Here's an explanation of the Fed's exit strategy, including why the Fed is planning to raise the interest rate it pays on reserves rather than the more traditional strategy of using open market operations to control the federal funds rate:
Wednesday, February 10, 2010
Friday, February 05, 2010
Devil's Advocate, by Tim Duy: Commentators, including myself, have been critical of a Federal Reserve policy stance that appears to place uncertain inflation concerns ahead of a very real unemployment problem. Playing devil's advocate, one can argue that Federal Reserve members are showing remarkable patience in keeping interest rates at rock bottom levels. Even more remarkable is that there is not a greater push to aggressively contract the balance sheet to a more traditional state. Central bankers are simply a very conservative lot, and the Fed is operating at the boundary of what many policymakers can stomach. Indeed, recent data must be somewhat disconcerting, with the US economy under the influence of an inventory correction that is having a very real positive impact on the manufacturing sector. And if the January employment report yields a substantial increase in nonfarm payrolls - something not out of the question in the wake of 5.7% growth in the fourth quarter of last year - policymakers may start to think that the balance of risks are turning rapidly toward inflation. Remember, the chief obstacle to tighter policy is the forecast of persistently high unemployment. Data flow that runs contrary to that expectation will raise fears among some policymakers that they are already dangerously behind the curve.
It is hard not to flag the flow of manufacturing data as a warning that a V-shaped recovery is at hand. The ISM manufacturing report was solid across the board as firms are caught in the midst of a traditional inventory correction. Particularly disconcerting to Fed officials will be the price data, with 44% of firms reporting higher prices, while only 4% seeing declines. No commodities were reported down in price. This follows a strong showing in manufacturing orders for December, with a clear upward trend established in the data:
Furthermore, highlights of the GDP report included a gain in equipment and software spending in addition to a positive contribution from net exports. Sustained improvement in the latter would be a very significant development, helping the US adjust to a less consumer-dependent economy and providing a basis for additional investment in export oriented and import competing industries. I have, however, been somewhat skeptical that US authorities would actually challenge the fundamentally currency "misalignments" that help perpetuate the still significant trade imbalance. President Obama's SOTU address, however, and its pledge to pursue export led growth looks to have lit a fire under policymakers. Perhaps the external sector will be a sustained source of growth. That said, talk is cheap - this Administration is not known for policy follow-through.
To be sure, I would be amiss if I did not identify less strong data. The ISM nonmanufacturing report was weaker than hoped for, throwing cold water on the notion that inventory correction is spreading more broadly into the service sector. Initial unemployment claims have backed up in recent weeks, a reminder of the still precarious state of the labor market. Auto sales slipped a notch, suggesting that the road to sustained improvement remains elusive. Finally, while retails sales posted solid gains in January, we really wouldn't have expected much else given the decline at this time last year. Overall, while none of this data is particularly strong, I would not describe it as particularly weak, nor should it alter the perception the economy is on a sustained upward trend.
But what is the pace of that trend? We always come back to this question, because it is the key to policy evaluation. If the pace is sufficiently high, then we would expect unemployment to come down quickly, and the Fed would be behind the curve, in which case the Treasury market will be in a world of pain. The expected path of activity, however, remains such that unemployment rates will come down gradually, thus alleviating the danger of a rapid reversal of monetary. What kind of growth would we need to send the Fed scrambling for the exits? On this issue, Brad DeLong provides some guidance by depicting the path of unemployment beginning in 1982 - the so-called "Morning in America" - versus the actual beginning in 2009 and the Administration projection for 2010 and beyond:
A good opportunity to look at real final sales - GDP excluding inventory changes - during the mid 80's:
As can be seen, the underlying rate of growth enjoyed a sustained surge from 4Q82 onward - an average of 5.4% growth through 1984. That is the kind of growth needed to drive down unemployment rates quickly. In contrast, real final sales climbed just 2.2% in 4Q09. We need to see sustained growth at more than twice that rate to bring unemployment quickly down to acceptable levels. But there is simply no faith that such a feat can be achieved. Most doubt there is sufficient pent up demand in the consumer to do the job, while Calculated Risk has repeatedly stated the case against a quick rebound in housing. With fiscal stimulus set to slow, that leaves investment and the external sector to big up the slack - neither of which packs the weight of the consumer. Consequently, the Fed can hold policy steady on the back of the current forecast, which lacks the post-1982 surge. But given the amount of cash sloshing around in the banking system, they will be sweating out the data, more concerned about the upside risk than the downside. In their defense, arguably the rapid and tepid recovery scenarios are observationally equivalent in the inventory correction phase of the recovery.
Bottom Line: An improvement in labor markets would not be unexpected given the GDP surge at the end of 2009. But sustainability is the key, and sustainability requires 4Q09 GDP numbers in the absences of inventory effects. Few forecasts are looking for such growth, certainly not yet at the Fed. Indeed, the recent travails of the stock market and sustained sub-4% level on 10 year Treasuries argues against such growth as well. Interestingly, at this juncture, I place more weight on the upside risk than the downside, although I suspect that is a factor of my relatively low expectations than any real optimism on my part. I don't see an actual return to recession short of another negative demand shock, but I am expecting the economy to settle into an anemic pace of growth. In this environment, I don't see how the Fed is interested in substantially tightening policy - but I can see how some policymakers could perceive that their hand was forced if they see a string of upside surprises in growth indicators, especially if the January read on employment is better than anticipated. Still, I think only clear evidence that a 1983 recovery is emerging would prompt a sudden policy shift at the Fed.
Wednesday, February 03, 2010
Chris Sims talks about difficulties of policy at the zero lower bound (wonkish). In particular, he discusses the difficulty of credible commitment to higher future inflation that is necessary in most New Keynesian models, the difficulty in achieving fiscal and monetary policy coordination, and the problems that may arise when the central bank takes quasi-fiscal actions:
Commentary on Policy at the Zero Lower Bound, by Christopher A. Sims, Princeton University, CEPS Working Paper No. 201, January 2010: I. ROBUST IMPLICATIONS OF CONVENTIONAL NEW KEYNESIAN MODELS FOR POLICY AT THE ZERO LOWER BOUND Monetary policy has been thought of, at least for several decades up until the fall of 2008, as interest rate policy. Certainly New Keynesian policy models treat it this way. At the zero lower bound (ZLB), the interest rate is stuck, so long as policy makers would like to be taking a more stimulative stance. This would seem on the face of it to imply that monetary policy is paralyzed. New Keynesian models like those in this volume generally agree that monetary policy can be effective, though, if policy can take the form of credible commitments to future interest rate paths. This optimistic conclusion was developed by Christiano, Motto, and Rostagno (2004), Eggertsson and Woodford (2003), and Eggertsson (2008), and emerges in this volume’s papers as well.
But the conclusion is less optimistic than it looks. In models, it is easy to specify an announced future policy stance and assume the public believes the announcement. In practice, there is inevitably uncertainty about exactly how firm are commitments to future policy, even if the future policy is announced in detail. The uncertainty implies volatility, as newly arriving information shifts the public’s perception of how easy it will be to deliver on the commitment.
Central banks in most developed countries have succeeded in convincing the public that they are committed to maintaining low and stable inflation. But this credibility has built up over decades as the central banks have acted to deliver on their commitment. In the presence of a binding ZLB, the result from the models is that the central bank ought to commit to expansionary future policy. A bank that has built up inflation-fighting credibility may find this is a liability if it tries to convince the public that it is temporarily committed to increasing the inflation rate.
Announcements about future policy at a time when the short rates that ordinarily are seen as set by the central bank are stuck at zero are particularly subject to doubt, just because they are accompanied by no current action.
Tuesday, February 02, 2010
Mortgage Choice and the Pricing of Fixed-Rate and Adjustable-Rate Mortgages, by John Krainer, Economic Letter, FRBSF: In the United States throughout 2009, the share of adjustable-rate mortgages among total mortgage originations was very low, apparently reflecting the attractive pricing of fixed-rate mortgages relative to ARMs. Government policy could have changed the relative attractiveness of the fixed-rate mortgages and ARMs, thereby shifting the market share of these two housing finance instruments.
One of the notable features of the current U.S. mortgage market is the predominance of fixed-rate mortgages. The interest rate differential between fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs) has fallen from a recent high of about 2.5 percentage points in the summer of 2004 to about 0.5 percentage point at the end of 2009. These changes in the interest rate differential have coincided with the collapse of mortgage securitizations other than those mediated by government-sponsored enterprises (GSEs), including Fannie Mae, Freddie Mac, and Ginnie Mae (see Krainer 2009). In addition, the Federal Reserve began large-scale purchases of GSE mortgage-backed securities (MBS) starting in January 2009, adding significant secondary market demand for fixed-rate mortgages. The Fed's purchase program has not included MBS containing ARMs.
This Economic Letter reviews some of the factors determining consumer mortgage choices. It shows that ARM share has declined in ways that parallel the behavior of several key mortgage market interest rates. These developments have coincided with, among other things, Fed intervention in the market through large-scale MBS purchases. Thus, the Fed program, while supporting the functioning of the residential mortgage market overall, could have affected the composition of the mortgage market. To help understand this dynamic, this Letter estimates what the ARM share might have been under alternative scenarios in which fixed mortgage rates were higher, which would likely have been the case if the Fed had not been intervening in the market to the extent that it did. ... [continue reading]
Thursday, January 28, 2010
Here's my reaction to the vote to reconfirm Ben Bernanke as Fed Chair:
Wednesday, January 27, 2010
Tim Duy reacts to today's FOMC meeting:
Dissent, by Tim Duy: The FOMC statement contained a mini-bombshell, the dissent of Kansas City Fed President Thomas Hoenig. I am skeptical, however, that this dissent is a significant shift in the policy environment. Instead, I view the statement as taking another baby step forward to a normalization of monetary policy now that the financial crisis has eased and that the economic environment has firmed. Many policymakers will simply find themselves increasingly uncomfortable holding rates at rock bottom levels while sitting on a bloated balance sheet -- regardless of the unemployment rate. Short of a significant reversal of recent economic gains, I would be hard pressed to see the Fed back away from a policy stance that is growing tighter, albeit slowly tighter.
The opening sentence of the statement maintains the position that the economy continues to strengthen while labor markets firm. Some may be surprised about the latter point given the disappointing December employment report. The Fed, however, will be expecting the road to sustained improvement to be bumpy; one month will not significantly impact their outlook given the sharp decline in the pace of job losses in the second half of 2009. The trend is clear. The Fed also upgraded slightly its assessment of business spending, consistent with data such as new orders for capital goods.
The opening paragraph, however, omitted mention of the housing market improvements as noted in the December statement. Are they less confident of a sustained rebound given the drop off that followed this summer's tax credit induced boom? Or do they just want to avoid mention of housing given that they intend to halt stimulus for that sector? In my opinion, of all the Fed interventions over the past year, the decision to acquire $1.25 trillion of mortgage securities is the most politically risky; more on that later.
There's always room for more debate on Ben Bernanke's reconfirmation:
The Quarrel Over Bernanke, Room for Debate: The Senate is expected to vote this week on whether to confirm Ben Bernanke to a second term as the Federal Reserve chairman. Though it appears that he will overcome a filibuster threat, opposition to Mr. Bernanke has grown, along with worsening jobs numbers and public anger over the Fed’s failure to regulate banks before the financial crisis. His Democratic and Republican opponents have criticized him as the architect of the Wall Street bailout and being out of touch with the woes of Main Street.
How much is Mr. Bernanke to blame for the regulatory failures, the weak recovery and high unemployment numbers? Could a new Fed chairman make a difference?
Monday, January 25, 2010
Paul Krugman's view on Ben Bernanke's reconfirmation as Fed Chair:
The Bernanke Conundrum, by Paul Krugman, Commentary, NY Times: A Republican won in Massachusetts — and suddenly it’s not clear whether the Senate will confirm Ben Bernanke for a second term as Federal Reserve chairman. That’s not as strange as it sounds: Washington has suddenly noticed public rage over economic policies that bailed out big banks but failed to create jobs. And Mr. Bernanke has become a symbol of those policies.
Where do I stand? I deeply admire Mr. Bernanke, both as an economist and for his response to the financial crisis. ... Yet his critics have a strong case. In the end, I favor his reappointment, but only because rejecting him could make the Fed’s policies worse...
Mr. Bernanke is a superb research economist..., his academic expertise and his policy role meshed perfectly, as he used aggressive, unorthodox tactics to head off a second Great Depression.
Unfortunately, that’s not the whole story. Before the crisis struck, Mr. Bernanke was very much a conventional, mainstream Fed official, sharing fully in the institution’s complacency. Worse, after the acute phase of the crisis ended he slipped right back into that mainstream. Once again, the Fed is dangerously complacent...
Consider two issues: financial reform and unemployment.
Back in July, Mr. Bernanke spoke out against ... the creation of a new consumer financial protection agency. He urged Congress to maintain the current situation, in which protection of consumers from unfair financial practices is the Fed’s responsibility.
But here’s the thing: During the run-up to the crisis, as financial abuses proliferated, the Fed did nothing. In particular, it ignored warnings about subprime lending. So it was striking that ... Mr. Bernanke ... gave no reason to believe that the Fed would behave differently in the future. ... As I said, the Fed has returned to a dangerous complacency.
And then there’s unemployment. The economy may not have collapsed, but it’s in terrible shape... Nor does Mr. Bernanke expect any quick improvement... So what does he propose doing...?
Nothing. Mr. Bernanke has offered no hint that he feels the need to adopt policies that might bring unemployment down faster. ... It’s harsh but true to say that he’s acting as if it’s Mission Accomplished now that the big banks have been rescued.
What happened...? My sense is that Mr. Bernanke, like so many people who work closely with the financial sector, has ended up seeing the world through bankers’ eyes. ... Given that, why not reject Mr. Bernanke? There are other people with the intellectual heft and policy savvy to take on his role: ...possible choices would be ... Alan Blinder ... and Janet Yellen...
But — and here comes my defense of a Bernanke reappointment — any good alternative ... would face a bruising fight in the Senate. And choosing a bad alternative would have truly dire consequences for the economy.
Furthermore, policy decisions at the Fed are made by committee vote. And while Mr. Bernanke seems insufficiently concerned about unemployment..., many of his colleagues are worse. Replacing him with someone less established, with less ability to sway the internal discussion, could end up strengthening the hands of the inflation hawks and doing even more damage to job creation.
That’s not a ringing endorsement, but it’s the best I can do.
If Mr. Bernanke is reappointed, he and his colleagues need to realize that what they consider a policy success is actually a policy failure. We have avoided a second Great Depression, but we are facing mass unemployment — unemployment that will blight the lives of millions of Americans — for years to come. And it’s the Fed’s responsibility to do all it can to end that blight.
I don't disagree at all with the pressure on the Fed to do more, unemployment is a big problem and I'm ready to give further easing a try (particularly since Congress has dropped the ball on additional fiscal policy to help with job creation). But I see this more as a disagreement over what type of monetary policy is best for unemployment now and in the future than I do as Bernanke taking the side of bankers over the unemployed.
Sunday, January 24, 2010
I think a lot of apparently mysterious things about Ben Bernanke’s career can be solved if you just assume that Ben Bernanke is doing things that a conservative Republican would do because he is a conservative Republican. For example, remember when conservative Republican George W Bush was president and made Ben Bernanke chairman of the Council of Economic Advisors? And remember when Bush put Ben Bernanke in charge of the Fed? ... If it looks like a duck and quacks like a duck, then it’s probably a duck. ...
I note that liberals, in their condescension toward conservatives, sometimes wind up tying themselves into knots about guys like Bernanke. Bernanke is very smart and incredibly accomplished. Many smart liberals think conservatives are dumb. So if Bernanke is so smart, it must be that he’s not really a conservative! But no. Smart conservatives are a very real phenomenon. And in politics the general idea is to give positions of authority to well-qualified people who share your political objectives.
Liberals think Bernanke can't be conservative because he's smart? Let me suggest that the support for Bernanke among some liberals is not the result of unfounded prejudice that only Matt Yglesias is free of, it instead results, at least in part, from the opinions of people who have spend a lot of time with him.
What do those people think, people who have had plenty of time to observe how he walks and talks, and whether he quacks Republican?:
Fed Official Moves Up and Into Politics, by Edmund L. Andrews, New York Times: For years, some of his closest friends did not know that Ben S. Bernanke was a Republican. It is not that Mr. Bernanke has been shy about his views. As an economist at Princeton, he broke new ground on the causes of the Depression. And as a governor on the Federal Reserve Board since 2002, he spoke bluntly about weakness in the job market, the dangers of deflation, the impact of higher oil prices and the need for the Fed to reduce uncertainty by being more open. ... But now Mr. Bernanke ... is moving directly into the political arena, taking over next week as chairman of President Bush's Council of Economic Advisers. He is also on the short list of potential candidates to succeed Alan Greenspan as chairman of the Federal Reserve. The two jobs are related, if only because Mr. Bush will be looking to name a new Fed chairman that he knows well and trusts. Two other possible candidates to succeed Mr. Greenspan, who has been atop the Fed for nearly 18 years, are also former council chairmen: Martin Feldstein, who served under President Reagan; and R. Glenn Hubbard, who worked for President Bush from 2001 to 2003.
Mr. Bernanke built a sterling reputation while at Princeton, and has won widespread praise for his cogent analyses while at the Fed. But he has studiously avoided partisan political issues, at least in public. He has said little about issues at the top of Mr. Bush's agenda,... and his economic writing betrays few hints of political ideology. "If you read anything he's written, you can't figure out which political party he's associated with," said Mark L. Gertler, a professor of economics at New York University who has written more than a dozen papers with Mr. Bernanke. Mr. Gertler, who said he did not know his close friend's political affiliation until relatively recently, added: "He's not ideological. I could imagine Ben working with economists in the Clinton administration." Alan S. Blinder, a longtime colleague at Princeton who has advised numerous Democratic presidential candidates, also said he had worked alongside Mr. Bernanke for years without having any sense of his political views. "We wrote articles together and sat at the same lunch table thousands of times before I knew he was a Republican," Mr. Blinder recalled. ... Mr. Bernanke enjoys enormous credibility among economists in academia as well as on Wall Street..."I think Wall Street would be more comfortable with Bernanke as Fed chairman, if only because he isn't viewed as being ideological," said William C. Dudley, chief United States economist at Goldman, Sachs. The disadvantage is that Mr. Bernanke may not be able to build up close ties in the White House, where Mr. Bush's inner circle places high priority on personal loyalty and passionate support for the White House's policy goals. ...
There is this:
People who know Mr. Bernanke say he is entirely comfortable in supporting President Bush's economic policies. He has expressed little worry about the current budget deficit,... and he has supported Mr. Bush's call to overhaul Social Security. ...
I don't like the Social Security statement either, but in general I don't think we can explain Bernanke's monetary policy stance by blaming it on his being a conservative republican.
Does it even make sense to say Bernanke's economic policies have been ideologically conservative?
This charge that Bernanke is ideologically motivated is all about the fact that Bernanke has not gone above and beyond the massive bailout of the financial system that has distressed conservatives and endorsed aggressive quantitative easing. The idea is that quantitative easing - the purchase of long-term securities by the government - will bring down long-term real interest rates, which is then supposed to spur investment (despite the recession), which then in turn will increase employment (with a considerable lag). Despite the massive intervention that the Fed has undertaken so far - one that has not pleased conservatives at all - the fact that Bernanke won't take policy as far as some, but by no means all on the left think, causes him to suddenly be tagged with the ideological conservative label to explain this resistance?
Sorry, but it just doesn't fit. If you want conservative, listen to someone like John Taylor who would likely already be raising interest rates and winding down asset purchase programs. Listen to someone like former Federal Reserve Bank of St. Louis President William Poole who would have likely let the too big to fail banks fail, Main Street be damned, and elevated inflation over all other goals. Ideological conservatives in general, and the inflation hawks among them in particular, do not approve of what Bernanke has done. Go ahead and criticize Bernanke for his policies, I think there is a genuine debate about quantitative easing that we can have, and it could be that not moving more aggressively is, in fact, a mistake, but don't blame it on his politics.
If you disagree with current policy, if you think it should be taken further, then explain why (and Matt Yglesias has done some of that). But don't take the lazy way out and simply tag Bernanke with an ideological conservative label that doesn't fit, and then use it to explain his policies. If we really had an ideological conservative as Fed Chair, there would be no need to wonder about the underlying politics, there would be no "probably a duck" about it, those policies would likely mean much worse conditions in labor markets right now. I think more could be done to help labor markets with both monetary and fiscal policy (though I should add that I think fiscal policy is a much more effective means of increasing employment, and I'm skeptical about the degree to which quantitative easing would actually work). But I don't believe that the barrier to pursuing these policies is Ben Bernanke's conservative ideology. It's his economics, and he has done far more than most in his career to have those views respected even when you disagree with his conclusions.
Update: Let me add one other thing. The other charge leveled against Bernanke is that his own work supports quantitative easing, yet he resists this policy, so it must be that his political ideology is in the way. Conservatives tried this with Christina Romer and her work on fiscal policy, but she made it clear that she was well aware what her own work said, that her position was fully supported by and consistent with her economics, and she swatted that charge way rather easily.
Bernanke also understands and is well aware of his own work, and of course he knows it better than anyone else, the charge against him is that he is abandoning his own research to serve conservative ideological principles. But the simpler explanation, the one that is actually supported by his past and all the testimonial above about his lack of political passion, is that it is his economics - which has been updated as the crisis evolves and he learns more - that is driving his policy choices. And his economics is not particularly conservative, it's fully consistent with the work that appears in mainstream journals. Again, that's not to say that there is no dispute here, different assumptions lead to different conclusions and there is plenty of room to argue over the best policy. But I just can't agree with the charge that he has abandoned his own research to pursue an ideological course.
Update: On a related note, from Paul Krugman:
Know Your Feds, by Paul Krugman: I’m hearing a lot from people who want Paul Volcker as Fed chair. (Consider the joke about exemplifying too big to fail as having been made). There really is nobody with his stature (literally, as it happens) and moral authority. And he’s a powerful advocate of financial reform.
You should know, however, is that Volcker is usually a hard-money guy. I haven’t had an opportunity to ask him, but my guess is that he’s suspicious of quantitative easing, and would be more likely to side with the Fed’s inflation hawks than with those of us who think the Fed should expand its balance sheet, target higher inflation, and in general do whatever it takes to bootstrap ourselves out of the liquidity trap.
This isn’t a simple question of good versus evil. There are substantive policy disputes, and some very good people are, in my view, on the wrong side of some issues.
Friday, January 22, 2010
I didn't want to be right about this (video from 12/17/2009):
From Market Talk:
...It seems hard to believe that Congress would not approve the President’s choice for the Federal Reserve, but the uncertainty of it is hanging in the air, after the confirmation vote was delayed to next week. Some time next week. The Fed chairman’s term expires Sunday.
Let’s just say it wouldn’t exactly send the right message to the rest of the world, and the bond market especially, should Congress vote Bernanke out. You have to expect a good amount of this is just posturing, something Congress does better than any other group on the planet. But, you know, wars tend to start with a single, errant shot.
The latest spanner in the works came from Nevada’s Harry Reid, who said he’s still undecided about how to vote. Reid happens to be the Senate’s Democratic leader, so his voice carries some amount of water. The odds are still that he gets reappointed — a senior Senate Republican aide said it’s not an issue as at least four GOPers intend to vote for him — but even the fact that it’s being discussed just a week before his term ends should give you some indication of just how unsettled things are these days....
What a great time to give financial markets a big dose of uncertainty along with the potential shock of replacing the Fed chair.
Update: What happens if he is not reappointed before his term ends on 1/31/2010?:
The chairman and vice chairman of the FOMC are chosen separately from the main Board of Governors. At the first meeting of the year, the committee members vote for the two positions. The chairman of the Board is usually named chairman of the committee and the president of the New York Fed is traditionally the vice chairman. At next week’s meeting, the FOMC is expected to vote for Bernanke and William Dudley of the New York Fed to take those positions for 2010. Though Bernanke’s term as chairman of the Fed’s Board is up on Jan. 31, he retains his position as Fed governor and remains on the FOMC. As long as he stays on the Board of Governors, he can lead the rate-setting committee.
But things won’t be as stable at the Board of Governors. When Bernanke’s term expires on Jan. 31, Vice Chairman Donald Kohn is set to become acting chairman. Kohn remains in that position until Bernanke or another nominee is confirmed.
Update: Brad DeLong:
Don't Block Ben!, by Brad DeLong: I wish Boxer and Feingold had not done this:
Patrick Yoest and Luca di Leo: Boxer, Feingold Come Out Against Fed Chairman Bernanke - WSJ.com: Ben Bernanke faced ebbing support for a second term as Federal Reserve chairman as more senators adopted a populist, antibank stance even as the White House launched a public push to defend his candidacy. The erosion of support crossed party lines. Two Democratic senators facing re-election in November, Barbara Boxer of California and Russ Feingold of Wisconsin, on Friday joined two Democrats and an independent who previously announced their opposition. Ten Republicans say they, too, will oppose Mr. Bernanke.
Alarmed that there might not be the 60 votes in the Senate needed to extend Mr. Bernanke's term beyond its Jan. 31 expiration, the White House entered the fray publicly for the first time, with officials trying to win support among Democratic senators...
First, a correction to the story: it's not 60 votes, it's 51--for there are many more people who want to be on record as opposing Bernanke than who actually want the Federal Reserve to be headless on February 1.
Second, I think Boxer and Feingold have fallen into a trap. If Bernanke's nomination fails, it will be because of a combination of left Democrats and right Republicans. Why would right Republicans vote against the nomination of a Republican-appointed hard-money Republican? So that they can then vote against financial regulatory reform without taking political damage. "You are too friendly to the banks!" their opponents will say. And they will respond: "Oh yeah? Your president wanted bank-friendly Ben Bernanke to stay at the head of the Fed. AND WE BLOCKED HIM!!"
Boxer and Feingold, it seems to me, are enabling the future Republican ability to block financial reform without taking political damage from it.
So I find myself thinking about last August, and the Bernanke renomination:
Bernanke's Reappointment: David Wessel
Obama to Reappoint Fed Chairman Ben Bernanke - WSJ.com: President Barack Obama will announce Tuesday that he is nominating Ben Bernanke for a second four-year term as chairman of the Federal Reserve, White House Chief of Staff Rahm Emanuel said...
I think Bernanke is one of the best in the world for this job--I cannot think of anyone clearly better. He has made only one big mistake--buckling under to pressure from all those yelling at him for enabling moral hazard and not finding a way to takeover Lehman Brothers, and he is not going to make the same mistake again...
I am surprised that he is being reappointed. I would have thought that the combination of people angry because he has given too much public money to the banks and people angry because he didn't stop the recession would together make him damaged and that Obama would want to bring in a fresh face--never mind that Bernanke had no way to try to lessen the recession save by policy steps that inevitably involve giving money to the banks. It shows, I think, a seriousness about getting the policies right--or as close to right as we can--that I like to see in a president...
Update: See also Why Bernanke should be reconfirmed, by Jim Hamilton.
Update: Support from a staunch libertarian.
Thursday, January 21, 2010
John Taylor answers a few of my questions in one part of an interview at Big Think (transcript and video of entire interview, video broken into parts). My biggest disagreement with his answers comes when he says it's time to start "letting interest rates rise appropriately and reducing the amount of quantitative easing," a theme that appears repeatedly in his answers to my questions and to those submitted by others. It's far too early for that, and if anything the Fed should be doing more to combat the slow recovery of labor markets. Where we agree the most is when he says the most important unresolved questions in monetary economics are about the connections between the financial sector and monetary policy. [As a lead-in, Dean Baker asks the first question below, and my questions follow. Questions were emailed in advance of the interview.]:
...Question: Would you advocate an aggressive strategy of
John Taylor: Well, the question is; given that the Taylor Rule has large negative interest rates right now, would I want more quantitative easing? First of all, I don't think the Taylor Rule does show a large negative interest rates right now. That's kind of a myth. The Taylor Rule is pretty simple. It just says, the interest rate should equal 1 1/2 times the inflation rate, plus 1/2 time the GDP gap, plus 1. Well, if you plug in reasonable estimates for what inflation is and what the GDP gap is, I get a number that’s pretty close to zero. Not minus four, minus five, not numbers like that. So, in fact I would say the amount of quantitative easing could be reduced right now. I hope it is reduced in a gradual way. Some of the mortgage purchases I think could be slowed down and then actually reversed.
So, the question is a good one, and I'm glad it was asked because there is a lot I think, of misinformation out there about what the Taylor Rule says. The Taylor Rule is very simple, as I just mentioned. You can say it in a sentence and you plug in the numbers, you don't get minus five, minus six percent. You get something much closer to zero where the interest rate is now. Now, that of course has implications going down the road because it says, to the extent that real GDP picks up; I hope it does, or if inflation picks up; hope it doesn't. But if either of those occur, then you'd have to see interest rates starting to move above the zero to 25 basis point range. And if we don't then we're going to be back in the same kind of situation we were in 2002 through 2004, and that of course could begin to induce bubbles and we certainly don't want that to happen.
Question: Would quantitative easing speed the recovery?
John Taylor: No. I don't think quantitative easing at this point would effectively smooth the recovery. I think right now, based on historical experience, the interest rate is about where it is, it's not that we don't need a lot of quantitative easing. We've had some and I think the job of the Fed now is to bring it back. They're talking about doing that, which is good. But I think, for me, the most important thing now for policy to have a good recovery is to reduce this tremendous amount of uncertainty that exists with both monetary policy and fiscal policy and the uncertainty for monetary policy is, we don't know how rapidly the quantitative easing will be reversed. We don't know what's going to happen with interest rates. There is a lot of questions there. So I’d say, get back to the things that were working during the great moderation period, the '80's and '90's primarily, and that means letting interest rates rise appropriately and reducing the amount of quantitative easing; getting back to where it was through most of policy of the '80's and '90's.
Question: What is the most important unresolved question in monetary economics?
John Taylor: I think the most important unresolved question of monetary economics is the interaction between the financial sector and monetary policy. There's been lots of thinking about it over the years, some of it actually done here at Stanford, e.g. Gurley and Shaw. A lot of it done by Tobin at Yale, Ben Bernanke has done some of it. But I think the most promising part is the combination of the newest work on pricing of bonds and securities. A lot of it's done by [people who] combine that with monetary policy so that you have a sense of what's going to happen to longer term rates when the short rate is reduced. What's going to happen to credit flows and how much are credit flows going to impact the economy?
This crisis has been very clear in demonstrating that more work on the connection between the financial economics and monetary policy is needed. In fact, there's still a lot of questions out there in policy about whether the financial markets performed well, or not. It seems to me, if you look at them, they absorbed a tremendous shock from policies. It's effectively a panic induced by some ad hoc policy changes and they responded quickly and they responded in a way which has been smooth, as the markets themselves. The institutions, the financial institutions of course, have been in great difficulty, but the markets themselves have worked well.
So, to me, where we should focus our attention really is this connection between the financial markets, including the financial institutions and the monetary policy itself.
Question: How important is Fed independence?
John Taylor: I think we need to have both independence and accountability. They go together. It's not one or the other. So, in answer to the question, how important is Fed independence? I say it is very important, but it needs to be matched with accountability.
A lot of the concerns that you're seeing in the Congress, in the country about the Fed; the Ron Paul bill, I think that's a reaction to what looks like a very interventionist action by the Federal Reserve. Not a lot of descriptions of how it actually occurred, there's no reports on what's called a Section 13-3 Intervention. Section 13-3 of the Federal Reserve Act which allows for such actions, but there’s very little reporting on how it actually took place.
So, I think the best thing the Fed can do to get back some of its independence, and quite frankly, I think it's lost a little bit in this crisis. The best thing it can do is be very accountable about some of the interventions in Section 13-3, that's where most of the transparency concerns exist at this point, and then of course to emphasize that the policy that has worked most well was the policy of the '80's and '90's and when we got off track on that, things deteriorated.
I think that some recognition of interest rates being so low for so long in the '02 to '04 period by the leadership would be very important. It’s discussed in the Fed system, is discussed by other central banks, it's discussed quite widely, but some recognition of that seems to me would be important in terms of bringing back some of the independence that the Fed lost.
So, I think that independence, just to summarize, is really important, it's essential, we've seen evidence over time about how it is. But it has to be matched with a strong sense of accountability to the Congress and to the American people of what the Fed is actually doing. ...
Wednesday, January 20, 2010
I agree with Brad DeLong:
Stimulus Too Small, by Brad DeLong, WSJ: Fourteen months ago, just after Barack Hussein Obama's election, most of us would have bet that the U.S. unemployment rate today would be something like 7.5%, that it would be heading down, and that the economy would be growing at about 4% per year. ... Well, we have been unlucky. Unemployment is ... not 7.5% but 10%. More important, perhaps, is that the expectation is for 3% real GDP growth in 2010.
That leaves us with two major questions: First, why has the outcome thus far been so much worse than what pretty much everyone expected in the late fall of 2008? And second, why is the forecast ... for growth so much slower than our previous experience with recovery from a deep recession in 1983-84?
I attribute the differences to four factors:
First, the financial collapse of late 2008 did much more damage than we realized... The shock now looks to have been about twice as great as the consensus in the fall of 2008 thought. ...
And that leads us to Factor No. 2. The Obama administration envisioned a $1 trillion short-term deficit-spending..., had the administration known how big the problem would turn out to be, it would have sought a $2 trillion stimulus. And what did we get once Congress got through with it? A $600 billion stimulus—about one-third of what we needed.
Making matters worse: The stimulus was not terribly well targeted. In an attempt to attract Republican votes, roughly two-fifths of it was tax cuts. Such temporary cuts are ineffective... (It also failed to win any extra votes.) Roughly two-fifths ... was infrastructure and other ... direct federal spending. But it is hard to boost federal spending quickly without wasting money, and those projects that are shovel-ready are not terribly labor intensive.
Meanwhile, the most-effective stimulus would have been aid to the states... But senators don't want to hand out money to governors; the governors then tend to run against the senators and take their jobs away.
This problem with both the quantity and quality of the stimulus is tied up with the third factor: that the Obama administration declared victory on fiscal policy with the American Recovery and Reinvestment Act ... and then went home.
There was no intensive lobbying for a bigger program,... no attempts to expand the stimulus programs... The background chatter is that trying for more deficit spending would have been fruitless, given the broken Senate...That background chatter is probably right. But ... there is still the Federal Reserve. And that's where the fourth factor comes in.
It is true that as far as normal monetary policy is concerned, the Federal Reserve was tapped out... But there is more in the way of extraordinary monetary policy that could have been attempted in 2009—including inflation-targeting announcements, the taking of additional risky assets out of the pool to be held by the private sector, larger operations on the long end of the yield curve.
And I must confess that what the Federal Reserve thought and did in 2009 remains largely a mystery to me.
Tuesday, January 19, 2010
Ben Bernanke tries to overcome some of the Fed's negative publicity:
Bernanke Invites GAO to Audit AIG Bailout, by Sudeep Reddy: In a bid to soften congressional criticism, Federal Reserve Chairman Ben Bernanke on Monday invited the Government Accountability Office to audit the central bank’s involvement in the U.S. rescue of American International Group Inc. In a letter to Acting Comptroller General Gene Dodaro, Bernanke said the Fed would provide “all records and personnel necessary” for the auditing arm of Congress to review the rescue. ...
The invitation from Bernanke does not change existing policies about congressional reviews of the Fed. The GAO already has authority to review the central bank’s involvement in the AIG bailout, along with other company-specific rescues by the Fed and Treasury Department. ...
Most people won't realize Bernanke is asking for something the GAO could have done on its own (though perhaps with less cooperation), e.g. the LA Times does not even mention this, so the politics work in the Fed's favor. And it does send the message that the Fed doesn't think it has anything to hide.
Friday, January 15, 2010
Tim Duy looks at the Fed's likely interest rate and balance sheet actions in the months ahead:
It's Not About Interest Rates Yet, by Tim Duy: Incoming data continue to support expectations that the Federal Reserve will hold rates at rock bottom levels for the foreseeable future - likely into 2011. But interest rates should not be the focus of policy analysts. The Fed will manipulate policy via the balance sheet long before they fall back to the interest rate tool. The question is whether or not the slow growth environment is sufficient to persuade the Fed to hold the balance sheet steady or even expand the balance sheet beyond current expectations. And there always remains the third option, favored by a minority of policymakers - withdraw the stimulus now that growth has reemerged. At this point, I suspect the Fed will stick with the hold steady option.
One of the key elements of the slow growth story was the inability and unwillingness of households to revert to past spending habits. The critical parts of the story are that savings rates would rise as household struggled to rebuild tattered balance sheets and that credits would become dearer. These stories are playing out in the data:
Yet the trend of consumer spending has undoubtedly been upward since June, as has been the trend of overall economic activity. Cyclically, the economy is on an upswing, surprising many who believed the apocalypse was at hand. But fears of a consumer apocalypse were always overblown; the change need only be moderate to have a large impact on the overall economic environment. It is not necessary that consumers crawl into their basements, curled into a fetal position hugging a bar of gold in one arm and a loaded shotgun in the other, to dramatically alter the role of households in the economy. Consider, for instance the path of retail sales excluding gasoline:
The November-December average monthly growth trend is 0.032% (note: log difference approximation), while the July-December trend is 0.03% and averages out the distortion caused by the "Cash for Clunkers" program. In either case, the spending trend is below the prerecession trend in sales growth. What are the takeaways from such an analysis?
Thursday, January 14, 2010
Andy Harless says that, in the future, the Fed should target a higher level of inflation to give it more room to maneuver in a crisis:
Inflation Targets and Financial Crises, by Andy Harless: There are basically four ways to deal with the possibility of severe financial crises. First, you can just cross your fingers, hope such crises don’t happen very often, and live with the consequences when they do. Second, you can publicly insure and regulate your economy heavily in an attempt to minimize the risk and severity of such crises. Third, you can have your central bank monitor the fragility of general financial conditions and “take away the punch bowl” when it thinks conditions are in danger of becoming too fragile. Fourth, you can have your central bank target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate.
I know you are tired of hearing me make this point, and that many of you disagree, but maybe you'll be convinced by Paul Volcker? Should the fire code designers, inspectors, and enforcers be part of the fire department, or housed in a separate, independent agency? Does, for example, the knowledge inspectors gain about the risks of fire in various buildings along with knowledge about the nature of those risks (e.g. of spreading to particular adjacent buildings) help firefighters plan a more effective response if a fire does break out? Conversely, does the knowledge that firefighters have help the inspectors to know what to regulate and what to look for during inspections? Are there economies of scale from consolidation, e.g. if we want experts on how fires spread from building to building present among both inspectors and firefighters, is it most efficient and effective to concentrate this expertise in a single agency?:
Volcker Stands Up for Fed Role in Financial Oversight, Reuters: The Federal Reserve must have a “strong voice and authority” on regulatory matters, Paul Volcker ... said on Thursday. Mr. Volcker, a former Federal Reserve chairman, told a lunch meeting at the Economic Club of New York that he had been “particularly disturbed” by proposals to strip the Fed of its supervisory and regulatory responsibilities. “What seems to me beyond dispute, given recent events, is that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined,” said Mr. Volcker...
What are the actual arguments for this?:
The Public Policy Case for a Role for the Federal Reserve in Bank Supervision and Regulation, by Ben Bernanke: Like many other central banks around the world, the Federal Reserve participates with other agencies in supervising and regulating the banking system. The Federal Reserve’s involvement in supervision and regulation confers two broad sets of benefits to the country.
Wednesday, January 13, 2010
In response to the question of whether the Fed's low interest rate policy is responsible for the bubble, most respondents point instead to regulatory failures of one type or another. Ben Bernake has also made this argument. However, I don't think it was one or the other, I think it was both. That is, first you need something to fuel the fire, and low interest rates provided fuel by injecting liquidity into the system. And second, you need a failure of those responsible for preventing fires from starting along with a failure to have systems in place to limit the damage if they do start.
Bank regulators didn't have the systems in place to prevent bubbles, they didn't see the bubble developing until it was too late to prevent major damage, and the systems needed to limit the damage were inadequate, e.g. there were insufficient limits on leverage and other protections in the system. By analogy, the Fire Department's inspections were inadequate and there was much more fire risk than anyone thought, they didn't notice the fire until it was already out of control (even though Dean Baker and others had tried to alert them), when they did notice and respond they were initially confused and didn't have the tools they needed to fight the fire or prevent it from spreading, and they hadn't thought to require protections such as automatic sprinkler systems that might have limited the damage.
What fueled the housing bubble? There were three main sources of the liquidity that inflated the bubble. First, the Fed's (and other central banks') low interest policy added cash to the financial system, second, the high savings in Asia, particularly China, along with cash accumulations within oil producing nations, and third, some of the cash was generated endogenously within the system (e.g. by increasing leverage or by diverting other investments into housing and mortgage markets).
Once the fuel was present, something had to allow the bubble to inflate and then do widespread damage, and that's where the regulatory failure comes in. But I don't think the regulatory failure matters much without a large amount of liquidity within the system, and I don't think the large amount of cash in the system is problematic without the regulatory failures.
I've been making this argument for some time, so is there any support for the idea that bubbles are fueled by excessive liquidity? In the video embedded below of Nobel prize winning economist Vernon Smith that posted today at Big Think, he notes that in the experiments he has conducted that reproduce bubbles in the lab, the existence and size of bubbles depends critically upon the amount of "cash slopping around in the system."
In the video, he also notes that if you ask a different question, why was this bubble so devastating as compared to the dot.com bubble even though the initial losses were smaller -- $10 trillion in 2001 compared to $3 trillion in the housing bubble collapse -- you get a different answer: a failure of regulation. Here, he points to a failure to impose sufficient margin requirements as the key difference between the two episodes (I agree that leverage should be limited through margin requirements, and this would have helped to contain the damage, but I would have focused on the markets for complex financial assets rather than down payments on homes).
So I think the bubble itself was driven by "cash slopping around in the system" that originated from several sources, the Fed being one, and the regulatory failures (such as failing to provide sufficient transparency so that the smoke from the fire could be spotted in time, and failing to limit leverage) allowed the fire to spread rapidly and do major damage.
Tuesday, January 12, 2010
Thursday, January 07, 2010
We're beginning to hear hawkish talk from some members of the Federal Reserve:
The 2010 Outlook and the Path Back to Stability, by Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City: ...Policy Challenges Ahead As I have indicated, a key contributor to the economic recovery is the extraordinary fiscal and monetary stimulus provided by governments and central banks around the world. In the U.S., we have seen the largest fiscal stimulus in history...
While these policy actions have been instrumental in helping to stabilize the economy and financial system, they must be unwound in a deliberate fashion as conditions improve. Otherwise, we risk undermining the very economic performance we hope to achieve. In the case of fiscal policy, the ballooning federal deficit must be controlled and reduced. ...
As the private sector recovers, increasing demand to finance both public and private debt will likely place upward pressure on interest rates. Eventually, there will be pressure put on the Federal Reserve to keep interest rates artificially low as a means of providing the financing. The dire consequences of such action are well documented in history: In its worst cases, it is a recipe for hyperinflation.
Addressing the deficit will be made all the more complicated by the fact that many of the stimulus programs are scheduled to wind down in 2011 at the very time the Bush administration tax cuts are also scheduled to expire. It will be an extremely abrupt shift in fiscal policy from stimulus to restraint that will cause the economy to weaken. Addressing the deficit under these types of circumstances will be controversial and desperately unpopular. ...
In the case of monetary policy, the challenges are no less daunting. The Federal Reserve must curtail its emergency credit and financial market support programs, raise the federal funds rate target from zero back to a more normal level, probably between 3.5 and 4.5 percent, and restore its balance sheet to pre-crisis size and configuration. ... However, normalizing monetary policy and the Federal Reserve’s balance sheet will be a ... contentious undertaking, and there are differing views regarding when this process should begin, how fast it should proceed, and what form it should take.
One view is that the Federal Reserve should delay interest rate normalization until there is more certainty that the economy and financial markets have completely recovered from this crisis. At that time, the accommodation can begin to be removed. Those who hold this view believe that high unemployment and low inflationary pressures due to excess capacity create considerable economic downside risks if the Federal Reserve removes stimulus. Their biggest fear is of the “double-dip” recession. In their minds, these immediate risks continue to outweigh concerns about long-term economic performance.
This is an appealing argument. The recovery is in its early stage, and weak data continue to emerge in some reports. State and local governments remain under severe fiscal pressures despite considerable federal assistance. Business investment spending for nonresidential construction and equipment remains weak. Additionally, those parts of the country heavily exposed to the subprime lending bust and to the auto industry remain depressed. Also, there is no denying the fact that despite improvements, labor markets and parts of our financial system remain under stress. Thus, while the economic and financial recovery is gaining traction, risks and uncertainty remain major deterrents to removing the stimulus.
Unfortunately, mixed data are a part of all recoveries. And, while there is considerable uncertainty about the outlook, the balance of evidence suggests that the recovery is gaining momentum. In these circumstances, I believe the process of returning policy to a more balanced weighing of short-run and longer-run economic and financial goals should occur sooner rather than later. ...
As I have already said today, experience has shown that, despite good intentions, maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations, more volatile and higher long-run inflation, and more unemployment — not today, perhaps, but in the medium- and longer-run. ...
Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis. ...
St. Louis Fed chief James Bullard said the U.S. jobless rate will start to fall soon and played down price pressures facing the United States in the near term, saying that the Fed's moves to pump liquidity into the economy were not an inflationary concern.
As noted above, there are two risks, one is high unemployment and the other is high inflation. However, the costs associated with high unemployment are larger than the costs of high inflation (Hoenig' mention of hyperinflation is merely to scare people, that's not going to happen). So preventing high unemployment should be the primary concern of policymakers. The Fed should not be in any hurry to tighten monetary policy, and if anything, it should drag its feet.
[Here's a bit more on the relationship between unemployment and the Fed's target interest rate in the aftermath of recessions. One more note. While I haven't been strongly in favor of further aggressive quantitative easing from the Fed due to pessimism that such policies would work (though I haven't strongly opposed such action either), that is different from being worried that the present policy will cause inflation problems. I don't think it will and I certainly don't think that the economy is anywhere near the point where we need to start worrying about tightening policy. Finally, I wonder what the correlation is between being hawkish about inflation and being hawkish about the deficit. I'd guess it's relatively high.]
In August 2005 at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo., Raghuram Rajan presented a paper filled with caution. Answering the question “Has Financial Development Made the World Riskier?” the University of Chicago economist observed that financial innovation had delivered unquestioned benefits, but also had produced undeniable risks.
“It is possible these developments may create … a greater (albeit still small) probability of a catastrophic meltdown,” he told the assembled central bankers and academics. “If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions.”
It was a discordant note at a forum celebrating Alan Greenspan’s tenure as Fed chairman; many deemed his conclusions “misguided.” But history, of course, proved that Rajan’s analysis was dead on. ...
Here is a blunt assessment of the Jackson Hole episode.
Here are a few sections from the (much longer) interview:
... Doubts about Diminishing Risk
[Ron] Feldman: In a prominent Jackson Hole paper,2 you talked about some of the technologies of banking that people thought were going to distribute risk widely and therefore diversify it, making the financial system and financial institutions less risky. It was less clear to you that risk reduction was actually occurring. Could you talk about how you came to that view and how important you think that was in the current crisis?
[Raghuram] Rajan: One of the things I was asked to do was to look at the development of the financial sector, and I have great admiration for some of the things that have happened. There have been good things in the financial sector which have helped us. But to some extent there was a feeling that when you distribute risk, you’ve reduced the risk of the banking system.
My thought was, what business are the banks in? They’re not in the business of being plain-vanilla entities, because they can’t make any money that way. They are in the business of managing and warehousing risk. So if it becomes easier to lay off a certain kind of risk, the bank better be taking other kinds of risk if it wants to be profitable. And if the vanilla risk is going off your books, presumably the risks that you’re taking on are a little more complex, a little harder to manage.
That was the logic which led me to argue ... that distance-to-default measures didn’t look like they were coming down despite all this talk about securitization and shifting risk off bank books. That struck me as consistent with my view that maybe the risks that banks were taking on were more complicated. Whether they were excessive or not, I couldn’t tell.
Also, as I saw the mood, I became worried. Having studied past financial crises, I knew that it’s at the point when people say, “There’s no problem,” that in fact all the problems are building up. So that was just another indicator that we should be worried.
I should add that while I thought we could have a crisis, I never thought that we’d come to the current pass. However, I did argue that it could be a liquidity crisis..., and even though banks in the past had been the safe haven, they could be at the center of this problem.
So, one strand of my argument was based on the business of banks, but the second strand was to think about the incentive structure of the financial system and say that while we have moved to a compensation structure that penalized obvious risk, risk that you could see and measure, that may have made employees focus on risks that could not be measured. An example of that is “tail risk,” because you can’t measure it until it shows up, and it shows up very infrequently. So part of the reason I was worried was that people were taking more tail risk; an insurance company writing credit default swaps was just one example of that.
It didn’t require genius at that point to look around and say the insurance companies were writing these credit default swaps as if there was no chance on earth that they would ever be asked to pay up, so they were really taking on tail risk without any thought for the future. AIG should not have been such a surprise to the Fed.
Feldman: Ex post it was clear to everyone that the incentives were aligned so that firms were taking on risk that people didn’t understand, but at the time there was push-back to what you were saying. ...
Rajan: There were two reasons for the push-back. One was just the venue. This conference was almost a Festschrift [farewell tribute] to Greenspan, and it seemed to some—though it wasn’t intended as such—that I was raining on the parade. This was his farewell, and I was talking about problems that had arisen during his tenure.
But the bigger issue was the collective sense that the private sector could take care of itself, and if not, the Fed would be able to clean up. We had been through two downturns: the 1998 emerging market crisis and the 2000-2001 dot-com bust, and we had understood the tools that were required. In 1998, it was a short reduction in interest rates, not a dramatic one. In 2000-2001, it was a dramatic reduction. And these “successes” led to a feeling that “the Fed can take care of it.”
You know the argument: Typically, the private sector will have the right incentives. Why would they blow themselves up? Regulators aren’t that capable: They’re less well-paid and less informed than the private sector, so what can they do? And finally, if worse comes to worst, the Fed will pick up the pieces.
I think there are three things wrong with this argument, one for each of those elements. Private sector—yes, it can take care of itself, but its incentives may not be in the public interest; may not even be in the corporate interest if corporate governance is problematic. So the trader could fail the corporation, could also fail society. That’s one problem.
Second, the public sector has different incentives from the private sector, and that’s a strength of the public sector. When we’re talking about regulators, because they’re not motivated in the same way as the private sector, they can stand back and say, “Well, I don’t fully understand the risks you’re taking, but you are taking lots of risk—stop.” So I think we’ve made too little of the incentive structure of regulators which should be different, can be different, which gives them a role in this, rather than saying they’re incompetent and they can’t do it. I think they can.
But the third aspect was that I think we overestimated the ability of monetary policy to pull us out of a serious credit problem. The previous problems we had dealt with in the U.S. were not credit problems. They were standard, plain-vanilla recessions. The bank system was still active, so monetary policy wasn’t pushing on a string: The Fed brought down interest rates, and things did come back up.
When credit problems arose—and real estate was central to credit problems because of the real estate securities which ended up on bank balance sheets—then the banks were incapable of being part of the transmission process, and now monetary policy lost a lot of traction, so it wasn’t simply a matter of cutting interest rates and seeing everything come back.
Feldman: People might have thought after the banking crisis of the 1980s and early 1990s—which did not have the same macroeconomic effect as this crisis—that they could respond effectively.
Rajan: Exactly. I guess we didn’t see anything as big, as deep in the recent past. And there was a certain amount of hubris that we could deal with this.
Why was the Crisis so Severe?
Feldman: Why do you think this financial crisis was more severe? There are lots of potential explanations. Some observers point to the failure of credit rating agencies; others point to flawed incentives in compensation and to the creation of new financial products as examples. If you had to list the two or three things that you think really underlie why there was so much risk-taking, why more risk-taking than people thought, what’s the deep answer for that?
Rajan: You can go right to the meta-political level, but let me leave that aside for now. If you hone down on the banking sector itself, I think it was a situation where it was extremely competitive. Every bank was looking for the edge. And the typical place to find the edge is in places where there are implicit guarantees. ...
I think the most damaging statement the Fed could have made was the famous Greenspan doctrine: “We can’t stop the bubble on the way up, but we can pick up the pieces on the way down.” That to my mind made the situation completely asymmetric. It said: “Nobody is going to stop you as asset prices are being inflated. But a crash is going to affect all of you, so we’ll be in there. By no means go and do something foolish on your own, because we’re not going to help you then. But if you do something foolish collectively, the Fed will bail you out.”...
People were acting as if liquidity would be plentiful all the time. And my sense of what the Fed does, in part, by reducing interest rates considerably is help liquidity, and so there was a sense that, well, we can take all the liquidity risk we want, and it won’t be a problem. Of course, it turned out that not just interest rates mattered; the quantity of available liquidity or credit also mattered at this point. And that was the danger. ...
Corruption, Ideology, Hubris, or Incompetence?
Feldman: One thing you haven’t mentioned as a proximate cause is issues around “crony capitalism.” Some seem to argue that banks were allowed to grow large and complex because they were run by friends or colleagues of people who were in power. And for similar reasons, these firms got bailed out—because they had colleagues and friends in “high places.” Given that you’ve thought a lot about that in your own writing, given that you were at the IMF [International Monetary Fund] where you had the ability to look across countries where it is an issue, how important would you say crony capitalism is in the U.S. context in the current crisis?
Rajan: Let me put it this way. There is always some amount of regulatory capture. The people the regulators interact with are people they get to know. They see the world from their perspective, and, you know, they want to make sure they’re in their good books. And so it’s not surprising that across the world, you have a certain amount of the regulators acting in the interest of, and fighting for, the regulated.
Beyond that: Is there naked corruption, or less naked corruption? “If you do my work for me as a regulator, then you can come and join me as a senior official in my firm, and I’ll pay you back at that point.” I’m sure there were stray instances of that, but that to my mind, wouldn’t be the number one reason for this crisis.
I think I would put more weight on a sense of market infallibility which pervaded the economics profession, not just regulators. ... I think across the field of economics, we stopped worrying about the details in industrial countries because we said, by and large, things get taken care of. Yes, there is the occasional corporate fraud or misaligned incentives, but those are aberrations rather than a systemic problem. So I think this view, that you couldn’t have a large systemic problem, this was the problem.
Overlaid on this was the view that regulation was less and less important. We put excessive weight on the private sector getting it right on their own without understanding that the private sector can also break down—the board may not know what management is doing, management may not know what the traders are doing, so that process can break down. But even if everybody is working in the interests of the corporation, the corporation may not be acting in the interests of the system. We’ve seen all these things happen. So the regulatory system had a role to play, and it did not play that as much as it should have. ...
I’m positive that there were situations that we will discover in hindsight where excessive influence was used. There’s cronyism. In a crisis like this, it’s hard to escape it. But I’m less convinced that systematic cronyism was the reason for this. I think ideology was part of the reason we went wrong, as also was the hubris built up over decades of fairly strong growth and deregulation. ...
I guess I’m paraphrasing Churchill, but my tendency is not to attribute to malevolence what can be more easily attributed to incompetence. I think there are a fair number of situations where things didn’t work out as advertised.
Feldman: But you’re talking about more than incompetence, right? You’re talking about the incentive structures within firms that would lead people to act as if they were incompetent.
Rajan: I’d even go one step further and say you don’t have to offer an explanation that relies on evil people or corrupt people. The entire crisis can be explained in terms of people who were doing the right things for their own organizations. You can even argue that it was not that they were misdirected by their own distorted compensation structures; they thought they were doing the right thing for their organization. But when you added it all up, it didn’t add up to doing good for society. And that’s where we have the problems. ...
The Economics Profession
Feldman: We just talked about the economics profession and what has worked well or hasn’t worked well. There’s been a lot of discussion about saltwater and freshwater schools in economics recently.4 I think you have an interesting background to talk about that since you’re at the [freshwater] University of Chicago business school and you’ve done a lot of work about financial systems, but you got your Ph.D. at [saltwater] MIT. Do you have a view about what the economics profession didn’t do well? And what the economics profession ought to be focused on going forward?
Rajan: I have a take on this, yes. But first, one has to remember that the saltwater economists, so to speak, were crowing victory in 1969. You see quotes from Paul Samuelson and Bob Solow [at MIT] saying essentially that the business cycle is dead; we have learned how to deal with it. And we know what happened after that.
I think there is a problem with economics when it thinks it has solved all the traditional problems. That’s when economics slaps you in the face and says, “Not so fast!” The reason rational expectations in macroeconomics and efficient markets in finance are under attack now is not so much because people can tie specific failings to these theories but because they’re the dominant part of the economics or finance profession right now. So I think debate has gone a little off track, in the sense of saying, “You were responsible.”
Would any of the neo-Keynesians have done any better? There were many of them in the Clinton administration where some of this stuff built up. Would anybody pin all this on the Bush administration only? No, it’s a systemic problem. So, I think the debate about “economics is to blame.” well, yes, it is to blame to the extent that it didn’t pick up on some of what happened. But this crisis is problematic for all broad areas of macroeconomics or even of finance.
It is clear that there are many areas of economics that have studied the problems we saw in this crisis. For example, the banking and corporate finance guys have looked at agency problems, looked at banking crises, etc. The behavioral theorists have inefficient markets and irrational markets. So, again, the profession as a whole, I don’t think, deserves blame. It has been studying some of these things.
The central question is why certain areas of economics, particularly macroeconomics, abstracted from the plumbing, which turned out to be the problem here. My sense is that that abstraction was not unwarranted given the experience of the last 25 to 30 years. You didn’t have to look at the plumbing. You didn’t have to look at credit. Monetary economists thought credit growth was not an issue that they should be thinking about. Interest rates and inflation were basically what they should be focusing on. The details of exactly how the transmission took place were well established, and we thought they would not get interrupted. Well, we’ve discovered they can get interrupted.
The natural reaction is now to write models which have the details of the plumbing, and you see more of that happening. So I think what the macroeconomists did was not because they were in the pay of the financial sector or consultants of whatever [laughter], as some have said. But I think it was that that was a useful abstraction given what we knew, and it’s no longer an abstraction that we can ever undertake now. ...
Tuesday, January 05, 2010
This is from Roger Farmer's "Farewell to the natural rate: Why unemployment persists." He argues that "the relationship between unemployment and inflation is more complicated than that suggested by simple new-Keynesian models that incorporate a “natural rate” of unemployment." Why is this important?:
...In two forthcoming books,... I provide a theory that explains these data. I argue that there is no natural rate of unemployment and that the economy can come to rest in a stationary equilibrium at any point on the Beveridge curve. Which equilibrium persists, is decided by the confidence of households and firms that pins down asset values as reflected in housing wealth and the value of the stock market.
When households feel wealthy, that belief is self-fulfilling. Consumers spend a lot, firms hire workers, and the economy comes to rest at a point on the Beveridge curve with low unemployment and high vacancies. When the values of houses, factories, and machines fall, households spend less, firms lay off workers, and the economy comes to rest at a point on the Beveridge curve with high unemployment and low vacancies. Both situations – and anything in between – are zero-profit equilibria. ...
Most policymakers subscribe to the theory of the existence of a natural rate of unemployment. The data suggest that this theory is unconfirmed at best. To make the theory consistent with data, one must posit that the natural rate changes between recessions in unpredictable ways. This version of natural rate theory is difficult or impossible to refute. It is religion, not science.
For more than fifty years policy makers have been trying to hit two targets, unemployment and inflation, with one instrument, the interest rate. Recently, central bankers have discovered a second instrument – quantitative easing. I believe that quantitative easing works by influencing the value of real assets as reflected in housing wealth and the stock market and that it was successfully deployed by central banks in 2009 to maintain aggregate demand. In my two forthcoming books, I argue that quantitative easing should permanently enter the lexicon of central banking as a second instrument of monetary policy and that it will prove to be a more effective and flexible tool than fiscal policy for restoring and maintaining full employment.
I seem to be the only skeptic about the ability of quantitative easing to have a substantial impact on unemployment.
Out of the Gate with a Bang, by Tim Duy: If you were looking for a final, cataclysmic collapse of the US economy, you remain disappointed. To be sure, the fallout from the financial crisis is severe, with the palpable wreckage evident in the bottom line, a rate of underemployment at 17.2%. Yet even the most diehard pessimist could not fail to recognize the numerous signs of a cyclical turning point in the second half of 2009. And those signs continued into the new year with today's ISM release. The bulls had reason to run with these numbers; the near term outlook appears baked in the cake. Yet the near term is not an interesting question, in my opinion. The interesting question is what will emerge in the second half of the year. Is the first half a head fake? And, more importantly, where will incoming data lead policymakers, particularly at the Fed? My expectation remains that the Fed will wait until the medium term uncertainty is lifted before raising interest rates, which would be well into the back half of this year if not into 2011. But that might not be the ball to watch; policymakers probably worry about the size of the balance sheet more than the level of interest rates. The near term risk is that stronger than expected growth in the first half would tempt the Fed to withdraw that liquidity before the recovery became fully entrenched.
The ISM manufacturing numbers for December stoked a fire on Wall Street Monday morning, with the better than expected headline number bolstered by strong gains in new orders, the lifeblood of future factory production. Moreover, the employment numbers moved higher, which, coupled with steady declines in initial unemployment claims, points toward actual - gasp - job growth as early as the first quarter. Industrial production gained a solid 0.8% in November, returning to something resembling a "V" shaped recovery in the making after a flat reading in October. Similarly, core manufacturing orders continued their upward trend that same month. Inventory to sales ratios continue to fall, arguing for continued restocking support. And consumer spending continues to edge forward despite declining consumer credit and rising saving rates, a dynamic that will be increasingly supported by firming job markets. What's not to like? No wonder then that Treasury markets have sold off modestly, the 10 year bond heading toward the 4% mark.
Indeed, using the typical post war recession as a guide, one would think the pessimists would by now have folded their cards, leaving that smoky back room of despair for the clear air and bright sunshine that mark the beginning of a new day. But alas, the fear remains that there is no longer such a thing as a "typical" post war recession. The recovery appears inexorably linked to a host of stimulus measures that reach into virtually every strand of the fabric that is the US economy. And therein lies the uncertainty - few are confident that the economy can stand on its own. And the hypothesis that it can has not been tested. The Fed continues to expand its holding of mortgage securities, still looking toward March as the end date for that program. The positive growth impulse from fiscal stimulus will continue through the first half of this year. Support for housing comes via many channels - and despite rising existing home sales and price stabilization, no one believes the housing market remains anything but broken. Moreover, it is difficult to forget that solid US growth of the past decade and earlier was dependent on asset bubbles to fuel consumer spending. No such convenient asset bubble is on the horizon at the moment.
Where does the economy stand when the support for housing is withdrawn, when fiscal stimulus runs its course, when the inventory correction process is complete?
Monday, January 04, 2010
Did the Fed Cause the Recession?, by Mark Thoma: I have been more defensive of the Fed's actions both before and after the crisis started than most, and I want to talk about why recent criticism of Bernanke and the Fed for their failure to use regulatory intervention to stop the housing bubble is correct, but perhaps directed at the wrong target. ...[...continue reading...]...
There's a pretty good chance that the next few economic reports will make it appear that the economy is improving, but those reports may not be as positive as they seem on the surface. Will policymakers "misinterpret the news and repeat the mistakes of 1937?":
That 1937 Feeling, by Paul Krugman, Commentary, NY Times: Here’s what’s coming in economic news: The next employment report could show the economy adding jobs for the first time in two years. The next G.D.P. report is likely to show solid growth in late 2009. There will be lots of bullish commentary — and the calls we’re already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder.
But if those calls are heeded, we’ll be repeating the great mistake of 1937, when the Fed and the Roosevelt administration decided that the Great Depression was over, that it was time for the economy to throw away its crutches. Spending was cut back, monetary policy was tightened — and the economy promptly plunged back into the depths. ...
As you read the economic news, it will be important to remember, first of all, that blips — occasional good numbers, signifying nothing — are common even when the economy is ... in a prolonged slump. ...
Such blips are often ... statistical illusions. But ... they’re usually caused by an “inventory bounce.” When the economy slumps, companies typically find themselves with ... excess inventories, [and] they slash production; once the excess has been disposed of, they raise production again, which shows up as a burst of growth in G.D.P. Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long-term investment, pick up.
Which brings us to the still grim fundamentals of the economic situation. During the good years of the last decade,... growth was driven by a housing boom and a consumer spending surge. Neither is coming back. ...
What’s left? A boom in business investment would be really helpful... But it’s hard to see where such a boom would come from: industry is awash in excess capacity, and commercial rents are plunging in the face of a huge oversupply of office space.
Can exports come to the rescue? For a while, a falling U.S. trade deficit helped cushion the economic slump. But the deficit is widening again, in part because China and other surplus countries are refusing to let their currencies adjust.
So the odds are that any good economic news ... will be a blip, not an indication that we’re on our way to sustained recovery. But will policy makers misinterpret the news and repeat the mistakes of 1937? Actually, they already are.
The Obama fiscal stimulus plan is expected to have its peak effect ... around the middle of this year, then start fading out. That’s far too early: why withdraw support in the face of continuing mass unemployment? Congress should have enacted a second round of stimulus months ago... But nothing was done — and the illusory good numbers we’re about to see will probably head off any further possibility of action.
Meanwhile, all the talk at the Fed is about the need for an “exit strategy” from its efforts to support the economy. One of those efforts, purchases of long-term U.S. government debt, has already come to an end. It’s widely expected that another, purchases of mortgage-backed securities, will end in a few months. This amounts to a monetary tightening, even if the Fed doesn’t raise interest rates directly — and there’s a lot of pressure on Mr. Bernanke to do that too.
Will the Fed realize, before it’s too late, that the job of fighting the slump isn’t finished? Will Congress do the same? If they don’t, 2010 will be a year that began in false economic hope and ended in grief.
Wednesday, December 30, 2009
Will the crisis teach economists not to be overconfident about their abilities?
My answer is here.
Monday, December 28, 2009
Why Christmas Eve?, by Tim Duy: One would think that policymakers would treat the day before Christmas as sacrosanct, if not for the sake of their employees, but to avoid the endless conspiracy theories that naturally arise when you partake in activities that look like they are intended to fly under the radar. Has US Treasury Secretary Timothy Geithner learned nothing in his long tenure serving Goldman Sachs the people of the United States of America? Ignoring the wisdom of the ages, Geithner made what appears to be unlimited funds available to Freddie Mac and Fannie Mae on the day when most of the nation is more concerned about getting presents under the tree (myself personally content that I can squeeze yet another year of magic under the Santa Claus myth) than the policy machinations of Washington.
But do we really care? Is this really a new news, or just a matter of questionable timing? Would the same announcement today have raised the ire of the blogoshpere?
To get at this issue, we should back up to a New York Times article a few weeks back (hat tip to Dean Baker):
Fannie Mae and Freddie Mac, which buy and resell mortgages, have used $112 billion — including $15 billion for Fannie in November — of a total $400 billion pledge from the Treasury. Now, according to people close to the talks, officials are discussing the possibility of increasing that commitment, possibly to $400 billion for each company, by year-end, after which the Treasury would need Congressional approval to extend it. Company and government officials declined to comment.
Apparently this little item was lost in the Christmas rush - seriously, could this even compare to the endless fascination with the status of holiday sales? The point is that hanging in the background was the likelihood that Mae and Mac were expecting some very, very bad fourth quarter numbers. Indeed, despite the massive efforts to support the housing market, Fannie Mae reported today that serious delinquencies continue to climb at an alarming rate. So, at second glance, Treasury's Christmas Eve announcement looks somewhat less disconcerting. The timing questionable, but the outcome expected. But why the essentially unlimited access to funds? I think this is pretty straightforward - Geithner simply lifted illusion (delusion?) that the GSEs were anything less than backed by the full faith and credit of the Uncle Sam. Seriously, at this juncture who believes that GSE debt is any different than Treasury debt? Or that the US will not pump in any amount of dollars necessary to keep the GSEs afloat?
That said, the Treasury's press release was bereft of explanatory information, giving rise to a host of theories as chronicled by Calculated Risk. In my mind, the most appealing of these explanations (other than that stated above) is the supposed intention to use the GSEs to absorb dysfunctional mortgages in an effort to revive floundering modification programs. Why? Because, as structured, modifications just simply don’t work in aggregate. I have thought this from day one of the modification story. And, frankly, I don’t think I am particularly insightful on this point. Seems obvious. Suppose homeowner A is underwater on a mortgage costing $4,000 a month for a property that now has a rental equivalent of $2,000. How exactly does it help that homeowner to "modify" their mortgage to $3,000 a month? They are still underwater, and they will likely have to sacrifice any potential gains (10-20 years down the road!). The modification leaves you with the choice of being a virtual renter for $3,000 a month or an actual renter for $2,000 a month. Moreover, what truly is better for the economy? To free up $2,000 in the household's monthly budget via a balance sheet restructuring, or to weigh down the household balance sheet with an impossible debt burden?
The Wall Street Journal recently printed a front page article on this topic that I thought was spot on:
Thursday, December 24, 2009
The excess capacity series (red line) peaked in June of this year, and has been moving downward ever since. If the pattern in the two most recent recessions holds, those in 1990-91 and 2001, the peak in the unemployment rate will come between 16 and 19 months after the peak in excess capacity, i.e. around a year from today (though prior to 1990 the peaks were coincident).
The most recent data on the unemployment rate showed a downward tick from 10.2 percent to 10.0 percent, so perhaps unemployment has already peaked and the lag will be shorter this time. But perhaps not. As an inspection of the unemployment series in the graph shows, the unemployment rate bounces around even when it is trending upward or downward. So it's hard to tell from one month's data whether the downward tick in the unemployment rate is temporary and unemployment still has a ways to go before peaking (as in the last two recessions), or a sign that a turning point has been reached and things are getting better (which would represent a reversion to the more coincident movement in the two series observed before 1990).
Note, however, that in the 2001 recession, unemployment fell briefly just after excess capacity peaked, but then resumed its upward movement for several more months before reaching a turning point 19 months after the turning point in excess capacity. Thus, while the recent downward tick in the unemployment rate is good news, certainly better than an uptick, we should be prepared for the possibility that the pattern in the last recession might repeat itself and unemployment will head back upward for several more months before it reaches its peak. I hope that doesn't happen, the sooner unemployment returns to normal the better, but we need to be better prepared than we are for the very real possibility that unemployment will continue to trend upward. I'd like to see more done on both the monetary and fiscal policy fronts as a preemptive measure, we can always ease off if things turn our better than expected, but at the very least we need to resist calls from the deficit and inflation hawks to begin pulling back and continue the programs that are already in place.
[Question: What happened from mid 1997 through the beginning of 1999 that caused the two series to move in opposite directions and separate?]
Update: Paul Krugman follows up here.
Tuesday, December 22, 2009
I have been more skeptical than most about the ability of quantitative easing to stimulate output and employment, so I thought I'd counter that with this explanation of how QE works, what might go wrong, and some of the evidence in its favor.
[My doubts come on two fronts. The first is the ability of QE to affect long-term real rates, and the evidence is somewhat favorable on this point, though not 100 percent compelling. It does seem that the Fed can lower long-term real rates, mortgage rates in particular, though why we want to stimulate investment in new housing in the aftermath of an housing bubble is a question we might want to ask.
My second objection is related to this - even if we do lower long-run real mortgage rates, will that stimulate new investment in housing given the inventory problem that already exists, and given the condition of the economy? I'm doubtful, and that doubt extends generally. The mechanism described below relies upon lower real interest rates stimulating new investment, but even if long-term rates fall across the board, will firms be inclined to go out and buy new factories and equipment when so much of what they have is sitting idle?
Fiscal policy can put these resources to work directly, but monetary policy must induce firms to invest (or induce households to purchase housing and durables), and in a recession that may be hard to do. That's why I've emphasized fiscal policy, and that is what my objection is mostly about. The focus on the Fed has made it appear that monetary rather than fiscal policy is our best bet at this point. Monetary policy might be able to help for the reasons explained below, so I have no objection to trying, but fiscal policy needs to take the lead.
I should acknowledge that it may not be politically possible at this point to do more on the fiscal policy front, and the 3.5 percent growth rate for third quarter GDP that turned out to be a false signal didn't help at all (note, however, that the Fed is equally unlikely to respond to calls for it to do more). But there did seem to be momentum building toward providing more help through fiscal policy -- there was even a jobs summit -- however the talk about fiscal policy suddenly ended as people turned their guns on the Fed. While that may have been needed to get the Fed thinking harder about what more it can do, we should have also kept up the pressure on fiscal authorities. That fiscal authorities have been let off the hook is disappointing]:
Conducting Monetary Policy when Interest Rates Are Near Zero, by Charles T. Carlstrom and Andrea Pescatori, Economic Commentary, FRB Cleveland: This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes how monetary policy might be conducted in such a situation. We argue that avoiding expectations of deflation is key and that the monetary authority needs to demonstrate an unequivocal commitment to preventing deflation. We also argue that price-level targeting might be a good device for communicating such a commitment.
While business cycles are inevitable, there is quite broad agreement among economists and policymakers that monetary policy can and should be used to damp fluctuations in economic activity. But some fluctuations can occur in an unusual economic environment in which the traditional tools of monetary policy become useless. When short-term interest rates are at or near zero, for example, monetary policy cannot be implemented in the usual way—by adjusting these short-term interest rates. If policymakers want to lower rates in such an environment, they must look for alternative ways of conducting policy. With the federal funds rate hovering just above zero since December 2008, the current U.S. economic situation is a case in point. To conduct monetary policy under these conditions, the Federal Reserve has had to turn to a new strategy and new tools.
Some economists have pointed to another problem that an environment of near-zero interest rates could pose for monetary policy. They suggest that the inability to lower interest rates could allow a sudden and unexpected fall in the demand for goods and services to push the economy into a deflationary spiral, a situation in which falling prices and falling output feed upon each other. The fear is that a negative demand shock that pushes down prices (in short, a deflationary shock) could further decrease output, thereby accentuating the deflationary process. This additional deflation will then lead to further output decline. Paul Krugman, the economist and New York Times columnist, has dubbed this downward spiral a “black hole,” from where there is no return.1
This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes some of the ways in which monetary policy might be conducted in this situation. We conclude by emphasizing that to be effective in an environment of zero short-term nominal interest rates, monetary policy needs to be unequivocally committed to avoiding expectations of deflation. We also argue that price-level targeting might be a good device for communicating such a commitment. While this policy prescription follows from the assumption that the zero interest rate bound is a consequence of a negative demand shock hitting the economy, it is worth stressing that falling prices can also be the consequence of a supply shock, namely particularly high productivity growth (not a bad thing!). This would clearly call for different policy actions than the ones described here.
Monday, December 21, 2009
Many of you will likely disagree with this:
Friday, December 18, 2009
At CBS MoneyWatch, why I haven't joined the loud calls for the Fed to engage in quantitative easing as a means of creating jobs:
The Fed Can Help, But Fiscal Policy Is The Key To Job Creation, by Mark Thoma: There are many people currently criticizing the Fed for worrying too much about inflation and not enough about employment. They want the Fed to use quantitative easing - the purchase of financial assets when interest rates are already at zero - as a means of stimulating the economy and creating jobs. I think it's a mistake ...[...continue reading...]...
Thursday, December 17, 2009
Ben Bernanke answers some questions:
Sen. Vitter Presents End-of-Term Exam For Bernanke, by Sudeep Reddy, WSJ: Earlier this month, Real Time Economics presented questions from several economists for the confirmation hearing of Federal Reserve Chairman Ben Bernanke. Many of the questions were addressed at the hearing, though not always directly. Sen. David Vitter (R., La.) submitted them in writing and received the responses from Bernanke, along with his own other questions. We offer them here.
The Wall Street Journal reported on some questions that different economists felt that you should answer. Let me borrow from some of those and I will credit them with their questions accordingly:
A. Anil Kashyap, University of Chicago Booth Graduate School of Business: With the unemployment rate hovering around 10%, the public seems outraged at the combination of three things: a) substantial TARP support to keep some firms alive, b) allowing these firms to pay back the TARP money quickly, c) no constraints on pay or other behavior once the money was repaid. Was it a mistake to allow b) and/or c)?
TARP capital purchase program investments were always intended to be limited in duration. Indeed, the step-up in the dividend rate over time and the reduction in TARP warrants following certain private equity raises were designed to encourage TARP recipients to replace TARP funds with private equity as soon as practical. As market conditions have improved, some institutions have been able to access new sources of capital sooner than was originally anticipated and have demonstrated through stress testing that they possess resources sufficient to maintain sound capital positions over future quarters. In light of their ability to raise private capital and meet other supervisory expectations, some companies have been allowed to repay or replace their TARP obligations. No targeted constraints have been placed on companies that have repaid TARP investments. However, these companies remain subject to the full range of supervisory requirements and rules. The Federal Reserve has taken steps to address compensation practices across all firms that we supervise, not just TARP recipients. Moreover, in response to the recent crisis, supervisors have undertaken a comprehensive review of prudential standards that will likely result in more stringent requirements for capital, liquidity, and risk management for all financial institutions, including those that participated in the TARP programs.
B. Mark Thoma, University of Oregon and blogger: What is the single, most important cause of the crisis and what s being done to prevent its reoccurrence? The proposed regulatory structure seems to take as given that large, potentially systemically important firms will exist, hence, the call for ready, on the shelf plans for the dissolution of such firms and for the authority to dissolve them. Why are large firms necessary? Would breaking them up reduce risk?
The principal cause of the financial crisis and economic slowdown was the collapse of the global credit boom and the ensuing problems at financial institutions, triggered by the end of the housing expansion in the United States and other countries. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn.
This crisis did not begin with depositor runs on banks, but with investor runs on firms that financed their holdings of securities in the wholesale money markets. Much of this occurred outside of the supervisory framework currently established. An effective agenda for containing systemic risk thus requires elimination of gaps in the regulatory structure, a focus on macroprudential risks, and adjustments by all our financial regulatory agencies.
Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers. On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firm-wide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or system-wide, approach that should help us better anticipate and mitigate broader threats to financial stability.
Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act to address the extremely serious problem posed by firms perceived as “too big to fail.” Legislative action is needed to create new mechanisms for oversight of the financial system as a whole. Two important elements would be to subject all systemically important financial firms to effective consolidated supervision and to establish procedures for winding down a failing, systemically critical institution to avoid seriously damaging the financial system and the economy.
Some observers have suggested that existing large firms should be split up into smaller, not-toobig- to-fail entities in order to reduce risk. While this idea may be worth considering, policymakers should also consider that size may, in some cases, confer genuine economic benefits. For example, large firms may be better able to meet the needs of global customers. Moreover, size alone is not a sufficient indicator of systemic risk and, as history shows, smaller firms can also be involved in systemic crises. Two other important indicators of systemic risk, aside from size, are the degree to which a firm is interconnected with other financial firms and markets, and the degree to which a firm provides critical financial services. An alternative to limiting size in order to reduce risk would be to implement a more effective system of macroprudential regulation. One hallmark of such a system would be comprehensive and vigorous consolidated supervision of all systemically important financial firms. Under such a system, supervisors could, for example, prohibit firms from engaging in certain activities when those firms lack the managerial capacity and risk controls to engage in such activities safely. Congress has an important role to play in the creation of a more robust system of financial regulation, by establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in an orderly fashion, without jeopardizing financial stability. Such a resolution process would be the logical complement to the process already available to the FDIC for the resolution of banks.
C. Simon Johnson, Massachusetts Institute of Technology and blogger: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?
The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.
D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.
The paper below says that, contrary to what you might think, the Great Moderation is not over. What is the Great Moderation? From the paper:
The idea of “the Great Moderation” came to widespread public attention in a 2004 speech by then-Federal Reserve Governor Ben Bernanke.1 He began his speech with a statement of empirical fact: “One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility.”
This empirical fact was established in two influential academic papers by Kim and Nelson (1999) and McConnell and Perez-Quiros (2000).2 Both papers presented evidence of a large reduction in the volatility of U.S. real GDP growth over the past half-century. Furthermore, both papers found that the reduction was sudden and estimated to have occurred in 1984Q1.
This sudden reduction in volatility is visible to the naked eye in Figure 1, which plots seasonally-adjusted quarterly U.S. real GDP growth for the period of 1947Q2-2009Q3.
Let me repeat a list of factors from a previous post that have been proposed to explain the Great Moderation:
- Better technology, e.g. information processing allowing better inventory control and management
- Better policy, e.g. inflation targeting
- Good luck so that no big shocks hit the economy
- Financial innovation and deregulation
- Globalization leading to dispersed risk
- Better business practices (this is less common, here's the link)
- Increased rationality of participants in financial markets
- Demographic shifts (again, since this less commonly offered as an explanation, here's the link)
Much of the literature prior to the crisis found that monetary policy was at least a contributing factor, if not the major factor behind this change (e.g. empirical evidence from Clarida, Gali, and Gertler of a large increase in the coefficient on inflation in the Taylor rule that, in New Keynesian models, would lead to a more stable economy). However, this paper focuses on the "good luck" explanation and finds that "smaller economic shocks related to oil prices, productivity, and inventories explain much of the Great Moderation." In addition, the paper finds that our good fortune may not be over:
The Great Moderation: What Caused It and Is It Over?, by James Morley: In this Macro Focus, our resident time series econometrician, James Morley, tries to rehabilitate the “Great Moderation.” His findings are both surprising and encouraging:
• Contrary to conventional wisdom, the Great Moderation was not a myth. There has been a very real, broad-based decline in U.S. macroeconomic volatility since the mid-1980s.
• The reduction in volatility does not appear to be primarily the result of better policy or changes in the structural response of the economy to shocks.
• Instead, the Great Moderation appears to be mostly due to smaller economic shocks (e.g., oil price shocks, productivity shocks, and inventory mistakes).
• The technological basis for the smaller shocks means that the prognosis for the continuation of the Great Moderation is much better than you might think.
Given the financial and economic turmoil of the past few years, it would be easy to believe the “Great Moderation” was a myth based on wishful thinking. Many commentators have proclaimed as much and even many of us who study the phenomenon have started to wonder whether it was all too good to be true.
Despite these doubts, a dispassionate examination of the data suggests that the stabilization of economic activity since the mid-1980s was very much a reality. The more legitimate question is whether or not it is now over. This Macro Focus seeks to answer this question through careful analysis of what caused the Great Moderation. The finding that it was largely due to smaller economic shocks for technological reasons implies a surprisingly optimistic prognosis for its continuation. ... [paper]
Wednesday, December 16, 2009
The Fed's assessment of the economy is slightly more upbeat as compared to the press release after its last FOMC meeting, but economic conditions are still bad, and there's no signal that the course of policy will change anytime soon. The target interest rate will remain near zero for the foreseeable future, and the Fed will slowly unwind its special facilities [See also: WSJ, NYT, FT, Bloomberg]:
FOMC Press Release for December 16, 2009: Information received since the Federal Open Market Committee met in November suggests that economic activity has continued to pick up and that the deterioration in the labor market is abating. The housing sector has shown some signs of improvement over recent months. Household spending appears to be expanding at a moderate rate, though it remains constrained by a weak labor market, modest income growth, lower housing wealth, and tight credit. Businesses are still cutting back on fixed investment, though at a slower pace, and remain reluctant to add to payrolls; they continue to make progress in bringing inventory stocks into better alignment with sales. Financial market conditions have become more supportive of economic growth. Although economic activity is likely to remain weak for a time, the Committee anticipates that policy actions to stabilize financial markets and institutions, fiscal and monetary stimulus, and market forces will contribute to a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability.
Tuesday, December 15, 2009
Sunday, December 13, 2009
Paul Volcker is interviewed:
Interview with Paul Volcker, by Gabor Steingart, Spiegel: ...Spiegel: ...[E]ven though there are still more people being fired than hired,... Ben Bernanke is saying that the recession is technically over. Do you agree with him?
Volcker: ...We had a quarter of increased growth but I don't think we are out of the woods. ... The recovery is quite slow and I expect it to continue to be pretty slow and restrained for a variety of reasons and the possibility of a relapse can't be entirely discounted. ... We have not yet achieved self-reinforcing recovery. We are heavily dependent upon government support so far..., both in the financial markets and in the economy. ...
I think we ... have a challenge... There is concern in our recovery advisory group about how to rebuild the competitiveness of the United States, which inevitably means rebuilding, in part, the manufacturing sector of the economy.
Spiegel: What part of the manufacturing sector do you envision?
Volcker: I think there are a lot of opportunities in the so-called green economy for taking leadership. ...
Spiegel: Outsourcing and off-shoring have been the key words of the last decades. You don't think that the times of "made in America" are over forever?
Volcker: That has been the mentality and we have to change that somehow. I think it's self-correcting in part. The glamour of going to Wall Street is not as great today as it was a few years ago.
Spiegel: Are you sure? The Wall Street businesses are doing well. The big bonuses are back.
Volcker: It's amazing how quickly some people want to forget about the trouble and go back to business as usual. We face a real challenge in dealing with that feeling that the crisis is over. The need for reform is obviously not over. ...
Spiegel: But the American government seems to have lost some eagerness in setting a tougher regime of rules and regulations to control Wall Street. Everything is being watered down. Why?
Volcker: I will do the best I can to fight any tendency to water it down. What we need is broad international consensus to make things happen. ...
Spiegel: During your tenure as chairman of the Federal Reserve, the bank was always part of the solution. Today..., many experts see it as part of the problem. ... Lawmakers on Capitol Hill are thinking about tougher controls over the Federal Reserve.
Volcker: I think the loss of independence and authority of the Federal Reserve would be a very serious matter for the United States. Not just in terms of monetary policy but in terms of our place in the world. People look to strong, credible institutions and I think the Federal Reserve has been such an institution. If that's lost or too hamstrung by legislation I think we will regret it.
Spiegel: But is the Fed still the same kind of institution as during your tenure as chairman? Or is it now more of a governmental instrument? The Fed is managing the TARP program and is also buying government bonds.
Volcker: In some sense the Federal Reserve is always an instrument of the government. It is a government body but it is independent within government. But you are right in the sense that part of the concern is that they have involved themselves quantitatively in entering markets and in that process, you are supporting some markets and not others. That is an area in which the Federal Reserve has never wanted to get into and one that most central banks don't want to get into. If you are going to maintain your independence you have to avoid that. To intervene in particular sectors of the market is not the proper role for the central bank over time. It could be justified only by extreme emergency.
Spiegel: So what do you expect in the very near future?
Volcker: As an American, I have to be an optimist. But we have got a big challenge and we have to face up to it. And as you know, there is a lot of concern about the dysfunction of the political system. ...
I think he's right that the Fed's support of the financial market and financial institutions made it appear that it favored some markets and some firms over others, and that has been a problem. But I don't think the Fed had a lot of choice. It lacked the authority to dismantle large financial institutions outside the traditional banking system, it lacked the plans to do so even if it had the authority, and the fact that regulators allowed these institutions to become such a threat to the economy if they failed meant the Fed had to intervene. That's why, going forward, three things need to happen. Regulators need to reduce the threat these banks pose, they need to have plans ready if a threat develops anyway, and legislators need to give regulators the authority to take control of troubled institutions outside the traditional banking system.
But I have to admit that "the dysfunction of the political system" makes me wary of what will happen once the legislative process begins. Things could get worse rather than better, and reducing the independence of the Fed is but one of many ways that could happen. Even so, the need for reform of the financial sector is sufficiently strong to justify taking that chance.
Friday, December 11, 2009
Bernanke’s Unfinished Mission, by Paul Krugman, Commentary, NY Times: Ben Bernanke, the Federal Reserve chairman, recently had some downbeat things to say about our economic prospects. ... All we can expect, he said, is “modest economic growth next year — sufficient to bring down the unemployment rate, but at a pace slower than we would like.”
Actually, he may have been too optimistic: There’s a good chance that unemployment will rise, not fall, over the next year. But even if it does inch down, one has to ask: Why isn’t the Fed trying to bring it down faster? ... My back of the envelope calculation says that we need to add around 18 million jobs over the next five years, or 300,000 jobs a month. ... So ... someone has to take responsibility for creating a lot of additional jobs. And at this point, that someone almost has to be the Federal Reserve.
I don’t mean to absolve the Obama administration of all responsibility. Clearly, the administration proposed a stimulus package that was too small to begin with and was whittled down further by “centrists” in the Senate. And the measures President Obama proposed earlier this week ... fall far short of what the economy needs.
But ... the political reality is that the president ... probably can’t get enough votes in Congress to do more than tinker at the edges of the employment problem. The Fed, however, can do more.
Mr. Bernanke has received a great deal of credit,... rightly so, for his use of unorthodox strategies to contain the damage after Lehman Brothers failed. But ... the urgency of late 2008 and early 2009 has given way to a curious mix of complacency and fatalism — a sense that the Fed has done enough now that the financial system has stepped back from the brink, even though its own forecasts predict that unemployment will remain punishingly high for at least the next three years.
The most specific, persuasive case I’ve seen for more Fed action comes from Joseph Gagnon, a former Fed staffer now at the Peterson Institute for International Economics. Basing his analysis on the prior work of ... Mr. Bernanke himself,... Mr. Gagnon urges the Fed to expand credit by buying a further $2 trillion in assets. Such a program could do a lot to promote faster growth, while having hardly any downside.
So why isn’t the Fed doing it? Part of the answer may be political: Ideological opponents of government activism tend to be as critical of the Fed’s credit expansion as they are of the Obama administration’s fiscal stimulus. And this has probably made the Fed reluctant to use its powers to their fullest extent. Meanwhile, a significant number of Fed officials, especially at the regional banks, are obsessed with the fear of 1970s-style inflation ... even though there’s not a hint of it in the actual data.
But there’s also, I believe, a question of priorities. The Fed sprang into action when faced with the prospect of wrecked banks; it doesn’t seem equally concerned about the prospect of wrecked lives.
And that is what we’re talking about here. The kind of sustained high unemployment envisaged in the Fed’s own forecasts is a recipe for immense human suffering — millions of families losing their savings and their homes, millions of young Americans never getting their working lives properly started because there are no jobs available when they graduate. If we don’t get unemployment down soon, we’ll be paying the price for a generation.
So it’s time for the Fed to lose that complacency, shrug off that fatalism and start lending a hand to job creation.
Tuesday, December 08, 2009
At MoneyWatch, some of the pressures the Fed might come under in the future if the government debt continues to rise, and the important role that Fed independence plays in making sure that the debt is not inflated away:
Budget Deficits, Fed Independence, and Inflation, by Mark Thoma: I have been critical of both Alan Greenspan and Ben Bernanke for giving recommendations concerning fiscal policy during their testimony before congress. In Greenspan's case, it was his comments about tax cuts that I found problematic, while for Bernanke it was his comments on entitlements.
But monetary and fiscal policy are connected, and the Fed chair should talk about the impact that a growing debt level might have monetary policy. That is, while I don't think the Fed chair should give advice on the specifics of fiscal policy, the chair should make clear how fiscal policy choices will affect or constrain monetary policy. ...[...continue...]...
Monday, December 07, 2009
Structural and Cyclical, by Tim Duy: For several months, I have been telling stories that decompose US economic activity into what I think of as cyclical and structural dynamics. I believe the distinction is very important to firms, markets, and policymakers who need to be aware when one dynamic is clouding their view of the other.
The cyclical dynamics, in my opinion, are the most spectacular, the most visible. The real cyclical fireworks began in the second half of 2009, as the energy price shock decimated household budgets, quickly followed by a financial shock that triggered an additional pullback in demand. Firms unexpectedly found they had far too much excess capacity in this environment, and began the process of "rightsizing." Lob losses mounted even as falling energy costs and lower interest rates for those not credit constrained began to put a floor under spending.
Eventually, firms would realign capacity with the new level of demand, and job losses would taper off. That would mark the early stages of the cyclical bottom, the point at which growths returns. The initial growth spurt could be very rapid, as firms restock inventory and pent-up demand comes into play. The additional of government stimulus will add additional fuel to the fire.
Once the early stages of recovery are complete, the story shifts from cyclical to structural. The boost from inventory correction, pent-up demand, and government stimulus fade, and the underlying growth rate, the fundamental rates of activity, becomes evident. Now your expectations about the nation's economic direction depend on the weight you place on the structural factors. If you place nearly zero weight on those factors, then growth remains fairly high as the economy rapidly returns to potential. In effect, cyclical dynamics dominate your story; the Fed is simply flipping a switch that shifts the economy from high to low states and back again, a traditional post-WWII business cycle. If you place heavy weight on structural stories, you talk about the inability to revert to past patterns of consumer spending growth due to excessive household debt, a reversion to global imbalances that supports outsized import growth, lack of an asset bubble to compensate for these structural problems, etc. With these stories in your toolkit, you expect a low underlying growth rate - barely at potential growth - in which case the gap between actual and potential output remains distressingly high for possibly years to come.
I tend to view incoming data through both cyclical and structural lenses. The employment report is a prime example. Clearly, the steady improvement in the rate of deterioration of nonfarm payrolls since the spring follows the cyclical pattern as firms stop chasing demand down and thus stabilize their workforces. Moreover, recent increases in temporary help hiring also points to firming labor demand in the months ahead. It would seem that stronger growth does in fact have the desired impact on labor markets, and that fiscal stimulus helped accelerate recovery in the labor markets.
At the same time, though, one has to wonder what happens as the stimulus begins to fade? Will there be sufficient demand from other sectors to compensate for fiscal and monetary withdrawal? It is worth recalling the patterns of labor market dynamics as we exited from the 2001:
After the post-recession boost - inventory correction, pent-up demand, etc. - labor markets quickly returned to a period of stagnation that lasted until the housing bubble began to take hold. What in the next two years can we expect to take the place of that bubble? Furthermore, if you are worried about a relapse in the pace of growth, the ISM reports last week were not exactly comforting. Both revealed an overall slowing of activity, and employment signals were not exactly consistent with a strong rebound in hiring anytime soon. For that matter, the ADP report, while not one of my favorites to begin with, came in far below the actual NFP numbers, suggesting that maybe this employment report was a little stronger than the underlying trend.
Also worth noting is the dismal reports on retail sales that appear to have largely slipped below the radar last week. From the Wall Street Journal:
Friday, December 04, 2009
Tim Duy passes this along:
No Exit: The Case for $6 Trillion More Monetary Stimulus, by Joseph Gagnon, Peterson Institute for International Economics: A lively debate is under way between those who want more fiscal stimulus to create jobs and those who worry that our national debt is already too high. Both sides are ignoring the obvious alternative--one that would create jobs and lower the deficit. In a newly-posted Policy Brief, I present the argument for easier monetary policy in all the main developed economies.
As the latest job figures demonstrate, the economies of the United States, the euro area, Japan, and the United Kingdom are suffering from historically high rates of unemployment. In all four economies, the overwhelming majority of forecasters see weak economic growth and lackluster job creation over the next two to three years. In Washington, the Obama administration has just held a Jobs Summit, underscoring the concern about how to put more Americans back to work. Clearly, we need more macroeconomic stimulus to reduce the suffering and allay the long-term damage caused by persistent unemployment as well as to ward off the risk of harmful deflation. But record peacetime fiscal deficits and rapidly rising public debt point to monetary policy, rather than fiscal policy, as the way to go.
Short-term interest rates already have been reduced to near zero. But the Federal Reserve and its counterparts have other tools to use for monetary stimulus. Over the past year, the Federal Reserve and the Bank of England have pushed down long-term borrowing costs for both the public and private sectors through their large-scale purchases of long-term bonds. There is considerable scope for additional purchases to drive borrowing costs even lower. The European Central Bank and the Bank of Japan should join the Federal Reserve and the Bank of England in combined purchases of an additional $6 trillion in long-term bonds designed to push 10-year bond yields down another 75 basis points. At a time of concern about fiscal deficits, it is important to note that reducing yields on government debt actually reduces the federal deficit. Reducing yields on private debt will also speed the repair of private sector balance sheets and encourage businesses to invest and expand employment. A more rapid recovery further reduces fiscal deficits by raising revenues.
It is time to stop arguing about tradeoffs. Monetary policy can create jobs and reduce the deficit at the same time.
Thursday, December 03, 2009
Tim Duy discusses the type of bubble-popping strategy the Fed ought to pursue:
Bubbles and Policy, by Tim Duy: The Wall Street Journal carried a front page article today detailing changing views at the Federal Reserve regarding the policy treatment of emerging bubbles of speculative activity. Much of the ground has been well tread. Is monetary policy or regulatory policy the best mechanism to address bubbles? I tend to favor the latter category, should we have a regulatory environment that is not essentially captured by those policymakers are supposed to regulate. Interest rate policy is a rather blunt weapon that kills indiscriminately. For instance, I am sympathetic with the view that interest rates were not necessarily too low during the build up of the housing bubble. Indeed, relatively low rates of investment (equipment and software) growth suggests that real rates were actually too high. But capital flowed to housing instead of more productive investment activities because that was the path of least resistance. Policymakers could have chosen to put some grit on that path by, for example, aggressively evaluating lending standards with regards to products such as "Liar's Loans," etc., but chose to follow a hands off approach.
What caught my attention in the article was this passage:
Yet the question of whether and how to tackle bubbles before they burst is becoming a growing concern amid fears of new bubbles developing in commodities markets and in emerging economies. Gold prices are up more than 50% in a year's time. China's Shanghai Composite stock index is up more than 75% this year. Stocks in Brazil are up even more. Oil prices have rebounded. They remain far below last year's peaks but a return to those highs could fuel inflation in goods and services more directly than tech stocks or housing did.
I think it is important to recognize what bubbles should be the focus of Federal Reserve concerns. After all, the Fed is charged with maintaining price stability and maximum sustainable employment in the United States. Why should the Fed be concerned with housing prices in Hong Kong or stock prices in Brazil and China? Don't those bubbles fall under the responsible of foreign central banks? It seems clear that in such cases, the extent of the Fed's concerns should be limited to the regulatory arena. Are US based banks lending into those bubbles, thereby setting the stage for negative feedback loops? If so, raise capital requirements on that lending, tighten underwriting standards, etc. Just don't derail the US recovery by raising rates to pop a bubble in Brazil.
I will admit that oil prices can be a bit more tricky. The gains in oil prices seem silly given ongoing evidence that the world is awash in oil. From the WSJ:
Café owner Ken Kennard sees the glut in the global oil market as a potential environmental threat to this sleepy seaside tourist hub.Mr. Kennard is worried about a fleet of oil tankers -- almost 40 in all, each packing hundreds of thousands of barrels of crude and oil-derived products -- that have anchored several miles off the coast of southeast England in recent months.The heavy traffic stems from a near-record excess oil supply, a byproduct of the recession, that is prompting producers to stash oil offshore until they can find customers. The excess supply hasn't stopped oil prices from surging almost 80% this year and padding the pockets of big oil producers like Royal Dutch Shell PLC and the Organization of Petroleum Exporting Countries.
To be sure, some of the rise in the price of oil is attributable to the decline in the Dollar, a natural consequence of low US interest rates and an important channel for the transmission of monetary policy. But it is not clear that higher oil prices necessarily yield additional core inflationary pressure given the current institutional arrangements between labor and management. The recent experience has been that individuals were not able to convert high inflation expectations in 2008 into higher wages. Instead, the opposite occurred as consumption sunk and unemployment skyrocketed. All of which means the Fed would need to think long and hard about leaning against the oil price increase if that entailed contractionary monetary policies; the costs are potentially high relative to the benefits. Here again, though, regulators need to be carefully evaluating the nature of lending into the oil space.
My views on this topic have shifted somewhat over the past two years. In early 2008, I was concerned that the Fed's rush to lower rates was contributing to destructive oil price bubble. But, in retrospect, nations that pegged to the Dollar and thus imported the Fed's easy policy were just as much, if not more, to blame, as those central banks failed to maintain policies appropriate for domestic conditions.
In short, the Fed does need to be aware of the full set of consequences of their policy stance. But bubbles abroad should not prevent the Fed from adopting the right policy stance for the US economy. Indeed, many of the bubbles discussed now clearly should not be the responsibility of the Fed.
Wednesday, December 02, 2009
Brad DeLong says the wrong people are meeting at the jobs forum:
The wrong jobs summit, by Brad DeLong, Commentary, The Week: The White House is hosting a jobs summit this week. I, however, cannot but think that ... it will be the wrong people talking about the wrong things.
Let me back up. Ever since the 1930s, economists trying to analyze the determinants of spending have focused on two of the economy’s markets: the market for liquidity and the market for savings. ...
For the government to boost jobs, it must to do something to change the balance of supply and demand in either the market for liquidity or the market for savings. In general, the ... Federal Reserve ... acts to tweak supply and demand in the market for liquidity. The president and Congress act to tweak supply and demand in the market for savings. ...
Right now, if you ask the decisive members of congress—by which I mean the Blue Dog Democrats in the House, or the most conservative Democrats and most liberal Republicans in the Senate —why the president and the Congress are not doing more to reduce unemployment and boost spending and income, the answer you’ll get is ... well, you probably wouldn't get an intelligible answer.
But if you did get an explanation for the lack of congressional action it would go something like this: Attempts to ... boost spending would (a) increase the national debt burden on future taxpayers and (b) lead to a large decline in bond prices and a boost in interest rates. Why? Because businesses would try to increase their liquidity to support higher spending, driving up interest rates, which, in turn, would cause businesses to cut back on investment, thus neutralizing most or all of the stimulative policies.
Similarly, if you were to ask the Federal Reserve why it isn’t doing more to reduce unemployment and boost spending and income, the answer you would get is this: Spending is in no way constrained by a shortage of liquidity..., indeed we have “flooded the zone” with liquidity. As a result, the Fed is disinclined to pursue additional tweaks ... in ... liquidity because it fears such efforts would fuel destructive inflation in the future without boosting employment and spending in the present.
Both of these arguments are comprehensible... But they cannot both be true at the same time. Either the economy is so awash in liquidity that the Federal Reserve cannot do much to boost spending—in which case additional spending by the government won’t generate any substantial rise in interest rates. Or additional government spending will crowd out investment...—in which case the economy is not awash in liquidity, and quantitative easing by the Federal Reserve could do a lot right now to boost spending and employment.
It appears that what we have here is a failure to communicate. ...
Thus we need a jobs summit right now. We need the White House's National Economic Council and key congressional “centrists” on one side and the Federal Reserve Open Market Committee on the other to meet. Those two groups seem to have very inconsistent views of the economic situation. ... Something has to give. If they could reach agreement on whose view ... is likely correct, then a rescue plan—entailing either more government spending or greater liquidity—would become obvious.
Until that “jobs summit” is convened, others are moot.
Saturday, November 28, 2009
As you might guess given my recent posts defending Fed independence, I agree with this:
The right reform for the Fed, by Ben Bernanke, Commentary, Washington Post: For many Americans, the financial crisis, and the recession it spawned, have been devastating... Understandably, many people are calling for change. ... As a nation, our challenge is to design a system of financial oversight that will ... provide a robust framework for preventing future crises...
I am concerned ... that ... some leading proposals in the Senate would strip the Fed of all its bank regulatory powers. And a House committee recently voted to repeal a 1978 provision that was intended to protect monetary policy from short-term political influence. These measures ... would seriously impair the prospects for economic and financial stability in the United States. The Fed played a major part in arresting the crisis, and we should be seeking to preserve, not degrade, the institution's ability to foster financial stability and to promote economic recovery without inflation. ...
The proposed measures are at least in part the product of public anger over ... the rescues of some individual financial firms. The government's actions... -- as distasteful and unfair as some undoubtedly were -- were unfortunately necessary to prevent a global economic catastrophe that could have rivaled the Great Depression in length and severity...
Moreover, looking to the future, we strongly support measures -- including the development of a special bankruptcy regime for financial firms whose disorderly failure would threaten the integrity of the financial system -- to ensure that ad hoc interventions of the type we were forced to use last fall never happen again. Adopting such a resolution regime, together with tougher oversight of large, complex financial firms, would make clear that no institution is "too big to fail" -- while ensuring that the costs of failure are borne by owners, managers, creditors and the financial services industry, not by taxpayers.
The Federal Reserve ... did not do all that it could have to constrain excessive risk-taking in the financial sector in the period leading up to the crisis. We have extensively reviewed our performance and moved aggressively to fix the problems. ... There is a strong case for a continued role for the Federal Reserve in bank supervision. Because of our role in making monetary policy, the Fed brings unparalleled economic and financial expertise to its oversight of banks...
This expertise is essential for supervising highly complex financial firms and for analyzing the interactions among key firms and markets. Our supervision is also informed by the grass-roots perspective derived from the Fed's unique regional structure and our experience in supervising community banks. At the same time, our ability to make effective monetary policy and to promote financial stability depends vitally on the information, expertise and authorities we gain as bank supervisors, as demonstrated in episodes such as the 1987 stock market crash and the financial disruptions of Sept. 11, 2001, as well as by the crisis of the past two years.
Of course, the ... ability to take such actions without engendering sharp increases in inflation depends heavily on our credibility and independence from short-term political pressures. Many studies have shown that countries whose central banks make monetary policy independently of such political influence have better economic performance...
Independent does not mean unaccountable. In its making of monetary policy, the Fed is highly transparent, providing detailed minutes of policy meetings and regular testimony before Congress, among other information. Our financial statements are public and audited by an outside accounting firm; we publish our balance sheet weekly; and we provide monthly reports with extensive information on all the temporary lending facilities... Congress, through the Government Accountability Office, can and does audit all parts of our operations except for the monetary policy deliberations and actions covered by the 1978 exemption. The general repeal of that exemption would serve only to increase the perceived influence of Congress on monetary policy decisions, which would undermine the confidence the public and the markets have in the Fed to act in the long-term economic interest of the nation. ...
Now more than ever, America needs a strong, nonpolitical and independent central bank with the tools to promote financial stability and to help steer our economy to recovery without inflation.
While I agree on the independence and regulation statements, one thing I do wonder about is why there is such widespread acceptance of the idea that we have to live with institutions that are so big that their failure is a threat to the financial system and the economy. The notion seems to be that large, dangerous firms are inevitable, so we need special procedures in place that we hope will allow them to fail without the problems spreading and creating a devastating domino effect. The concern seems to be mainly about having the procedures and authority to allow orderly dissolution of large, dangerous firms rather than preventing these firms from getting too large and too interconnected to begin with.
We need procedures for orderly dissolution in any case -- we didn't think firms were systemically important before the crash, so we need to be ready (e.g., recall the many, many statements that the crisis would be "contained"). But what is the minimum efficient scale (MES) for financial firms? That is, what is the smallest size at which economies of scale and economies of scope are fully realized?
There has been some discussion of this (e.g. Economics of Contempt versus The Baseline Scenario), but it doesn't seem to me that this question is very close to being settled. I want to know how the MES relates to the minimum size where a bank becomes systemically important. If the MES is smaller than the size where banks become systemically dangerous, break them up - their size adds nothing but risk. But if the MES is greater than the minimum dangerous size, then we have a tradeoff to make -- safety for efficiency -- and we may or may not want to force firms to reduce their size and connectedness. It depends upon the tradeoff.
But until we know what these tradeoffs are -- and I don't think we have a good sense of this -- it's very difficult to determine if the costs of breaking up banks and reducing their connectedness are greater than the benefits. I suspect that if the MES is greater than the minimum safe size, then the extra safety from reducing bank size and connectedness would be worth the loss of efficiency, and I'd like to push that position much more than I have to date. But without knowing the MES, the minimum threatening size, the minimum threatening degree of connectedness, and the costs and benefits of reducing size and connectedness, it's hard to do so with confidence.
Wednesday, November 25, 2009
Worries about Budget Deficits and Inflation: Let’s Avoid Repeating Our Mistakes, by Mark Thoma: There is a lot of concern about the future course of the economy, and there are two separate worries that are getting confused. The purpose of this post is to distinguish between the two sets of worries, and to discuss whether the worries are justified. ...
Tuesday, November 24, 2009
Tim Duy says -- correctly -- "that a significant portion of policymakers are simply clueless":
Ahead of Black Friday, by Tim Duy: We are embarking once again into that time of the year when reporters around the world become entranced and enthralled with that orgy of consumerism that defines Christmas in America. Soon we will be tracking the ups and downs of holiday sales with a zeal that is unmatched by any other regular economic event. Weary reporters - those who clearly disappointed their editors at some point during the year - will be dispatched to local big box stores across the nation to record the lines forming in anticipation of 5am openings on the fabled Black Friday. We will be bombarded with hundreds if not thousands of conflicting reports regarding the amount and patterns of holiday shopping, leaving overworked and underpaid analysts awash in data as they desperately try to quantify, once and for all, the "true" state of consumer spending - and thus by extension, the true state of the economy - in America.
Oooo, how I have come to loathe this exercise. And yet, here I am again, fretting over the financial state of US households in between checking off items on the Thanksgiving shopping list. It is like a car wreck - you don’t want to watch, but you can't take your eyes off it.
Car wreck is something of an appropriate comparison. Recently I have begun using charts of this sort to depict the current economic environment:
Not fancy econometrics, I know - most of my audiences are not interested in unit root tests. The point, obviously, is that even as activity creeps upward, the gap between the past and current trajectory of consumer spending is likely still widening. Much, much faster growth is necessary to close that gap. And households as of yet are seeing nothing to convince them their fortunes are set to change, that some Christmas miracle awaits. To be sure, Bloomberg trumpeted today's data:
Confidence among U.S. consumers unexpectedly rose in November as a brightening outlook masked growing concern over joblessness.
How much did the outlook brighten? The story continues:
The Conference Board’s confidence index increased to 49.5 from 48.7 the prior month. The New York-based Conference Board’s index, which focuses on the labor market and purchase plans, averaged 58 in 2008 and 103.4 in 2007.
Not much brighter. Indeed, Economix more accurately reports the dismal mood of consumers, noting:
Over the last 30 years, the index has averaged about 95. In November, it was 49.5, up from 48.7 the previous month.
Yes, for three decades the Conference Board measure of confidence has averaged nearly twice current levels. This tells us something about the strength of consumer spending. Using the parallel measure from the University of Michigan:
Real year over year growth in the 1% range is not going to bring households back to trend anytime soon. To be sure, given the dependence of household on debt financed spending, it is arguably correct that past trends were unsustainable, that the only possible outcome from this mess was a permanent shock to the level of household spending. That, however, is likely cold comfort to the millions of Americans - those not employed by Goldman Sachs, of course - who are just now realizing that their standard of living has shifted permanently lower. Lacking sufficient income gains and the ability to use debt to cover up their relative poverty, households are not seeing a path to a brighter future. And they will increasingly look for someone to blame. No wonder the knives are sharpening for Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke. They are the public faces for an Administration that now owns this economy.
And where are policymakers as we slog through the final month of 2009? The Administration is poised to do virtually nothing:
The White House is lukewarm about proposals by congressional Democrats to introduce broad legislation to create jobs, instead favoring targeted measures that would be less likely to inflate the deficit, administration officials said.
There is as yet no agreement within the White House or in Congress on how to try to curb the U.S. jobless rate. But the differences in opinion suggest that rifts could emerge among Democrats as they wrestle with how to beat back the highest unemployment rate in a generation.
...Hamstrung by the nation's $1.4 trillion deficit and his pledge not to raise taxes on middle-class Americans, Mr. Obama is keen to avoid any measures suggestive of a second, big-ticket stimulus.
Indeed, the failure of the Administration to take bold moves early in the year now cripples it in any attempt to take bold action now. Apparently, the best we can expect now is a "Cash for Caulkers" program that will dribble money into the economy, ensuring that we do little if any better than limp along.
Likewise, monetary policymakers too are caught in the headlights. As has already been widely noted, the minutes of the most recent FOMC meeting reiterated the Fed's eagerness to reverse, not extend, policy:
...Overall, many participants viewed the risks to their inflation outlooks over the next few quarters as being roughly balanced. Some saw the risks as tilted to the downside in the near term, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public's concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation. To keep inflation expectations anchored, all participants agreed that it was important for policy to be responsive to changes in the economic outlook and for the Federal Reserve to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.
Read that carefully and realize this: An apparently not insignificant portion of the FOMC believes that there is a terrible risk that banks loosen their credit standards and increase lending at a time when, even if the economy posts expected gain, unemployment remains at unacceptably high levels. Silly me, I thought increased lending was the whole point of the exercise to lower interest and expand the balance sheet. That whole credit channel thing. If not to expand lending during a credit crunch, then what else are they expecting?
I am in shock that this sentence made it into the minutes. One can only conclude that a significant portion of policymakers are simply clueless. Or, more disconcerting, they have lost all faith in the ability of financial institutions to channel capital into activities with any hope of financial returns. Has the Fed now embraced the view that they manage the economy through little else then fueling and extinguishing bubbles?
At this juncture, only St. Louis Fed President James Bullard is signaling a willingness to at least keep the option of ongoing balance sheet expansion alive:
Federal Reserve Bank of St. Louis President James Bullard wants the Fed to continue to buy mortgage-backed securities beyond the March 2010 cutoff to give policy makers more flexibility as they seek to shepherd the economy toward recovery.
"I have advocated to keep the asset-purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal-funds rate remains at zero," Mr. Bullard told Dow Jones Newswires in an interview Sunday. He said "no decision has been made" about the program's fate.
Mr. Bullard will be a voting member on the interest-rate-setting Federal Open Market Committee in 2010. In its statement after the November FOMC meeting, the central bank reiterated that it will continue to monitor its asset-purchase programs "in light of the evolving economic outlook and conditions in financial markets."
Maybe if unemployment continues to rise Bullard's vote will matter next year. Maybe.
Considering what all this means in light of Black Friday, I tend to think Phil Izzo at the Wall Street Journal is on the right path:
New reports Monday didn’t paint an encouraging picture. The Conference Board released a survey of spending intentions that showed U.S. households expect to spend an average of $390 this season, down 7% from estimates of $418 last year. That number is especially distressing because consumers were unusually pessimistic last year as the financial crisis went into full swing just as holiday shopping was getting underway.
“Job losses and uncertainty about the future are making for a very frugal shopper. Retailers will need to be quite creative to entice consumers to spend, both in stores and online this holiday season,” said Lynn Franco, director of the Conference Board Consumer Research Center.
A separate report from retail-tracking firm NPD Group indicated consumers may not be flocking to the mall for Black Friday. Just 32% of respondents said that they expect to begin their holiday shopping on Thanksgiving weekend or earlier.
Still, more broadly, whether sales gain 2% or 4% this holiday season may have great influence on the animal spirits that govern equity markets, I doubt it would alter much what should be our overall assessment of the economy: Economic activity is now increasing, something for which we should all be thankful this weekend. The alternative would be very unpleasant. But that growth should not lull us into policy complacency with regards to the very real economic stress felt across the nation. By all forecasts, it simply falls far short of what is necessary to restore confidence among households. 2.8% just won't cut it.
Like Tim Duy in the post above this one, David Altig is also puzzled by analysts who, to quote from the FOMC minutes highlighted in Tim's post, that "banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially":
The Treasury sold $44 billion of two-year notes at a yield of 0.802 percent, the lowest on record, as demand for the safety of U.S. government securities surges going into year-end.
"Demand for safety" is not the most bullish sounding phrase, and it is not intended to be. It does, in fact, reflect an important but oft-neglected interest rate fundamental: Adjusting for inflation and risk, interest rates are low when times are tough. ...
The intuition behind this point really is pretty simple. When the economy is struggling ... the demand for loans sags. All else equal, interest rates fall. In the current environment, of course, that "all else equal" bit is tricky, but the latest from the Federal Reserve's Senior Loan Officer Opinion Survey is informative:
"In the October survey, domestic banks indicated that they continued to tighten standards and terms over the past three months on all major types of loans to businesses and households. ..."
Demand also appears to be quite weak:This economic fundamental is, in my opinion, a good way to make sense of the FOMC's most recent statement:
"Demand for most major categories of loans at domestic banks reportedly continued to weaken, on balance, over the past three months."
The Committee… continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period.
Not everyone is buying my story, of course, and there is a growing global chorus of folk who see a policy mistake at hand:
Germany's new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.
Wolfgang Schäuble's comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.
Last weekend, Liu Mingkang, China's banking regulator, criticised the US Federal Reserve for fuelling the 'dollar carry-trade', in which investors borrow dollars at ultra-low interest rates and invest in higher-yielding assets abroad.
The fact that there is a lot of available liquidity is undeniable—the quantity of bank reserves remain on the rise:
But the quantity of bank lending is decidedly not on the rise:
There are policy options at the central bank's disposal, including raising short-term interest rates, which in current circumstances implies raising the interest paid on bank reserves. That approach would solve the problem of… what? Banks taking excess reserves and converting them into loans? That process provides the channel through which monetary policy works, and it hardly seems to be the problem. In raising interest rates paid on reserves the Fed, in my view, would risk a further slowdown in loan credit expansion and a further weakening of the economy. I suppose this slowdown would ultimately manifest itself in further downward pressure on yields across the financial asset landscape, but is this really what people want to do at this point in time?
If you ask me, it's time to get "real," pun intended—that is to ask questions about the fundamental sources of persistent low inflation and risk-adjusted interest rates (a phrase for which you may as well substitute U.S. Treasury yields). To be sure, the causes behind low Treasury rates are complex, and no responsible monetary policymaker would avoid examining the role of central bank rate decisions. But the road is going to eventually wind around to the point where we are confronted with the very basic issue that remains unresolved: Why is the global demand for real physical investment apparently out of line with patterns of global saving?
Monday, November 23, 2009
Marty Ellison and Thomas Sargent defend the FOMC:
Bad forecasters can be good policymakers, by Martin Ellison and Thomas J. Sargent, Vox EU: The value of the Federal Reserve’s Open Market Committee (FOMC)1 has recently been questioned in a highly provocative paper by two professors at the University of California, Berkeley. The two professors are husband-and-wife team Christina and David Romer, who are amongst the most influential economists in the world today. Christina Romer is Chair of the Council of Economic Advisers in the Obama administration and a co-author of Obama’s plan for recovery, and David Romer is the author of a very popular macroeconomic graduate textbook. Their paper was published in The American Economic Review, arguably the most influential journal in economics.
The Romers criticize the FOMC because of its poor performance in forecasting economic developments. Specifically, the Romers show that the FOMC is even worse at forecasting than its underlings, the staff of the Federal Reserve System. This is surprising because the FOMC should have all the advantages when forecasting. The FOMC has the staff forecast available when preparing its own forecast and the FOMC presumably knows its own policy objectives and preferences better than anyone else. Despite this, the Romers find that:
- It is best to ignore the FOMC forecast when predicting inflation or unemployment.
- The FOMC makes larger forecast errors than the staff.
- Monetary policy reacts when the FOMC forecast differs from the staff forecast
The Romers use these findings to paint a bleak picture of the FOMC as "not using the information in the staff forecasts effectively" and accuses that the FOMC "may indeed act on information that is of little or negative value". In their opinion, the evidence is sufficiently damning to warrant a radical restructuring of the role of the FOMC in policymaking:
"a more effective division of labor within the Federal Reserve System might be for the staff to present policymakers with policy options and related forecast outcomes, and for policymakers to take those forecasts as given. With this division, the role of the FOMC would be to choose among the suggested alternatives, not to debate the likely outcome of a given policy."
These criticisms are understandable in a world where consumers, workers, policymakers, and researchers perfectly understand the workings of the economy. In such a context, it is difficult to justify the apparently poor forecasting performance of the FOMC. Our defense of the FOMC therefore rests on asking what happens if the FOMC doubts how much the staff understands about how the economy works (Ellison and Sargent 2009). In our view of policymaking, the staff uses state-of-the-art but imperfect economic models to produce the best possible forecasts, but these forecasts are not taken at face value by the members of the FOMC. Instead, the FOMC suspects that the staff's model is imperfect and wants policies that will work well even if the staff model is misspecified.
Saturday, November 21, 2009
The Fed in a Corner, by Tim Duy: Over the years, I have warned a seemingly countless number of undergraduates that Fed's hold on monetary independence was tenuous at best. Independence is not guaranteed by the Constitution. Congress made the Fed, and Congress can unmake the Fed. The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth. Deviating from such paths would have consequences.
The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed's independence.
Some find the loss of support for the Fed puzzling. Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:
First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.
The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure. Fair enough; I have few quibbles with policy since last fall. But what about the years before Lehman, when the crisis was building? Where was the Fed then? Did they abdicate regulatory responsibility? How did banks develop such incredible exposure to off-balance sheet SIV's? How could the Fed ignore increasingly predatory lending in the mortgage market? What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising? Clearly not Citibank.
To be sure, there were plenty of other regulatory failures along the way, but the Fed - an independent Fed - should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible agencies. The Fed's independence should have allowed it to be a leader, not a follower. Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard. Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.
The resulting crisis left the Fed struggling to keep the ship afloat - and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time. But that mission creep was simply incompatible with the Fed's desire for secrecy. This was all to predictable: Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback. The last I checked, this was still a democracy.
Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street. Of course, Fed officials see this a bit differently - they see supporting Wall Street as their mechanism for supporting Main Street. Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows. The purpose of Wall Street is supposed to be to channel investment funds into Main Street. But most Americans no longer view Wall Street as ultimately working in their best interests - maybe correctly. This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation. When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many? And when did policymakers embrace this view? As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance. Yet this is a world tht failed us to completely.
Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?
Now the Fed's relationship with the public is a mess. And I suspect it is going to get much worse. Free Exchange succinctly identifies the new challenge:
An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.
The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist. Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment. They equate credibility with maintaining a 1.7-2% inflation target. Couldn't credibility be consistent with a 4% inflation target? And wouldn't such a target be more appropriate in a zero interest rate world? But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively.
What if the only way to get the Fed to do the right thing is to strip them of their independence? It is a real possibility, although disastrous in the long-run. Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:
It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy “extremely accommodative.”But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.
Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES! Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain. Is the Fed headed to the same place? Maybe.
I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event). The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public. I think the Fed needs to make clear that they work for the people, not for Wall Street. A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start. Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park. If Wall Street is no longer working for Main Street, it is time to side with Main Street.
Friday, November 20, 2009
I agree with this:
Threatening the Fed's independence, by By Alan S. Blinder, Commentary, Washington Post: The Federal Reserve's performance in this ... crisis deserves separate grades. For the early crisis period, from the summer of 2007 until a few weeks after the Lehman Brothers failure in mid-September 2008, the Fed's response was uneven. ... But the Fed deserves extremely high marks for its work since then. It has hit the bull's-eye regularly under very trying circumstances.
In academia and in the financial markets, the overwhelming attitude is: Hurrah, and thank goodness, for Ben Bernanke, who gets kudos for his boldness, creativity and smarts.
But not in the political world. The Fed is extremely unpopular in Congress and is facing hostile and potentially detrimental actions from both sides of the aisle. ... Christopher Dodd ... would clip the Fed's regulatory wings substantially.
Worse, legislation that just proceeded through the House Financial Services Committee could imperil the Fed's ability to conduct an independent monetary policy. With more than two-thirds of the House co-sponsoring the so-called Paul bill, prospects for floor passage unfortunately look good.
The ... bill would subject the Fed's monetary policy decisions and its dealings with foreign central banks to audit by the Government Accountability Office (GAO) -- which normally acts on requests from Congress. Under current law, these aspects of Fed business have been explicitly ruled off-limits (though the rest is auditable).
Is this extension of the GAO's reach, and hence that of Congress, a good idea? If you believe we'd get better monetary policy with decisions made by Congress in open debate, or heavily influenced by congressional opinion, it certainly is. But how many actually believe that? Very, very few. ...
The ... GAO is already authorized to examine most aspects of Fed operations. It can audit the Fed's special financial arrangements for Bear Stearns, AIG, Citigroup and Bank of America -- to name the most prominent examples. ...
But a congressional audit of monetary policy -- remember, the GAO works for Congress -- could easily develop into something quite different. ... It is entirely predictable that some in Congress will be unhappy with the Fed's decisions... Would we welcome a critical GAO audit of monetary policy, which members of Congress could use to browbeat, perhaps even to intimidate, members of the Fed's rate-setting body, the Federal Open Market Committee? ... Would we like Congress to override the Fed's decisions and set monetary policy -- which is its constitutional right? I think and hope not.
An independent monetary policy ... is one of the great and enduring achievements of the Progressive Era. ... Passage of the Paul bill would be a step away from independent monetary policy and a step toward ending the Fed as we know it. That is a step we should not take.
Monday, November 16, 2009
Sudden financial arrest, by Ricardo Caballero, Vox EU: “Sudden cardiac arrest (SCA) is a condition in which the heart suddenly and unexpectedly stops beating. When this happens, blood stops flowing to the brain and other vital organs…. SCA usually causes death if it’s not treated within minutes….” – US National Institute of Health
There are striking and terrifying similarities between the sudden failure of a heart and that of a financial system. In the medical literature, the former is referred to as a sudden cardiac arrest (SCA). By analogy, I refer to its financial counterpart as a sudden financial arrest (SFA).
When an economy enters an episode of SFA, panic takes over, trust breaks down, and investors and creditors withdraw from their normal financial transactions. These reactions trigger a chain of events and perverse feedback-loops that quickly disintegrate the balance sheets of financial institutions, eventually dragging down even those institutions that followed a relatively healthy financial lifestyle prior to the crisis. In this article I draw on the parallels between SCA and SFA to characterize the latter and to argue that a pragmatic policy framework to address SFA requires a much larger component of systemic insurance than most policymakers and politicians currently support.
Should the Fed Be Doing More?, by Tim Duy: Monetary policy looks to be at a protracted standstill - or even arguably becoming less accommodative as purchases of long dated securities draws to a close - despite incoming information that points toward persistently high unemployment rates and an ongoing disinflationary environment. Is policy stability the consequence of changing economic conditions, a perceived ineffectiveness of nontraditional policy, or a willingness of policymakers to be constrained by conventional policy limitations in the absence of impending financial doom? My sense is that all three elements are in play.
It is pretty clear that economic conditions changed dramatically mid-year as inventory correction and policy stimulus brought the recession to a close, at least if measured by growing output. To be sure the sustainability of the gains are in question. I hold little hope that growth could have be sustained in the absence of the policy efforts to date, and the Administration is likely starting to realize that it underplayed its hand this year, offering far to little stimulus to effect stabilization from the all important jobs perspective. Calculated Risk sees growing potential for a second stimulus package (in spirit if not in name), the support for which will gain as concerns about midterm elections grow. Still, from the perspective of monetary policymakers, positive growth after such a long recession could only be met with a sigh of relief and, perhaps inevitably, a willingness to pause and assess the implications and impact of policy to date.
The problem with pausing, however, is that a combination of maximum sustainable growth and price stability are in fact the Fed's objective, we seem to be falling short on both measures. Unemployment continues to climb, nonfarm payrolls continue to fall, and core-PCE inflation continues to decelerate. Moreover, Fed forecasts suggest that these trends will continue for literally years. Leaving aside inflation fears that seem to be largely contained in a handful of what I think are crowded trades (gold and TIPS), what should the Fed be doing on the basis of actual, incoming data? Have they truly hit the limits of policy? This brings be to an ongoing debate between Paul Krugman and Scott Summner, with the recent participation of Joe Gagnon.
A starting point for further analysis is Krugman's assertion that conventional policy has been brought to a standstill. Zero is zero: