interpretations of "late 2014," we distinguish between two kinds of forward guidance. Odyssean forward guidance changes private expectations by publicly committing the FOMC to future deviations from its underlying policy rule. Circumstances will tempt the FOMC to renege on these promises precisely because the policy rule describes its preferred behavior. Hence this kind of forward guidance resembles Odysseus commanding his sailors to tie him to the ship's mast so that he can enjoy the Sirens' music.
All other forward guidance is Delphic in the sense that it merely forecasts the future. Delphic forward guidance encompasses statements that describe only the economic outlook and typical monetary policy stance. Such forward guidance about the economic outlook influences expectations of future policy rates only by changing market participants views about likely outcomes of variables that enter the FOMC's policy rule. ...
The monetary policies elucidated by Krugman (1999), Eggertsson and Woodford (2003) and Werning (2012) rely on Odyssean forward guidance, and these have inspired several policy proposals for providing more accommodation at the ZLB. The more aggressive policy alternatives proposed include Evans's (2012) state-contingent price-level targeting, nominal income-targeting as advocated by Romer (2011), and conditional economic thresholds for exiting the ZLB proposed by Evans (2011). These proposals' benefits depend on the effectiveness of FOMC communications in influencing expectations. Fortunately, there exists historical precedent with which we can assess whether FOMC forward guidance has actually had an impact. The FOMC has been using forward guidance implicitly through speeches or explicitly through formal FOMC statements since at least the mid-1990s. Language of one form or another describing the expected future stance of policy has been a fixture of FOMC statement language since May 1999. The first part of this paper uses data from this period as well as from the crisis period to answer two key questions. Do markets listen? When they do listen, do they hear the oracle of Delphi forecasting the future or Odysseus binding himself to the mast?
Our examination of whether markets are listening to forward guidance builds on prior work... We find results that are similar to, if not even stronger than, those of Gurkaynak et al. (2005). That is, we confirm that during and after the crisis, FOMC statements have had significant affects on long term Treasuries and also corporate bonds and that these effects appear to be driven by forward guidance.
Studying federal funds futures rates during the day FOMC statements are released identifies forward guidance, but does not disentangle its Odyssean and Delphic components. ... To answer our second key question, we develop a framework for measuring forward guidance based on a traditional interest rate rule that identifies only Odyssean forward guidance. ... We highlight here two results. First, the FOMC telegraphs most of its deviations from the interest rate rule at least one quarter in advance. Second, the Odyssean forward guidance successfully signaled that monetary accommodation would be provided much more quickly than usual and taken back more quickly during the 2001 recession and its aftermath. Overall, our empirical work provides evidence that the public has at least some experience with Odyssean forward guidance, so the monetary policies that rely upon it should not appear entirely novel.
The second part of the present paper investigates the consequences the Odyssean forward put in place with the "late 2014" statement language. On the one hand this language resembles the policy recommendations of Eggertsson and Woodford (2003) and could be the right policy for an economy struggling to emerge from a liquidity trap. On the other hand there are legitimate concerns that this forward guidance places the FOMC's mandated price stability goal at risk. We consider the plausibility of these clashing views by forecasting the path of the economy with the present forward guidance and subjecting that forecast to two upside risks: higher inflation expectations and faster deleveraging. ...
Evans (2011) has proposed conditioning the FOMC's forward guidance on outcomes of unemployment and inflation expectations. His proposal involves the FOMC announcing specific conditions under which it will begin lifting its policy rate above zero: either unemployment falling below 7 percent or expected inflation over the medium term rising above 3 percent. We refer to this as the 7/3 threshold rule. It is designed to maintain low rates even as the economy begins expanding on its own (as prescribed by Eggertsson and Woodford (2003)), while providing safeguards against unexpected developments that may put the FOMCs price stability mandate in jeopardy. Our policy analysis suggests that such conditioning, if credible, could be helpful in limiting the inflationary consequences of a surge in aggregate demand arising from an early end to the post-crisis deleveraging.

Wednesday, March 21, 2012

Fed Watch: On Straw Men

Tim Duy:

On Straw Men, by Tim Duy: Arnold Kling claims I am using a straw man:

Recently, bloggers have been talking about potential output or potential GDP. I find the discussion to be frequently misleading. For example, Mark Thoma quotes Tim Duy:

If we claim the economic potential of the nation has declined - that in aggregate, we can not make as much stuff as we did a few years ago...

But nobody claims that. The pessimists on potential output only claim that it is growing below some previous trend. They never claim that it has declined in absolute terms.

I refer Kling to St. Louis Federal Reserve President James Bullard:

The wealth shock view puts a different expectation in play. The negative wealth shock lowers consumption and output. But after the recession ends, the economy simply grows from that point at an ordinary rate, neither faster nor slower than in ordinary times. It is more like an earthquake which has left one part of the land higher than another part. There is no expectation of a “bounce back” to a higher level of output after the recession ends. This is closer to what has actually happened since mid-2009. Output has grown at a moderate rate, but not a rapid rate, since the recession ended.

Read carefully: " an earthquake which has left one part of the land higher than another part." (Side note: I kind of like that simile). He is clearly saying that the 5% drop in output during the recession was a permanent shift. Unless you really believe that potential GDP was overestimated by 5% - in which case we would expect inflation to have been much higher than actually experienced - the only reasonable conclusion is that at least one person believes that in fact potential GDP declined in absolute terms during the recession.

Also refer to Grep Ip:

You don’t need to be a supply sider to believe that potential has fallen; you could equally worry that actual output has been depressed for so long, that hysteresis has set in and dragged potential down with it.

He proceeds with charts of GDP for Sweden and Korea, both of which reveal what are interpreted as downward shocks to the absolute level of potential output. And note, I don't ignore the possibility that Ip is in fact correct - the failure to respond with significant force to the recession may very well have allowed cyclical issues to fester into structural ones. And this is even more likely if Bullard's position is widely adopted by policymakers such that they actively manage the economy along the new trend. In such a case the hysteresis can be the result of a self-fulfilling prophesy. If we deliberately keep people unemployed, they will eventually become structurally unemployed or exit the workforce.

I don't in any way disagree that the rate of potential output growth may be slower than prior to the recession, thus estimates of the output gap might be lower than those currently available. But there is indeed another concern that there has been a negative shock to (long run) potential output in absolute terms.

Tuesday, March 20, 2012

Fed Watch: Fed Still Lowering Potential Output Growth Estimates?

Tim Duy:

Fed Still Lowering Potential Output Growth Estimates?, by Tim Duy: While financial market participants continued to sell Treasury bonds thinking that the Fed is out of the game, New York Federal Reserve President WIlliam Dudley gave no indication to suggest that either QE3 was off the table or just around the corner. Still, he was clearly concerned that the recovery is more fragile than the data would have us believe, suggesting that he would leap relatively quickly into additional easing if the economy faltered.

While Dudley certainly did not ignore the improved tenor of economic data in recent months,

The incoming data on the U.S. economy has been a bit more upbeat of late, suggesting that the recovery may be finally establishing a somewhat firmer footing.

he also suggested caution:

While these developments are certainly encouraging, it is far too soon to conclude that we are out of the woods. To begin with, the economic data looked brighter at this point in 2010 and again in 2011, only to fade as we got into the second and third quarters of those years.

In particular, he pointed to the moderate weather as a factor in the recent numbers:

Moreover, the United States has experienced unusually mild weather over the past few months, with the number of heating degree days in January and February about 17 percent below the average of the preceding five years. While this reduces the amount that households and businesses must spend for heating, I suspect that it temporarily boosts economic activity overall.

In the question and answer period (via the WSJ), Dudley commits to nothing but a data dependent policy:

Dudley was asked by an audience member what he expects will be the future path of interest rates. “We will continue to assess what’s appropriate” for monetary policy, he answered, saying “if the economy were to change in a meaningful way, obviously we’d change” the current plans for interest rates and other stimulus efforts.

Specifically on QE3, via Reuters:

"Nothing has been decided," he said of QE3, in which the Fed would make large-scale asset purchases in an attempt to lower rates and give the economy another controversial shot of adrenaline.

"It all depends on how the economy evolves," Dudley added. "It's about costs and benefits, and if we get to a point where we think the benefits of another program of QE outweigh the costs, then we'll certainly do so."

More interesting, in my view, were his comments on potential growth:

To put the recent pace of growth into perspective, we believe that the economy's long-run sustainable growth rate (what economists call the potential growth rate) is around a 2 1/4 percent annual rate. We need sustained growth above that rate to absorb the substantial amount of unused productive capacity. Thus, our recent growth rates are barely keeping up with our potential.

The 2.25% rate caught my eye, as it was slightly below the 2.3-2.6% range for longer term growth in the most recent Fed projections. And that itself was a downgrade from the 2.4-2.7% November projection.

At this point, it becomes a little tricky:

Although the sharp decline in the unemployment from 9 percent last September to 8.3 percent in February suggests we are doing better than that, it is important to recognize that about half of that decline was due to a declining labor force participation rate. In fact, had the labor force participation rate not declined from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.

So half the decline in the unemployment rate since last September was due to falling labor force participation, while the other half was the result of growth slightly above potential. GDP growth in the second half of last year averaged 2.4%, slightly above Dudley's estimate of potential GDP, and enough to bring down unemployment somewhat.

Looking back to what Dudley said last November:

After a very weak first half, when GDP growth was less than 1 percent, economic activity has strengthened somewhat and inflation pressures are starting to ease. Growth in the third quarter is currently estimated to be 2.5 percent, and recent indicators suggest growth in the fourth quarter could be somewhat higher...However, as we look toward 2012, the U.S. economy continues to face several obstacles to a robust recovery. Accordingly I expect growth of about 2.75 percent for 2012...One summary statistic says it all—the unemployment rate is unacceptably high at 9 percent. Given my outlook, the decline of unemployment over the next year is likely to be modest...To sum up, growth has picked up modestly in the second half of 2011, but not enough to bring unemployment down.

Last fall, Dudley thought that growth somewhat above 2.5% would not bring unemployment down, while 2.75% would only have modest impacts. That suggests an estimate of potential growth around 2.6-2.7%. Now we only need to cross the 2.25% mark to bring unemployment down. That is a fairly rapid adjustment, and not just due to slower labor force growth:

Also, it appears that productivity growth has slumped recently. Although that means that a given amount of growth translates into bigger employment gains, it certainly is not an unmitigated good development.

This isn't sounding so good - growth is weak, but the hurdle is lower. Does this mean that Dudley is less dovish than widely suspected? I don't think so. Another excerpt from Dudley's speech today:

More importantly, real economic activity has yet to be strong enough on a sustained basis to make a big dent in the overall amount of slack in the U.S. economy. While it is true that growth was stronger in the fourth quarter, most of that growth was due to inventory accumulation. Growth of final sales was actually quite weak. Historically, a quarter in which inventory investment makes a significant growth contribution is typically followed by a quarter in which that growth contribution is modest or even negative. That appears to be what is shaping up for the first quarter of this year.

This I find just plain irritating, as it sure sounds like he is saying that even though potential output growth has slowed, the existing gap remains unacceptably wide. If so, why is a policy change dependent on incoming data as he says in the Q and A? This is somewhat more amazing given his lack of faith in the quality of the recovery:

Based on available data, current expectations are that real GDP will expand at around a 2 percent annual rate during the first quarter of 2012. Despite the increase of light vehicle sales, overall consumer spending has been sluggish. While growth of retail sales in February was reasonably strong in nominal terms, it was considerably less impressive when the large increase of gasoline prices that occurred that month is taken into account. Based on data for the first half of March, gasoline prices are continuing to move higher which will further sap consumers' real purchasing power. And growth of business investment spending, which was quite strong in the second and third quarters of 2011, entered the new year with little forward momentum.

Not exactly a resounding endorsement of the economy. Sounds like he views the downside risks as the greater concern. But apparently not enough that the costs of additional easing (which I think amounts to the perception that QE is an inflationary nightmare waiting to happen) outweigh the benefits.

Bottom Line: Dudley presents a rather sober view of the US economy - signs of life are hopeful, but he isn't counting on their sustainability in any way, shape, or form. His estimate of potential output growth is falling, but the existing gap remains wide. The gap coupled with his obvious lack of enthusiasm for the quality of the recovery should point him in the direction of QE3 sooner than later. But there is nothing to suggest that such a move is imminent barring a deterioration of the data - he seems to make this clear in the Q&A. He seems ready to stick with the wait and see approach to policy, possibly because the declining potential growth rate makes him somewhat concerned the output gap could close faster than he would expect. But it sure doesn't sound like it would take too much disappointment in the days ahead to push him to support going back to the monetary well for another round of easing.

Monday, March 19, 2012

Fed Watch: The Output Gap Debate Continues

Tim Duy:

The Output Gap Debate Continues, by Tim Duy: The blogoshpere witnessed some additional contributions to the output gap debate this weekend. Greg Ip offers up the possibility that potential output, both level and trend, are much lower than previously imagined. Karl Smith responds with what I believe is an important point:

I’d, however, encourage everyone, as well, to think of the disaggregated story that we are telling here. If trend GDP is overstated, then we are arguing that one or more sectors of the US economy will is less capable of producing output over the next decade or so, than we would have otherwise thought.

Smith suggests we focus on the construction of housing, hospitals and medical facilities, public infrastructure, and transportation equipment. He concludes:

So, if we think these things will repair themselves then we have an obvious path back to trend.

and then extends:

I don’t want to get too invested in this but a cursory look at the data suggests that GDP is likely to grow above trend in the coming years because two very high productivity export sectors are expanding – computers and gasoline and distillates.

What I like in Smith is the more careful consideration of the structural change story. If we claim the economic potential of the nation has declined - that in aggregate, we can not make as much stuff as we did a few years ago - we need to identify what stuff isn't being made, why it isn't being made, why we don't think it should be made, and why no other sectors are growing to compensate for those in decline.

Mark Thoma makes an important contribution to the debate by identifying a short-run path for potential output:

Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, idle equipment, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.

Mark notes, however, that policy makers should not focus too intensely on short-run potential output because capacity will grow as the economy recovers. In other, don't confuse a temporary decline in potential with a permanent decline. Mark extends this to an explanation for relatively stable inflation during the recession.

That said, Ip does note that a permanent - or at least very persistent - drop in labor force participation rates could cause at least some downward shift in potential output, with a story that in aggregate we cannot make as much as before because we lack sufficient labor, although here too there should be sector specific impacts similar to Smith's critique (unless all sectors lost access to a more or less proportionate share of labor). And Ip also raises the somewhat different issue of the path of potential output going forward - a decline in both productivity and labor force growth implies a lower path forward, although would not explain a sharp drop in the past.

Finally, I find Felix Salmon's explanation for fall in potential GDP less compelling:

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt.

Then, suddenly, the growth of the credit markets screeched to a halt, and we had a major recession. And since then, the size of the credit market has been roughly flat.

It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly.

Salmon is telling a story about this chart (although he actually uses what I believe is a more difficult chart):


Smith responds by noting this is really a story about mortgage debt, with the first run-up being a natural consequence of the Volker Disinflation and the second being the housing bubble, which Smith views as largely an internal transfer of wealth.

My additional criticisms of Salmon approach is that is seems primarily a demand side story to a supply-side question. Presumably, all of the productive resources (or nearly all of them, allowing for some hysteresis effects) still exist. The debt is just plumbing in the background that helps support the demand for those resources. So Salmon's story just collapses down to an aggregate demand shortfall that really has nothing to do with potential output.

Moreover, Salmon ignores the assets on the other side of the debt. We really need to look at some story about net worth:


Here again I think you are fundamentally telling a demand side story to explain the past two business cycles - both were dependent on asset price bubbles to hold output at potential (or even slightly above at the peaks). Why did the US become dependent on these bubbles? Here I tend to find the global saving glut story compelling. A combination of aging developed economies combined with the high savings propensities of primarily Asian central banks has pushed the equilibrium real rate into negative territory, below that attainable given the zero bound and low inflation expectations. Absent an asset bubble to compensate by adding wealth-effect induced aggregate demand, we are left with a savings-investment imbalance that becomes evident as a subpar equilibrium level of output.

I still believe that primarily we are looking at an aggregate demand shortfall rather than a collapse of potential output, but would agree that only one thing is for sure: That we haven't seen the end of this debate.

Sunday, March 18, 2012

The Gap In Monetary and Fiscal Policy

One of the big questions for policymakers is how much of the current downturn represents of temporary cyclical fluctuation and how much of it is a permanent reduction in out productive capacity. If the downturn is mostly temporary, then we will eventually bounce back to the old output trend line. Something like this:


But if it's mostly permanent, i.e. if the trend has fallen to a lower value and will stay there, then the picture is different:


In the first case, highly stimulative policy is appropriate to help the economy get back to the long-run trend as soon as possible. There's still a lot of ground to cover, and policy can help. But in the second case the economy is already back to it's long-run trend at most points in time, or nearly so, and there is no need for policymakers to do much of anything at all. At least that's what we're told.

However, I think this misses part of the story. What it misses is that AS shocks themselves can be both permanent and temporary, and some people may be confusing one for the other. For example, when there as a large AD shock in the form of a change in preferences, say that people no longer like good A as it has gone out of fashion and have now decided B is the must have good, then there will be high unemployment in industry A and excess demand for labor and other resources in industry B. As workers and resources leave industry A, our productive capacity falls and it stays lower until the workers and other resources eventually find their way into industry B. When this process is complete, productive capacity returns to where it was before, or perhaps goes even higher. Thus, there is a short-run cycle in productive capacity that mirrors the business cycle.

Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, idle equipment, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.

The point is that there can be short-run cyclical AS effects, and failing to account for these can lead to policy errors. Consider the following diagram:


Up until the point where the line splits into three pieces, assume the economy is in long-run equilibrium with output at the natural rate (we can discuss whether the natural rate actually exists another time, I want to work in the standard model for the moment since that is where the policy discussion is centered). Then, for some reason, aggregate demand falls leading the economy into a recession. As AD falls, people are laid off, equipment is stored, factories are shuttered, and so on and the economy's capacity to produce falls in the short-run as shown by the blue line on the diagram.

But this is a temporary, not a permanent situation. Eventually people will be put back to work, trucks in parking lots will be back on the road, factories will reopen -- you get the picture -- and productive capacity will grow as the economy recovers. I believe many people are treating what is ultimately a temporary fall in capacity as a permanent change, and they are making the wrong policy recommendations as a result.

In fact, there's no reason to think productive capacity can't return to its long-run trend just as fast or faster than output can recover. If so, then it would be a mistake to do as many are doing presently and treat the blue short-run y* line as a constraint for policy, conclude that the gap is small and hence there's nothing for policy to do. Capacity will recover, and policymakers must take this into account when looking at whether additional policy can help the economy. If capacity can grow fast as the economy recovers, then it poses little constraint and policymakers should try to return us to the long-run trend as soon as possible. That is, aggressive policy is still called for even if productive capacity is presently relatively low.

And even if the economy can recover faster than productive capacity can return to its long-run trend, i.e. actual output can "catch" the blue line before it reaches the dotted long-run y* line, it would still be wrong for policymakers to treat the value of productive capacity today is a constraint. Since short-run y* is cycling back to trend, and since it takes time for policy to work, policymakers are shooting at a moving target (a target that might move even faster with effective stimulus). And in any case, there's nothing wrong with catching short-run y* as soon as possible -- in fact that's desirable.

The fear, of course, is that once the economy catches short-run y*, trying to push beyond that constraint would be inflationary. Some argue we are close to that situation already, and additional policy could well cause prices to increase, but I just can't see significant inflation risks at the present time, in part because of my differing views on where the recovery of capacity.

Finally, the discussion about inflation brings up another point. One of the puzzles in the macroeconomic literature about business cycles is that prices don't move anywhere near as much as a gap analysis implies they should. But the gap used in this analysis of often the distance between long-run potential output and actual output (i.e. the difference between the dotted line and the solid black line in figure 1 or figure 3). But if price pressure depends upon the gap between short-run capacity and actual output (the blue and black lines), as you would expect it would, and if output and short-run capacity co-vary positively after a shock (I gave reasons above why this could happen), then the gap and hence prices could be relatively constant throughout the cycle. The gap between the blue and black lines doesn't change much and hence inflation doesn't change much either.

One last point about the diagram. I drew the long-run line so there is a long-run decline in the trend of our productive capacity after the recession (i.e. a permanent shock). However, it's hard to see because, consistent with my beliefs, I do not think the change in our long-run capacity to produce goods and services will be as negative as many others. So the effect is not large in the diagram (I acknowledge I'm more optimistic on this point than many others that I respect). But even if the long-run trend had fallen by more than shown in the diagram, say by 50%, the points above would still hold. If the capacity to produce recovers as the economy recovers, and does so relatively fast, then policymakers should not be constrained by the belief that the natural rate of output is relatively low at the present time. Aggressive policy is still the best course of action.

Thursday, March 15, 2012

Testing the Inflation "Floodgates"

Simon Wren-Lewis on fear of inflation:

The inflation floodgates, mainly macro: Mark Thoma bemoans the attitude of inflation hawks on the FOMC (the US equivalent of the Bank’s Monetary Policy Committee). He writes “Unfortunately, the hawks on the committee seem to be afraid that if they allow inflation to creep up even a little bit over their long-run target, the inflation flood gates will open and they won’t be able to help themselves from a repeat of the 1970s.” From this profile by Roger Lowenstein, the floodgates view may not be confined to the hawks (HT Karl Smith). It occurred to me that we have just had a little experiment in the UK to test this floodgates view, and it looks like being completely rejected. ...[continue reading]...

Robert Waldmann also comments.

Wednesday, March 14, 2012

Fed Watch: FOMC Recap

Tim Duy:

FOMC Recap, by Tim Duy: The FOMC met today, and delivered the widely expected result of no policy shift. Wait and see mode continues. Arguably, the statement has a slightly hawkish tinge compared to the January statement in that it recognizes the improve flow of data and reduced financial strains. Most of the action is in the second paragraph. The growth/employment sentence (perhaps we should call this the Okun's Law sentence?) from January:

The Committee expects economic growth over coming quarters to be modest and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate.

morphed into:

The Committee expects moderate economic growth over coming quarters and consequently anticipates that the unemployment rate will decline gradually toward levels that the Committee judges to be consistent with its dual mandate.

"Modest" growth became the more optimistic "moderate" growth, suggesting some more certainty in the outlook, downgrades to Q1 forecasts notwithstanding. Also, the modifier "only" before "gradually" disappeared - a very slight positive shift. Fears of a European collapse shifted from:

Strains in global financial markets continue to pose significant downside risks to the economic outlook.


Strains in global financial markets have eased, though they continue to pose significant downside risks to the economic outlook.

I find this sentence interesting given the relative calm in financial markets, both here and across the Atlantic. The Fed, it appears, is less confident than their European counterparts that the crisis has been brought to a halt once and for all. Finally, the inflation outlook, which was:

The Committee also anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate.


The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.

The Fed did recognize the impending rise in headline inflation, but wisely emphasized its temporary nature and thus reaffirmed their view that inflation would remain contained. This is also reiterated in the first paragraph where they noted stable inflation expectations. We will see headline inflation rise, but no need to panic. Nothing to see here, move along.

I see this statement as a double-edged sword. On one hand, the improved economic outlook argues against additional easing. Unless the unemployment rate starts trending sideways or inflation takes a downward turn, it is hard to see the Fed advancing with plans for additional easing. That said, they are making an effort not to suggest a tightening is imminent. They do not overemphasize the improvements in recent data, nor do they suggest that energy prices should be a concern. And, despite Richmond Federal Reserve President Jeffrey Lacker's objection, they did not retreat from their expectation that rates will remain low though at least late 2014. This is important, as a commitment to low rates would have more of an effect when there exists upward pressure on interest rates, as opposed to being simply another confirmation that the economy is operating at a decidedly sub-par equilibrium. Moreover, they telegraphed that additional easing is still a possibility, indicating that tightening is not the only game in town. Perhaps they have learned a lesson from last year's turn toward hawkishness in the spring.

Bottom Line: The Fed isn't ready to ease further, but isn't ready to tighten either. If you are looking for the Fed to leverage the current momentum with another blast of easing in an effort to lift us well clear of the lower bound, you are likely to remain disappointed. But at least you can find some comfort, however small, in their obvious effort to make clear they remain far from taking a more hawkish turn anytime soon.