Category Archive for: Monetary Policy [Return to Main]

Thursday, March 15, 2012

Testing the Inflation "Floodgates"

Simon Wren-Lewis on fear of inflation:

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

Robert Waldmann also comments.

Wednesday, March 14, 2012

Fed Watch: FOMC Recap

Tim Duy:

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

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

morphed into:

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

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

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


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

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

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


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

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

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

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

Tuesday, March 13, 2012

Can the Doves Cage the Hawks?

What I think the Fed should do:

Can the Doves Cage the Hawks?

Why does overshooting the inflation target in the short-run induce such fear in so many members of the Fed's monetary policy committee?

Monday, March 12, 2012

Stiglitz: The US Labor Market is Still a Shambles

Joe Stiglitz:

The US labour market is still a shambles, by Joseph Stiglitz, Commentary, Financial Times: It is understandable, given the number of times green shoots have been seen since the downturn began in December 2007, that there might be some skepticism about claims the recovery is finally under way. To me the question is what does it imply for policy? Does it mean we can be more relaxed about the demands for budget cuts emanating from fiscal conservatives? Or that the US Federal Reserve should start paying more attention to inflation, and begin contemplating raising interest rates? Even if this is not one of the many green shoots that soon turn brown, the economy will almost certainly need more stimulus if it is to return to full employment any time soon.
This is the inevitable conclusion from looking at the state of the labour market today. It is a shambles. ...
Today the American economy faces three big risks. First, a steeper European downturn, as a result of the excessive austerity and the euro crisis. Second, complacency that the economy will recover quickly without government support. Though every downturn comes to an end, that should not be of much comfort. Third, that we accept that an unemployment rate above 7 per cent is inevitable.
If my Cassandra forecast turns out to be wrong, stimulus can be cut. But if it turns out to be right, and we do too little, we will live to regret it.

I hope you know by now that I agree.

Friday, March 09, 2012

Fed Watch: Another Positive Employment Report

I missed this post from Tim Duy earlier today:

Another Positive Employment Report. by Tim Duy: It is increasingly difficult if not impossible to deny the real improvements in labor markets in recent months. First, the ongoing declines in initial jobless claims clearly suggested the recovery was gaining depth and sustainability:


Then comes the February employment report along with upward revisions to the December and January numbers:


Nonfarm payroll gains are averaging a solid 245K per month over the last three months. Does this mean the Federal Reserve can pull back on the throttle? No, although I am sure you will hear the more hawkish policymakers using this report as evidence that policy reversal will happen sooner than markets anticipate. To be sure, that may still turn out to be true, but this data still reveals the depth of the hole left behind by the recession. But he majority of the FOMC will notice the stagnant unemployment rate (8.3%), a consequence of a small gain in labor force participation. If labor force participation rates begin to rebound, the improvement in the unemployment rate will stall, and the Fed could find itself willing to ease again later this year as suggested in this week's well documented Wall Street Journal article.
Moreover, note that wage gains remain anemic, both for all workers:


and for non supervisory and production workers:

The lack of substantial wage gains, combined with relatively low labor force participation rates suggests that we still have a long way to go before labor markets normalize:


Of course, if labor force participation rates stagnate while job growth continues unabated, the Fed will find themselves facing a more rapid drop in unemployment. That would certainly take QE3 off the table, and turn attention back to the timing of the next tightening cycle. This is not my expectation, but it certainly bears watching.
Bottom Line: Another good report, although still suggestive of the beginning of recovery. In my mind, true recovery will come when the cyclical declines in labor force participation are further reversed. At this point, there is no reason for the Fed to pull their foot off the gas. On net though, the employment report does push back the timing of any additional easing. The Fed will move to the sidelines while policymakers assess the level of slack in labor markets. If the cyclical downturn resulted in sustained structural damage, there may be little slack. But if an influx of returning workers puts a floor under the unemployment rate, the Fed will have more work still to do.

Thursday, March 08, 2012

The Fed's Latest Plan to Boost the Economy

I have an explanation of the sterilized bond purchases the Fed is considering, and how this differs from "operation twist":

The Fed's latest plan to boost the economy

The Fed is still unduly afraid of inflation and that is limiting its options.

Wednesday, February 29, 2012

Has the Fed Learned Its Lesson?

I have been pretty critical of the Fed throughout the crisis. I still don't think policy is aggressive enough, and the Fed has been behind the developments in the economy due to its propensity to see green shoots that aren't actually there. But at least it's leaning in the right direction:

Has the Fed Learned Its Lesson?, Mark, Thoma, CBS News: COMMENTARY Federal Reserve Chairman Ben Bernanke seems to have learned an important lesson. In his appearance before House Committee on Financial Services, Chairman Bernanke said the monetary policy committee does "not anticipate further substantial declines in the unemployment rate over the course of this year. Looking beyond this year, FOMC participants expect the unemployment rate to continue to edge down only slowly toward levels consistent with the Committee's statutory mandate." In addition, "participants agreed that strains in global financial markets posed significant downside risks to the economic outlook." There were other cautionary statements as well.

That is quite a change from Bernanke's pronouncement that the Fed was seeing "green shoots" in the economy back in 2009, and similar optimistic statements about the prospects for recovery many times after that. Time and again, however, the green shoots withered and policy ended up in catch up mode rather than out in front of the economy as it ought to be. Policymakers were consistently behind.

I don't think either monetary or fiscal policymakers have been aggressive enough throughout the crisis, and I have also worried that policymakers in Congress and at the Fed would withdraw support for the economy too soon and harm the recovery. There's little chance that policy will march the aggressiveness I believe is called for, especially this late in the game, and I'm still very worried about Congress turning to budget balancing before the economy is ready to handle it. Premature austerity could damage our recovery prospects.

But I'm becoming less concerned that the Fed will withdraw support too soon. It has committed to keeping interest rates low through the end of 2014, an extension of an earlier commitment through mid 2013. However, the commitment has wiggle room, and there are voices on the Fed who are calling for interest rate increases now. But as Chairman Bernanke made clear today, the Fed as a whole remains cautious and monetary policymakers as a whole are not ready to conclude our troubles are over. I think that's exactly the right stance to take -- hope for the best, but prepare for the worst. In the past the Fed let its hopes interfere with its preparation, but this time does indeed appear to be different.

Monday, February 27, 2012

Fed Watch: Oil Prices - It's What Everyone is Talking About

Tim Duy:

Oil Prices - It's What Everyone is Talking About, by Tim Duy: Via Ryan Avent, Matt Yyglesias opines on the link between oil prices and monetary policy:

But it looks to me as if a demand-side oil issue is really just the same old issue of the trade deficit and the international balance of payments and not the second coming of a 1970s-style oil price shock. Perhaps it's a monetary policy issue. We send dollars abroad in exchange for oil, but then the dollars get sent back in exchange for bonds. That ought to lower interest rates and induce investment in the United States, but nominal interest rates are already at zero so the loop is cut. Even so, higher gas prices should push the price level up which pushes real interest rates down which induces investment in the United States. The chain will only be broken here if the Fed decides to ignore its own self-guidance and target headline inflation instead of core inflation.

There is a lot going on in these few sentences, but I am going to focus on the last two lines. As a point of clarification, the Fed does not target core inflation. Refer to the Fed's freshly printed statement on long-run goals and strategy:

The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

That's headline inflation, not core inflation. Of course, there is a near-term focus on core inflation, but not as a target, but as a guide to the path of headline inflation. Monetary policymakers should be wary about overreacting to movements in headline inflation if they are not evident in core inflation.

Consider also that the Fed is setting inflation expectations at 2 percent. Technically, expected, not current, inflation should be a determinant of investment spending. Which means that a spike in headline inflation should not stimulate investment spending via this channel assuming inflation expectations remain anchored. And, at this point, inflation expectations appear anchored:


Still below what we saw last spring. To be sure, we could see inflation expectations edge up, but anything significant would draw the attention of the Federal Reserve. I think they are pretty serious about that 2 percent target. In other words, I would be cautious about reading too much into a drop in ex-post real interest rates due to a rise in energy costs.

Note that this is a criticism of Fed policy at the zero bound, that by locking in inflation expectations at 2 percent they have effectively placed their most powerful remaining policy tool off-limits.

I could imagine that higher-gas prices induce additional investment via some other mechanism, such as increased purchases of energy efficient machinery, etc. But this would not necessarily be a sufficient offset to other, negative impacts of higher energy prices.

In any event, we are all struggling to extract a signal from the data - is this primarily a "good" shock that indicates improving global activity, or a "bad" shock due to a supply constriction? Arguably, both factors are at play - see Jim Hamilton here. Putting aside the possibility of a bad shock for the moment (I think we all agree that a supply disruption stemming from a conflict with Iran would be fairly negative, especially for Europe), I tend to see the challenge in terms similar to this from Reuters:

Looking past the near-term uncertainty surrounding Iran, Andrew Sentance, a former member of the Bank of England's Monetary Policy Committee, said high and fluctuating prices for energy were part of a "new normal" economic climate in which Asia is the main engine of global growth.

Periodic bursts of inflation would add to the volatility of what was likely to be disappointing growth in the West for quite some time, according to Sentance, a senior economic adviser to PricewaterhouseCoopers, an accounting and advisory firm.

"This strong growth in Asia and other emerging markets is putting considerable pressure on markets for energy and other commodities and that is one of the reasons why we are finding growth so difficult to achieve," he told a conference organized by the Institute of Economic Affairs, a free-market think tank in London.

"That's not just a short-term phenomenon. It's a secular issue that's going to persist through the middle of this decade," he said.

Even if higher oil prices are a symptom of improving global growth (a "good" shock) and do not trigger a US recession, they will certainly place some additional strain on US household budgets, which will in turn depress growth relative to what it would have been in the absence of the higher oil prices (consider instead the relatively low and stable prices of oil during much of the US boom during the 1990s). In effect, we could be running up against a global bottleneck that places something of a speed-limit on US (and global) growth.


As to the international finance story Yglesias tells, I think this does come back to a monetary policy story, but I think the direction might be backwards. I am still working this one out:

Yglesias is telling a story of recycling petro-dollars. In order to finance a given level of trade deficit, the dollar outflow must be recycled back into the US economy as a dollar inflow that supports some type of domestic absorption. I shy away from using the term "investment" strictly as it could support government spending or even consumption spending (think of households borrowing against home equity to buy a boat). If foreigners don't not want to recycle their dollars back into the US economy via financial inflows, the value of the dollar falls to stimulate exports and deter imports, thus improving the external deficit.

Now, to Yglesias' point, we may have something of an interesting situation whereby foreign investors find themselves holding dollar assets as cash or near-cash equivalents (low yielding Treasuries). And unless the federal government utilizes that potential via expanded borrowing (note that in the private sector, savings exceeds investment already), little additional demand is supported. Now it is interesting that foreign investors would prefer to hold relatively low-yielding assets rather than using their dollars to purchase US goods and services, but such is the outcome of so many dollars being held for central banks around the world.

As Yglesias' says, the "loop" is cut, but not necessarily because of the zero bound, but by the global demand for dollars, which arguably is the cause of the zero bound. Which then does brings us back to Yglesias' point that this is a monetary policy issue - policymakers could more actively drive down the value of the dollar by raising inflation expectations, thus making it increasingly unattractive for foreigners to hold cash or cash equivalents, and force the funds into either demand for US goods and services or investment goods. Certainly, however, policymakers would view this as a risky strategy, and thus have not gone down this road.

Thursday, February 23, 2012

Strategic Forecasting at the Fed

Minimizing the forecast error, i.e. providing the best possible forecast of future variables such as output, inflation and employment, does not appear to be the main goal of some members of the Fed's monetary policy committee. Instead, the forecasts appear to be set strategically in an attempt to influence policy decisions:

Federal Open Market Committee forecasts: Guesses or guidance?, by Peter Tillmann, Vox EU: On 25 January 2012, the Federal Open Market Committee (FOMC), the decision-making body of the US Federal Reserve, took yet another step towards higher transparency of US monetary policy. Besides publishing the usual set of macroeconomic forecasts, the FOMC for the first time also published the interest-rate projections formulated by its members...
A week later ... Richard W Fisher, president of the Federal Reserve Bank of Dallas ... argued that “at best, the economic forecasts and interest-rate projections of the FOMC are ultimately pure guesses”. Furthermore, he said that “forecasts issued by the FOMC are tactical judgments of the moment, made within a broader strategic context”...
Given the enormous attention Fed watchers pay to every piece of information officially endorsed by the Fed, the interpretation of the economic projections is a highly topical question. If projections were just “guesses”, the ability to guide market expectations would eventually suffer.
FOMC vs private-sector forecasts ...Gavin and Mandal (2003) ... show that the FOMC’s real growth forecasts are at least as good as those provided by the private sector. The inflation forecasts were more accurate than private-sector forecasts. In light of these findings, Fisher’s (2012) first conjecture seems less convincing.
But what about Fisher’s (2012) other claim..., are motives other than achieving maximum forecast accuracy reflected in FOMC projections? One interpretation is that members pursue strategic motives to have an additional leverage on policy decisions of the committee. ... McCracken (2010) argues that “... an inflation hawk has an incentive to forecast very high inflation regardless of whether that outcome is the most likely, and an inflation dove has a similar set of incentives to forecast lower inflation.”
Strategic forecasting: Voting vs non-voting members’ forecasts ...While all regional presidents take an active part in the policy deliberation, the formal voting right rotates across Federal Reserve districts. ... While only a subgroup of members votes on interest-rate policy, all FOMC members regularly submit forecasts for important macroeconomic variables. The incentives to pursue strategic motives are stronger for members without a direct say on policy. ...
I show that non-voters systematically over-predict inflation relative to the consensus forecast if they favor tighter policy and under-predict inflation if they prefer looser policy. These findings are consistent with non-voting members following strategic motives in forecasting ... to influence policy.
This line of research is extended in my research with Jan-Christoph Rülke... We test whether these forecasts exhibit herding behavior, a pattern often found in private-sector forecasts. While growth and unemployment forecasts do not show herding behavior, the inflation forecasts exhibit strong evidence of anti-herding, i.e. FOMC members intentionally scatter their forecasts around the consensus. Interestingly, anti-herding is more important for non-voting members than for voters. Put differently, non-voting members submit forecasts that are systematically further away from the forecast consensus. ...
Are FOMC forecasts special? Taken together, there is indeed evidence suggesting that motives other than forecast accuracy play a role in the forecasting process. Is this a case for concern? Probably not. It ... is well known that professional forecasts are affected by factors other than accuracy (see Lamont 2002 and Pons-Novell 2003). The available empirical evidence suggests that FOMC members are prone to similar incentives. While individual forecasts might be affected by those factors, the distribution of views among committee members can still be a valuable source of information...

Tuesday, February 21, 2012

"Political Constraints in the Aftermath of Financial Crises"

Political constraints limit the options for rescuing the financial sector after a meltdown:

Political constraints in the aftermath of financial crises, by Atif Mian, Amir Sufi, and Francesco Trebbi, Vox EU: Financial crises of all colors (banking, currency, inflation, or debt crises) leave deep marks on an economy. ... What exactly occurs in the aftermath of financial crises that makes recovering from such shocks so hard? This column argues that the answer may lie mostly with the politics, not the economics.

Let us start with some stylized facts. One thing that happens with some regularity, but seems not to have been systematically documented, is an association of financial crises with ...  increases in income inequality...

Although the relationship between higher inequality and persistent contractions is not conceptually straightforward, the evidence is consistent with the view of a financial crisis damaging certain constituencies in society more than others.

As an example we can look at ... the disparity of how the value of real estate assets, mostly held by middle- and low-income indebted households, is still far from having recovered to pre-crisis levels, while financial assets, mostly held by the wealthy, have already bounced back. Some may be hit harder than others in a financial crisis, and this is a consequential phenomenon. ...

Individuals differentially affected will probably support different policy responses to the crisis. Agreement on unified reactions to the negative financial shock may become harder to achieve or nonexistent. This may stall potentially beneficial macro-financial reform, which could speed up the recovery. ...

A systematic analysis of ‘politics after the crisis’ fits this logic. ... Voters become more ideologically polarized... Government coalitions become weaker... Opposition coalitions become larger. Party fragmentation increases across the board. ...

As one would expect,... after the crisis hits, the moderate middle sinks and the extremes rise. This is reminiscent of the rise of the Tea Party on the right and of Occupy Wall Street on the left in the post-Great Recession US. ...

Political gridlock and lack of reform are natural outcomes of polarization. Gridlock delays reform and possibly makes recovery slower (explaining the long recessions and sluggish recoveries). ... Crises are occasionally thought of as critical junctures where macroeconomic reform unlocks by shattering entrenched conditions (Drazen and Easterly 2001). The opposite seems true.

The list of potential negative implication does not stop here though.

  1. Gridlock brings selective intervention. In the aftermath of a financial crisis, any type of reform, including bailouts, faces a higher bar for passage. Unfortunately, if a reform overcomes political gridlock, it may well be not because of efficiency or merit, but because of strong political organization by its constituency... Is it surprising that concentrated special interests (such as large US banks...) got a sizeable bailout through TARP, while diffused special interests (such as mortgage debtors) did not? This selective intervention may then feed back into further increasing economic and political polarization.
  2. Gridlock brings political uncertainty. Markets for sovereign debt do not seem particularly appreciative of governments engaging in stalemate or political bickering at the time a country needs decisive intervention the most. Recent credit rating downgrades of US or European debt fit this interpretation. ...
  3. In the same way that financial crises appear to polarize constituencies at the national level, it is not hard to envision polarization at the international level playing an important role. ...

In conclusion, to those of us interested in efficient policy response in the aftermath of financial crises, understanding the logic of political constraints may be useful. The chances are that a country will not achieve reform precisely when it needs it the most. Any model of post-crisis macro intervention that leaves this political feature aside forgoes an important dimension. ...

We didn't have until after the fact to learn this lesson. At the time, many of us were urging the administration to consider the distributional consequences of the financial bailout -- who was helped and who wasn't -- and to adjust policy accordingly (e.g. the banks could have been saved without rewarding financial executives who had a hand in creating the problems). But the administration was afraid that if it took the steps required to do this, i.e. if it nationalized the banks temporarily, removed the management, put the good assets in one pile, the junk in another, and then sold the good assets back to the private sector, Republicans would have been upset. They might have called the administration socialists, criticized the bailout, something like that, you know --like they did anyway.

The administration argues it had little choice about how to conduct the bailout due to legal restrictions that prevented it from taking over shadow banks in the same way it could traditional banks, and there was an urgent need of an intervention of some sort. Nevertheless, there were other options it could have pursued even within the structure the administration adopted, e.g. more aggressive clawback on profits resulting from the bailout through warrants and other means. In any case, I just wish more had been done for the households that were struggling every bit as much as the banks. A lot more.

Saturday, February 18, 2012

Potential Output: Measuring the Gap

There's been quite a bit of discussion recently about the output gap. I want to make a simple point in this post, how the gap is measured can have a big impact on the estimate of the state of the economy, and hence on the need for policy. Below, three different gap measures are presented, one that measures a large gap and hence implies the need for a large stimulus, one that measures a "medium size" gap, and one where the gap is absent altogether. In fact, according to this model we have already exceeded the full employment level of output.

In the first model, the trend is assumed to be linear, i.e. Ytrend = b0 + b1*t. Recall that the gap is measured as (Y - Ytrend), i.e. as the distance between the red and blue lines in the following diagram showing the estimated trend for GDP (click on figures for larger versions):

Continue reading "Potential Output: Measuring the Gap" »

"Heartening News About What Economists Think"

Brad DeLong is heartened by the response of economists to the question "Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill":

Effects of the 2009 Recovery Act: Heartening News About What Economists Think--Although Caroline Hoxby and Ed Lazear Do Go All-in for Team Republican..., by Brad DeLong: The University of Chicago's IGM Forum:

Poll Results | IGM Forum: Question A: Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill.

At the time, back at the start of 2009, arguments that the Recovery Act would not push the unemployment rate down over the two years after its enactment took one of three lines:

  1. Unemployment is really not cyclical but structural, so whatever boost to spending it might generate would show up in higher prices and wages as businesses trying to satisfy demand bid against each other for a fixed pool of non-zero-marginal-product workers.
  2. Government purchases must be financed by issuing government debt, and debt issues would push up interest rates and so would discourage private investment spending.
  3. Government purchases must be financed by issuing government debt, and the future taxes needed to amortize the extra debt would frighten businesses and investors, so we would see equity prices tank as this fear would discourage private investment.

None of those things happened. And that is why the Chicago panel agrees 80%-4% with the statement that the Recovery Act the unemployment rate in 2010 below what it would otherwise have been.

And in this context it is worth noting that the two members who want to go on record agreeing with the Republican Party line and disagreeing with the statement appear to do so very carefully... Caroline Hoxby and Ed Lazear, both of Stanford [disagree]. Note that Hoxby appears to be evaluating a different statement--that the ARRA was worth doing--rather than the question asked--that the ARRA reduced the unemployment rate in 2010 below what it would otherwise have been. ...

And note that Lazear's comments--"the estimates [of the Recovery Act's effects] are varied and the highest are based on ex-ante models, not experience-based data. The upper bound estimate is low"--appear to justify the position that he is uncertain about the truth of the statement, not that he disagrees with the statement.

From one perspective, this is quite heartening: 183 years after John Stuart Mill and Jean-Baptiste Say agreed that Say's Law applies in the long run but not in the short business-cycle run, 4 years after what John Quiggin calls its zombie-like rising from the grave, the claim that increases in government purchases must by the metaphysical necessity of the case--no matter what happens to asset or commodity prices--crowd out an equal and opposite amount of private spending appears to be dead.

And staked.


To Be Continued...

I don't know that we've learned one important lesson about the use of fiscal policy to attenuate the effects of a downturn. For the most part, even economists who supported fiscal policy as an option insisted that we try monetary policy first and give it a chance to work. Monetary policy alone, we were told, would likely get the job done. And in the unlikely case that it didn't, we could then turn to fiscal policy for help.

That was the wrong advice (and I get annoyed when people who insisted that we wait pat themselves on the back over their support of things like infrastructure spending). By the time we realized that monetary policy would help, but wouldn't be enough to turn things around by itself, it was very late in the game to be applying fiscal policy. Fiscal policy still had an impact, but had it been put in place much earlier -- before problems had a chance to worsen and gel making them harder to overcome -- it would have been much more successful.

When this happens again, we need to to use both monetary and fiscal policy tools to full effect instead of trying one policy, realizing it's not enough, and then turning to the other. But it's not at all clear we've learned this lesson (and, to refine it a bit, we need to get help to state and local governments immediately -- the failure to effectively backfill the budget problems at the state and local level was a big mistake).

Let me emphasize that I'm not saying fiscal policy did not work -- see the following from Jeff Frankel -- only that it could have been much more effective if we hadn't waited so long to put the policies into place:

... The full force of the fiscal stimulus package began to go into effect in the second quarter of 2009, with the NBER officially designating the end of the recession as having come in June of that year. Real GDP growth turned positive in the third quarter, but slowed again in late 2010 and early 2011, which coincides with the beginning of the withdrawal of the Obama administration’s fiscal stimulus.
Other economic indicators, such as interest-rate spreads and the rate of job loss, also turned around in early 2009. ... Again, such data do not demonstrate that Obama’s policies yielded an immediate payoff. In addition to the lags in policies’ effects, many other factors influence the economy every month, making it difficult to disentangle the true causes underlying particular outcomes.
Given that difficulty, the right way to assess whether the fiscal stimulus enacted in January 2009 had a positive impact is to start with common sense. When the government spends $800 billion on such things as highway construction, salaries for teachers and policemen who were about to be laid off, and so on, it has an effect. Workers who otherwise would not have a job now have one, and may spend some of their income on goods and services produced by other people, creating a multiplier effect.
Those who claim that this spending does not boost income and employment (or that it causes harm) apparently believe that as soon as a teacher is laid off, a new job is created somewhere else in the economy, or even that the same teacher finds a new job right away. Neither can be true, not with unemployment so high and the average spell of unemployment much longer than usual. ...
Economists’ more sophisticated forecasting models also show that the fiscal stimulus had an important positive effect... Allowing for a wide range of uncertainty, the CBO estimates that the stimulus added 1.5-3.5% to GDP by the fourth quarter, relative to where it otherwise would have been. The boost to 2010 GDP, when the peak effect of the stimulus kicked in, was roughly twice as great.
Of course, econometric models do not much interest most of the public. A turnaround needs to be visible to the naked eye to impress voters. Given this, one can only wonder why basic charts, such as the 2008-2009 “V” shape in growth and employment, have not been used – and reused – to make the case.

Friday, February 17, 2012

Fed Watch: Will They Or Won't They?

Tim Duy:

Will They Or Won't They?, by Time Duy: Calculated Risk reads this passage in a recent speech by San Francisco Federal Reserve President John Williams:

This is a situation in which there’s no conflict between maximum employment and price stability. With regard to both of the Fed’s mandates, it’s vital that we keep the monetary policy throttle wide open.

and concludes:

QE3 is coming.

Dallas Federal Reserve President Richard Fisher states:

“In my view, it’s not going to happen,” he said. “It’s a fantasy. Wall Street keeps dangling QE3 out there [but] I just don’t see it happening.”

I guess we are going to see who knows more about monetary policy - CR or Fisher. My instinct tells me CR, but Fisher seems just a little too certain to dismiss entirely. Reviewing the most recent minutes, one find to the now oft-repeated line:

A few members observed that, in their judgment, current and prospective economic conditions--including elevated unemployment and inflation at or below the Committee's objective--could warrant the initiation of additional securities purchases before long.

Presumably, Williams is among the few. I would like the Fed to publish their definition of a "few." In my book that is three or less, which is well short of the the majority necessary to shift policy. That said, the next line of the minutes is:

Other members indicated that such policy action could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

Now you have a solid majority willing to move forward with QE3 if the economy sags or inflation remains below 2%. The recent US data flow, however, has been generally positive, and it is hard to ignore the steady drop in initial unemployment claims. To be sure, we have been fooled by seemingly upbeat data in the past. But I suspect the median FOMC member will be wary about dismissing the generally positive data - sooner or later, some parts of the US economy, such as home building, are going to come back on line. Which leaves us pondering inflation data. With gasoline prices marching higher, headline inflation will head in that direction as well. Typically, however, the Fed will look toward core inflation as a gauge of where headline will eventually settle, and recently core has been soft:


Still, notice the recent uptick. And if FOMC members want to focus on the year-over-year numbers, it looks like core and headline are set to converge at the 2% mark:


All in all, I tend to view the Fed as generally in wait and see mode. I doubt very much the case is as clear cut as Fisher or CR believes. However, I tend to think the general mood of the FOMC favors CR's position, as long as core inflation stays on the weak side of 2%. But if inflation ticks up and general economic data remains solid, hope of QE3 may quickly be dashed.

Update: In a second post, Tim adds:

Who Thinks Unemployment Isn't Too High, by Tim Duy: I noticed this line in the most recent Fed minutes:

While overall labor market conditions had improved somewhat further and unemployment had declined in recent months, almost all members viewed the unemployment rate as still elevated relative to levels that they saw as consistent with the Committee's mandate over the longer run.

"[A]lmost all" means that as least one FOMC member does not believe that the unemployment rate is not well above the natural rate. Who is it?

Thursday, February 16, 2012

Tug of War at the Federal Reserve

I have a few general comments on the Fed at CBS News on the policy divide between hawks and doves:

Tug of war at the Federal Reserve

"I believe the most likely outcome is that the Fed will live up to its commitment to keep rates low through 2014." But if the economy continues to show improvement and prices begin ticking upward, that's not assured.

Wednesday, February 15, 2012

Fed Watch: Again With Potential Output

Tim Duy:

Again With Potential Output, by Tim Duy: St. Louis Federal Reserve President James Bullard graciously responded to my most last post regarding his much considered speech. I actually do not enjoy drawing Bullard's attention, in that it makes me fear that one day I will find that my access to FRED has been disabled.

On what Bullard and I agree on is this: There are different estimates of potential GDP. I discussed this point last year:

Now, before you roll your eyes, as I am inclined to do, note the CBO estimate of potential output is not the only estimate. Menzie Chinn reminds us of the variety of estimates of potential output, some of which suggest that, at the moment, the output gap is actually positive.

In that post I discussed some possible reasons we might consider a downward shock to potential GDP. Near the end, I concluded with this:

While not discounting the probability that some structural factors are at play, the primary challenge facing the US economy is insufficient demand. Optimally, I think the best solution to this challenge is that demand emerges from the external sector – and here I mean NET exports, export and import competing industries. This source of demand would support needed structural change, ultimately for the good of the US and global economies. This adjustment requires a relatively complicated expenditure-switching story on a global basis. I don’t know how to avoid such a story. Barring this outcome, one falls back on fiscal policy, which can surely do the job, but risks maintaining the current pattern of global imbalances. And perhaps such concerns are overblown; after all, so far the fears of a Dollar/current account crisis have not emerged.

Bullard takes a different approach. First, he rejects the CBO estimate offhand because it is not the outcome of "full DSGE model" and "there is nothing about the CBO potential calculation that allows "bubble" levels of output." Before we reject the CBO model outright, it is worth considering it basic effectiveness as a guide:


I see two recent episodes of output in excess of CBO potential, both of which were associated with what I believe were asset-price bubbles and also induced monetary tightening to stem inflationary pressures (which seems to contradict Bullard's assertion that the CBO estimate leaves no room for bubbles). If this was a significant overestimate of potential output in during the housing bubble, I would have expected more severe inflationary pressures.

Of course, even if the CBO estimates were roughly correct during the bubble, perhaps there has been a significant downward shift in potential. And here again I think Bullard and I can find common ground - potential output is not a measured variable, it is estimated. We really shouldn't blindly follow such estimates, but instead look for corroboration in other data. I tend to fall back on unit labor costs for a signal that wages pressures are outstripping productivity growth and threatening to sustain an inflationary dynamic:


I don't see a reason for concern at this point. But put aside the CBO estimate for a moment, and move onto the crux of Bullard's argument:

If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important. But our rhetoric about the decade suggests otherwise. Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived. Output went up, and labor supply was higher than it otherwise would have been.

There are two parts to this theory. One is a demand side story - the debt-fueled housing bubble supported consumption and investment, supporting actual GDP growth. I don't think anyone disagrees with that view. The second part of the story is supply side, that the extra activity induced additional labor supply. With the housing bubble now popped, all of the related output and labor supply now melts away:

So, what Irwin's picture is doing is taking all of the upside of the bubble and saying, in effect, "this is where the economy should be." But that peak was based on the widespread belief that "house prices never fall." We will not return to that situation unless the widespread belief returns. I am saying that the belief is not likely to return--house prices have fallen dramatically and people have been badly burned by the crash. So I am interpreting your admonitions on policy as saying, in effect, please reinflate the bubble. First, I am not sure it is possible, and second, that sounds like an awfully volatile future for the U.S., as future bubbles will burst once again.

Now, I agree that the bubble cannot be reflated, nor should it. But this leads into what I don't like about Bullard's story housing bubble story. From my post last July:

Also arguing for a largely demand side explanation to the current weak employment numbers is what looks like a pretty obvious link between asset bubbles and full employment over the last decade. As long as households had a mechanism to support demand, achieving full employment was not a problem. If not households, then why can’t another form of demand fill the gap?

In Bullard's model, the housing bubble popped, and millions of people who were employed are no longer employed, nor should we expect them to be employed (or to reenter the labor force) as there is no way to do so absent another bubble. This seems to me an obvious place for fiscal policy and monetary policy to step into the breach and compensate for the lost demand. That millions of people's labor and output be lost simply because they no longer believe that housing prices don't always rise is a gross waste of resources.

You can tell a story in which that bubble-driven demand was necessary to compensate for negative equilibrium interest rates for risk free assets (driven by excessive saving by Asian central banks and aging demographics in the developed world). Rather than wait for another asset bubble to come along and lift demand, or twiddle your thumbs hoping another recession doesn't hit while you are at the zero bound, you could pull out the old-Bernanke playbook and implement an even more aggressive mix of fiscal and monetary policy to compensate for the lost demand and flood the world with risk free assets.

Now, as to Bullard's appeal instead to a New Keynesian framework, I am more sympathetic. Basu and Fernald opine:

..the major effects of the adverse shocks on potential output seem likely to be ahead of us. For example, the widespread seize-up of financial markets has been especially pronounced only in the second half of 2008. We expect that as the effects of the collapse in financial intermediation, the surge in uncertainty, and the resulting declines in factor reallocation play out over the next several years, short-run potential output growth will be constrained relative to where it otherwise would have been.

This is similar to my thoughts that somewhere in the background there is need for some structural change, toward export and import competing industries. That said, I still find it hard to believe that this is the primary story given that the downturn negatively affected employment across almost all industries. If structural adjustment was the primary issue, I would have anticipated a narrower range of affected industries.

Bottom Line: Bullard and I agree that there are different estimates of potential output. I think that if he wants to throw out the CBO estimate, he needs to provide another estimate to serve as a policy guide. And I would agree that any estimate, CBO included, needs to be continuously monitored in the light of actual incoming data. I still disagree with his asset-bubble model of potential GDP shifts. At its core it is a demand story with maybe a second-order labor supply aspect, and does not explain why no other source of demand can compensate for the lost housing bubble and induce higher labor supply. In the past I have considered reallocation stories similar to what can be derived from a time-varying NK measure of potential output, but again question that this is the primary concern at the moment.

And if you just can't get enough of this debate, Barkley Rosser argues there are arguments in favor of Bullard's position.

Let me add one note of my own. Bullard argues that the difference between the flexible and sluggish price outcomes in a New Keynesian model, measured by the difference between the "sticky price and flexible price level of output," is superior to the standard output gap measure. I have no argument with that in the context of a standard NK model. However this measure is based upon the assumption that Calvo type price rigidity (or something similar) is driving economic fluctuations. If this is not the way in which shocks are being transmitted to the real economy in this crisis, then this measure may not be the right index for setting monetary policy. I think stickiness in housing prices is part of the story, and perhaps wage rigidity as well -- so price stickiness is part of the slow recovery (though it's not clear that housing really fits the Calvo framework) -- but I'm not convinced this fully captures the breakdown in financial intermediation, balance sheet losses, and solvency/liquidity issues (for banks, businesses, and individuals) that characterized the recession, and that are still holding back the recovery. If we haven't captured the important ways in which shocks are affecting the real economy in our models, then the models won't serve as effective guides to policy.

Tuesday, February 14, 2012

James Bullard Responds to Tim Duy

This is a letter from James Bullard, president of the St. Louis Fed, in response to this post from Tim Duy:

14 February 2012

Dear Tim,

I appreciate your commentary, and all the commentary, on my Chicago speech from last week.  I take the gist of these comments to be "you didn't show us a model."  That is fair enough, I did not.  (Readers may also wish to check Scott Sumner, Noah Smith, Paul Krugman, David Andolfatto, Brad DeLong, David Beckworth, and Steve Williamson at their respective blogs, and possibly others I have not seen yet.)

As you know, I am not too keen on "output gap" ideas as they are knocked around in the business press and in policy circles.  I just do not think the output gap rhetoric matches up very well with the state of knowledge in the macroeconomics literature, either conceptually or empirically.

Neil Irwin at the Washington Post does an excellent job of telling the standard story concerning the output gap.

I know you like this story, and you have a lot of company, because it dominates much of the discussion about the U.S. economy.  I said this potential output calculation is basically an extrapolation of real GDP from 2007Q4 using growth rates from the years immediately preceding.  Of course it is not, it is just ... statistically indistinguishable from an extrapolation of real GDP from 2007Q4 using growth rates from the years immediately preceding!  

For more detail on approaches to measuring potential output, see the St. Louis Fed's 2008 conference "Projecting Potential Growth: Issues and Measurements," published in 2009.

Readers might be especially interested in the paper by Susanto Basu and John Fernald, "What Do We Know (And Not Know) About Potential Output?"

As Basu and Fernald make clear, a lot rides on what is meant by potential output, and one really needs an explicit general equilibrium model to give an appropriate definition.

First, I want to restate my bubble idea in more geeky terms based in part on the basic story presented by Irwin.  I know I am an army of one on this issue, but I think it is important to debate the output gap concept because it is having a huge impact on policy choices.  And, I think my approach makes more sense given the very damaging housing bubble in the U.S. during the mid-2000s.

Second, as I am under no illusions that I can get you to come to reason on the fallacies behind the Irwin graph any time soon, I want to make a plea to at least use the available literature to define potential output appropriately for monetary policy purposes.  As Basu and Fernald stress, we need a full DSGE model to be able to discuss the appropriate measure of the output gap for monetary policy.  Fortunately, outstanding work by Mike Woodford at Columbia and co-authors has at least given us a benchmark model.  In that work, the key gap concept is the difference between the sticky price and flexible price level of output, not the difference between actual output and a measure of trend output as in the Irwin graph.

The housing bubble in the 2000s

Here is a shorter and geekier version of the Chicago talk:  If we look at Irwin's graph, actual output is essentially at CBO potential during 2005, 2006, and 2007.  There is nothing about the CBO potential calculation that allows "bubble" levels of output.  That is just not part of the analysis--it is off the radar screen.  Potential in this picture is simply a projection based on a production function approach.

At the same time, we often say that these years were characterized by a bubble in housing.  One way to interpret this is that fluctuations in real variables were driven by beliefs alone.  We certainly have a very good candidate for what this widespread belief was--namely, "house prices never fall."

If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important.  But our rhetoric about the decade suggests otherwise.  Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived.  Output went up, and labor supply was higher than it otherwise would have been.

Rhetorically, this is consistent with what most analysts say happened.  But we also have a large literature on so-called sunspot equilibria which tells us that fluctuations can be self-fulfilling (driven by beliefs alone) and consistent with rational expectations.  According to that literature, the technology for the production of goods would not have to change at all, but the amount of output, consumption, labor supply and other real variables would fluctuate solely in response to the belief.  These fluctuations lower welfare for risk-averse households.  Potential output via a production function approach would then be sensibly described as that amount of output which would have been produced in the absence of the belief.  I think it is plausible that such a line would be lower than the CBO potential line in Irwin's picture, and thus that the current output gap even by a production function metric would be smaller than the one in the picture.

So, what Irwin's picture is doing is taking all of the upside of the bubble and saying, in effect, "this is where the economy should be."  But that peak was based on the widespread belief that "house prices never fall."  We will not return to that situation unless the widespread belief returns.  I am saying that the belief is not likely to return--house prices have fallen dramatically and people have been badly burned by the crash.  So I am interpreting your admonitions on policy as saying, in effect, please reinflate the bubble.  First, I am not sure it is possible, and second, that sounds like an awfully volatile future for the U.S., as future bubbles will burst once again.

This is admittedly a qualitative story, but much of the rhetoric about the U.S. economy during this period fits this description.  So it is not that the bubble destroyed potential, instead it is that actual output was higher than properly-defined potential during the mid-2000s, and then it crashed back as the bubble burst.

The macroeconomic literature on sunspot equilibria is dense and filled with conditions under which such phenomena could occur.  But I will say that one key condition keeps recurring:  low real interest rates.

As I noted earlier, the Irwin description is the dominant view of the U.S. economy.  But, as you and many others have stressed, we have not seen the bounce back toward potential that would be suggested by that picture.  That is giving me pause, and frankly I think it is giving everyone who follows the U.S. economy pause.  We owe it to ourselves to at least consider alternative possibilities.

Basu and Fernald

Ok, let's now forget about self-fulfilling beliefs and simply assume that whatever was going on in housing during the mid-2000s was more benign.

As Basu and Fernald discuss, "... few, if any, modern macroeconomic models would imply that, at business cycle frequencies, potential output is a smooth series."  One possibility would be to use the leading monetary policy literature (e.g., Woodford [2003, Interest and Prices, Princeton University Press]) available to tell us what potential output should be.  According to the New Keynesian literature, the relevant output gap is the distance between the actual level of output under sticky prices and the flexible price level of output.  It is the flexible price level of output that represents the potential in the economy.  The flexible price level of output would fluctuate continuously in response to shocks hitting the economy.  This gap has been estimated in the literature, and I think it is fair to say that the concept is quite different from what is in the traditional story as told by Irwin.  There are also unemployment versions of this (that is, NK models with search unemployment included)--I might recommend papers by Mark Gertler at NYU and co-authors.  But the concept is the same.

So, if you do not believe my sunspot story, then fine, we can assume that housing price appreciation during the 2000s did not importantly affect output and other key macroeconomic variables.  But let's at least use the appropriate definition of the output gap according to the available NK literature.

I know this last point was not in my talk in Chicago, but it is a theme that I often return to because I think is important in the output gap context.

Thanks again for the comments.  As always, I find them stimulating and insightful.  I think ongoing debate concerning these difficult issues is important.

Best regards,


Monday, February 13, 2012

Fed Watch: It's Worse Than You Think

Tim Duy:

It's Worse Than You Think, by Tim Duy: The last few days have seen a number of reactions to St. Louis Federal Reserve President James Bullard's recent speech, inflation targeting in the USA. Critical reactions came from Scott Sumner, Noah Smith, Mark Thoma, and Paul Krugman. I think so far the only real support for Bullard comes from David Andolfatto here and here.

Bullard was moving in this direction last month, but he really didn't outline his thinking. Now he has, and sadly revealed that there really wasn't that much thinking at all. Bullard attempts to argue against the "output gap" framework shaping monetary policy:

The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation.

First off, Bullard just flat out does not understand the definition of potential output:

The key to the large output gap story is the use of the fourth quarter of 2007 as a benchmark for where we expect the economy to be today. The idea is to take that level of real output, assume the real GDP growth rate that prevailed in the years prior to 2007, and project out where the “potential” output of the U.S. should be.

Estimates of potential GDP are not simple extrapolations of actual GDP from the peak of the last business cycles. They are estimates of the maximum sustainable output given fully employed resources. The backbone of the CBO's estimates is a Solow Growth model. So I don't think that Noah Smith is quite accurate when he says:

So, basically, what we have here is Bullard saying that the neoclassical (Solow) growth model - and all models like it - are wrong. He's saying that a change in asset prices can cause a permanent change in the equilibrium capital/labor ratio.

Bullard can't be saying the Solow growth model is wrong because he doesn't realize that such a model is the basis for the estimates he is criticizing.

Second, as as already been widely circulated, Bullard then attempts to use a demand side shock to justify his contention that estimates of potential GDP are too high:

A better interpretation of the behavior of U.S. real GDP over the last five years may be that the economy was disrupted by a permanent, one-time shock to wealth. In particular, the perceived value of U.S. real estate fell substantially with the 30 percent decline in housing prices after 2006. This shaved trillions of dollars off of the wealth of the nation. Since housing prices are not expected to rebound to the previous peak anytime soon, that wealth is simply gone for now. This has lowered consumption and output, and lower levels of production have caused a significant disruption in U.S. labor markets.

Follow the links above to Sumner and Krugman for rebuttals to this line of thought. Brad DeLong tries to give Bullard a little help by noting that the bubble may have influenced labor force participation rates, but DeLong also notes these are at best small and were not Bullard's argument in any event. Bullard's chain of thinking is not so sophisticated. Sure, you can argue that he does have labor in the equation:

I mentioned that a wealth shock significantly upsets labor market relationships. This is because output declines, so less labor is required. It takes a long time for those displaced by the shock to find new working relationships.

But again, this is a demand side story. If output were higher, then so too would be the demand for labor. Simply put, Bullard simply moves from the wealth effect to a drop in consumption, and assume that drop in consumption represents a shock to potential GDP, inexplicably confusing demand and supply.

I don't think there is much of a viable defense of Bullard - he gets both the empirics and the theory wrong. He doesn't attempt to define a change in the factors of production that would lead to a shift in potential GDP, nor does he attempt to argue that the estimates of potential GDP are wrong, either from a time series trend/cycle decomposition framework or a CBO Solow growth framework. But note that it gets worse when he extends his faulty logic to policy:

I have argued that the large output gap view may be keeping us all prisoner—tethering our expectations for output, in effect, to the collapsed bubble in housing. It is setting a very high bar for the U.S. economy, one that may not be appropriate given the nature of the shock that the economy has suffered. Importantly, it may influence the FOMC’s near-zero rate policy far into the future, since output is continually viewed as falling short of the high-bar benchmark.

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.

In particular, the lengthy near-zero rate policy punishes savers in the economy...

According to Bullard, monetary policy is stuck at near zero-interest rates because of overestimation of the output gap, and as a consequence savers are suffering. First, if the output gap is smaller than estimated, or the economy outperforms, the Fed can change course and raise interest rates. They have only issued a forecast, not a commitment.

And, second, I have been through this before - while I am very sympathetic to the plight of savers, Bullard does not consider that the Fed is merely following the lead of the economy. Another way to think about the situation is that the supply of savings and the demand for investment currently would clear only at a negative interest rate - see Paul Krugman here. Also note the excess of private saving over private investment, which is exactly what you would expect if the market clearing interest rate was below the zero bound:


If the Fed's zero-interest rate policy is leading to fundamental distortions in the economy, it is because the Fed is not taking seriously enough the need to lift the economy away from the zero-bound. And I don't know that they can push the economy off the zero-bound if they limit their policy options with a strict two percent inflation target.

Bullard also shows significant sympathy for the notion that Fed policy is a net drag on activity:

These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back. In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today. However, this demographic group faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption. Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive.

If you truly believe this argument, then you must believe that a higher Federal Funds rate will have a net positive impact on output. But I have yet to see a convincing argument as to why this should be so - raising rates will only make matters worse if the market clearing rate is already negative. Note also that the ECB's last two forays into the realm of tighter policy have not been particularly successful, to say the least.

Bottom Line: Bullard really went down an intellectual dead end last week. He criticized the focus on potential output, but revealed that he doesn't really understand the concept of potential output either empirically or theoretically. He then compounds that error by arguing against the current stance of monetary policy, but fails to provide an alternative policy path. And the presumed policy path, tighter policy, looks likely to only worsen the distortions he argues the Fed is creating. I just don't see where Bullard thinks he is taking us.

Wednesday, February 08, 2012

"What Output Gap?"

I have been more optimistic than most about the return to long-run trend, i.e. that the shock we experienced is mostly temporary rather than permanent, but here's another view arguing that we have had a substantial decline in the natural rate of output:

What output gap?, by David Andolfatto, Macromania: In case you haven't seen it, you may be interested in this speech given recently by Jim Bullard, president of the St. Louis Fed: Inflation Targeting in the USA.

This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below "potential" GDP owing to "deficient demand," the correct view? Or should we instead be thinking in terms of a large negative shock to "potential" GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential). Among other things, he says:

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.
Precisely how such a policy "distorts fundamental decision-making" needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.
At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it's shown that we shouldn't grow complacent over what we think we understand.

I believe that costs are asymmetric -- doing too little to help the economy is worse than doing too much -- and the conclusion that the shock is mostly permanent rather than temporary is more likely to lead to policymakers giving up too soon (resulting in the more serious error). Thus, those that hold this view need to recognize the asymmetric nature of the mistakes they are likely to make and adjust their policy recommendations accordingly.

However, inflation hawks see the costs as more symmetric, and they are convinced the shock is mostly permanent, so they would disagree with the need to adjust their policy recommendations. But as noted above, I think the shock is highly persistent but ultimately mostly temporary, and I just don't see the equivalence between a marginal increase in inflation versus a marginal decrease in unemployment. For me, unemployment is a much higher priority (and yes, I understand the argument that inflation problems ultimately impact employment).

Update: There are two concerns here that I may not have done enough to separate in the comments above. First, there is the concern that the asymmetric nature of the costs of inflation and unemployment is being ignored in policy recommendations (though, again, inflation hawks see inflation as more costly than I do, and hence see the costs as more symmetric, and they believe that a short burst of inflation to fight a recession is likely to lead to a long-run inflation problem -- I have more faith in the Fed than that). This means, for me anyway, that policy ought to tilt toward unemployment (i.e., I disagree with Ben Bernanke's recent assertion in testimony before Congress that inflation and unemployment should be and are weighted equally).

The second concern is the assumption that the natural rate has fallen permanently. Making this assumption when in fact the shock is largely temporary will lead to a miscalculation of the chance that we will face an inflation problem -- the calculated odds will be too high -- and the undue fear of inflation will cause policy to tighten too soon. This results in an error where unemployment rather than inflation is higher than desired. The opposite belief -- the belief that the shock is temporary when it turns out to be permanent -- leads to the opposite policy error, i.e. unemployment lower and inflation higher than desired, but to me that is more tolerable. That's not why I hold the view it's mostly a temporary shock -- that's a conclusion based upon economic considerations -- but given that the costs are asymmetric the belief that the shock is temporary does result in a less serious policy error if it is wrong.

Monday, February 06, 2012

Stiglitz: Capturing the ECB

A quick post between appointments -- Joe Stiglitz is unhappy with the ECB. He says, "The ECB’s behavior should not be surprising: as we have seen elsewhere, institutions that are not democratically accountable tend to be captured by special interests":

Capturing the ECB, by Joseph Stiglitz, Commentary, Project Syndicate: Nothing illustrates better the political crosscurrents, special interests, and shortsighted economics now at play in Europe than the debate over the restructuring of Greece’s sovereign debt. Germany insists on a deep restructuring – at least a 50% “haircut” for bondholders – whereas the European Central Bank insists that any debt restructuring must be voluntary.
In the old days – think of the 1980’s Latin American debt crisis – one could get creditors, mostly large banks, in a small room, and hammer out a deal, aided by some cajoling, or even arm-twisting, by governments and regulators eager for things to go smoothly. But, with the advent of debt securitization, creditors have become far more numerous, and include hedge funds and other investors over whom regulators and governments have little sway.
Moreover, “innovation” in financial markets has made it possible for securities owners to be insured, meaning that they have a seat at the table, but no “skin in the game.” They do have interests: they want to collect on their insurance, and that means that the restructuring must be a “credit event” – tantamount to a default. The ECB’s insistence on “voluntary” restructuring – that is, avoidance of a credit event – has placed the two sides at loggerheads. The irony is that the regulators have allowed the creation of this dysfunctional system. 
The ECB’s stance is peculiar. ... There are three explanations for the ECB’s position, none of which speaks well for the institution and its regulatory and supervisory conduct. ...[continue reading]...

Old versus New Keynesian Models

In response to Tyler Cowen, if the alternative hypothesis to his null that Old Keynesian models have failed is New Keynesian models, and he has rejected the Old in favor of the New, then I don't have many problems with his overall conclusion (which is not to say I agree with every detail of his argument). I thought his alternative hypothesis was broader than just the New Keynesian model, i.e. that he was arguing against Keynesian models of all varieties, but he says "I very much prefer New Keynesianism over Old." So if he is really saying the data support the New Keynesian model, I don't have much to disagree with. (See here for a post highlighting the difference between Old and New Keynesian IS-LM models. I posted this when people tried to claim I support Old Keynesian models as a way of discrediting what I have to say, and I've posted lots of New Keynesian work on fiscal multipliers as well. But people like Williamson, who Tyler points to authoritatively for reasons that escape me, still make the false charge that I promote old-fashioned Keynesian ideas.)

A few notes:

People seem to forget that the federal fiscal policy efforts were almost entirely offset by declines in spending and/or tax increases at the state and local level. Given that, it's not clear why we should expect to see a big effect in the data on output and employment. Fiscal policy at the federal level simply stopped things from getting even worse that they already were -- the bottom would have been much worse without it. Thus, when natural recovery finally began to take hold, it did so from a higher base than without the federal effort (and perhaps started sooner). Think of it this way -- fiscal stimulus allowed us to hold ground we would have lost otherwise -- again things would have been much worse without it -- until the natural recovery process was ready to begin.

I don't see how the fact that the economy is presently recovering at a rate where we will get to full employment by 2019 (or a few years earlier with very optimistic projections) says much about the effectiveness of fiscal policy. It kept things from getting worse, then it ran out, and now we are still looking at a relatively slow recovery by historical standards. What we want to know, but won't find out due to opposition in Congress, is if the recovery would be even faster from this point forward with additional fiscal policy efforts. Nobody ever said the economy wouldn't recover without stimulus, it's the rate of recovery that is at issue. Past efforts have kept GDP and employment from declining even more and made it easier for the natural recovery process to take hold, and additional fiscal policy timed correctly could have helped even more.

On the "timed correctly" point, people also seem to forget about policy lags. The same people who were arguing that infrastructure spending would take too long, that by the time it took hold the economy would already be recovering and it wouldn't be needed, now criticize policy as though it happens instantaneously. It doesn't. How much of the recovery is being driven by the lagged effects of our fiscal policy efforts? That will need to be teased out of the data -- a difficult task since monetary policy easing was going on at the same time and those effects have to be separated from fiscal policy and other factors that affect output and employment. For example, a firm that sees extra spending as a result of tax cuts may do a bit better than otherwise, and then decide to invest in an expansion of the business. It takes time to realize things are a bit better, plan the expansion, and then build it. The expansion is properly attributed to fiscal policy efforts, but this is very hard to see in the data (note that many of the tax measures are still in place, and that spending can also generate these types of effects). Tyler says "Frankly, it is a bit of an embarrassment for many commentators that the (admittedly weak) recovery is coming right after the end of the fiscal stimulus," but I don't see why that necessarily proves the case. Again, past policy efforts allowed us to take off from a higher base, and likely sooner than otherwise, and policy lags (plus the continuation of many tax breaks) imply that fiscal policy could still be active. I think the main effect of fiscal policy was to stop things from getting worse, I am not saying that fiscal policy is still necessarily present to a significant extent, only that we can't rule out that it is still helping without doing the economtric analysis.

Finally, in passing, liquidity traps exist, at least in theory, in both Old and New versions of the model (e.g. see the discussion in Carl Walsh's text on monetary economics). I disagree on with Tyler's point on the liquidity trap -- I think the evidence suggests we did enter a liquidity trap and that it is still a problem -- but in any case the failure to find a liquidity trap does not distinguish one model from the other (though to be fair, it's possible to construct versions of both models where a liqudity trap does not exist, but this is easier in the New Keyneisan model than in thye Old).

Update: Paul Krugman (this is part of a longer post):

...Tyler Cowen now says that he was making the case for New Keynesianism in a recent post that actually said,

The big winners, apart from the American public?: real business cycle theory.

Oh well. I guess we’ve always been at war with Eastasia.

Paul Krugman: Things Are Not O.K.

We seem to have turned the corner, but policymakers should not relax yet -- we still have a long way to go to get back to full employment:

Things Are Not O.K., by Paul Krugman, Commentary, NY Times: ...So, about that jobs report:... for once falling unemployment was the real thing, reflecting growing availability of jobs rather than workers dropping out of the labor force... That said, our economy remains deeply depressed. As the Economic Policy Institute points out,... even at January’s pace of job creation it would take us until 2019 to return to full employment.
And we should never forget that the persistence of high unemployment inflicts enormous, continuing damage on our economy and our society,... in particular,... that long-term unemployment ... means more Americans permanently alienated from the work force, more families exhausting their savings, and, not least, more of our fellow citizens losing hope.
So this encouraging employment report shouldn’t lead to any slackening in efforts to promote recovery. ... Policy makers should be doing everything they can to get us back to full employment as soon as possible.
Unfortunately, that’s not the way many people with influence on policy see it. Very early in this slump — basically, as soon as the threat of complete financial collapse began to recede — a significant number of people within the policy community began demanding an early end to efforts to support the economy. Some of their demands focused on the fiscal side, with calls for immediate austerity... But there have also been repeated demands that the Fed ... raise interest rates.
What’s the reasoning behind those demands? Well, it keeps changing. Sometimes it’s about the alleged risk of inflation... And the inflation hawks ... seem undeterred ... by the way the predicted explosion of inflation keeps not happening...
But there’s also a sort of freestanding opposition to low interest rates, a sense that there’s something wrong with cheap money and easy credit even in a desperately weak economy. I think of this as the urge to purge, after Andrew Mellon, Herbert Hoover’s Treasury secretary, who urged him to let liquidation run its course, to “purge the rottenness” that he believed afflicted America.
And every time we get a bit of good news, the purge-and-liquidate types pop up, saying that it’s time to stop focusing on job creation. ... And the sad truth is that the good jobs numbers have definitely made it less likely that the Fed will take the expansionary action it should.
So here’s what needs to be said about the latest numbers: yes, we’re doing a bit better, but no, things are not O.K. — not remotely O.K. This is still a terrible economy, and policy makers should be doing much more than they are to make it better.

I'm also worried that "Policymakers are Too Anxious to Reverse Course."

Saturday, February 04, 2012

Policymakers are Too Anxious to Reverse Course

I am worried that policymakers are too anxious to reverse course. That is, despite recent communications suggesting that policy will remain on hold or even be eased further, I'm worried that the Fed will increase interest rates too soon. In the past, any sign of green shoots has brought inflation worries to the forefront, and this time is unlikely to be different even though those fears have been groundless to date. But I'm even more worried that large scale deficit reduction will begin before the economy is strong enough to withstand a large negative shock to demand. Congress is clearly anxious to get on with it.

So here are two views of why we shouldn't relax just yet about the employment situation (beyond risks such as oil price spikes from trouble in the middle east and fallout from rekindled troubles in Europe), and why we should do more, not less, to promote recovery of employment:

Employment: Some good news, some bad news, by Julie Hotchkiss, macroblog:  ...The median three-digit..AICS ... industry lost 7 percent of its jobs during the most recent recession. ... Industries faring the worst (those in the 75th percentile of job losses) shed 13 percent of their jobs. And what might be considered "fortunate" industries (those in the 25th percentile of job losses) saw only 3 percent of their jobs disappear over this time period. ... At the current rate of growth, those industries that experienced above-median job loss during the recession will not regain prerecession employment levels until the end of 2015. ... [note: prerecession levels is not full recovery since it ignores subsequent population growth.]
Does the projected labored employment recovery among these particularly hard-hit industries suggest there are more serious structural impediments to the efficient operation of the labor market today than there were after the previous two recessions? ...
Plotting the annual growth rates back to 1990 illustrates that the industries that were hardest hit during the most recent recession were also those with the greatest job losses during the previous two recessions. So there appears to be nothing special about these industries that led to their suffering during the most recent recession.
Additionally, the pattern of recovery of these hardest-hit industries is similar to that experienced after the previous two recessions. Like before, the worst performing industries (those with job losses in the 75th percentile) ... added jobs in 2011 at an average monthly rate of 0.22 percent; industries with below-median losses added jobs at an average monthly rate of 0.12 percent. This analysis does not suggest to me that unique structural features of this recession or recovery are holding employment growth back—it appears that the culprit is simply the extraordinarily deep hole the economy, and thus the job market, fell into this time around. The bad news, then, is that time may be the only answer for those industries to fully recover.

Time, or more help from policymakers (however, as noted above, forget about more help -- we'll be lucky if policymakers don't reverse course too soon). Here's more on why we shouldn't turn our backs on the unemployed anytime soon:

Still losing the war on unemployment, by Mohamed A. El-Erian, Commentary, Washington Post: ...While the [employment] numbers have markedly improved over the past year, too much of the commentary has been overly partial and, sometimes, dangerously misleading...
The pace of job creation is certainly picking up but, as yet, is insufficient to overcome our unemployment crisis. ... Meanwhile, attention is diverted from something critical to the future of the economy — namely, what is happening to the composition of U.S. joblessness.
The composition indicators have been flashing yellow, if not red, for a while. With 43.9 percent of the unemployed (5.5 million people) out of work for 27 weeks or more, today’s America faces the unusual challenge of “long-term unemployment”: The longer people are unemployed, the harder it is for them to return to the labor force at the same level of productivity and earnings, and the poorer the prospects for national competitiveness and prosperity.
The numbers for youth unemployment are even more disturbing. A staggering 23.2 percent of 16- to 19-year-olds in the labor force do not have jobs. A prolonged period of inactivity at that stage of life risks turning these younger adults from unemployed to unemployable.
These disturbing realities ... don’t cover the significant number of workers who are no longer counted because they have dropped out of the labor force... The longer that corrective measures are delayed, the harder the task at hand will be and the greater the eventual costs to society. ... In fact, our current unemployment crisis ...will ... further polarize an unusually dysfunctional political discourse, worsen income inequality, and fuel protest movements around the country. ...
Congress and the administration need to [do more]... Have no doubt, this is a complex, multiyear effort... One would think that, given all this, it has become more than paramount for Washington to elevate — not just in rhetoric but, critically, through sustained actions — the urgency of today’s unemployment crisis to the same level that it placed the financial crisis three years ago. ...

[Time to hit the road -- will post again when I can...]

Friday, February 03, 2012

Fed Watch: Good News on Employment

Tim Duy:

Good News on Employment, by Tim Duy: With only a minimal drag from the government sector, the February employment report shined on the back of a solid gain in private sector hiring:


The last couple of months look more like the optimistic numbers seen early in 2011 before the mid-year slowdown raised the specter of another recession. As has been widely noted, there is little to complain about in this report. To be sure, in many respects we are still deep in the hole. Long-term unemployment remains a challenge:


Wage growth is meager:


And the employment to population ratio remains sits a levels not seen since the early 1980s:


Still, as noted earlier, these issues should be alleviated if job growth is sustained. And as a precursor to such improvements, the unemployment rate is falling, and at a reasonably quick pace:


What will this mean for the Fed? As I discussed earlier, the unemployment rate looked to be the weak link in the Fed's most recent forecast of 8.2-8.5% by year end. We are at 8.3% in January, and unless either waves of workers re-enter the job market or the economy shifts gears dramatically soon, we will be easily below 8% in just a couple of months. Under such a trajectory, I have to imagine that another round of QE, as well as the Fed's interest rate projection, are not sure bets at all.
To be sure, one can argue the Fed should seize this opportunity to entrench the recovery with more easing. After all, the employment to population ratio suggests plenty of slack in the labor market, as does minimal wage growth. And unit labor labor costs are moving sideways as well:


We know that at least one policymaker, Chicago Federal Reserve President Charles Evans, would already be easing much more aggressively, but we also know that others, such as Philadelphia Federal Reserve President Charles Plosser thinks the current rate outlook is not consistent with an improving economic environment. A couple of reports like this will find others in his camp as well.
I think it still premature to expect the Fed to dramatically shift forward their own expectations of a rate hike. That said, since the recession ended, Federal Reserve officials have tended to shift expectations away from more easing and toward tightening every time the data shows a little life, only to have to backtrack six months later when hopes are dashed. Assuming the Fed follows the same pattern, watch for a shift in tone from Fed officials.

I'm starting to wonder how the Fed will wiggle out of its interest rate commitment should the economy turn out to be stronger than the Fed's forecast. I still think the Fed needs to insure against potential problems -- it's far too soon to conclude our troubles are over, we're still in a deep, deep hole and a slower than tolerable recovery is certainly still possible, perhaps even likely -- but it does look as though there's a chance the Fed will have to reconsider its recent interest rate commitment ("exceptionally low levels for the federal funds rate at least through late 2014"). The FOMC does give itself an out by saying conditions are "likely to warrant" this policy, but it seems to me it has been interpreted as a pretty firm commitment. (Note: To be clear, I am not advocating interest rate increases any time soon -- I think the Fed is likely to pull the interest rate trigger too early rather than too late -- but given the Fed's inclination to raise rates sooner rather than later, how will it explain itself if that time to raise rates comes earlier than projected?)

Thursday, February 02, 2012

How Did the Fed Get Things So Wrong?

[Busy day today -- teaching then travel -- so another quick "hit and run" post.]

A column from a couple of weeks ago:

How Did the Fed Get Things So Wrong?, by Mark Thoma: The public’s faith in the Fed’s ability to protect the economy from economic problems has been shaken by the Fed’s failures before and during the Great Recession. The recent release of the transcripts from 2006 monetary policy meetings where Federal Reserve policymakers discuss and ridicule the suggestion that the economy is threatened by a dangerous housing bubble has undermined its reputation even further.
How did the Fed get things so wrong? How can policy be improved?
The first step in the policy process is for policymakers to be aware that there’s a problem in the economy, and access to reliable, timely, and informative data is critical. Unfortunately, there are substantial lags in the availability of data that indicate where the economy is headed, and it can be six months or longer before key variables such as GDP are known. This is a problem that doesn’t get enough attention, and in the information age we ought to be able to do better.
The fact that these data are not very timely, and are often revised substantially after they are released is not the Fed’s fault. But that doesn’t mean that the Fed can’t do more on its own. The Fed needs to do a much better job than it did before the crisis of using the data at its disposal to construct stress indices, measures of network reliability, price-rent ratios, credit measures, and so on to figure out what is happening in financial markets.
Prior to the crisis, policymakers were not asking the right questions and hence saw no need to collect such data, or to believe what the data they did have was telling them. Policymakers did not believe a severe financial meltdown was possible in modern economies featuring modern policy tools –those problems had been overcome long ago – so they hardly bothered to look for signs of bubble trouble. They are beginning to bring these measures into play now, and seem to have a better understanding of their importance, but only time will tell if they’ve truly learned their lesson.
But even if the Fed recognizes that a problem exists, how it responds to trouble depends critically upon the relative weights it attaches to its goals of low inflation, low unemployment, and financial stability.
When the public looks at the Fed’s recent policy choices, it sees a Fed that appears to place worries about inflation – which is a big concern of finance and business – over the high levels of unemployment that have caused so much misery for the working class. Is there a reason why financial and business interests, banking interests in particular, might be overrepresented at the policymaking table?
Yes, there is. The problem, in large part, is the way in which the presidents of the twelve Federal Reserve District banks are chosen. The district bank presidents, who are an important part of the monetary policymaking committee, are chosen by the Board of Directors for individual banks. The make-up of those boards is dominated by wealthy business and banking leaders, and that leads to suspicions that these interests are overrepresented in monetary policy decisions. The Dodd-Frank legislation recognizes this problem, but it’s not clear that the proposed solution of eliminating bankers from the selection process goes far enough.
A final problem policymakers must confront is the time it takes for policy to have an effect after it is put into place. It can take several months for policy to fully impact the economy after it is enacted, so it’s important for the Fed to react quickly in response to changing economic conditions. Unfortunately, policymakers were far too slow and timid in reacting to problems they encountered as the crisis unfolded. Had the Fed been more concerned about unemployment and less concerned about inflation, there might have been more urgency in its response.
The Fed’s errors can be placed into two broad categories, the failure to ask the right questions before the crisis, and the failure to act quickly and aggressively enough once the crisis began. The first problem had a lot to do with economists’ undue faith in their own models and abilities – the financial meltdown problem had been solved so no need to worry about that – while the second problem is at least partly due to the way in which the public interest is represented on the Fed.
I don’t know how to insulate economists from themselves, every few decades we seem to have the need to declare that we have solved important problems only to be spectacularly wrong, but the representation of the public interest in policy decisions can certainly be improved. That won’t fully overcome the Fed’s tendency to hesitate and take small steps when bold action is needed, but better representation would certainly give more weight to the public’s desire for the Fed to do its utmost to bring an end to the many problems that households face when the economy is operating at subpar levels.

Monday, January 30, 2012

Fed Watch: Europe Needs a Real Fiscal Union

Tim Duy:

Europe Needs a Real Fiscal Union, by Tim Duy: The rhetoric is heating up as we head into Monday's European Union's summit. On one hand, we see rumors circulating that a deal in the Greek debt talks is in the works. Via the Wall Street Journal:

But in Athens, the mood Saturday was upbeat. "We really are one step away from a final agreement [on the debt deal]," Finance Minister Evangelos Venizelos told reporters following a day of hectic talks in the Greek capital. "Next week we will be in a position to complete this procedure along with the talks we are holding on the new loan program."

Note, however, that these negotiations are just one piece of the puzzle. Via the New York Times:

Though a debt agreement may spur Greece’s next bailout installment, the deeper loss being inflicted on bondholders carries the risk that many investors, in particular hedge funds that in recent months have loaded up on cheap Greek bonds in hopes of a payday this March, will refuse to participate in the deal.

Greece will try to impose the terms on all investors by writing collective-action clauses into the contracts of its old bonds. By doing this, the hope is that the holdouts, estimated to sit on 10 percent to 15 percent of the 206 billion euros ($272 billion) in outstanding securities, will exchange their old bonds for new bonds — preferring the new discounted bonds to their old ones, which may become worthless.

Some hedge funds that have bought at rock-bottom prices may decide to pursue legal action, although such a process could take years with small certainty of success.

Also undecided is what the European Central Bank, which owns 55 billion euros of Greek bonds, will do. Despite public pressure that it, along with investors, accept a loss on its bonds, the bank has not budged.

It seems to me more accurate to state that one portion of the debt deal may be in place, but in the interest of unity on the eve of the EU summit, we will pretend that the issues of holdouts and the ECB are not relevant. In any event, given the steady deterioration of the Greek economy, I find it unlikely that this is the last word in the debt story.

More interesting, however, is German demands that Greece cede its budgetary authority to the Troika. Athens of course was a bit perturbed by the escalation of demands. Via the Financial Times:

The Greek finance minister has lashed out against a German proposal for its budget to be controlled by a eurozone commissioner as a condition for receiving a second €130bn bail-out, saying the country was already prepared to “implement tough but necessary decisions”...

...The German plan, widely circulated in Athens and dubbed “the document of shame” by a local newspaper, would require Greece to pass legislation making debt repayments a budget priority, and would also give the new commissioner a veto over large-scale spending.

Perhaps the Greeks are not moving ahead swiftly enough with reforms, but consider that they are stuck between a rock and a hard place - anything positive in the long-run looks to be devastating in the short run. For example:

One main sticking point has been demands by EU and International Monetary Fund negotiators for a 25 per cent cut in the €750 minimum monthly wage and the abolition of an annual bonus paid as 13th and 14th salaries – measures that would improve competitiveness and bring Greece in line with minimum wages in Spain and Portugal.

George Koutromanis, labour minister, argued that the measure would reduce output by about 1.5 percentage points of gross domestic product and prolong the country’s recession, now in its fifth year.

Greece needs more carrots to move forward; Germany offers only the stick. Speaking of which, Germany subsequently responded to Athens indignation. Via the Wall Street Journal:

Germany's finance minister issued an unusually blunt warning that the euro zone might refuse to grant Greece a fresh bailout, pushing Athens into default unless it persuades Europe it can overhaul its state and economy...

...Europe is "prepared to support Greece" with the new loan package, Mr. Schäuble said, but he warned: "Unless Greece implements the necessary decisions and doesn't just announce them ... there's no amount of money that can solve the problem."

The options for Greece are narrowing quickly - either willingly accept German rule, or exit the Euro. And perhaps plans for the latter are already well established. Via The Examiner (hat tip Ed Harrison):

Greece plans an orderly exit out of the Eurozone according to two sources close to Mr. Papademos, Greek Prime Minister, who spoke on condition of anonymity earlier today.

The sources confirmed that plans are ready to return to a legacy currency given the current circumstances and that such exit would be dealt with, quote “in as orderly a fashion as possible” unquote.

I am starting to wonder if Greece is going through the motions to get one more tranche of aid before they come to the conclusion that they must exit the Eurozone. Absent real transfers from Germany, staying in the Eurozone now means crushing recession under German rule. Exiting just means crushing recession. Germany, however, is playing a dangerous game testing Greek nationalism. Either outcome is bad for Greece, but I suspect pushing Greece out of the Euro is ultimately bad for Germany as well.

Meanwhile, other nations need to pay attention to how this all plays out, because austerity is just not working anywhere. Take Spain for example, where unemployment is at a depression-like level of 23%. A clear symbol of the failure of European economic policy, to be sure. Spain gets a pass, however, as for now it is playing the German game. Via the Wall Street Journal:

In an interview this week with Spain's El Pais newspaper, German Chancellor Angela Merkel noted Spain's high unemployment rate, and said her country was willing to help the region's fiscally frail countries, but that they must take steps to solve their own problems.

Soraya Sáenz de Santamaría, spokeswoman for Spain's new government, repeated that a sweeping overhaul of Spanish labor laws is coming in weeks. "To all those millions of people who are looking for a job, I want to tell them...we are speeding up the reforms that are necessary to turn this situation around," she told journalists after the weekly cabinet meeting.

The story is that high dismissal costs deter hiring. To be sure, a real issue. I would note, however, that this did not seem to be a problem a few years back when the construction boom fostered unemployment rates below 10%. While structural reforms are important, so to is demand. And where will that demand come from in the short run?

Even more pressing is the issue of Portugal, which will almost certainly need another bailout. Moreover, the 15.2% rate of 10 year debt calls into question the EU claim that the Greek PSI was an isolated event. Via Business Insider:

While on some level it is crucial for the country to sustain the idea that it is meeting its debt obligations until it has more aid in the bag, the truth might be that the gig is up; it's just unlikely that Portugal will continue to meet its debt and deficit goals amid mounting pressures, even if it complies with the troika plan.

This is much the same psychological development that took place in Greece last summer, as EU politicians realized that a managed default might be the best way to return Greek debt levels to sustainability.

Note that swift passage of an even watered-down commitment to EU-wide fiscal austerity may not be as easy as it sounds. Perhaps the Irish are no longer willing to suffer in silence, via the Financial Times:

The Irish government faces intense pressure to hold a referendum on the eurozone fiscal treaty after a poll that showed almost three quarters of the public want a vote on the agreement.

Months of uncertainty lie ahead. That said, perhaps their is some hope that Europe leaders will actually move where they need to go - true fiscal union. On the eve of the summit, we learned that EU leaders are starting to see the writing on the wall. Via the New York Times:

Bowing to mounting evidence that austerity alone cannot solve the debt crisis, European leaders are expected to conclude this week that what the debt-laden, sclerotic countries of the Continent need are a dose of economic growth.

A draft of the European Union summit meeting communiqué calls for ‘‘growth-friendly consolidation and job-friendly growth,’’ an indication that European leaders have come to realize that austerity measures, like those being put in countries like Greece and Italy, risk stoking a recession and plunging fragile economies into a downward spiral.

But the devil is in the details:

The difficulty, however, is that reaching such a conclusion is not the same as making it happen.

Instead, leaders will discuss long-term structural reforms and better use of E.U. subsidies, while avoiding mention of the one thing that could change the climate: a fiscal stimulus from Germany, the euro currency zone’s undisputed powerhouse.

Easy to say, tough to do given Europe's political makeup. At what point will Germany be willing to justify fiscal transfers to the rest of Europe. For now, the EU appears able to come up with little more than token sums of cash to support growth. According to Reuters:

The summit is expected to announce that up to 20 billion euros ($26.4 billion) of unused funds from the EU's 2007-2013 budget will be redirected toward job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies.

A paltry sum when placed in context of 23 million unemployed in Europe.

Bottom Line: The European Central Bank's LTRO dramatically eased financial market tensions throughout Europe, revealing the important role of a lender of last resort. But underneath those tensions exist some very real and deep economic and political fractures in the European economy. And unless those fractures are quickly healed via a real fiscal union - not just an agreement to balance budgets, but a union in which rich countries transfer, not lend, resources to poor - the Euro experiment will be torn asunder.

Thursday, January 26, 2012

Fed Watch: Notes on the Fed Meeting

Tim Duy:

Notes on the Fed Meeting, by Tim Duy: Just a quick note today – I am swamped with classes and travel this week, and sadly cannot really do justice to the wealth of information provided today by the Fed.
The basics are well known at this point. The Fed extended its expectation for low rate out through the end of 2014, with the new hawk on the FOMC, Richmond Fed President Jeffrey Lacker, dissenting. The growth and inflation forecasts for 2012 were downgraded, while the unemployment forecast was upgraded slightly. Individual forecasts of the path of the Federal Funds rate were revealed, with six participants anticipating interest rate hikes in 2012 or 2013, in contrast to the broader expectation for low rates through 2014. The Fed now has an explicit inflation target of 2%. No new QE at this time.
Some initial thoughts:
First, the forecast for unemployment and inflation, combined with the restatement of the dual mandate with an explicit inflation target, scream for additional QE at this time. This is especially so when you realize the range of 2014 inflation forecasts remains centered on something south of the 2% target. Simply put, the Fed is clearly falling short of both mandates at this point. We need to be patient for the minutes where we can expect to learn more about QE options, and I agree with Calculated Risk that the Chairman paved the way for additional QE, assuming of course that the economy does not show immediate signs of improvement. Still, the delay is frustrating given the forecasts. That said, I think in the last minutes it was clear the Fed was moving in stages, and the communication stage is now complete. Now we can focus on the next round of QE. In addition, most participants would not see a need for immediate action given the improvement in the data flow combined with still stable inflation expectations.
Second, the unemployment forecast appears vulnerable given how quickly the rate decreased in recent months. If the rate of job growth necessary to keep with labor force growth is significantly less than the 125k-150k estimates often used, then I would expect even tepid growth would send the unemployment rate lower than the Fed’s forecast. The Fed is likely expecting a rebound in the labor force participation rates, but is that likely given the tepid growth forecasts? And how much of a decline of unemployment over the next month or two would prompt Bernanke to put a hold on QE3?
Third, I don’t read too much into the divide between the hawks and the doves regarding the timing of a rate increase. That timing is based on each participant’s individual forecasts, with the hawks likely having somewhat more optimistic forecasts for growth and employment compared to the doves. If forecasts disappoint, then the hawks will not be in a position to push for a more aggressive path of tightening. Likewise, the doves will modify their position relative to how their forecasts evolve. Which is why I am looking at that unemployment rate forecast – it seems the most vulnerable.
Bottom Line: The Fed is poised for additional easing, but the next round of QE is not quite a certainty yet. But I think we would need to see some significant upside surprises in the data in the near term to put plans for additional easing on hold. Watch the unemployment rate. We are already at 8.5%, the upper end of the Fed’s forecast. The lower end is just 8.2% - not far away, and something that is plausible at early as next week. The Fed’s forecast just doesn’t feel right given the 0.6 percentage point decline over the past four months.

Wednesday, January 25, 2012

The Fed will Keep Rates at "Exceptionally Low Levels" Through Late 2014

The Press Release describing the decisions of the Fed's monetary policy committee decisions was released this morning, and it is very similar to the press release from its last meeting in mid December with one notable exception. The Fed announced a commitment to "maintain a highly accommodative stance for monetary policy" by keeping the federal funds rate at "exceptionally low levels" at least through late 2014. The previous policy was to keep rates low through "at least through mid-201," so this extends the commitment by a year and a half and represents an easing of policy (I would have preferred more aggressive easing, it's not clear how much effect extending the commitment will have -- I don't expect it to be large -- but this is certainly a step in the right direction).

As for the tone of this statement relative to the statement in December, there is not much of a difference. There are a few minor changes, for example the statement about business investment is slightly more negative this time, and the committee dropped a statement about continuing to monitor inflation and inflation expectations closely (the "subdued outlook for inflation over the medium run" is one of the reasons the Fed decided to ease policy further), but beyond the change described above the two statements are very similar.

Here's the latest release:

Continue reading "The Fed will Keep Rates at "Exceptionally Low Levels" Through Late 2014" »

Thursday, January 19, 2012

Fed Watch: Japan Revisited

Tim Duy:

Japan Revisited, by Tim Duy: I haven't had a chance to comment on the recent debate regarding Japan's lost decades, so I am coming to the party a bit late. A view is forming that the situation is not as dire as many believe. Paul Krugman notes:

This picture suggests that the Japanese economy was indeed depressed for about 16 years, and deeply so after the slump of the late 1990s. But it may have returned to more or less potential output on the eve of the current crisis.

Just to be clear, this is not a picture of policy success; it is, in fact, a picture of enormous waste. But the condition wasn’t permanent.

Yes, the lost years surely indicate a policy failure. But arguably there is some success. On one hand, we can see this as vindication of massive deficit spending. But is this really success? Because on the other hand, there is no end in sight of such deficit spending. On Japan's 2012 budget, via the FT:

Even by current grim international fiscal standards, Japan’s budget for the year from April 1 makes scary reading.

For the fourth year in a row, government revenue from bond issuance is set to exceed that from all taxes. Outstanding government debt is expected to hit an extraordinary Y937tn.

I don't intend to go down the "Japan's bond market is about to collapse" path. But what I am wondering about is Krugman's description of the condition as not permanent. Do we need to see a reversal of debt to GDP ratios to declare victory? Well, even on that metric it looks like there was some hope heading into the recent downturn:


But such hopes have since been dashed.

Where does this leave me? Yes, fiscal policy can work - it can back fill missing demand. But we haven't seen enough activity in Japan to really jump start the economy to a point that fiscal policy is no longer an economic necessity. And I am not sure we can expect such a jump start without more explicit help from the central bank. In which case, Japan has not truly "recovered." Thus, we cannot yet conclude their condition is not permanent.

In short, before we can declare recovery in Japan, we need to define what a successful recovery should look like. Is it just about returning to potential output (adjusted, in this case, for demographics), or should it be recovery to the point that deficit spending is no longer necessary to support that output?

Tuesday, January 17, 2012

How Did the Fed Get Things So Wrong?

We are, as they say, live:

How Did the Fed Get Things So Wrong?

It's about the Fed's mistakes before and during the crisis, and how it might improve going forward.

Thursday, January 12, 2012

There Is No Bubble and Even if There Is It's Not a Problem...

The big story today seems to be the Fed's comments about the housing bubble in transcripts from their meetings in 2006. The transcripts show what we already knew, that the Fed was never fully convinced there was a housing bubble, and asserted that even if there was the dmage could be contained -- they could easily clean up after it pops without the economy suffering too much damage:

Greenspan image tarnished by newly released documents, by Zachary A. Goldfarb, Washington Post: The leaders of the Federal Reserve went around the room saluting Alan Greenspan during his last major meeting as chairman of the central bank Jan. 31, 2006. ...
Some six years later, Greenspan’s record — sterling when he left the central bank after 18 years — looks much more mixed. Many economists and analysts say a range of Fed policies contributed to the financial crisis and resulting recession. These included keeping interest rates low for an extended period, failing to take action to stem the bubble in housing prices and inadequate oversight of financial firms.
The Thursday release of transcripts of Fed meetings in 2006 shows that top leaders of the Fed — several of whom continue to hold key positions today — had a limited awareness of the gravity of the threat that the weakness in the housing market posed to the rest of the economy. And they had what turned out to be an excessive optimism about how well things would turn out. ...
A Fed economist reported in a 2006 meeting that “we have not seen — and don’t expect — a broad deterioration in mortgage credit quality.” That turned out to be incorrect. ...

Wednesday, January 11, 2012

Democrats are Not Anti-Market

A recent column (on the claim that Democrat are anti-market, socialists, see here too):

Democrats are Not Anti-Market, by Mark Thoma: Republican hopefuls are attempting to portray the coming presidential election as a battle between people who believe in free markets and those who want to turn the U.S. into a socialist state. Michele Bachmann has been quite explicit  with this charge, and Mitt Romney Newt Gingrich, and the other leading Republican candidates have made similar claims.

There are certainly those on the left who call for radical change, including the elimination of the market system, just as there are those on the right who have extreme views on a variety of topics. But the Democratic Party is not calling for the overthrow of capitalism, and the claim that Democrats prefer a socialist state is false. Democrats support markets too. The disagreement is about the best way to bring about a well-functioning market system, and whether that system produces an equitable distribution of income and opportunity.

Conservatives believe that markets work best when government involvement is minimal or absent altogether. They don’t deny that individual markets can fail for a variety of reasons, and they acknowledge that the aggregate economy is subject to cyclical swings that bring periods of high unemployment. However, with patience markets and the macroeconomy will fix themselves. If the government steps in and tries to help, on net it will make things worse, not better. Thus it’s almost always best to wait for the economy to heal itself, even if the wait is a long one.

Democrats have different ideas about what it takes for markets to fully realize their potential. They believe that individual markets work best when government takes an active role to prevent market failures. They also believe that monetary and fiscal policies are useful tools to offset cyclical swings in the aggregate economy.

Democrats also differ from Republicans on the need for government to redistribute income. Republicans believe that redistributing income reduces the incentive to pursue economic gains, and this lowers long- run economic growth. Democrats believe that a more equitable distribution of income is desirable in some instances, and that worries about the impact redistribution will have on economic growth are overstated. Democrats also believe there are significant concentrations of political power and market failures that distort the distribution of income, and these distortions should be corrected through government action.

Which of these two visions is correct? Republicans have tried to blame the financial crisis on the government, in particular government programs to support housing for low-income households, but the evidence overwhelmingly refutes this claim.  The problem wasn’t too much government, it was that government did not do enough.

We would be much better off today if government had ignored Alan Greenspan and other advocates of deregulation who argued that financial markets are self-policing, and had instead provided strong regulatory oversight of both the traditional and shadow banking sectors. We would also be better off if the Fed had intervened and popped the housing bubble as it was inflating rather than denying there was a bubble and arguing it could always clean up the mess quickly and neatly in any case.

And in assessing the two views, it’s important to note that the things the government did do were helpful. Though the design of the Bush administration’s bailout of the financial sector left much to be desired, it prevented a much worse outcome. There’s also little doubt that the fiscal stimulus put in place during the Obama administration helped the economy. Things would be better today if we had resisted the austerity minded and done even more to stimulate output and job creation.

In the coming year, we will have to choose between these competing views of the government’s proper role in the economy. The Republican view is that the economy can take care of itself. There’s no need for government to intervene, and the distribution of income – no matter how skewed – should also be left alone.

We’ve already tried Republican policies in recent decades and the promised economic growth, stability, and widely shared prosperity did not materialize. Instead we had a Great Recession, inequality widened substantially, and market and political power became more and more concentrated.

In addition, the recent recession challenges the GOP’s “markets are magic” point of view. During the time when the housing bubble was inflating, markets misdirected resources and too much of our intellectual talent, labor, and raw materials were drawn into housing and finance. Markets also failed to optimally hedge against risks, they have been very slow to self-correct – labor markets in particular – and the fact that the extraordinarily high profits in the financial sector have not been eroded away through new entry is a sign of excessive and persistent market imperfections.

The other view, that of Democrats, speaks directly to these problems. It embraces active oversight of markets to ensure they are operating to maximize social good, it encourages the use of countercyclical monetary and fiscal policies to stabilize output and employment, and it advocates correcting the inevitable inequities in income and opportunity that arise in imperfect, real world market systems.

Thus, contrary to the charge from Republicans that Democrats are anti-market, there’s a strong argument to be made that it’s the policies of Democrats rather than Republicans that do the best job of allowing markets to reach their full potential.

Fed Watch: Output Gaps and Inflation

Tim Duy:

Output Gaps and Inflation, by Tim Duy: Regarding, again, the size of the output gap, this remark is found in the most recent Fed minutes:

However, a couple of participants noted that the rate of inflation over the past year had not fallen as much as would be expected if the gap in resource utilization were large, suggesting that the level of potential output was lower than some current estimates.

I think this has less to do with the size of the output gap and more to do with downward nominal wage rigidities. Note that wages are still rising, although the pace of wage growth for production and nonsupervisory workers is still falling:


Perhaps a better example is the relatively new series, wages for all workers:


Overall private wage growth bottomed out in 2009 and held around 1.75%, perhaps just beginning to rise in recent months.
Despite very high unemployment and underemployment, wage growth is still positive. It tends to be very difficult to induce workers to take wages cuts (think also how the newly unemployed will resist taking new jobs with a substantially lower pay), which in-turn helps put a downside to inflation. In other words, one would expect the relationship between the output gap (or, similarly, high unemployment) and inflation to flatten as inflation rates fall toward zero.
This is also covered by Paul Krugman here and here.
Also note that rising wages doesn't necessarily imply higher inflation. Between the two is productivity growth. To account for the latter, we can look at unit labor costs:

Not exactly a lot of inflationary pressures stemming from unit labor cost growth. Presumably, high real wages could come by redistributing productivity gains to workers in the context of low inflation. For that to happen, however, I think we will need a lot more upward pressure on the labor market than we are seeing right now.

Monday, January 09, 2012

Fed Watch: More on the Output Gap

Tim Duy:

More on the Output Gap, by Tim Duy: Only time for a quick post between classes today...

Hoisted from the comments from my last piece, Steve notes:

In an interview with Bloomberg last week, Bullard explicitly said he expected the economy to follow a new output trend out of the base of the recession rather than a recovery to a trend from the previous peak. The written media didn't pick up on these quotes; rather they focused his comments that explicit inflation targeting is near.

I missed that interview, but found it here. And yes, St. Louis Federal Reserve President James Bullard does say that estimates of the output gap are too high and will be revised downward. He says the outcomes of the last expansion were not related to economic fundamentals and thus we should not expect to be able to return to those levels of output and, presumably, employment. He does not aim to return to the pre-recession trend of output growth and is instead ready to manage the economy along the new path. Bullard does admit, however, that he has gotten little traction for his view.

On the other end of the spectrum, San Francisco Federal Reserve President John Williams offers an interview to the Wall Street Journal, and sounds dovish even after the most recent employment report:

In a follow-up email exchange, Mr. Williams wrote that the report didn't fundamentally alter his views on the economy.

"My view of it is inflation is going to be for a sustained period below target," he said. "Unemployment is going to be sustained above a reasonable estimate of the natural rate of unemployment, which is closer to 6.5% than the 8.5% that we have now. That does make an argument that we should have more stimulus."

There is a caveat, however:

Mr. Williams also hedges, though, adding that it "really depends in how much confidence you have in that forecast. And also there are costs to taking greater policy action. There are always trade-offs that have to be weighed."

This is frustrating, because if there is indeed an argument further stimulus, what is holding the Fed back? Why hedge by questioning the forecast? And what are the costs? Presumably the cost is higher inflation, but Williams already says he expects inflation to be below target. So why pull your punches?

I am starting to wonder if the whole "we can do more" meme from the dovish side of the FOMC has more to do with just offering a counterweight to the hawks who seem to see an imminent need for tightening rather than a push for an actual policy change.

Fed Watch: QE3 or Not?

Tim Duy:

Tim Duy, by Tim Duy: Last week - before the most recent employment report - the Wall Street Journal offered up the odds of another round of quantitative easing:

“Primary dealers,” those 21 lucky banks that answered the Old Bridge Troll’s questions correctly and were granted the right to do business directly with the Fed, see QE3 coming and don’t see the Fed raising rates for at least two years.

That’s according to the results of a new survey of primary dealers by the New York Fed.

Primary dealers, on average, assign a 45% chance of a Fed interest-rate increase in the second quarter of 2014. Before that, the chances of a rate increase are never higher than 15%.

High expectations are not a surprise given the propensity of some officials to make remarks like these from New York Federal Reserve President William Dudley:

However, because the outlook for unemployment is unacceptably high relative to our dual mandate and the outlook for inflation is moderate, I believe it is also appropriate to continue to evaluate whether we could provide additional accommodation in a manner that produces more benefits than costs, regardless of whether action in housing is undertaken or not.

It's no secret some Fed officials have been looking into additional purchases of mortgage-backed assets to support the economy via the housing market. And once they started talking about it, market participants began to assume it was imminent. Moreover, the idea of additional easing popped up in the most recent minutes:

A number of members indicated that current and prospective economic conditions could well warrant additional policy accommodation, but they believed that any additional actions would be more effective if accompanied by enhanced communication about the Committee's longer-run economic goals and policy framework.

So now we have a timeline - first, enhanced communication. Second, additional easing. Seems straight forward, especially now that inflation looks to be trending downward, alleviating the panic that appeared to seize FOMC members in the first part of 2011.

But after the first part of 2011 comes a string of relatively solid data, at least as solid as one gets in this recovery. That data culminates with the decidedly not-terrible employment report. How long could it be before monetary policymakers started to question the need for additional easing?

Just a single day. On Saturday, St. Louis Federal Reserve President started to toss cold water on the idea of additional easing. Via MarketWatch:

“I don’t think it [QE] is very likely right now because the tone of the data has been very strong right now,” Bullard told reporters after a speech at the American Economic Association meeting....

...Bullard said he was encouraged by the December employment report that showed a drop in the unemployment rate to near a three-year low of 8.5%.

“I thought the jobs report was encouraging. Hopefully it is harbinger of more robust activity,” he said.

Bullard said he thinks Wall Street is too gloomy about the outlook.

“I think forecasters are a bit too pessimistic about the U.S. economy,” he said. “The recession has been over for fair amount of time. It is a logical point in the recovery where you would expect somewhat more rapid growth and somewhat better jobs market, so we’ll see if that is what happens.”

The logical point to see more rapid growth is in the quarters immediately following a significant contraction, not two years later. But putting that aside for the moment, I think it is easy for the Federal Reserve to read the recent data as signs the Great Depressing is beginning to unwind. Consider recent behavior of monthly private nonfarm payrolls:


Just eyeballing the chart, it looks like payroll growth is settling into a trend consistent with something around what we would think of as potential growth, except that growth may be a little slower than in the pre-recession period and is occurring along an equilibrium path below the pre-recession path. And that growth is translating into a falling unemployment rate:

At this rate, we could be approaching 7% by next year, which would then put unemployment below the Fed's forecast for 2014. By my standards still an unacceptably slow pace given that decelerating inflation provides room for additional easing, but I can easily see where FOMC members decided the risk of additional easing outweigh the benefits.

Now, in my mind, this would guarantee that the Fed would not be really unwinding the Great Depression as much as managing a the economy along a new trend. Unwinding the Great Depression, I think, means fully reversing the drop in the employment to population ratio:


Note that in the previous recession, the employment to population ratio edged up, but fell short of regaining the previous peak. Imagine the same occurring this time. Complicating a complete unwind is the economy's dependence on asset bubbles to support high levels of employment:


It seems that the loss of net wealth equal to 100% of GDP must be a depressing effect on spending. My sense is that we are unlikely to craft another widespread asset bubble and thus we will be missing a piece of demand that was critical to supporting the economy. How I think you might compensate for this lost demand is for the Fed to explicitly raise the inflation target and stimulate growth such that nominal wages rise sufficiently to quickly erode the real value of debt. If the Fed doesn't allow that to happen, instead sticking with the 2% target, then I suspect they will reduce accommodation long before the economy would regain the pre-recession equilibrium path. In other words, the Fed manages the economy along the new equilibrium path, and makes no pretense of trying to achieve pre-recession employment targets.
Could the Fed credibly commit to a higher inflation target and make actionable such a commitment? I think they can, but would need to announce they are making some permanent additions to the money stock and ease the expectation that the balance sheet expansion will be fully unwound at the first possible moment. In other words, to convince the public that you intend to raise the level of the price path relative to the existing path, you need to be willing to allow for the permanent increase in the money supply that would allow that to happen. Barring that, they can target the dollar directly and do what they won't do - buy foreign currency or foreign debt. But this is now a more academic than practical discussion. The Fed has a target. Period. End of story.
Bottom Line: Bullard reminds us that QE3 is not a certainty. True, inflation is easing and in aggregate the labor market remains weak, even if recent numbers are coming in a bit stronger. Arguably plenty of room for additional easing, which is why I have tended to think the Fed would eventually take additional action (that and the never-ending European mess). But the Fed hasn't shown an eagerness to ease further despite what they saw as a very slow reduction in unemployment - and it is reasonable to assume that forecast is getting a little bit brighter. Under such conditions, one or two months of "positive" employment news could fully derail the QE3 train. I increasingly think it depends on what the Fed's ultimate objective is - to unwind the Great Recession and attempt to restore pre-recession employment to population ratios, or just manage along a new output path. I used to think the former was the Fed's objective, but now am questioning that belief.

Sunday, January 08, 2012

Fed Watch: Ultimately, It's About the Inflation Target

Tim Duy:

Ultimately, It's About the Inflation Target, by Tom Duy: Ryan Avent reports from Chicago on the willingness to believe the Fed is powerless to produce additional inflation:

Why is Mr Hall—why are so many economists—willing to conclude that the Fed is helpless rather than just excessively cautious? I don't get it; it seems to me that very smart economists have all but concluded that the Fed's unwillingness to allow inflation to rise is the primary cause of sustained, high unemployment. And yet...this is not the message resounding through macro sessions. Instead, there are interesting but perhaps irrelevant attempts to model the funny dynamics of a macro challenge that actually boils down to the political economy constraints (or intellectual constraints) facing the central bank. Let's focus our attention on that, for heaven's sake.

Avent is correct. It does seem that most economists believe that at the zero bound, allowing inflation expectations to rise is an effective - perhaps the only effective - mechanism for the central bank to accelerate activity. Moreover, if, as Avent says, we believe the Fed can prevent deflationary expectations, then they can certainly create inflationary expectations. The fact that they don't would then be something of a mystery, as certainly we don't see Federal Reserve Chairman Ben Bernanke as intellectually deficient on this issue. He can clearly do the math as well as anyone.

An answer to this conundrum is evident in the Fed's forecasts (dark blue is the central tendency):


The disconnect between the unemployment and inflation forecasts is clear. The Fed has a dual mandate, and, according to its forecasts, it cannot meet both of the mandates in the near to medium terms under the expected policy path. So a choice needs to be made. And the Fed has chosen to focus on meeting the inflation side of the mandate (note, headline PCE inflation in the long-run, which is why I focused on that measure in a piece last week). No mystery. No reason for vast intellectual expenditures. Price stability means 2% inflation, and if we can't meet the unemployment target within that mandate, so be it.

In other words, they are certainly capable of inducing higher inflation. They just don't because, in their view, 2% is a firm target, and the costs of exceeding that target, or, more importantly, changing that target, are effectively assumed to be infinite and thus by definition exceed any expected benefits.

Now, you could argue, that it really isn't this simple, since the "price stability" objective is not legally defined at 2% (Notice also that 2% is really the upper limit. On average, it appears that monetary policymakers would actually like something closer to 1.8%). There is a real question here that I don't believe the Fed has adequately answered - why should the definition of price stability be 2% rather than 3%?

So what is the constraint - political, intellectual, or irrational - that forces the Fed to adopt a 2% inflation target, and then choose to act as if that target was written in stone? I imagine policymakers would respond to the first point by claiming that price stability really means zero percent inflation, and that they choose 2% because we overestimate inflation and need some cushion from the lower bound problem. Fine, but what if you are already in the liquidity trap? For the second part, they would argue that the economy would be less stable in the absence of a firm target. My reply is that this might be correct for the eight decades a century that you are not in a liquidity trap, but what about the other two decades you are in a liquidity trap? Is a target calibrated during normal economic conditions then supporting suboptimal outcomes in a liquidity trap?

I expect to get some relief in at least the near term inflation forecasts at the conclusion of the next FOMC meeting, a decrease of the lower boundary of the central tendency which then helps clear the way for additional Fed easing. Core inflation has clearly been rapidly decelerating in recent months:


If you believe, as the Fed appears to, that core-inflation provides useful information on the direction of headline inflation, then the message is clear - headline inflation is likely to drift lower, and the economy needs more stimulus. What the Fed will deliver, however, will still be within the bounds of the 2% inflation target, and thus still falls short of the increase in expected inflation that the Fed should really be delivering.

Saturday, January 07, 2012

Confused about Communication about Improving Communication

Apparently the Fed do a poor job of communicating its new communications policy. David Altig tries to clear things up:

In the interest of precision, by David Altig: As you may have heard, the minutes of the December 13 meeting of the Federal Open Market Committee (FOMC) contained the news that, starting with this month's meeting, committee members will be jointly publishing not only their personal projections for gross domestic product growth, unemployment, and inflation, but also the monetary policy assumptions that underlie those forecasts. In an article published earlier this week, the enhancement to these projections, known as the Summary of Economic Projections (SEP), was described in the Wall Street Journal this way (with my emphasis added):

"Federal Reserve officials this month will begin detailing their plans for short-term interest rates, a move that could show that the central bank's easy-money policies will remain in place for years and give the economy a boost."

A similar description appeared in the Journal yesterday (again, emphasis added):

"The Fed has just taken a historic step towards increasing its transparency and accountability... This means Fed officials will soon let the world know exactly what path they believe interest rates will follow—and they, after all, set the path of interest rates."

I added the emphasis in both of those passages because I think the highlighted language isn't quite right. ...

The minutes are pretty clear about what this information is intended to convey… and what it is not intended to convey (here too, emphasis added):

"Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable…"

...The broader point is that the new information in the SEPs, according to the minutes, is not intended to be a device for signaling the policy path that the FOMC, by official vote, intends to pursue.

This may seem like a small detail. But when it comes to the central bank's communications tools, even the small details matter.

Friday, January 06, 2012

Fed Watch: A Few Quick Charts on Consumer Spending

Tim Duy:

A Few Quick Charts on Consumer Spending, by Tim Duy: In my last piece, I noted that excessive optimism or pessimism essentially cancelled each other out over the course of 2011 when tracking the overall economy. The same held true of consumption spending as well:
Since the recession ended, consumer spending has been tracking a slightly slower growth trend than prior to the recession. Again, there looks to have been a long-lasting shock to the path of consumer spending. Interesting changes have occurred underneath the surface, however. The path of spending on services is markedly lower:


This was the subject of a Wall Street Journal article last November:

Increasingly, that means service businesses find it harder to get their share of consumer spending, which is prompting many business owners to scale back. At The Wall Street Journal's CEO Council conference this month, Alan Krueger, chairman of the president's Council of Economic Advisers, highlighted the service sector's central role for jobs growth. "Services account for about half of GDP, and over half of jobs," Mr. Krueger said. "Particularly discretionary services…people have been putting off getting their cars repaired because of concerns about jobs and income growth."

This is certainly something weighing on job growth. That said, consumers are not foregoing all spending. The Wall Street Journal pieces ends with:

Small cutbacks are a big reason Massimo Liguori, owner of Salon Massimo in Connecticut, closed down one of his two locations...In turn, Mr. Liguori said he now goes out to dinner with his wife twice a month or so, compared with at least once a weekend previously. "What happens is you start becoming skeptical of the future," he said...Still, a sense of austerity didn't prevent him from buying a $49,000 Lexus sport-utility vehicle. "A car is different because I put my family in that," he said.

Which brings us to the upturn in durable goods spending:


The rebound in auto sales clearly is supporting this trend. How much of this is pent-up demand that has already been satisfied? How much support will we get from auto sales in 2012? Hopefully enough to match last year's growth, but MarketWatch recently pointed to a troubling sign:

But there’s also some negative news buried in the Conference Board release, and that’s a big drop in the percentage planning to buy an automobile in the next six months. At 9.8%, it’s the worst since October 2010.

One can always discount a single data point, but the decline fits a broader story: Americans needed to buy cars after the Great Recession because theirs were simply getting too long in the tooth.

But this replacement-cycle impact, which has been a tailwind for the likes of General Motors and Ford Motor Co., was bound to end at some point.

Has much of the auto rebound already taken place? How much more can we expect given the vehicle miles driven continues to decline, suggesting existing vehicles will last even longer? Something to think about as we ponder the strength of the economy this year.

Finally, the path of nondurable goods spending has been erratic:


Certainly, the upturn in gas prices played a role in tempering the pace of growth in nondurable spending this year:


The trend of nondruable goods spending is tracking the pre-recession trend. So, at this point, we are seeing overall consumption supported by a rebound in durable goods spending that offsets a deterioration in the path of spending on services. The bounce in durable goods spending will come to an end at some point, as 16 million units is likely an upper bound for auto sales. Will service spending accelerate to compensate? Or will we see a new normal, with a constrained consumer spending at a path and rate below those prior to the recession? I am sympathetic to that outcome, with a corresponding increase in export growth to foster rebalancing of the economy (of course dependent upon growth in the rest of the world, something in question at this point).
But that still is not a story that rapidly returns the economy to potential output. Which brings me back to a familiar place - putting aside the threats to the economy, it is easy to see a positive growth path for the economy, but more difficult to see a rapid closure of the output gap.

Wednesday, January 04, 2012

Fed Watch: Still Cautious Heading Into 2012

Tim Duy:

Still Cautious Heading Into 2012, by Tim Duy: I have been hesitant to embrace the recent positive data flow - once bitten, twice shy perhaps. Something about the current dynamics that seems a little too familiar. Indeed, I felt something of relief when FT Alphaville came to a similar conclusion in the waning days of 2011. Cardiff Garcia reports on a Nomura research note that details a new bias in the seasonal adjustment process, noting:

Up next, writes Nomura, you can expect exaggeratedly strong readings from the Chicago PMI later this month and the next ISM manufacturing survey at the start of January.

I imagine it is premature to call the readings "exaggerated," but both did surprise on the upside, as much data has of late. Read the whole piece - it is worth the time.

Indeed, flirtations with either excessive optimism or excessive pessimism were not richly rewarded last year, as on average the economy simply edged upward in pretty unremarkable fashion:


It seems reasonable to expect the same in 2012, at least as a baseline - a slow "recovery" that is really more of an adjustment to what appears to be the economy's new equilibrium path, one that is decisively subpar to the pre-recession trend. I don't believe that such an adjustment is necessary, as in my view it simply reflects a shortfall of aggregate demand. That said, the longer the cyclical downturn grinds on, the more likely it is that we will indeed see a new equilibrium path. A greater percentage of the cyclical unemployment will become structural unemployment or permanent shifts in the labor force participation rate. In addition, investments will go unmade as firms hoard cash. And, increasingly, policymakers will manage policy along the new equilibrium path, forgetting entirely the pre-recession path.

More than not, this is already the case. To be sure, some FOMC members are moving toward QE3, setting the stage for additional asset purchases, perhaps in the spring now that inflation concerns have eased somewhat. Still, the pace of policy change is agonizingly slow. From the most recent minutes:

A number of members indicated that current and prospective economic conditions could well warrant additional policy accommodation, but they believed that any additional actions would be more effective if accompanied by enhanced communication about the Committee's longer-run economic goals and policy framework. A few others continued to judge that maintaining the current degree of policy accommodation beyond the near term would likely be inappropriate given their outlook for economic activity and inflation, or questioned the efficacy of additional monetary policy actions in light of the nonmonetary headwinds restraining the recovery. For this meeting, almost all members were willing to support maintaining the existing policy stance while emphasizing the importance of carefully monitoring economic developments given the uncertainties and risks attending the outlook. One member preferred to undertake additional accommodation at this meeting and dissented from the policy decision.

"Could well" warrant, but might not. Other than Chicago Federal Reserve President Charles Evans, FOMC members have been hesitant to act further despite the gaping and persistent output gap. It would seem that they are more willing to manage the economy along it current path, allowing unemployment to slowly decrease gradually - job gains or labor market exodus - rather than risk another percentage point of inflation. And with the PCE price index essentially now returned to pre-recession trend, there has been little enthusiasm to embrace such a risk:

But again only Evans appears willing to accept higher inflation. Perhaps policy change will accelerate now that Presidents Kocherlakota, Fisher, and Plosser are rotated off the FOMC, but note that this was always a minority block. Had the majority wished to advance policy more aggressively, they could have. The majority simply was not motivated enough to fight such a battle. And while they would act should the economy falter, that action will be delayed if the incoming data once again reflects Nomora's upward seasonal bias, regardless of the underlying trend.
In short, while the FOMC has been edging toward additional action - and will likely do something after first enhancing communication procedures with additional rate forecast - they have not done so with the urgency called for by the anemic recovery.
While a repeat of last year is a reasonable baseline, I remain more concerned with downside rather than upside risks. Europe is still on the ropes, in my opinion. The ECB has bought some time with its LTRO, but the still high yields on long-term Italian debt suggest that that southern European nation is suffering from something closer to a solvency crisis than a liquidity crisis. And the austerity push is far from over, as, unsurprisingly, peripheral European nations will continue to miss budget targets, with Spain being the latest example. In my view, the European periphery will have trouble breaking the debt-deflation dynamic in the absence of currency devaluation. Such devaluation is a key mechanism to resolving balance of payments crisis, allowing for a rapid increase in competitiveness and stoking inflation that reduces the real burden of domestic-denominated debt. No such option is available to European nations, locked in as they are to the Euro. Consequently, I see 2012 as another year of challenge as Europe struggles to hold the Euro together by pressuring troubled nations into ever-greater austerity.
In addition to Europe, I remain concerned that US politics will usher in an ill-timed fiscal contraction. The payroll tax credit was extended for just another two months, and Stan Collender is warning that there may not be an easy path to an extension. And I continue to think that spending would be vulnerable to any sudden hit to income, especially when disposable personal income isn't exactly surging forward:
Finally, the festering Iran situation is a wildcard, with posturing by both the US and Iran looking increasingly like a game of chicken, and both sides looking to provoke the other into a rash action. Of course, if any escalation of hostilities triggers an actual supply disruption that spikes oil back to $150 or higher, we would expect the global economy to lurch downward. Note, however, this is a perennial concern, and one that will not fade until we find an alternative to fossil fuels. Something we simply learn to live with, it seems.
Bottom Line: I want to believe the recent improvement in the tenor of economic data signals that activity is set to accelerate substantially in 2012. But the ups and downs on the past two years smoothed out to nothing exciting or catastrophic, just a moderate path of activity that remains woefully insufficient to return the US economy to its pre-recession trend. For now, I will stick to that middle ground, while remaining watchful of the all-too-many downside risks that leave me just a little bit sleepless each night.

Friday, December 30, 2011

Paul Krugman: Keynes Was Right

There are quite a few people in denial about one lesson from the crisis -- the value of the Keynesian perspective:

Keynes Was Right, by Paul Krugman, Commentary, NY Times: “The boom, not the slump, is the right time for austerity at the Treasury.” So declared John Maynard Keynes in 1937, even as FDR was about to prove him right by trying to balance the budget too soon, sending the United States economy — which had been steadily recovering up to that point — into a severe recession. Slashing government spending in a depressed economy depresses the economy further; austerity should wait until a strong recovery is well under way.
Unfortunately, in late 2010 and early 2011, politicians and policy makers in much of the Western world believed that they knew better, that we should focus on deficits, not jobs, even though our economies had barely begun to recover... And by acting on that anti-Keynesian belief, they ended up proving Keynes right all over again.
In declaring Keynesian economics vindicated ... the real test ... hasn’t come from the half-hearted efforts of the U.S. federal government to boost the economy, which were largely offset by cuts at the state and local levels. It has, instead, come from European nations like Greece and Ireland that had to impose savage fiscal austerity as a condition for receiving emergency loans — and have suffered Depression-level economic slumps, with real GDP in both countries down by double digits.
This wasn’t supposed to happen, according to ... the Republican staff of Congress’s Joint Economic Committee ... report titled “Spend Less, Owe Less, Grow the Economy.” It ridiculed concerns that cutting spending in a slump would worsen that slump, arguing that spending cuts would improve consumer and business confidence, and that this might well lead to faster, not slower, growth.
They should have known better...
Now, you could argue that Greece and Ireland had no choice about imposing austerity ... other than defaulting on their debts and leaving the euro. But another lesson of 2011 was that America did and does have a choice; Washington may be obsessed with the deficit, but financial markets are, if anything, signaling that we should borrow more. ...
The bottom line is that 2011 was a year in which our political elite obsessed over short-term deficits that aren’t actually a problem and, in the process, made the real problem — a depressed economy and mass unemployment — worse.
The good news, such as it is, is that President Obama has finally gone back to fighting against premature austerity — and he seems to be winning the political battle. And one of these years we might actually end up taking Keynes’s advice, which is every bit as valid now as it was 75 years ago.

Tuesday, December 27, 2011

"I Can't Think of a Better Intellectual Qualification"

Richard Green on Jeremy Stein (nominated earlier today to fill an open position on the Federal reserve Board):

Personally, I am a big fan of Stein's work. The shortest way to explain why is to list the titles of his five most cited papers:

  • Herd Behavior and Investment
  • A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets
  • Rick Management: Coordinating Investment and Financing Policies
  • Bad News Travels Slowly: Size, Analyst Coverage and the Profitability of Momentum Strategies
  • Internal Capital Markets and the Competition for Corporate Resources.

Stein has spent his career trying to figure out how capital markets really work instead of pledging fealty to models that don't work very well.  I can't think of a better intellectual qualification for a Federal Reserve Board member.

Obama Noninates Jeremy Stein and Jerome Powell to Fed Board of Governors

During the biggest financial panic in many, many decades, Congress has refused to confirm nominees to the Federal Reserve Board leaving the Fed short-handed. David Wessel reports there's some chance that will change:

President Barack Obama will announce Tuesday that he plans to nominate a Harvard University finance professor and a former private-equity executive to fill the two vacancies on the seven-member Federal Reserve Board, a White House official said.

The nominees are Jeremy Stein, 51 yeas old, an economist who did a five-month stint in the Treasury and White House in the early months of the Obama administration, and Jerome Powell, 58, who was undersecretary of the Treasury for domestic finance in the early 1990s during the George W. Bush administration.

If confirmed by the Senate...

A Republican and a Democrat -- this looks like an attempt to get both through by allowing one from each side of the political fence. But as Justin Wolfers said, "An independent Fed is not one that is half from one team, and half from the other."

More on Stein from Noam Scheiber.

...he’s an absolutely terrific choice. He was consistently on the side of more capital for banks (often to the discomfort of other Obama officials and regulators throughout Washington). Relatedly, he was in favor of bank shareholders suffering large losses through dilution, and even favored foisting losses onto some of the banks' junior debt-holders, which put him at odds with colleagues in Tim Geithner’s Treasury Department. Anyway, anyone frustrated with a generally overly-credulous, overly-sympathetic posture toward the banks among the powers-that-be in Washington should want to see Stein confirmed. ...

Powell is more of a mystery. From the first link above:

Mr. Powell would fill a different niche on the Fed board, which has been without a governor with Wall Street experience since Kevin Warsh, a Morgan Stanley alumnus, left in April. A lawyer, Mr. Powell worked before and after his Treasury stint at investment bank Dillon Read & Co. He also has worked at private-equity firms Carlyle Group and Global Environment Fund and at Bankers Trust Co.

Known as Jay, Mr. Powell ... took a high-profile role over the summer warning about the adverse consequences of a failure to lift the federal debt ceiling.

One outcome would be for Powell to get confirmed, but not Stein (the reverse -- Stein but not Powell -- is harder to imagine).

Thursday, December 22, 2011

Central Banks and Treasuries Need to be "Pumping Out Safe Assets"

Brad DeLong is hoping that if he and others make this point often enough, policymakers will finally listen:

Why the U.S. Treasury, the Bundesrepublik Treasury, the Japanese Treasury, the Fed, the ECB, and the BoJ Need to Be Pumping Out Safe Assets at a Much Faster Pace..., by Brad DeLong: Full-employment equilibrium in the demand and supply of currently-produced goods and services requires that there be enough cash to grease all the transactions so that sellers are happy selling to would-be buyers. If not--if there is a liquidity squeeze--we see a downturn and the shortage of cash reflected in low asset prices of (and high interest rates on) pretty much all other financial assets as people scramble to dump other assets for cash and do so until they can no longer bear the cost of letting value go at fire-sale prices.
Full-employment equilibrium in the flow of funds through financial markets requires that businesses (and governments) issue enough liquid savings vehicles to absorb all the planned full-employment saving in financial assets. If not--if there is a savings vehicle shortage--we see a downturn and not low but high prices of financial assets and we see what should be the transactions balances of the economy diverted as cash is transformed into a savings vehicle.
Right now, however, it is not the case that we are in a liquidity squeeze: the debts of credit-worthy governments are not at a discount but at a premium. Right now, however, it is not the case that we have a shortage of liquid savings vehicles: equities and corporate and junk bonds--and the bonds of non-credit worthy governments--are selling not for high prices but for low ones.
There is, however, a third market equilibrium condition: a credit-channel equilibrium condition. The economy must possess enough AAA-rated assets suitable to serve as collateral to keep the moral hazard associated with lending your wealth to somebody who knows more about the deal than you do from causing a Minsky meltdown. If not we see a downturn and what we see now: relatively low asset prices for risky assets and assets perceived as safe selling at values far above any reasonable estimate of long-run fundamentals that does not take account of their value as collateral for greasing financial-intermediation transactions.
It is in that context that we need to look at what has happened to the global supply of suitable AAA assets as shown in Cardiff Garcia's unwanted mutant offspring of the most important chart in the world:

Saturday, December 17, 2011

"A Financial Crisis Needn’t Be a Noose"

It doesn't have to be this way:

A Financial Crisis Needn’t Be a Noose, by Christina Romer, Commentary, NY Times: Recessions after financial crises are long and severe, and the subsequent recoveries are protracted. That is the bold conclusion of “This Time Is Different,” the book by Carmen Reinhart and Kenneth Rogoff, and it has become conventional wisdom. ...
But while there are strong patterns in the authors’ mountains of data, this simple summary misses an important fact: There’s dramatic variation in the aftermaths of crises, and much of it is caused by how policy makers respond. ......
The ... importance of the policy response in determining the effects of crises argues strongly against complacency here at home. A country as creditworthy as the United States can continue to use fiscal stimulus to help return the economy to full employment. And, as I argued in a previous column, there’s much more the Fed could be doing. Whether we continue to fester or finally embark on a robust recovery depends on whether we choose to use the tools available. ...

Tuesday, December 13, 2011

The Fed Leaves Policy Unchanged

A few comments on today's FOMC decision:

The Fed Leaves Policy Unchanged

Friday, December 09, 2011

"A Mixed Bag From Europe"

Tim Duy:

A Mixed Bag From Europe, by Tim Duy: I find it somewhat hard to judge the merits of this week's developments in Europe. Some positives, some negatives. On net, though, I remain a Europessimist. In my opinion, the issues of internal rebalancing remain completely ignored, and this will eventually doom the Euro if not addressed.

The European Central Bank moved forward with additional easing specifically intended to alleviate pressures in the banking system. The breakdown in the interbank lending market threatened to create a Lehman-type event sooner than later, and that threat was receded with the ECB's extension of liquidity facilities and cutting in half reserve requirements for commercial banks. The ECB also cut interest rates to 1%, with more cuts expected.

That said, the European financial system remains under pressure with continuing deleveraging and eventually more bank recapitalizations efforts needed. The result will be a worsening of the European recession, an event that is only in its infancy. And, as has been widely reported, ECB President Mario Draghi did not offer unlimited support for Eurozone sovereign debt, which was greeted with disappointment yesterday. I think it is premature to expect such a commitment; they will only play that card as a very last measure.

Overall, somewhat more aggressive than than I expected, and a clear indication that the ECB now realizes the depth of the Eurozone's financial problems. So far, so good. Yes, I would be happier with a clear statement that the ECB is the lender of last resort for European sovereign debt, but I just don't expect to hear this yet anyway.

In contrast, the Eurozone summit predictably failed to meet expectations. The UK bowed out of the agreement, guaranteeing a lack of EU wide commitment. At best you get the 17 Eurozone nations plus a few others to sign up. This opens up the possibility of more EU ruptures in the future. The seal has been broken. Second, as Felix Salmon points out, we have an agreement in principle, but ratification battles lie ahead:

It seems that German chancellor Angela Merkel is insisting on a fully-fledged treaty change — something there simply isn’t time for, and which the electorates of nearly all European countries would dismiss out of hand. Europe, whatever its other faults, is still a democracy, and it’s clear that any deal is going to be hugely unpopular among most of Europe’s population. There’s simply no chance that a new treaty will get the unanimous ratification it needs, and in the mean time the EU’s crisis-management tools are just not up to dealing with the magnitude of the current crisis.

Many opportunities for national politics to blow this agreement apart in the weeks ahead.

As far as Eurozone crisis-management tools are concerned, we are simply still where we have always been - the wealthier nations of the Eurozone - largely Germany - continue to resist putting in the necessary capital to create effective crisis funds. Moreover, the ECB appears to remain unwilling to lend the necessary money to rescue funds. In the absence of internal support, Europe continues to look toward international support. I still think this is ludicrous. How much help should Europe really expect knowing that Germany is not willing to go all-in financially to save the Euro, and now that we know the UK is making a calculated bet that the Euro is already a doomed experiment?

Let's put aside the above concerns for a minute. When all is said and done, I am still amazed that the outcome of this summit is being described as a move toward fiscal union. It is not that - it is commitment to unified fiscal austerity, nothing more. Consider just a strict enforcement of the 3% deficit ceiling in light of actual deficits in the EU. Via NPR:


Just on the surface, it is tough to see any commitment to fiscal austerity as credible. Germany itself exceeded the targets in 7 out of the past 11 years. Talk about the pot calling the kettle black. France missed 6 in the past 11 years. And Italy 8 times. Thus, in addition to the periphery nations, the biggest economies in the Eurozone will all need to increase government saving to meet these targets.
Such saving will be attempted in the context of a recession in which the private sector also will be increasing savings as well. In other words, the public sector will be engaging in massive pro-cyclical fiscal policy as the recession intensifies. You have to imagine the end result is a substantial deflationary environment.
In short, I think Europe is rushing full speed to a Japanese outcome, with slow growth coupled with an appreciating currency. And it is that promise of slow growth and a strong currency will be what eventually tears the Eurozone apart. And this is truly sad given that deficits are not really the problem to begin with.
Why will the Eurozone fail? Because we still see nothing that addresses the internal imbalances between the core (largely Germany), and the periphery. That is the result of failing to commit to a real fiscal union. Such a union would include automatic internal fiscal transfers that are essential to maintaining regional economic stability. For example, economic distress in a US state results in an automatic relative transfer of resources via decreased tax revenue from and increased transfer payments to that state. Lacking such a mechanism, a slow growth, hard money regime will increasingly ratchet up the levels of economic distress in the periphery. And eventually the costs of staying in the Euro will exceed the costs of exit.
If Europe was serious about saving the Euro, they would commit to issuing more safe assets (more sovereign debt), using the ECB backstop to create such assets, and engage in direct fiscal transfers to reduce economic pain in the periphery while encouraging continuing structural and budget reforms in recipient economies. I don't think we are anywhere near such a plan - and are arguably moving in the opposite direction.
Bottom Line: I remain a Europessimist. The ECB is moving aggressively to preventing an imminent financial collapse. That should be seen as good news. But there remain unresolved deeper issues. At the core of those issues is the inability to see Europe as one large, fiscal unified economy rather than a combination of separate, fiscally austere economies. And in that remains the long-term vulnerability of the Euro experiment.

Tuesday, December 06, 2011

"Bankers Should Not Profit from the Fact That They Were Over Leveraged"

The Fed fires back:

Fed Shoots Back at Media Portrayal of Crisis Lending, by Luca Di Leo, Real Time Economics: Federal Reserve Chairman Ben Bernanke shot back in unusually strong terms at news reports it blamed for making “egregious errors” about the size and impact on Americans of the Fed’s emergency lending during the 2008 financial crisis.
In a letter to the Senate banking committee, Bernanke released a staff memo that rebuts the portrayals in recent Bloomberg and other news articles that the Fed was aiming to help big banks’ profits at the expense of taxpayers. (Read the letter)
A Bloomberg Markets Magazine article released Nov. 27 said that big banks reaped an estimated $13 billion of income after the Fed committed $7.7 trillion in funds as of March 2009 to rescuing the financial system. ...
Calling the lending numbers in the media “wildly inaccurate,” the Fed said total credit outstanding under its liquidity programs was never more than the $1.5 trillion peak reached in December 2008. ...
The Fed said that nearly all of the emergency assistance has been fully repaid or is on track to be, something it said wasn’t stressed in news articles. The central bank claimed that the loans benefited American taxpayers by generating an estimated $20 billion in interest income for the U.S. Treasury. ...

I don't think this addresses Brad DeLong's criticism of how the program was structured:

When you contribute equity capital, and when things turn out well, you deserve an equity return. When you don't take equity--when you accept the risks but give the return to somebody else--you aren't acting as a good agent for your principals, the taxpayers.
Thus I do not understand why officials from the Fed and the Treasury keep telling me that the U.S. couldn't or shouldn't have profited immensely from its TARP and other loans to banks. Somebody owns that equity value right now. It's not the government. But when the chips were down it was the government that bore the risk. That's what a lender of last resort does.
That's why Bagehot's rule is to lend freely but at a penalty rate. The bankers should not profit from the fact that they were over leveraged, and compelled the government to act as a lender of last resort.

Update: I should add that I am not questioning the Fed's role as a lender of last resort, only how the gains from fulfilling that function are divvied up.

Monday, December 05, 2011

Possible Fed Communication Strategy

Tim Duy:

Possible Fed Communication Strategy, by Tim Duy: As is widely known, the Federal Reserve is working on improving its communication strategy to provide better guidance about monetary policy and thus hopefully induce better outcomes. From today's Wall Street Journal:

The Fed has taken ad hoc steps in this direction. During the financial crisis, it said rates would stay low for an "extended period." In August, it said they would stay low "at least through mid-2013." Quarterly projections would formalize this guidance and make it more specific. If the Fed signals that rates will stay lower even longer than investors expect, it could push long-term interest rates down now, spurring investment, spending and growth.p>

"The scope remains to provide additional accommodation through enhanced guidance on the path of the federal funds rate," Fed vice chairwoman Janet Yellen said in a speech last week. She is chairing the Fed subcommittee designing the communications overhaul.

The "mid-2013" formulation is especially problematic. At some point it will need to be updated. With unemployment high and not falling quickly, it is possible the Fed won't raise interest rates until much later. Of course, if inflation surprisingly picks up, it might need to move rates up sooner.

What form might "enhanced" guidance take? It seems unlikely that the Fed would limit itself to point estimates on the future course of interest rates. Reality is much more probabilistic, and I would expect additional Fed guidance to reflect forecast uncertainty via confidence intervals. One such example would be the Monetary Report of the Swedens' central bank. Forecasts for inflation:

Fed2yield interest rate guidance:


Essentially, this formalizes what we already expect - if inflation exceeds forecasts, then it is likely interest rates will rise at a greater rate than currently expected. It also provides information on the magnitude of any deviation from the interest rate forecast given differing inflation forecasts. Of course, we would expect the Fed to include a similar forecast for unemployment. And, given the current range of policy tools, it would be nice to have guidance on the balance sheet as well, although I sense it to be unlikely.

Expect some push back from some Federal Reserve policymakers:

Some Fed officials still aren't convinced this is the right approach. Giving interest rate guidance "might be an interesting exercise," Richard Fisher, president of the Dallas Fed, said in an interview last week. "Its utility I wonder about."

Some officials, like Mr. Fisher, doubt it will accomplish much. One risk is the Fed's signals about the expected path of rates might even confuse the public, rather than clarify the central bank's intentions.

I tend to think this is misguided - that a probabilistic assessment of the Feds' forecast will make it easier to interpret the implications of incoming data for the evolution of Fed policy, thus making the public less reliant on the often discordant views of Fed officials. Importantly, in the current environment I think additional guidance would make clear that the more hawkish policymakers are outliers, thus minimizing the likelihood of raising premature expectations of policy tightening as we experienced earlier this year. Which would explain Fisher's resistance to chance - he would prefer not to be further marginalized in the policymaking process.

Note: Sorry to be short on posts recently. I have been running around the last few days trying to tie up loose ends at the end of the term.

Friday, December 02, 2011

Unemployment Falls, But Is It Good News?

I just posted this at CBS News:

The Department of Labor released the employment report on Friday, and it shows 120,000 jobs created in the month of November, and the unemployment rate falling from 9.0 percent to 8.6 percent.

At first glance the fall in the unemployment rate seems like good news, but a closer look at the numbers reveals some weakness in the report.

First, note that depending upon which estimates you look at, it takes from 90,000-125,000 jobs just to keep up with the growth in the population. Thus, the 120,000 jobs that were created in November is enough to keep the unemployment rate from going up, but it is not enough by itself to absorb all the new workers entering the labor force and at the same time reduce the fraction of people that are currently unemployed. So the fall in the unemployment rate cannot be attributed to robust job growth.

Second, the report shows a decline in the labor force of 315,000 for November, and about half of the decline is attributed to discouraged workers giving up the search for a job. This exit of workers rather than job creation is the main source of the fall in the unemployment rate, and since so much of it is from discouraged workers this is not an encouraging development. Note, however, that there is a lot of month to month variability in the labor force participation numbers, and some of this may simply be month to month noise in the measurement.

Third, many of the unemployment duration numbers continue to increase. Average search duration reached a new peak for this downturn of 40.9 weeks, and hence long-term unemployment is getting worse, not better.

Fourth, many of the jobs that were created are in the retail sector. Thus, while some workers are finding new jobs, the new employment does not, in general, pay as well as previous employment. In addition, if the seasonal factors are different this year, e.g. if some of this is hiring for the holidays that seasonal adjustment procedures miss, then the picture is even weaker than the numbers suggest.

There are positive trends in this report as well. For example the number of people working part-time involuntarily fell by 374,000, employment in construction increased, and employment in manufacturing held its own, but there is a reason to point out the weak points in the report. Congress is considering two initiatives, maintaining or even increasing the payroll tax cut enacted to fight the recession, and an extension of unemployment benefits. If this report is interpreted as unambiguous good news and a sign that things are getting better at a relatively rapid pace -- at .4 percent decline per month the unemployment rate would fall at a fairly rapid pace over a year -- then Congress may not feel as much pressure to extend the tax cuts and unemployment benefits. It's something they'd rather not do, and they are looking for excuses that avoid the need to make tough decisions. But the problems for the labor market are far from over and we could use some insurance against the risks from Europe, so now is not the time to conclude that our troubles are over and we can turn our attention to other things. It's been nearly three years since Ben Bernanke first talked about green shoots, and that was used as a reason to pursue less aggressive monetary and fiscal policy than we needed, and we should avoid making the same mistake again. Maybe the green shoots are real this time -- I certainly hope that they are -- but it's too early to be certain, and it would be a mistake for policymakers to conclude that the labor market is on its way to a healthy recovery and no longer needs their help.

Wednesday, November 30, 2011

Did the Fed Go Far Enough?

More comments at the NY Times Room for Debate on today's announcement that monetary authorities are taking steps to increase the availability of dollar loans to foreign banks in the hopes of avoiding a Lehman-like crisis. The question we were asked is:

Should the Fed be more aggressive in dealing with Europe’s financial crisis? What are the risks of its involvement?

Here are our responses:

[Additional comments here.]

Tuesday, November 29, 2011

Time for the Fed to Take Over the ECB’s Job?

Dean Baker says the Fed should step in if the ECB refuses to act as a lender of last resort (Antonio Fatas is also frustrated with the ECB's failure to act):

Time for the Fed to Take Over the European Central Bank’s Job, by Dean Baker, Al Jazeera English: The European Central Bank (ECB) has been working hard to convince the world that it is not competent to act as central bank. One of the main responsibilities of a central bank is to act as the lender of last resort in a crisis. The ECB is insisting that it will not fill this role. It ... would sooner see the eurozone collapse than risk inflation exceeding its 2.0 percent target.
It would be bad enough if the ECB’s incompetence just put Europe’s economy at risk. ... However, it is also likely that the financial panic following the collapse of the euro will lead to the same sort of financial freeze-up that we saw following the collapse of Lehman. In this case,... we will be seeing unemployment possibly rising into a 14-15 percent range. This would be a really serious disaster.
Fortunately, the Fed has the tools needed to prevent this sort of meltdown. It can simply take the steps that the ECB has failed to do. First and most importantly it has to guarantee the sovereign debt of eurozone countries. ... This doesn’t mean giving the eurozone countries a blank check. The Fed can adjust the interest rate at which it guarantees debt depending on the extent to which countries reform their fiscal systems. ... The difference between a 2.0 percent interest rate and 7.0 percent interest would be a powerful incentive to eliminate corruption and waste. ...
Of course this sort of intervention will look horrible from the standpoint of the eurozone countries. It will appear as though they cannot be trusted to manage their own central bank and deal with their own economic affairs.
Unfortunately, this is the case. They have entrusted the continent’s most important economic institution to a group of ideological zealots who are infatuated by the sight of low inflation rates...
Perhaps the Europeans will respond... But if they can’t rise to the task, we should not allow the ECB ideologues to wreak havoc on the lives of tens of millions of innocent people in Europe, the developing world, and here in the United States.

While the Fed is solving the world's problems, it might also think about the high rates of unemployment that already exist in the US, and how easing policy at home could help.