Category Archive for: Monetary Policy [Return to Main]

Thursday, June 07, 2012

Bernanke's Disappointing Testimony

Two posts on Bernanke's testimony, one from me and one from Tim Duy. First, I posted this at CBS (the editors wanted this one to be more news than commentary, so I held back on saying how disappointed I was in the outcome -- but I did try to make it clear anyway, or at least hint in that direction -- Tim has this covered):

Ben Bernanke: No change in policy unless conditions deteriorate further, by Mark Thoma: Federal Reserve Chairman Ben Bernanke said today that the risks to the economy have increased, and the Fed is prepared to take action if conditions deteriorate. But in his testimony before the Congressional Joint Economic Committee there was no indication that the Fed is prepared to alter policy at this point.
Expectations that the Federal Reserve might ease policy were raised this week when three regional bank presidents, John Williams of San Francisco, Dennis Lockhart of Atlanta, and Eric Rosengren of Boston all seemed to indicate a willingness to consider further easing. Remarks by Federal reserve governor Janet Yellen also encouraged speculation that Bernanke might hint at a change in policy at the next monetary policy meeting.
But with Bernanke's testimony, expectations that the Fed will change course soon have been all but eliminated. Instead, the Fed will stay in "wait and see" mode on the belief that its policy stance is already highly accommodative, and further easing is only called for if the economy begins to show signs of weakening further, or turns downward. In particular, the Fed fears deflation above all else, and any sign that inflationary expectations are plunging would likely motivate the Fed to action.
But for now the Fed believes it has done enough despite that fact that a large number of economists outside the Fed are urging immediate action to help the recovery along, and more importantly to ensure against future problems in Europe or a spike in oil prices. There is lag between the time the Fed alters policy and when it affects the economy, and the wait and see approach is risky in that it can cause the Fed to end up behind the curve. Nevertheless, the Fed feels the risks of acting now, in particular the risk of inflation, trumps fears about present and future economic growth.
Chairman Bernanke also discussed fiscal policy in his testimony, and urged lawmakers to put the budget deficit on a long-run sustainable path without "unnecessarily impeding the current economic recovery." He cited the fiscal cliff as an immediate concern, and he is clearly worried about the impact on the economy if there is a large reduction in the federal deficit while the economy is struggling to recover. The Fed chief indicated they would very much appreciate help from lawmakers in the short-run, he mentions infrastructure spending frequently when discussing this topic, as well as in the long-run. Like most mainstream economists, he is calling for more stimulus in the short-run, or at least no reduction in what is already being done, and a plan for a sustainable long-run budget. Whether Congress can deliver or not is an open question, stimulus in the short-run is surely a long shot given the political gridlock that currently exists in Congress, and the long-run brings a high degree of uncertainty as well. But however this turns out, as Bernanke notes it will have consequences for monetary policy and the Fed would feel more confident in its own abilities with more support from Congress.
The main message from Bernanke's testimony is that while the Fed is aware that the risks to the economic outlook have increased, it is not yet convinced that current troubles are anything more than a bump in the road, and worries about the future are not enough to motivate action. That may change if conditions deteriorate, but like the Fed we will just have to "wait and see."

Next, Tim Duy:

Federal Reserve Chairman Ben Bernanke did not deliver another Jackson Hole speech in today's testimony to the Senate. Instead, he stuck to his usual style of delivering just the facts, or at least his version of the facts, and letting us pick apart the implications for monetary policy. On on critical issue, the jobs report, he takes both sides of the debate:

This apparent slowing in the labor market may have been exaggerated by issues related to seasonal adjustment and the unusually warm weather this past winter. But it may also be the case that the larger gains seen late last year and early this year were associated with some catch-up in hiring on the part of employers who had pared their workforces aggressively during and just after the recession. If so, the deceleration in employment in recent months may indicate that this catch-up has largely been completed, and, consequently, that more-rapid gains in economic activity will be required to achieve significant further improvement in labor market conditions.

On net, I think Bernanke would like to see more data before he committed to further easing, which would push additional action into later this summer or early fall. The near-term path of fiscal policy is also weighing on his mind:

Another factor likely to weigh on the U.S. recovery is the drag being exerted by fiscal policy. Reflecting ongoing budgetary pressures, real spending by state and local governments has continued to decline. Real federal government spending has also declined, on net, since the third quarter of last year, and the future course of federal fiscal policies remains quite uncertain, as I will discuss shortly

He later covers much of the previous ground on fiscal spending - maintain short-run stimulus while defining a path to longer-term consolidation. Overall, though, the fiscal cliff is also an issue that does not need immediate attention.

As an aside, note that Bernanke's repeated warnings about the fiscal cliff imply something interesting about his views on the limits to monetary policy. Specifically, he does not think the Federal Reserve can offset entirely the negative impact of the cliff. If the Fed could offset the impact, then why worry about it? After all, the fiscal cliff does put the federal budget back on a sustainable path. He should just embrace the cliff and let the Fed compensate with additional easing. That is, of course, unless he thinks the Fed is really at the end of its rope.

The only real hint that easier policy is imminent is his concern about Europe:

Nevertheless, the situation in Europe poses significant risks to the U.S. financial system and economy and must be monitored closely. As always, the Federal Reserve remains prepared to take action as needed to protect the U.S. financial system and economy in the event that financial stresses escalate.

The question is if he sees the risks tilted to the downside, the view of his colleague Vice Chair Janet Yellen. If there is anything that will drive immediate action, it is the European risk. In the absence of that never ending crisis, he would treat the labor report as a wait-and-see issue. But if that situation continues to deteriorate and roil US markets over the next two weeks, additional action seems likely. But of what form? Guidance, twist, or purchases? That still remains an open question.

The most disappointing part of the speech was his thoughts on inflation expectations:

Longer-term inflation expectations have, indeed, been quite well anchored, according to surveys of households and economic forecasters and as derived from financial market information. For example, the five-year-forward measure of inflation compensation derived from yields on nominal and inflation-protected Treasury securities suggests that inflation expectations among investors have changed little, on net, since last fall and are lower than a year ago.

Bernanke doesn't appear to see that the inability to hold market-based inflation expectations at a consistent level as a problem:


What's wrong with this picture? Notice the volatility of expectations after the recession (Ryan Avent has made this point as well). The Fed claims to have some mythical "credibility," but it certainly isn't evident in this graph. If anything, it is clear that the Fed has failed miserably in establishing credible expectations for either 2 percent or stable inflation. Instead, what they have created is very unstable expectations because of start-stop policy. It is almost ludicrous to place so much blame on Congress for the unstable fiscal picture when they themselves are creating an unstable financial and economic environment.

The source of instability is the Fed's insistence on putting a time limit on every policy. When the US economy was operating above the zero bound, the Federal Reserve would never issue a statement to the effect of "We instruct the New York open-market operations desk to target the federal funds rate at 3.75% for a period of six months." Of course, that would be silly. It would create too many discrete points in the policymaking process that are devoid of macroeconomic context. But that is exactly what the Federal Reserve does now - effectively setting policy to have an end date without a clear expectation of why that end date is important.

And it isn't important. It is just arbitrary. The Federal Reserve would have been better off to buy a set quantity of assets every week, adjusting that number as they might the interest rate, until certain macroeconomic objectives are met. This would let the expectations channel shoulder some of the work by laying out a clear path for monetary policy. Moreover, they would probably need to buy fewer assets overall. Instead, now we have policy scheduled to end discretely in the absence of the consideration of the macroeconomic backdrop, thus disrupting the expectations channel because market participants don't know what will trigger continuation of the policy. It simply isn't the way to manage the monetary affairs of the nation.

Bottom Line: Bernanke gives few hints. I think he would let the data play itself out a bit more before changing the current policy path. But the European crisis is throwing that wrench in his plans. And if market turmoil persists, and risks remain tilted to the downside, then more easing is coming.

Ben Bernanke: No change in policy unless conditions deteriorate further

Fed Watch: Yellen Gives a Green Light

Tim Duy:

Yellen Gives a Green Light, by Tim Duy: Quick one tonight. After a succession of Fed speakers pouring cold water on the idea of further easing, Federal Reserve Vice Chair Janet Yellen opened the door for additional easing at the next FOMC meeting. Perhaps I have simply been too pessimistic in my concern that we would need to wait until later this summer. Yellen gets to the point quickly, at the end of the second paragraph:

As always, considerable uncertainty attends the outlook for both growth and inflation; events could prove either more positive or negative than what I see as the most likely outcome. That said, as I will explain, I consider the balance of risks to be tilted toward a weaker economy.

A tilt in the balance of risks to the weaker side argues for easier policy. On the labor market:

Smoothing through these fluctuations, the average pace of job creation for the year to date, as well as recent unemployment benefit claims data and other indicators, appear to be consistent with an economy expanding at only a moderate rate, close to its potential.

Obviously, we need better than potential to close the output gap - a gap that Yellen believes to exist. She clearly believes the dominant problems are cyclical, not structural. Still, she recognizes that cyclical unemployment can become structural if leftunattended. Again, a reason for additional stimulus. She identifies housing, the fiscal cliff, and Europe as actual and potential drags on US economic activity. And she dismisses the idea that a large output gap is inconsistent with current inflation:

...substantial cross-country evidence suggests that, in low-inflation environments, inflation is notably less responsive to downward pressure from labor market slack than it is when inflation is elevated. In other words, the short-run Phillips curve may flatten out. One important reason for this non-linearity, in my view, is downward nominal wage rigidity--that is, the reluctance or inability of many firms to cut nominal wages.

Europe is clearly on her mind:

The deterioration of financial conditions in Europe of late, coupled with notable declines in global equity markets, also serve as a reminder that highly destabilizing outcomes cannot be ruled out.

One might think that the inner chamber at the Federal Reserve thinks their European counterparts are clueless. And they would be right. I am not impressed by this paragraph:

Of course, much of this revision in interest rate projections would likely have occurred in the absence of explicit forward guidance; given the deterioration in projections of real activity due to the unanticipated persistence of headwinds, and the continued subdued outlook for inflation, forecasters would naturally have anticipated a greater need for the FOMC to provide continued monetary accommodation. However, I believe the changes over time in the language of the FOMC statement, coupled with information provided by Chairman Bernanke and others in speeches and congressional testimony, helped the public understand better the Committee's likely policy response given the slower-than-expected economic recovery. As a result, forecasters and market participants appear to have marked down their expectations for future short-term interest rates by more than they otherwise would have, thereby putting additional downward pressure on long-term interest rates, improving broader financial conditions, and lending support to aggregate demand.

In some sense, this is right - market participants expect that economic conditions will be such that the Fed will need to keep interest rate low for a long time. But the Fed should not be content with low rates. If policy was effective, longer term interest rates would rise in expectation of eventual Fed tightening. The collapse of rates - again - is an indication that the Fed needs to be doing much, much more. And Yellen is a dove! Note also that although expectations of additional easing seemed to set a fire underneath Wall Street today, 10-year Treasury yields gained a meager 6bp. Credit markets are not easily impressed.

Yellen concludes that the Fed has room to do more - should they want to:

If the Committee were to judge that the recovery is unlikely to proceed at a satisfactory pace (for example, that the forecast entails little or no improvement in the labor market over the next few years), or that the downside risks to the outlook had become sufficiently great, or that inflation appeared to be in danger of declining notably below its 2 percent objective, I am convinced that scope remains for the FOMC to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions.

Bottom Line: Of course, Yellen is just one of the committee, but an important one. And I think she would be perfectly happy to ease in this environment. The risks tilting to the downside are key. The twist is that she opened the door for additional easing via forward guidance. Market participants are really looking for something bolder, on the order of QE3. And I don't think an extension of Operation Twist will do the trick. That has a short half-life given the Fed's dwindling stock of short-term securities. One more caveat: Yellen, I believe, would have supported easier policy before now. What really matters is Federal Reserve Chairman Ben Bernanke. Tomorrow we learn if he follows Yellen and gives a green light for further easing.

Tuesday, June 05, 2012

Fed Watch: More Cold Water

One more from Tim Duy:

More Cold Water, by Tim Duy: This is an extension of my last post. I see St. Louis Federal Reserve President James Bullard also spoke today, and downplayed the employment report:

The recent nonfarm payrolls report was disappointing, but not enough to substantially alter the contours of the U.S. outlook.

He suggested seasonal distortions are at work - although, if they are at work, it means that the gains we saw earlier were outsized. In other words, once again, expectations for high growth were excessive - which should suggest to Bullard that his earlier concerns that tightening would occur sooner than 2014 were misplaced. He later makes this interesting comment after reviewing the path of Treasury yields:

One possible FOMC strategy is to simply pocket the lower yields and continue to wait-and-see on the U.S. economic outlook.

He doesn't really appreciate the negative signal currently sent by global interest rates. I don't think the US needs lower rates at the moment, what it needs is policy that actually induces higher rates in response to an improving economic environment. I imagine that, since Bullard believes the economy is operating at potential output, he might think lower rates are helpful as they would be consistent with easing some resource constraint, but I interpret the lower rates as evidence of being well below potential output.

Moreover, Bullard continues to believe that monetary policy is easy:

Current policy is already very easy, as the policy rate remains near zero and the balance sheet remains large.

If policy was easy, market participants would expect the Fed to raise interest rates sooner, and thus longer term yields would rise. If anything, the fall in rates implies that the Fed will need to keep interest rates low for a longer period. Policy is not easy.

Bullard also dismisses financial market distress as an artifact of the European crisis:

The global problems are clearly being driven by continued turmoil in Europe.

China might be a bigger driver than we realize, but I digress. Given that this is a European problem, the Fed is helpless:

A change in U.S. monetary policy at this juncture will not alter the situation in Europe.

This is one of those things that makes you shake your head in the wonder of it all. The point of further easing would not be to alter the situation in Europe - THE POINT IS TO PREVENT THE SITUATION IN EUROPE FROM WASHING UP ON US SHORES. You know, offer a counterweight to softer demand Moreover, if easier policy induces a weaker Dollar which then in turn prompts easier policy at the ECB (one can can dream), then the Fed is in fact altering the situation in Europe. So US monetary policy might, just might, have an important role even if the proximate cause of the distress is in Europe.

Bottom Line: Bullard downplayed the employment report adn doesn't sound like he wants additional easing. Like the stance of his colleague Dallas Federal Reserve President Richard Fisher, not a surprise. This kinds of comments keep me on edge that the pace of policy change will be slower than market participants believe. But again, this is an issue of how far the regional bank presidents are behind the policy curve. They could be close, they could be far. We will get a better idea in the back half of this week.

Fed Watch: Cold Water on QE3?

Tim Duy:

Cold Water on QE3?, by Tim Duy: I am supposed to be working on a fifty-minute presentation on the global economy, but am struggling to wrap my mind around all the moving pieces at this time. It would be easier if I had two or three hours. So, in the meantime, I choose to procrastinate with a little Fed-watching.

It seems that market participants are looking for the Fed to ride to the rescue with another round of quantitative easing. I doubt that conditions are dire enough to deliver that outcome at the next meeting, but could easily see a European-driven deterioration in financial markets driving such an outcome. A lot could hinge on tomorrow's ECB meeting - they really need to cut rates to at least sustain some expectation channel. Consensus view, however, is no policy change. From the Wall Street Journal:

Although a rate cut this week can't be ruled out entirely, the central bank is likely to hold off this time while potentially starting to prepare the ground for a rate cut at its next meeting in July or later.

Behind the curve, per usual. I think no action is going to be a significant disappointment, so I am hoping to be surprised. Quite honestly, doing nothing is really almost impossible to imagine as it would represent complete and total failure on the part of the ECB. Still, I don't put it past them.

We have a couple of new comments in the wake of last week's disappointing jobs report. One from a credible policymaker, via the Wall Street Journal:

"I'd have to see a substantial change in my outlook" to be convinced the Fed should do more, Ms. Pianalto, 57 years old, said Friday, in the second of two exclusive interviews with The Wall Street Journal over consecutive days. "I don't think this employment report, in and of itself, is likely to lead to a substantial change in my outlook. Consequently, it would not lead me, at this time, given what I know about my outlook, to change my position on policy." It was her first interview with a national news outlet in her 10 years as a regional Fed chief.

Sounds like middle-ground contentment with current policy. I don't think Cleveland Federal Reserve Bank President Sandra Pianalto would say something that was not broadly consistent with the dominate view with in the Fed. That said, there is some wiggle room here. The current baseline is for Operation Twist to come to an end. Arguably, not continuing the program could be seen as doing less, while continuing is just maintaining the status quo. Indeed, extending Operation Twist is the path of least resistance for policymakers should they want to act.

Turning to less-credible policymakers, we also got comments from Dallas Federal Reserve President Richard Fisher. Via Reuters:

Asked directly whether the May jobs report could prompt the central bank to embark on a third round of quantitative easing, or QE3, Fisher said the Fed must be careful not to overreact to economic data. "Short of an implosion, I cannot support further quantitative easing," he said.

No surprise here, but I would say that Fisher's confidence is waning. He can't support further easing, but doesn't say it will not happen. This is less certain than his comments earlier this year that QE3 is a "fantasy."

More important guidance is still coming. Pianalto's message might be consistent with the last FOMC meeting, but we have frequently seen the regional presidents fall behind the thinking at the Board of Governors. Tomorrow night we get some insight into the Board with a speech by Vice-Chair Janet Yellen, followed on Thursday with Senate testimony by the Chairman Ben Bernanke. These are really the speeches to watch, and both will have to tread carefully. Considering the relative fragility of financial markets, they will not want to send mixed signals going into this next meeting.

Bottom Line: Arguably, Pianalto and Fisher threw cold water on the idea of further action. The former voice is credible, but could easily be behind the curve. The latter voice is simply not credible. More important signals should come latter this week. If Yellen and/or Bernanke (I suspect they will coordinate) follow in Pianalto's footsteps and downplays the jobs report, the expectation should be for steady policy later this month. But if Yellen/Bernanke embrace the report, we should anticipate an extension of Operation Twist at a minimum.

Saturday, June 02, 2012

Catastrophic Credibility

Paul Krugman today:

Catastrophic Credibility, by Paul Krugman: A little while ago Ben Bernanke responded to suggestions that the Fed needed to do more — in particular, that it should raise the inflation target — by insisting that this would undermine the institution’s “hard-won credibility”. May I say that what recent events in Europe, and to some extent in the US, really suggest is that central banks have too much credibility? Or more accurately, their credibility as inflation-haters is very clear, while their willingness to tolerate even as much inflation as they say they want, let alone take some risks with inflation to rescue the real economy, is very much in doubt. ...

I took this up in a recent column:

Breaking through the Inflation Ceiling: 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 percent 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 percent 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?
An abundance of credibility allows the Fed to bring the inflation rate down from, for example, 5 percent to 2 percent at minimal cost to the economy. It also makes it less likely that inflation will become a problem in the first place, because high credibility makes long-run inflation expectations less sensitive to temporary spells of inflation. So maintaining high credibility has substantial benefits.
Does this mean the Fed should do its best to keep the inflation rate at 2 percent?
Sticking to a 2 percent target independent of circumstances is not optimal. There are times, such as now, when allowing the inflation rate to drift above target would help the economy. Higher inflation during a recession encourages consumers and businesses to spend cash instead of sitting on it, it reduces the burden of pre-existing debt, and it can have favorable effects on our trade with other countries.  
If inflation begins to rise before the recovery is complete the Fed could, for example, announce that it is willing to allow the inflation rate to stay above target temporarily in the interest of helping the economy. But once unemployment hits a pre-set rate, for example 6.25 percent,  or core inflation rises above some predetermined threshold, for example,  5 percent, then, and only then, will the Fed step in and take action. And it should leave no doubt at all about its commitment to step in if either condition is met.
But there is a tradeoff to consider. Allowing a temporary spell of higher inflation during the recovery does pose some risk to the Fed’s credibility. I think the risk is small precisely because the Fed has been so careful to establish its inflation fighting credibility in the past. And the risk is even smaller with the 5 percent limit on the Fed’s tolerance for inflation described above. But the risk is there.
When the economy is near full employment, the tradeoff between the risk to credibility and the prospect for a faster recovery is unattractive. There’s little room to stimulate the economy and hence little room to benefit from a higher inflation rate. And the loss of credibility is potentially large because creating inflation in such a circumstance – when the economy is already growing robustly – would be viewed as irresponsible. Thus, the tradeoff is negative overall.
But when there is considerable room for the economy to expand, as there is now, the potential benefits from the increase in employment  that this policy is likely to bring about are much larger. Why the Fed places so little weight on these benefits when unemployment remains so high is a mystery.
In comparison to the risks to credibility, which are smaller than they are near full employment, the benefits are large and the tradeoff is positive rather than negative. There does come a point when the tradeoff is negative again – hence the 6.25 percent unemployment and 5 percent inflation triggers described above – but in the interim we should be willing to allow modestly higher inflation. I have no doubt that, once the economy has finally recovered, the Fed will ensure that the inflation rate is near its target value, so long-run credibility is not at risk.
If inflation begins to rise before the economy has fully recovered, the Fed shouldn’t react as though its world is coming to an end and immediately begin reversing its stimulus efforts. The resulting increase in interest rates would make the recovery even slower. In fact, given the net benefits that more inflation would provide right now, the Fed should try to raise the inflation rate through additional stimulus programs.
Unfortunately, the Fed has made it abundantly clear that’s not going to happen. But at the very least the Fed should continue its present attempts to help the economy, even if that means a temporary increase in the inflation rate.

Friday, June 01, 2012

Will the weak employment report prompt action from policymakers?

Here's a quick reaction to today's employment report:

Will the weak employment report prompt action from policymakers?

It won't, but it should.

Monday, May 28, 2012

Plosser on the Risks from Europe

Philadelphia Fed president Charles Plosser on the risks from Europe:

Q&A: Philadelphia Fed President Charles Plosser, by Brian Blackstone, WSJ: On whether Europe could have a significant effect on the U.S. economy:
Plosser: Europe is clearly near recession. That impacts the U.S. in part through trade ... but Europe is not our largest trading partner at the end of the day. The thing that people really worry about is you have some financial implosion in Europe and markets freeze up and you have some serious financial disruptions.
There are several ways this could go. At one level the U.S. has been trying to insulate itself from that risk. The Fed and regulators have tried to stress to money market funds, for example, to reduce their exposure to European financial institutions. So on a pure exposure basis I would say U.S. financial institutions are taking the steps they need to ensure that ... financial distress in Europe it doesn’t necessarily lead to distress for them...
People have made the analogy that an implosion in Europe would be a Lehman Brothers-type event. It might be a Lehman Brothers-kind of event for Europe. And if the market is sort of indiscriminate in whom they withdraw funding to, you could have indiscriminate funding restrictions on U.S. institutions just because everybody’s scared.
There’s another scenario that is exactly the opposite. There might be–and you already see some of this–a flight to safety. So rather than the markets freezing access to short-term funding for U.S. institutions, you could have a flood of liquidity that gets withdrawn from European institutions ... and floods into the United States. That’s exactly the opposite problem.
On which scenario is more likely:
Plosser: I don’t have the answer to that. ... I don’t think a flood of liquidity is a huge problem. That would be manageable. The bigger problem is if it dries up for everybody. The Fed still has the tools it used during the crisis. ... So I think we have the tools at our disposal if they become necessary. ...

Thus, he thinks the Fed can handle whatever comes its way, and hence sees no need to alter his forecast:

On his economic forecasts:
Plosser: I’m still looking for 2.5% to 3% growth over the course of this year. I think the unemployment rate is going to continue to drift downward to 7.8% by the end of this year. I would think for 2013 we’ll see similar developments. As long as that’s continuing then I don’t see the case for ever increasing degree of accommodation.

Since he believes output will grow no matter what happens in Europe, inflation is the biggest risk:

On inflation:
Plosser: I think headline will drift down just because of oil and gasoline. It will be interesting to see what happens with the core. The inflation risk we have is longer term. The problem is that as the U.S. economy grows we have provided substantial amounts of accommodation. We have $1.5 trillion in excess reserves. Inflation is going to occur when those excess reserves start flowing into the economy. When that begins to happen we’ll have to restrain it somehow. The challenge for the Fed is will we act quickly enough or aggressively enough to prevent that from happening.
It may be a challenge politically when we have to start selling assets, particularly if we have to start selling (mortgage backed securities) to shrink the balance sheet and to prevent those reserves from becoming money.

My view is different. I'm more worried about output and employment being affected by events in Europe than he is, and less worried about long-run risks from inflation (both the chance that it will happen and the consequences if it does). So I see a far greater need for policymakers -- monetary and fiscal -- to take action now as insurance against potential problems down the road.

It is interesting, however, that he sees the political risk as the primary challenge  for controlling inflation for a supposedly independent Fed, especially since several Fed presidents recently assured us that politics plays no role whatsoever in the Fed's decision making process (I also wonder why he didn't mention raising the amount paid on reserves as a way of keeping reserves in the banks).

Finally, I'm glad he said "I don’t see the case for ever increasing degree of accommodation," rather than saying he thought we needed to begin reducing accommodation. We may not get any further easing, but perhaps there's a chance we can keep what we have, at least for now.

Saturday, May 26, 2012

"We Need a Hegemon Who Won't Drive Us Crazy..."

Tyler Cowen is pessimistic:

We may be entering a new world where international cooperative arrangements, in environmental areas as well as finance, are commonly recognized as impossible.  If the core European nations cannot coordinate effectively, what can we expect in dealings with China, Russia and other countries that have less of a common background and understanding?

What is the answer?:

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences.

Which reminds me of something Brad DeLong wrote awhile back:

We Need a Hegemon Who Won't Drive Us Crazy...: ...monetary policy is and always has been about supporting asset prices at a level that allows firms that ought to be expanding to obtain finance and expand profitably. And ever since 1825 the central bank has done this by, whenever it needs to, taking long-duration and risky assets into its own portfolio--and thus off of the stock that must be held by the private sector whose risk tolerance has collapsed. Given that there are going to be sudden shocks to risk and duration tolerance on the part of global investors, we need a global institution to provide support for asset prices in an emergency: a global lender of last resort.
That lender of last resort needs two things if it is to function. First, it needs to be able to "print money"--to have its own liabilities be and be perceived to be the safest assets in the world so that when it borrows it calms markets by giving them more of the high-quality short-duration low-risk paper for which they suddenly have such a great craving. Second, it needs to know what it is buying--to have sufficient regulatory oversight and control over global finance to be able to limit the growth of potentially toxic assets beforehand and then to understand what prices it should offer when it does decide that it is time to support the market.
As my old teacher Charlie Kindleberger taught me (or, rather, taught Barry Eichengreen, who in turn taught me), when the global financial system has had a hegemonic lender-of-last-resort with the power and the will to exercise this function, things have gone relatively well. And when the possible candidates for the role have lacked either the power or the will, things have gone relatively badly.
Back in the 1997-1998 crisis the U.S. Federal Reserve and Treasury acting alongside the IMF had the power and the will. Right now the U.S. Federal Reserve and the Treasury in cooperation with the IMF and the ECB have the power (but they may not have the will). In the future the world is likely to become a more complicated place without a single hegemonic and dominant public financial institution. To my mind, this creates grave dangers for the next quarter century. ...

[Brad's response was part of a roundtable at The Economist on an article written by Dani Rodrik. I participated as well, and said pretty much the same thing.]

Friday, May 25, 2012

Fed Watch: Is QE3 Just Around the Corner?

Tim again:

Is QE3 Just Around the Corner?, by Tim Duy: From the Wall Street Journal today:

As measured by Treasury bonds, inflation expectations are falling amid heightened concerns that the discord in Europe will threaten U.S. growth. Some observers say that the lowered outlook for inflation gives the Federal Reserve more leeway to stimulate the economy, possibly through another round of quantitative easing. In "QE," the Fed pumps money into the financial system through asset purchases.

Financial market participants are anticipating Fed action. Are monetary policymakers on the same page? St. Louis Federal Reserve President James Bullard yesterday:

Bullard said he believes the European Central Bank is committed to backing the continent's brittle banking system, and therefore the risks to the U.S. economy are smaller than some analysts perceive.

Indeed, Bullard added he expects the U.S. economy to perform better than many forecasters anticipate and that the Fed will therefore need to raise interest rates in late 2013, not late 2014 as its policy committee is currently indicating.

Minneapolis Federal Reserve President Narayana Kocherlakota yesterday:

“I see these changes as a signal that our country’s current labor-market performance is much closer to ‘maximum employment,’ given the tools available to the [Fed], than the post-World War II U.S. data alone would suggest,” Kocherlakota said. “As I’ve argued in the past, appropriate policy should be responsive to such signals.”...

...Earlier in May, Kocherlakota said the Fed should start looking at tightening monetary policy in the next six to nine months. He said he saw inflation at around 2% this year and 2.3% in 2013, numbers that signal the need to start exiting the central bank’s current ultra-easy policy.

Arguably, neither Bullard not Kocherlakota are critical voices in the FOMC. More interesting are today's comments from New York Federal Reserve President Wiliam Dudley. From the Wall Street Journal:

Expectations for U.S. economic growth, while “pretty disappointing” at around 2.4%, is sufficient to keep the central bank from easing monetary policy, Federal Reserve Bank of New York President William Dudley said.

“My view is that, if we continue to see improvement in the economy, in terms of using up the slack in available resources, then I think it’s hard to argue that we absolutely must do something more in terms of the monetary policy front,” Dudley said in an interview with CNBC, aired Thursday.

Dudley is considered part of the inner circle; if he doesn't think the Fed needs to do something more, the baseline scenario should be that QE3 is not on the table.

At least for the moment. Simply put, I think market participants are getting ahead of the Fed. My suspicion is that the Fed will need to see a weaker data flow in the months ahead to justify getting back into the game. And I don't think the TIPS-derived inflation expectations are lower enough to trigger action either. I think we need to go down at least another 25bp if not 50bp until the Fed pulls the trigger:


That said, of course the risks to the outlook could shift by the June meeting. The trend in new orders for nondefense, nonair durable goods suggests that some of the global weakness is catching up with the US:



That said, no clear sign that industrial demand has rolled over. Overall, it seems unlikely that the data flow as a whole will turn fast enough to prompt the Fed into easing next month. Only the next employment report stands out as a potential deal breaker. In general, though, I would think you need at a minimum the Q2 GDP report to justify additional easing - which pushes us out to the July/August meeting at least.
So if we take the US data off the table, then we are looking for financial disruption, which is obviously a possibility given the current unpleasantness in Europe. Indeed, we should not be surprised if the Fed needs to further improve dollar liquidity abroad (an action that is sure to be taken as a sign that QE3 is imminent; expect Fed speakers to deny a policy shift is afoot). And note that the next FOMC meeting is just 2 days after the June 17 Greek vote - and that could be the vote heard round the financial world that prompts the Fed to act.
Bottom Line: The data flow is soft, but Dudley indicates it is not soft enough to ease. And while some are pointing to falling TIPS-derived inflation as  given the Fed room to move, they have traditionally delayed until conditions are more dire (they are not exactly prone to overshooting in the first place). The Fed doesn't think they will ease further; they think their next move will be to tighten. Which means that financial conditions will need to deteriorate dramatically to prompt action in June. So if you are looking for the Fed to ease in just four weeks, you are looking for financial markets to turn very, very ugly. Lehman ugly. And I wish that I could say that it won't happen, but European policymakers are hell-bent to push their economies to the wall while worshipping at the alter of moral hazard.

Thursday, May 24, 2012

Fed Watch: Rumors and Threats

Tim Duy:

Rumors and Threats, by Tim Duy: From the Wall Street Journal's MarketBeat blog this morning:

“We’re now in a very sentiment-driven, rumor-driven, nonsense-driven market that’s prepared to grasp onto anything,” Dow Jones’s Katie Martin said this morning on the Markets Hub.

One of the only things holding the euro up, she said, is the so-called “announcement risk,” the fear that the eurocrats will actually pull together some kind of solution. But it’s just a hope, she said

From Bloomberg this afternoon:

U.S. stocks rose, sending the Standard & Poor’s 500 Index higher for a fourth day, after Italian Prime Minister Mario Monti said a majority of leaders at a European Union summit backed joint European bonds.

Timing is important on this one. From the Financial Times:

But summit leaders agreed such measures were months – and, in the case of eurozone bonds, years – away, and some officials have in recent days begun to express concern that the EU has not properly prepared itself for the whirlwind that could strike if a new Greek government defaults on its bailout loans and is forced out of the euro.

Most of Europe might support Eurobonds, but it isn't going to happen in the near-term. Interestingly, Monti also laid down his own gauntlet to Germany. From Bloomberg:

Italian Prime Minister Mario Monti said Germany has an interest in ensuring that no country leaves the euro.

Monti said that, in a hypothetical case, Germany would be harmed should Italy “one day leave the euro.” A weak “new lira” would put German exports at a disadvantage, though an exit from the currency region would also harm Italy, Monti said in an interview today on Italian television La7.

While “anything can happen in Greece,” the nation is likely to remain in the 17-nation currency, Monti said.

A clear escalation of the doctrine of mutually assured financial destruction - now Italy has its hand on the button. The more hands on the button, the greater the chance that someone pushes it. Meanwhile, while European politicians fiddle, Europe burns. From Reuters:

The euro zone's private sector has sunk further into the doldrums this month as new orders shrivel, forcing firms to run down backlogs and slash workforces, key business surveys showed on Thursday.

And worryingly for policymakers, a downturn that started in smaller periphery members is taking root in the core countries of Germany and France, whose tepid growth had been keeping the troubled bloc afloat.

For his part ECB President Mario Draghi is throwing down his own gaunlet:

We are living at a critical juncture in the history of the Union. The sovereign debt crisis has exposed serious weaknesses in the institutional framework; in this context, the difficulties in finding common solutions are having a negative impact on market valuations. The extraordinary measures taken by the ECB have gained us time; they have preserved the functioning of monetary policy.

But we have now reached a point where European integration, in order to survive, needs a bold leap of political imagination. It is in this sense that I have referred to the need for a “growth compact” alongside the well-known “fiscal compact”.

That sounds to me like he is saying their is not much more that the ECB can or will do. Policymakers need to get their act together. I'll see your moral hazard, and double it. See who blinks first.

Moreover, it is increasingly clear it's not just Europe anymore. Ed Harrison reiterates that this is turning into a global slowdown:

Me, I am more concerned about the global growth slowdown in emerging markets than the crisis in Europe. This is a big, big story but no one is talking about it because Europe is sucking up all of the air. It’s not only Europe here. The reality is we are seeing a global economic backdrop with nearly every major developed and developing country slowing – all with less policy space across the board. That is not bullish.

The world looks riskier with each passing day.

Fed Watch: The Fed and the Fiscal Cliff

One more from Tim Duy:

The Fed and the Fiscal Cliff, by Tim Duy: Ryan Avent has an ambitious post, in which he claims the Federal Reserve will resist proclaiming it has the tools to offset the fiscal cliff, should it even occur:

The Fed could therefore proclaim to the world that will maintain aggregate demand growth (in the form of, say, nominal income growth) at all costs, and that it would by no means allow the fiscal cliff to knock the economy off its preferred path. It could explain in great detail what specific steps it would be willing to take to achieve this goal, so as to boost its credibility. And if demand expectations as reflected in equity or bond prices showed signs of weakening ahead of the cliff, the Fed could preemptively swing into the action to establish the credibility of its purpose.

The Fed will almost certainly not do this.

Why? Because the Fed is thinking about moral hazard, specifically, that if it promises to protect the economy against reckless fiscal policy Congress will have no incentive to avoid reckless fiscal policy...

I understand where Avent is going with this. The Fed should be concerned that Congress will never get its act together if the Fed is always there to bail them out. But reading the comments by Minneapolis Federal Reserve President Narayana Kocherlakota today makes me think his concerns are at least for the moment misplaced. From the Chicago Tribune:

The U.S. Federal Reserve, which has kept short-term rates near zero since December 2008, may need to ease monetary policy further if U.S. unemployment rises or inflation falls, a top Fed official said on Wednesday.

Those are possible outcomes if U.S. lawmakers allow a raft of tax breaks to expire on schedule at the end of the year, pushing the nation over a "fiscal cliff" in 2013, Minneapolis Fed President Narayana Kocherlakota said in answer to an audience question after a talk at the Black Hills Knowledge Network.

But, he added, "I don't see that that is a policy choice that the Congress and President wind up making," he said.

That sounds to me like a pretty explicit promise to step up if Congress falls down on the job. Likewise, St. Louis Federal Reserve President James Bullard, via Reuters:

"If there was a sharp slowdown in the U.S. I do think we'd have further scope to take action, we'd be taking on more risk, but we could do it if the situation called for it," he said.

I take this to implicitly include a fiscal cliff slowdown. So it seems to me that at least some monetary policymakers are already promising, explicitly or implicitly, to offset the fiscal cliff.

My guess is that in a low-inflation environment, monetary policymakers would have little reason to engage in moral hazard games, in that any hesitation on their parts would not be credible. It seems pretty likely they would step on the monetary gas, even if doing so allowed Congress another year of reckless behavior. Not doing so would be a clear violation of the dual-mandate. As such, are they really able to play coy?

Whether they accurately gauge the impact of the fiscal cliff and engage in the appropriate degree of easing, however, is another matter entirely.

Fed Watch: Total Failure

Tim Duy:

Total Failure, by Tim Duy: With the crisis once again nipping at their heels, European policymakers accomplished exactly what was expected of them. Absolutely nothing. From the FT:

European leaders put off any decisions on shoring up the region’s banks at a late-night summit on Wednesday despite rising concerns that instability in Greece was undermining confidence in the eurozone’s financial sector.

Instead, the heads of the EU’s main institutions were given the task of drawing up proposals for closer fiscal co-ordination in time for another summit next month, including plans that could include a path towards a Europe-wide deposit guarantee scheme and, in the longer term, commonly-backed eurozone bonds.

The trouble is that Europe doesn't have a month to wait for another summit. I am not confident they even have a week. But not to fear - the ECB is expected to step into the breech once again. At least that is the hope. But notice the irony. Germany doesn't want Eurobonds because of the moral hazard risk. They don't want to get stuck paying for Southern Europe's profligacy. At the same time, the ECB does want to act as lender of last resort for fear that will only encourage policymakers to put off hard decisions on fiscal union. Moral hazard to the right, moral hard to the left. The only path left is gridlock - and failure.

In the meantime, the Wall Street Journal reports on accelerating plans for a Greek exit.

European officials are stepping up contingency planning for a possible Greek exit from the euro zone, even as Europe's leaders struggled to overcome differences on how to resolve the currency bloc's crisis at a summit meeting here.

And, for good measure, St. Louis Federal Reserve President James Bullard let's us know that he sleeps easy at night. Via Reuters:

"I'm one that thinks that Greece could exit, and it could be handled in an appropriate way without causing too much damage, either in Europe or in the U.S.," St. Louis Federal Reserve Bank President James Bullard told Reuters.

I wish I could be so confident.

Saturday, May 19, 2012

Do the FOMC Meeting Minutes or the New Fed Appointments Change the Expected Path for Monetary Policy?

I wrote this the other day and then forgot to post it at CBS and/or here:

Information in the minutes from the April 24-25 meeting of the Federal Reserve's policymaking committee released last week led many observers to conclude that monetary easing was more likely than we thought. The confirmation of Jeremy Stein and Jerome Powell as Federal Reserve governors on Thursday did little to alter that view since most believed these appointments would do little to change the balance of power in monetary policy meetings. However, the real news from these two events isn't about potential changes in the policy outlook, it's that current policy is now even more entrenched than before.

The key reason that many analysts changed their policy outlook was language in the minutes from the last meeting of the Federal Open Market Committee, in particular this phrase: "Several members indicated that additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough." However, the fact that "several members" of the committee favored more easing if the economy deteriorates "enough" was well known before the minutes were released. The speeches given by presidents of the regional Fed banks, members of the Board of Governors, and most importantly Chairman Bernanke himself, made this clear. Thus, the minutes confirm the commitment to existing policy -- stay the course for now unless conditions change dramatically in either direction -- rather than signaling a deviation from it.

The appointment of Jeremy Stein and Jerome Powell as Federal Reserve governors, the first time all seven positions on the Board of Governors have been filled since April 2006, also gives more gravity to existing policy. Both appointees are experts in the operation of financial markets, expertise that is needed at the Board. But they are not experts on the use of monetary policy tools such as quantitative easing to stabilize the economy, and are thus likely to defer to majority opinion on these matters, Chairman Bernanke's opinion in particular. This gives majority opinion more weight making it harder to change.

There is a final factor that will tend to lock present policy in place, the upcoming election. The Fed is historically reluctant to do anything in election years that appears to favor one party over the other. Thus, big policy moves are unlikely unless there is a clear justification for them. A substantial deterioration in the economy would provide the needed justification, but the hurdle for what constitutes "substantial" is larger in a presidential election year.

Together, all of these factors point to more persistence in current policy. If the economy takes a large unexpected downward turn, or if inflation begins to rise to worrisome levels policy could change, but for now present policy is firmly anchored in place.

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.