Category Archive for: Monetary Policy [Return to Main]

Wednesday, December 15, 2010

Fed Watch: Turning Tide

It wasn't quite as Tim describes, but glad he could do this:

[Note: I apologize for being missing in action. I have been deep in the weeds at work for the last month. I hadn't even really realized how long it had been since I last wrote until Mark cornered me Monday afternoon, and none-too-subtlety suggested that I was supposed to be busy writing a post, what with the impending FOMC meeting and all. So, with acknowledgement of Mark's wisdom….]

For the past three years, it has paid to bet on the pessimistic side of the outlook. For the past few months, I have privately fretted that this bet would soon wear thin. And it sure looks like it has. The flow of data in recent weeks has been, on net, very positive, offering a vision of a sustainable recovery.

The Fed, however, has not yet gotten that memo. From today's FOMC statement:

Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment. Household spending is increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. The housing sector continues to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward.

The Fed remains locked into a forecast that anticipates output growth hovering near potential. Contrast this with rising expectations for, at a minimum, solid near term growth:

In the most recent Wall Street Journal forecasting survey, conducted last week, the 55 economists on average expected GDP to grow 2.6% at a seasonally adjusted annual rate in the fourth quarter from the third. But on the back of today’s retail report and a strong increase in October exports reported Friday, many are revising their estimates to more than 3%. Of seven revised forecasts, the average expected fourth-quarter growth forecast is now 3.3%, compared to 2.6% before the retail release.

Despite all the weights on the consumer - the FOMC statement reiterates that list - consumer spending is accelerating, pulling the post-recession trend rate close to that pre-recession:

Over the last four months, the rate for nonauto retail sales less gas has accelerated to an monthly average gain of 0.8%. That is nothing to sneeze at, and easily explains rising forecasts.

Still, the gap between the old trend and the new remains. Moreover, earlier this year, I would have tended to dismiss higher consumer spending on the grounds that it would simply be offshored in the form of higher import spending, a reemergence of the global imbalance that plagued output growth in the second and third quarters of this year. The most recent trade report indicates the opposite - that maybe, just maybe, the external sector will behave as it should in the wake of a financial crisis and provide a sustained boost to growth. To be sure, we would prefer not to see imports collapse, as this would signal a rather nasty demand shock. Instead, we are looking for import growth to stall as import competing firms become more competitive while export growth continues unabated. That has been the general trend of the last few months, giving rise to a more supportive trend in the trade balance:

This year, the external drag was an important factor in limiting the US recovery. Ending that drag would provide a significant boost - note that trade contributed a negative 2.63 percentage points to GDP growth, on average, in the second and third quarters. Thus, just going flat means a large gain to output. It's simply a big deal - it's enough to put output growth solidly in the sustainable region, not to mention solidly above trend.

And if an improving consumer and external outlook themselves would have been sufficient to generate above trend growth, the tax cut deal is icing on the cake. On net, it is more than anti-contractionary. It offers some real stimulus - for example, the payroll tax holiday will be less easily saved than a lump-sum check in the mail. To be sure, we can debate the political wisdom of the move from the Democrat's perspective, not to mention the long-term consequences of no real baseline for the US tax code, but in the short run, it is another shot in the arm.

And a shot in the arm is desperately needed. I do not intend to dismiss the real challenges the economy still faces. The plight of the 99er's in an economy of near double-digit unemployment rates is an obvious reminder. And, for that matter, so is the most recent employment report. Of course monthly changes in nonfarm payrolls are notoriously volatile, and the average of the last two months revealed that payrolls are growing just above 100k a month. The right direction, but not fast enough. More demand is clearly needed - and a solid consumer sector bolstered by external support and fresh stimulus would clearly help in that regard.

In this environment, it is not really much of a surprise that long term interest rates are headed higher. I tend to agree with those analysts echoed by Jim Hamilton and Brad DeLong - rising rates are a signal that the economy is strengthening. And strengthening enough that, despite the pessimistic tone of today's FOMC statement, it seems likely that the Fed will not feel compelled to extend large scale asset purchases beyond the existing plans. Without the Fed to serve as an excuse to keep buying Treasuries, traders are sending rates exactly where they should be going.

But won't rising rates slow the housing recovery, thereby putting the recovery in jeopardy? Seriously, what housing recovery is there left to protect? Should we really care at this point? Housing is SOOO 2005. The consumer is getting over it - the retail sales numbers tell that tale. Consumer spending is growing solidly in the absence of easy credit. I think we are finally in the acceptance phase when it comes to the housing market. Just like we eventually got to the acceptance phase in the wake of the tech collapse. We use even more technology, but that still doesn't justify the valuations we saw in the late 1990s. Same for housing - it is reverting back to an asset that provides primarily a service for the household rather than an investment. And that reversion will leave the economy healthier in the long run.

Will the Fed shift course, even in a rosier environment? Doubtful, at least near term. They will likely see the current plan through to its fruition, while holding rates at rock bottom levels until it is quite evident that the output gap is closing, which will take a few years even if growth accelerates sustainably to 4%. Will more be forthcoming? Also doubtful, especially as the composition of the FOMC turns more hawkish. Moreover, enough risks remain to keep Fed officials from sleeping too soundly at night. The European debt crisis runs hot and cold. The trade story could turn against us. Again. And uncertainty over the economic direction of China will be an ongoing challenge. I suspect the Fed will adopt the widely accepted view that a China slowdown would be a net negative to the global economy. Michael Pettis makes a convincing argument to the contrary.

In short: In general, the data flow of the last eight weeks is clearly encouraging. To be sure, not every release, like the employment report, is perfect. But enough are perfect that forecasters are quickly reversing the downgrades made just a few months ago during the mid-year slowdown. Will the data suddenly turn on us again? Always possible, always something to watch for, but I don't think that should be the expected path. Right now, the data suggest the US economy might start firing on more than just a few of its eight cylinders. A little optimism is justified. Don't expect the Fed to reverse course soon - they have yet to embrace the possibility that the economy is set to grow at something above trend. But a data flow like this cannot be ignored forever. Look for more glimmers of hope creeping into Fedspeak in the weeks ahead.

Tuesday, December 14, 2010

The Fed Leaves the Target Rate and QEII Unchanged

At MoneyWatch, I have a reaction to today's decision by the FOMC to leave policy unchanged, and a forecast for how long it will be until the Fed changes course:

The Fed Leaves the Target Rate and QEII Unchanged

Sunday, December 05, 2010

Bernanke on CBS’s '60 Minutes'

[Excerpts from the interview, Transcript and unaired excerpts.]

Narayana Kocherlakota: Monetary Policy Actions and Fiscal Policy Substitutes

On many occasions when the Fed was dragging its feet in terms of implementing a second round of quantitative easing, I made the claim that fiscal policy authorities don't have to wait for the Fed to take action, they can use tax changes to duplicate the incentives that are created when the Fed lowers the interest rate. Furthermore, while the Fed may have difficulty cutting interest rates as much as needed when the interest rate is near the zero bound, fiscal policy authorities have much more room to maneuver.

I missed this speech by Narayana Kocherlakota when it was given a couple of weeks ago, but it makes this point explicitly:

Monetary Policy Actions and Fiscal Policy Substitutes, by Narayana Kocherlakota, President, Federal Reserve Bank of Minneapolis: ...I’ll begin by discussing current macroeconomic conditions and the Federal Open Market Committee’s recent actions...
This is the economic situation that confronted the FOMC in its November meeting. Inflation and employment are both too low, and the pace of recovery is too slow. Economic growth is low and softening further. I think it is safe to say that, given this situation, the FOMC would have liked to have been able to cut its target interest rate. But this option is not available. ...
But the FOMC does have another policy instrument available: its balance sheet. ... At its November 3 meeting, the FOMC announced that it plans to buy $600 billion of long-term Treasuries in the open market by mid-2011. ... This kind of action is known as quantitative easing, or QE. ...
I believe that QE is a move in the right direction. However,... I also think there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest. That’s why I would have greatly preferred for the committee to have been able to cut its target rate rather than using QE. The problem is that its target rate is already essentially at zero, and so it was not possible...
Given this constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative.2 Their key insight is that there is a broad equivalence between monetary and fiscal policy. ...
In the remainder of my remarks, I’ll illustrate this insight by describing one particular fiscal policy plan that is equivalent to a 100-basis-point cut by the Fed. The proposal has three parts. The first part is a permanent consumption tax of 100 basis points, instituted with a one-year delay.3 The second part is a permanent decrease in labor income taxes of 100 basis points, also instituted with a one-year delay. The third part is an investment tax credit undertaken in 2011. The Nicolini et al. results demonstrate that, in a wide class of economic models, the effects of this three-part plan would be equivalent to the effects of a 100-basis-point interest rate cut. ...
The 1 percent permanent consumption tax that begins in 2012 stimulates consumption demand in 2011. The permanent reduction in labor income taxes ensures that this new consumption tax does not deter labor supply. Finally, the investment tax credit makes sure that the new consumption tax does not deter investment in 2011.
I’ll make two additional comments about this plan. First, how much would this three-pronged change in taxes cost the American taxpayer? The exact answer to this question would depend on a host of details... But let me offer a very rough calculation..., the first two parts of the plan would add about $20 billion per year to government revenue beginning in 2012. The plan also involves an appropriately sized investment tax credit..., a one-time cost in 2012 of $20 billion. These calculations, while obviously very rough, do indicate that the plan has the potential to be fiscally responsible.4
Second, I’ve not discussed distributional considerations. Raising consumption taxes by 1 percentage point and lowering labor income taxes by 1 percentage point for all Americans would tend to redistribute the burden of taxes toward lower-income citizens. For this reason, I believe that it would be desirable to redesign the labor income tax reduction to make it more progressive.
Overall, I believe that this analysis has both policy and intellectual aspects. From a policy point of view,... I find the resultant policy to be attractive because may be able to generate macroeconomic stimulus without increasing the deficit. From an intellectual point of view, the analysis demonstrates the remarkable power of public finance in addressing important macroeconomic questions. ...

The point is that the effects of QE are likely to be modest, and with unemployment remaining persistently high, we need to do more than monetary policy has to offer. Thus, fiscal policy has a key role to play, either through direct spending on infrastructure and other projects -- my first choice -- or through tax schemes designed to create incentives for increased economic activity.

Monetary policy has done all it can do, pretty much. I would like to see the Fed be even more aggressive, but even if it did implement a larger QE program, it can't do enough to solve the economic growth and unemployment problems by itself. Fiscal policy authorities need to step up and do more -- statements like the one above and those made recently by Ben Bernanke are pleas for help from fiscal authorities. But, unfortunately, Congress has fallen down on the job, there is no leadership from the White House promoting such action, and there is very little hope, none really, that more help will be forthcoming.

Monday, November 29, 2010

"Milton Friedman Would Have Supported QE2"

David Beckworth:

Case Closed: Milton Friedman Would Have Supported QE2, by David Beckworth: The debate over what Milton Friedman would say about QE2 can now be closed. Below is a Q&A with Milton Friedman following a speech he delivered in 2000. In this excerpted exchange with David Laidler, we learn that Friedman's prescription for Japan at that time is almost identical to what the Fed is doing now with QE2:...

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?
Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.
During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”
It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.
The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

...Thanks to Doug Irwin for locating this gem.

Tuesday, November 23, 2010

Why Republicans are Wrong to Oppose Quantitative Easing

I have a new column on QEII: 

Faith in the Fed: QE2 Will Not Spur Inflation

Friday, November 19, 2010

Paul Krugman: Axis of Depression

What's behind recent attacks on the Federal Reserve?:

Axis of Depression, by Paul Krugman, Commentary, NY Times: What do the government of China, the government of Germany and the Republican Party have in common? They’re all trying to bully the Federal Reserve into calling off its efforts to create jobs. And the motives of all three are highly suspect. ...
It’s no mystery why China and Germany are on the warpath against the Fed. Both nations are accustomed to running huge trade surpluses. But for some countries to run trade surpluses, others must run trade deficits — and, for years, that has meant us. The Fed’s expansionary policies, however, have the side effect of somewhat weakening the dollar, making U.S. goods more competitive, and paving the way for a smaller U.S. deficit. And the Chinese and Germans don’t want to see that happen.
For the Chinese government, by the way, attacking the Fed has the additional benefit of shifting attention away from its own currency manipulation, which keeps China’s currency artificially weak — precisely the sin China falsely accuses America of committing.
But why are Republicans joining in this attack?
Mr. Bernanke and his colleagues seem stunned to find themselves in the cross hairs. They thought they were acting in the spirit of none other than Milton Friedman, who blamed the Fed for not acting more forcefully during the Great Depression — and who, in 1998, called on the Bank of Japan to “buy government bonds on the open market,” exactly what the Fed is now doing.
Republicans, however, will have none of it, raising objections that range from the odd to the incoherent.
The odd: on Monday, a somewhat strange group of Republican figures — who knew that William Kristol was an expert on monetary policy? — released an open letter to the Fed warning that its policies “risk currency debasement and inflation.” These concerns were echoed in a letter the top four Republicans in Congress sent Mr. Bernanke on Wednesday. Neither letter explained why we should fear inflation when the reality is that inflation keeps hitting record lows.
And about dollar debasement: leaving aside the fact that a weaker dollar actually helps U.S. manufacturing, where were these people during the previous administration? The dollar slid steadily through most of the Bush years, a decline that dwarfs the recent downtick. Why weren’t there similar letters demanding that Alan Greenspan, the Fed chairman at the time, tighten policy?
Meanwhile, the incoherent: Two Republicans, Mike Pence in the House and Bob Corker in the Senate, have called on the Fed to abandon all efforts to achieve full employment and focus solely on price stability. Why? Because unemployment remains so high. No, I don’t understand the logic either.
So what’s really motivating the G.O.P. attack on the Fed? Mr. Bernanke and his colleagues were clearly caught by surprise, but the budget expert Stan Collender predicted it all. Back in August, he warned Mr. Bernanke that “with Republican policy makers seeing economic hardship as the path to election glory,” they would be “opposed to any actions taken by the Federal Reserve that would make the economy better.” In short, their real fear is not that Fed actions will be harmful, it is that they might succeed.
Hence the axis of depression. No doubt some of Mr. Bernanke’s critics are motivated by sincere intellectual conviction, but the core reason for the attack on the Fed is self-interest, pure and simple. China and Germany want America to stay uncompetitive; Republicans want the economy to stay weak as long as there’s a Democrat in the White House.
And if Mr. Bernanke gives in to their bullying, they may all get their wish.

Bernanke: Rebalancing the Global Recovery

Ben Bernanke defends the Fed (text of speech):

Bernanke Faults China for ‘Persistent Imbalances’, by Sewell Chan, NY Times: Ben S. Bernanke ... plans to argue Friday that currency undervaluation by China and other emerging markets is at the root of “persistent imbalances” in trade that “represent a growing financial and economic risk.” ...
For the last two weeks, the Fed has been criticized for its Nov. 3 decision to inject $600 billion into the banking system through next June, resuming an effort to lower long-term interest rates. ...
Mr. Bernanke’s speech argues that unemployment in the United States is at “unacceptable” levels, and gingerly wades into the fiscal policy debate roiling Washington.
“In general terms, a fiscal program that combines near-term measures to enhance growth and strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve,” Mr. Bernanke will say. ...
Mr. Bernanke’s remarks amount to an endorsement of crucial elements of President Obama’s economic approach. But that endorsement ... could further stoke criticism by Congressional Republicans, who say the Fed is defying voters’ skepticism about large-scale government intervention in the economy and setting the stage for inflation later, and by foreign officials, who fear the Fed is trying to weaken the dollar to make American exports more competitive.
Mr. Bernanke ... will reiterate his argument that the Fed felt compelled to act because inflation is so low ... and unemployment so high... “In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years,” he will say. “As a society, we should find that outcome unacceptable.” ...
The text includes indirect responses to domestic and overseas critics. He intends to argue that the Fed “remains unwaveringly committed to price stability” and that buttressing growth is “the best way to continue to deliver the strong economic fundamentals that underpin the value of the dollar.”
The speech addresses the anxieties of Brazil, Thailand and other emerging economies, which fear that a surge of foreign capital will drive up prices and interest rates.
If exchange rates were allowed to move freely, Mr. Bernanke will argue, emerging markets would raise interest rates — and allow their currencies to appreciate — even as advanced economies like the United States maintained expansionary monetary policies. That would curb the emerging markets’ trade surpluses and shift demand toward domestic consumption and away from export-led growth.
Instead, Mr. Bernanke plans to say, currency undervaluation in big surplus economies has led to unbalanced growth and “uneven burdens of adjustment.” ...

Antonio Fatás wonders why the Fed seems "so obsessed with ensuring that inflation always stays at or below 2%." Allowing inflation to rise above 2% temporarily could help the Fed with its goal of spurring the economy and increasing employment:

How negative should real interest rates be?, by Antonio Fatás: Standard monetary policy is about setting short-term nominal interest rates. Most macroeconomic models assume that inflation is sticky (constant) in the short run and by moving nominal interest rate the central bank is actually setting the real interest rate and by doing so influencing spending (consumption and investment) decisions. Of course, these spending decisions might depend on long-term interest rates and therefore we also need to understand how short-term interest rates affect both nominal long-term rates and inflation over a longer horizon (where we cannot assume that inflation is constant).
We can use this logic to think about the most recent quantitative easing policies announced by the Fed. That's what Mark Thoma does very well ... in his blog. One issue that I am missing in his analysis is how we think about real interest rates (not just nominal) in the current context. This is very much related to the defense that some Fed officials have done over the last hours of their policies. For example, in his interview with the WSJ, Janet Yellen argues that QEII (the next round of quantitative easing) is not intended to raise inflation. That the Fed is happy with an inflation rate below but close to 2%.
I understand the importance of having a "low and stable" inflation target but we need to keep in mind that these targets should be interpreted in a medium-term framework, we are not asking the central bank to deliver a constant 2% inflation every month, quarter or year. And given that the Fed has refused to adopt a formal inflation target to keep its flexibility to set inflation on a short-term basis, why do they seem so obsessed with ensuring that inflation always stays at or below 2%? Even the ECB that is some times seen as putting too much emphasis on inflation has let the Euro inflation rate go above 2% during many of the months it has been in existence, so a little flexibility above 2% in the communications of the Fed might not hurt.
We can also think about what all this implies for real interest rates, by asking: what should the level for real interest rates be given current economic conditions? We know that with short-term rates at zero (and they cannot go lower) sending a strong message about inflation being below 2% sets a floor for how low real interest rates can go (the floor is -2%). Estimates of what the appropriate real interest rate is in the current situation (which tend to be made within the context of a Taylor rule) vary but some suggest that real interest rates might need to be even lower than that [By the way, I find this related post by Krugman very useful to understand the logic behind negative real interest rates].
In addition, we have the issue of the dynamics of expectations and actual inflation. It might be that Fed officials by sending a very strong message about not wanting to increase the inflation rate above 2% will keep inflation expectations low and actual inflation remains significantly lower than the 2% "target". My guess is that their conservatism when it comes to inflation is the result of the strong criticism that they have received (both at home and abroad), which has sent them into a defensive position where they need to reassure everyone that their current policies are not about raising inflation. But this might not be optimal, while anchoring long-term expectations of inflation around a low target is reasonable, there is nothing wrong in admitting that one of the goals of the current policy is to ensure that inflation stops falling and that we go back towards 2% or even higher in the short-term.

Wednesday, November 17, 2010

Mankiw on QE2

Greg Mankiw:

QE2: ...I judge QE2 to be a small but risky step in the right direction.

Update: In his post, Mankiw says:

I do see some potential downsides.  In particular, the Fed is making its portfolio riskier.  By borrowing short and investing long, the Fed is in some ways becoming the hedge fund of last resort.  If future events require higher interest rates, the Fed will end up making losses on its portfolio.  And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds.  Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles).  Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road.  I trust the team at the Fed enough to think they will avoid that mistake.

Economics of Contempt emails:

Pretty absurd post on QE2 from Mankiw, don't you think? Calling the Fed the "hedge fund of last resort" is about as disingenuous as it gets. If the Fed is becoming a hedge fund, it's a hedge fund that only invests in *Treasuries*! Is Mankiw seriously worried about the risks of the Fed owning 10YR and 30YR Treasuries? I *highly* doubt it.

Interest on Reserves and Inflation

[I originally had this as part of the post below this one on the most recent inflation data, but decided to make it a separate post.]

There's been a lot of talk lately about the Fed's policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn't paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all.

First, on whether paying interest on reserves is a constraint on loan activity, the supply of loans is not the constraining factor, it's the demand. Increasing the supply of loans won't have much of an impact if firms aren't interested in making new investments. Businesses are already sitting on mountains of cash they could use for this purpose, but they aren't using the accumulated funds to make new investments and it's not clear how making more cash available will change that.

Second, I doubt very much that a quarter of a percentage interest -- the amount the Fed pays on reserves -- is much of a disincentive to lending (market rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption).

Third, this a safety net for the Fed with respect to inflation. Paying interest on reserves gives the Fed control over reserves they wouldn't have otherwise, and control of reserves is essential in keeping inflation under control. If, as the economy begins to recover, the Fed loses control of reserves and they begin to leave the banks and turn into investment and consumption at too fast a rate, then inflation could become a problem. 

But by changing the interest rate on reserves, the Fed can control the rate at which reserves exit banks. The incentive to loan money is the difference between what the bank can earn by loaning the money or purchasing a financial asset and what it can make by holding the money as reserves. Suppose, for example, that the Fed raises the interest rate on reserves to the market rate of interest. In that case, banks would have no incentive at all to make loans and would instead just hold the reserves.

The tool the Fed has for removing reserves from the system is open market operations (QEI and QEII are essentially traditional open market operations, but the Fed buys long-term rather than the more traditional short-term financial assets). So why do they need another tool -- interest on reserves -- to control reserves? Removing reserves too fast through open market operations could disrupt financial markets. Paying interest on reserves gives the Fed a way to remove reserves in a more leisurely fashion while still maintaining control over inflation. They can raise the interest rate on reserves freezing them within the banking system, and then remove the reserves over time through open market operations as desired.

To say this another way, traditionally the only way the Fed could raise the federal funds rate is through open market operations that remove reserves from the system. However, since interest on reserves is a floor for the federal funds rate (it's a floor because nobody would lend reserves at a rate less than they can earn by holding them), an increase in the rate the Fed pays on reserves will increase the federal funds rate even though the reserves are still in the system. The economy can be slowed through increases in the federal funds rate without having to remove substantial quantities of reserves all at once as would be the case if open market operations were the only tool available.

Thus, though I don't think paying interest on reserves has much of an effect on loan activity right now, even if you believe it has, this is the price that must be paid for the ability to do QEI and QEII. If the Fed did not have this tool available, it would be much more fearful about its ability to control inflation, and much less likely to try to use unconventional policy to spur the economy.

Update: In comments, Andy Harless correctly points out that the Fed could cut the rate it pays on reserves to zero now, but still have the authority to raise rates later as necessary to help to fight inflation.  As I noted in a reply to Andy, I agree, but the Fed does not -- I meant to, but forgot to include Bernanke's worries that cutting the rate to zero would cause problems in the federal funds market. Bernanke's argument is:

“The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,” he said.

“Because if rates go to zero, there will be no incentive for buying and selling federal funds — overnight money in the banking system — and if that market shuts down … it’ll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.”

The argument itself is a bit hard to swallow and I don't buy it, prior to the recession the rate was zero and the markets functioned fine. But from the Fed's perspective that doesn't matter -- they seem to believe that it is necessary to pay something on reserves to prevent problems in the overnight market for reserves. Thus, in the Fed's view, paying a quarter of a percent right now is a necessary part of this policy, a policy that gives them the comfort they need to employ quantitative easing. The Fed may or may not be correct about the impact on the overnight federal funds market, but it holds all the cards and as a practical matter, if you want QEII, then this is part of the bargain.

"Pretty Good for Government Work"

Warren Buffett thanks the government for saving the day:

Pretty Good for Government Work, by Warren Buffett, Commentary, NY Times: Dear Uncle Sam,
...Just over two years ago, in September 2008, our country faced an economic meltdown. ... A destructive economic force unlike any seen for generations had been unleashed.
Only one counterforce was available, and that was you, Uncle Sam. Yes, you are often clumsy, even inept. But when businesses and people worldwide race to get liquid, you are the only party with the resources to take the other side of the transaction. And when our citizens are losing trust by the hour in institutions they once revered, only you can restore calm. ...
 The challenge was huge, and many people thought you were not up to it. Well, Uncle Sam, you delivered. People will second-guess your specific decisions; you can always count on that. But just as there is a fog of war, there is a fog of panic — and, overall, your actions were remarkably effective.
I don’t know precisely how you orchestrated these. But I did have a pretty good seat as events unfolded, and I would like to commend a few of your troops. In the darkest of days, Ben Bernanke, Hank Paulson, Tim Geithner and Sheila Bair grasped the gravity of the situation and acted with courage and dispatch. And though I never voted for George W. Bush, I give him great credit for leading, even as Congress postured and squabbled. ...
Delusions, whether about tulips or Internet stocks, produce bubbles. And when bubbles pop, they can generate waves of trouble... This bubble was a doozy and its pop was felt around the world.
So,... Uncle Sam, thanks to you and your aides. Often you are wasteful, and sometimes you are bullying. On occasion, you are downright maddening. But in this extraordinary emergency, you came through — and the world would look far different now if you had not.
Your grateful nephew,
Warren

Tuesday, November 16, 2010

QEII and the Yield Curve

Posted at MoneyWatch:

What is QEII?

QEII is explained through its effects on the yield curve.

"How to Restore Confidence in the US Economy"

I'm guessing you won't like this idea very much. Roger Farmer argues that the Fed should stabilize the stock market in order to restore confidence in the economy:

How to restore confidence in the US economy without inflating a new asset market bubble, by Roger Farmer, Commentary, Financial Times: ...I have argued ... that more QE can create jobs and prevent a second Great Depression. But it matters how the policy is implemented. ...
Currently, investors hold more than a trillion dollars in excess reserves at the Fed... The problem is that investors are fleeing from risk and are demanding safe assets. The Fed is uniquely positioned to provide a safe haven for investors by buying risky securities from the public and replacing them with interest bearing deposits at the Fed.
What kind of risky assets should the Fed buy? Mr Bernanke plans to purchase treasury bonds..., a better plan would be to ... buy and sell stocks with the goal of reducing private sector risk. How might this be achieved? ...
QE is a new, unconventional monetary policy and ... there are two ways that it can be implemented. One is to buy securities in fixed amounts each month. That is what Mr Bernanke plans to do, although he proposes to buy bonds rather than stocks. The other is to buy and sell shares to stabilize fluctuations in the stock market. I propose this second strategy.
If the Fed were to announce that the Dow would not be allowed to drop below 11,000 over the next three months, for example, it would provide the confidence to private investors to move back into the market and spend some of the $1,000bn in excess reserves that are sitting in the banking system. But guaranteeing no downside to stocks is not, on its own, a good idea. The Fed must also limit swings on the upside. If QE simply fuels another unsustainable asset market bubble it will have made the problem worse, not better. Just as conventional monetary policy stabilizes swings in interest rates, so unconventional monetary policy must stabilize swings in asset prices.

Monday, November 15, 2010

GOP's Pence: The Fed Should Drop Its Dual Mandate

This says a lot about how much Republicans care about the unemployed:

GOP’s Pence Calls for Fed to Drop Focus on Employment, by Sudeep Reddy: Rep. Mike Pence of Indiana, a top House Republican, said he plans to introduce legislation Tuesday to end the Federal Reserve’s dual mandate, which requires the central bank to balance both employment and inflation concerns in its monetary policy. ... On Monday, he called for striking the dual mandate to force the Fed to focus only on price stability. The Fed today, under a 1977 law, also must pursue maximum sustainable employment... “The Fed’s dual mandate policy has failed,” Pence said in a statement. “For a record 18th straight month the nation’s unemployment rate is at or above 9.4 percent. It’s time for the Fed to be solely focused on price stability and not the recently announced QE2 which will monetize our debt and trigger inflation.”

The unemployment rate would be even higher if the Fed had not acted but, in any case, a single mandate wouldn't alter the Fed's current course of action. If the Fed is worried about disinflation/deflation, as it should be, then QEII is what is required for price stability. Dropping the dual mandate won't change that (and the debt will be "unmonetized" when conditions return to normal and the Fed begins to remove reserves from the system to avoid inflation, so the debt monetization argument doesn't hold unless you believe the Fed will abandon its long-run inflation target -- something it has made very clear it has no intention of doing).

Republicans oppose fiscal policy -- including things such as extending unemployment compensation and job creation initiatives to help to overcome severe conditions (though tax cuts for the wealthy are okay) -- and they oppose monetary policy that tries to lower the unemployment rate. So, in essence, they oppose doing anything to help the unemployed during a recession.

Welcome to the "you're on your ownership society."

"Republicans, Democrats, the Fed and QE2"

Jeff Frankel says conservative economists should learn "some insufficiently understood history" before expressing worries about Democrats and monetary policy:

The Pot Again Calls the Kettle Red: Republicans, Democrats, the Fed and QE2, by Jeff Frankel : Some conservatives are attacking current monetary policy as being too expansionary, as likely to lead to excessive inflation and debauchment of the currency. The Weekly Standard is promoting a critical letter to Fed Chairman Ben Bernanke signed by a list of conservatives, most of whom are well-known Republican economists. Apparently they are taking out newspaper ads tomorrow. If the National Journal and Wall Street Journal are right that the Republicans are trying to stake out a position that Democrats are pursuing inflationary monetary policy, they are on very shaky ground.

I will leave it to others to make the most important point, how low is the risk of excessive inflation now compared to the risk of alarming Japan-style deflation, with the economy having only begun to recover from its nadir of early 2009. Or to acknowledge that QE2 — the Fed’s new round of monetary easing — is only a second best policy response to high unemployment. (Fiscal policy would be much more likely to succeed at this task, if it were not for the constraints in Congress.)

I will, rather, respond to the partisan content of the National Journal’s question by pointing out some insufficiently understood history:

  1. Republican President Nixon successfully pushed Fed Chairman Arthur Burns into an excessively easy monetary policy in the early 1970s — leading to high inflation which the White House tried to address with wage-price controls. Nixon, of course, also devalued the dollar, and took it off gold, thereby ending the Bretton Woods system.
  2. Republican Presidents Ronald Reagan and George H.W. Bush repeatedly tried to push Fed Chairmen Paul Volcker and Alan Greenspan into easier monetary policy. This is documented in Bob Woodward’s 2000 book Maestro. The White House succeeded in making life unpleasant enough for inflation-slayer Volcker that he eventually asked not to be reappointed, prompting James Baker to exult “We got the son of a bitch!” (p.24).
  3. Democratic Presidents Jimmy Carter and Bill Clinton are the two presidents who have refrained from pushing their Fed Chairmen (Volcker and Greenspan, respectively) into easier monetary policy.
  4. Under Republican President G.W.Bush, monetary policy once again became excessively easy, during 2003-06, contributing substantially to the housing bubble and subsequent crash.

...Perhaps such accusations will strike some who don’t pay close attention as superficially plausible, even after all these years. But they nonetheless fly in the face of history. Another case of the pot calling the kettle “red.” Yes, I know, the usual saying is about the color black. But red is the color of deficits, overheating, … and Republicans.

I document this history in “Responding to Crises,” Cato Journal 27, 2007.

Friday, November 12, 2010

Fed Watch: Will the Fed Scale Up QE2?

Tim Duy:

Will the Fed Scale Up QE2?, by Tim Duy: I often feel caught between two complementary yet seemingly contradictory narratives regarding the US economy, one that sounds very optimistic while the other, in my opinion, pessimistic. Nevertheless, I think both narratives can be embraced, at least to a certain extent. And which narrative the Federal Reserve embraces will determine the dominate monetary policy question: Will the Fed scale up quantitative easing, or scale down?

It is reasonable to conclude that the US economy possess the basis for sustained growth in the quarters ahead. Indeed, the signs of a cyclical upturn are all over the data - manufacturing, investment, retail sales, inventories, take your pick, they are generally moving in the right direction. And my take on the recent spate of data is that economic conditions firmed somewhat as we entered the fourth quarter. The ISM reports, both manufacturing and service sectors, were looking much more solid than the previous months. Initial unemployment claims have drifted downward, possibly even poised to make a sustained break below the 450k mark. And the all important employment report did surprise on the upside.

Overall, the four quarter average of GDP growth is 3.1% - perhaps a bit higher than potential (or perhaps not, given earlier productivity gains), consistent with the relatively steady path of the unemployment rate since the beginning of the year. And note private sector payrolls are rising at a monthly rate of about 112k this year, at the low end of estimates necessary to absorb the growing labor force (albeit acknowledging the potential for additional drag from the public sector). To be sure, during the past two quarters, average GDP growth slowed to an average of 1.9%, threatening to undo these patterns and prompting the Fed to step up large scale asset purchases. But the pick up in activity suggested by the ISM reports signals that growth will edge back up in the final quarter of this year.

Like others, I could find quibbles with the data. For instance, the household side of the October employment report was not exactly inspiring, suggesting that high unemployment continues to drive persons out of the labor force. And the gains on the employment side were concentrated in a handful of sectors - retail and wholesale trade, temporary employment, and health and education services accounted for 123.1k of the 159k total. I would prefer broader based increases, but will hold out hope that the temp employment gains foreshadow a more durable recovery in the months ahead.

Moreover, I believe households are setting the groundwork for sustained spending growth in the quarters ahead. Not only are savings rates well off their lows, meaning that some or even much of that adjustment is already behind us. And financial obligations have collapsed back to levels last seen prior to the 2001 recession:

Goodness, consumer credit even rose a touch in September! Moreover, steady gains in the labor market would go a long way in supporting the handoff from spending sustained on transfer payments to spending sustained on wages. The net impact might not cause a surge in consumer spending, but it would at least keep it on its recent steady upward trend.

And yes, of course, households are still fundamentally challenged relative to five years ago. Housing markets remain a mess, net worth has been shredded, etc. And these events appear to have made something of a permanent mark on consumer psychology. Witness as retailers rush to get the jump on the holiday shopping season, ratcheting up discounts amid worries that consumers remain frugal and more discerning about their spending. From the Wall Street Journal:

Retailers and manufacturers are slashing flat-screen television prices more aggressively than usual this holiday season in hopes of avoiding a pileup of inventory.
Wal-Mart Stores Inc., Best Buy Co. and Amazon.com Inc. are touting deals ahead of Black Friday to clear out older and cheaper sets before an anticipated flood of deeper price cuts in coming weeks...
...The frenzy is being fueled by such top makers as Sony Corp. and Samsung Electronics Co., which are reducing suggested retail prices and sweetening their promotions with such extras as free Blu-ray movie players and 3-D glasses after initially overestimating the American consumer's appetite for pricey features….
...Television makers had expected bullish sales for 2010 on the theory that Americans were slowly loosening their purse strings and becoming receptive to new, pricier technologies such as ultrathin LED screens, Internet-connected sets and 3-D TV.
But slow 3-D TV sales and a buildup of U.S. television inventories in August and September showed that Americans were still behaving frugally amid continuing high unemployment...

That said, I think it is important to recognize that the relative challenges still facing households - namely a loss of asset values and the access to credit those values provided - is more a story of why spending did not quickly revert to trend, not a reason to believe that spending cannot be maintained along its current anemic trend:

FWexctra

Overall, I believe it is reasonable to embrace a story that the economy settles into a trend near potential growth - by some measures, an optimistic outlook. Indeed, I believe this was a story the Federal Reserve was willing to embrace, and would have had it not been for the slowing evident over the past two quarters.

That said, the recent flow of data does little to convince me that the US economy is set to grow much faster than potential. For the sake of argument, supposed that QE2 does in fact support the economy, pushing growth back up to the 3% range in 2011 and 2012. Sales increases, profits increase, jobs increase, everyone's happy, correct? Probably not. Consider the trajectory of the output gap under such circumstances:

FW1112103

I included the path of the output gap through the 1981 recession cycle, centering both on the begining of the respective recessions. At 3% growth, the output gap will narrow to 4.5% by the end of 2012, 14 quarters after the "end" of the recession. In contrast, in the mid-1980s, it took just 7 quarters to collapse the output gap to just 1%. Perhaps more dramatic is a look back at the employment to population ratio:

Continue reading "Fed Watch: Will the Fed Scale Up QE2?" »

Thursday, November 11, 2010

Hall: Inability to Cut Rates Fuels Joblessness

Robert Hall says we need to institute monetary policies that make current purchases cheap relative to future purchases (as with inflation):

Inability to Cut Rates Fuels Joblessness, by Timothy Aeppel: American consumers borrowed and spent their way into today’s slow recovery, and the jobless rate is being held near 10% because the Federal Reserve is unable to cut interest rates below zero, says Stanford University economist Robert E. Hall.
In a paper presented Thursday at a Federal Reserve Bank of Atlanta conference, Mr. Hall calculates that loose credit earlier in this decade resulted in consumers buying 14% more long-lasting items — from cars and dishwashers to houses — than they would have if credit conditions had remained as they were in the previous decade.
The recession was marked by those overextended households cutting spending and saving more in the face of hard times. The problem now is that the normal tool used to revive consumer spending and hiring — cutting interest rates well below the inflation rate — isn’t available because rates are nearly at zero. So unemployment has remained stuck at a high level, currently 9.6%.
Mr. Hall ... concludes that the only way to get the job market growing is to institute monetary policies “that emulate the effect of low real rates — making current purchasing cheaper than future.” That should be music to the ears of many at the Fed...

That is not the only way to get the job market growing, there's also fiscal policy. It's not politically viable right now, but it is an alternative tool. Fiscal policy can mimic the incentive effect of changes in real interest rates and expected inflation through changes in taxes, and it can stimulate the economy directly by purchasing goods and services from the private sector.

Too Much Concern about the Upside Risk to Inflation

 Japan also has inflation hawks on its monetary policy committee:

Maybe economists should only have one hand, by Antonio Fatas: ...[T]he debate about whether inflation or deflation is more likely, and about whether the aggressive response of central banks is appropriate today is at the heart of some of the most basic issues in macroeconomics. ...
One example that I always find interesting is the debate that one finds in the minutes of the monetary policy meetings at the Bank of Japan. When discussing the inflation outlook in Japan in recent years, you can always find views on both sides, those who are concerned with deflation and those who are concerned with inflation picking up. Here is a paragraph from the meeting back in April 2010.
Regarding risks to prices, some members said that attention should continue to be paid to a possible decline in medium- to long-term inflation expectations. One member expressed the view that attention should also be paid to the upside risk that a surge in commodity prices due to an overheating of emerging and commodity-exporting economies could lead to a higher-than-expected rate of change in Japan's CPI.
Of course, given the last 10 years of data in Japan, it seems awkward that some are concerned with the upside risk to inflation. While one cannot completely rule out this possibility maybe erring on the other side, making the mistake of letting inflation be "too high", for a few years would be good for the Japanese economy.
Clearly the US or Europe are not in the same situation as Japan but given some of the recent commentary about inflation I wonder whether we are getting close to a debate with too many hands and too many scenarios that leads to a lack of strong actions in the right direction. One can make mistakes in both directions (too much or too little inflation) and only time will tell in which direction our mistakes go, but given what we know about inflation, inflation expectations and long-term interest rates (all of them are low, stable or falling), it seems that we are worrying too much about the potential mistake of being too aggressive when it comes to monetary policy.

Tuesday, November 09, 2010

The GOP Victory and Macroeconomic Policy

I have a new column:

GOP Victory May End Government Economic Intervention: One of the oldest, most controversial issues in economics is how active government should be in managing the economy. Views on this have varied greatly through the ages, and we are in the middle of yet another large change in attitudes about the proper role of government. ...

I hope I'm wrong about this, and I think there's a decent chance that I am.

Monday, November 08, 2010

Paul Krugman: Doing It Again

The "inflationistas" are standing in the way of policy that might help the unemployed:

Doing It Again, by Paul Krugman, Commentary, NY Times: Eight years ago Ben Bernanke ... spoke at a conference honoring Milton Friedman. He closed his talk by addressing Friedman’s famous claim that the Fed was responsible for the Great Depression, because it failed to do what was necessary to save the economy.
“You’re right,” said Mr. Bernanke, “we did it. We’re very sorry. But thanks to you, we won’t do it again.” Famous last words. For we are, in fact, doing it again. ...
We’ve already seen this happen with fiscal policy: fearing opposition in Congress, the Obama administration offered an inadequate plan, only to see the plan weakened further in the Senate. In the end, the small rise in federal spending was effectively offset by cuts at the state and local level, so that there was no real stimulus to the economy.
Now the same thing is happening to monetary policy. The case for a more expansionary policy ... is overwhelming. Unemployment is disastrously high, while U.S. inflation data ... almost perfectly match the early stages of Japan’s relentless slide into corrosive deflation. ...
Yet the Pain Caucus —... those who have opposed every effort to break out of our economic trap — is going wild.
This time, much of the noise is coming from foreign governments ... complaining vociferously that the Fed’s actions have weakened the dollar. All I can say ... is that the hypocrisy is so thick you could cut it with a knife.
After all, you have China, which is engaged in currency manipulation ... unprecedented in world history — and hurting the rest of the world by doing so — attacking America for trying to put its own house in order. You have Germany, whose economy is kept afloat by a huge trade surplus, criticizing America for running trade deficits — then lashing out at a policy that might, by weakening the dollar, actually do something to reduce those deficits.
As a practical matter, however, this foreign criticism doesn’t matter much. The real damage is being done by our domestic inflationistas — the people who have spent every step of our march toward Japan-style deflation warning about runaway inflation just around the corner... — and they may already have succeeded in emasculating the Fed’s new policy.
For the big concern about quantitative easing isn’t that it will do too much; it is that it will accomplish too little. Reasonable estimates suggest that the Fed’s new policy is unlikely to reduce interest rates enough to make more than a modest dent in unemployment. The only way the Fed might accomplish more is by ... leading people to believe that we will have somewhat above-normal inflation over the next few years, which would reduce the incentive to sit on cash. ...
But in the same remarks in which he defended his new policy, Mr. Bernanke — clearly trying to appease the inflationistas — vowed not to change the Fed’s price target: “I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy.”
And there goes the best hope that the Fed’s plan might actually work.
Think of it this way: Mr. Bernanke is getting the Obama treatment, and making the Obama response. He’s facing intense, knee-jerk opposition to his efforts to rescue the economy. In an effort to mute that criticism, he’s scaling back his plans in such a way as to guarantee that they’ll fail.
And the almost 15 million unemployed American workers, half of whom have been jobless for 21 weeks or more, will pay the price, as the slump goes on and on.

Sunday, November 07, 2010

Williamson Yet Again

Steven Williamson replies again. He says things like:

I don't know what "aggregate demand" is.

I'll let him figure that out on his own, so let me deal with another part of his reply. He says this graph shows why we should fear inflation:

Presumably Mark would characterize the current state of the economy as "depressed." And, the fact is that reserves are leaving banks in the form of currency as we can see in this chart.

 

Note in particular that reserves have recently been leaving banks at a more rapid rate. It's possible that we would get more inflation even without QE2.

Ah, I see, the surge in 2008 is why we are having such a problem with inflation today! Oh wait.

It would be nice if he would take logs so that the "surge" is not misrepresented visually. And it would also be nice if he presented the entire series so we can see if there is, in fact, a surge relative to the historical average:

Logcurr
I'll let you decide if there has been a sudden surge in the growth rate of currency. It does appear to be a bit higher relative to the bubble years, but not relative to the entire history.

But what does an increase in currency holdings tell us anyway? People sitting on cash is no different than banks sitting on excess reserves. Are they spending the money right away or holding it for long periods of time? It matters.

In any case, the charts above show currency in circulation. But Wiliamson says that "Inflation is everywhere and always a monetary phenomenon." So what has been happening to (the log of) M2 (the monetarists' favorite measure of money -- he does call himself a New Monetarist after all)? Not much:

M2

There was a little bit of a surge (remember all that inflation when it happened?), but M2 appears to be mostly back to trend. Maybe a second round of QE can change that?

And what do we know from other evidence on this question? Let me turn it over to Williamson's bestest buddy in the whole world, Paul Krugman (the monetary base is the sum of currency in circulation plus bank reserves):

Here’s a chart of growth rates of the monetary base and of M2, Friedman’s preferred monetary aggregate:
DESCRIPTION
Bank of Japan
So, after 2000 the Bank of Japan engineered a huge increase in the monetary base; this was the original quantitative easing. And it didn’t even translate into a surge in the money supply!

And we are all aware of the severe problems Japan has faced with inflation as a result of its quantitative easing policy.

Just for completeness, here is the same graph with the growth in currency in circulation shown just underneath it for comparison (taken from the Bank of Japan web site):

DESCRIPTION
Curr
Currency in Circulation - Bank of Japan

Japan had surges in currency too, but they did not translate into an outbreak of inflation.

Finally, I found this to be an interesting argument that the presence of excess reserves has nothing to do with the lack of demand for bank loans:

If the opportunities are there, the banks will lend.

Well, yes, but that begs the question of whether the opportunities are, in fact, there. I also like the contention that calling Bernanke a "wuss" is not "disparaging Bernanke's character." Yes, saying Bernanke is lying to himself or the rest of us when he claims, as he has repeatedly over the last week, that he will not let inflation get out of control is not a comment of his character, but whatever.

Despite Williamson's wishes to the contrary, there's no evidence here that inflation is just around the corner, or even down the street.

Update: Williamson replies yet again. I have interspersed my own comments [in brackets to keep them separate]:

Thoma - Last Comment: Thoma is back again with this. Replies as follows:
Ah, I see, the surge in 2008 is why we are having such a problem with inflation today!

He's talking about the surge in currency in circulation in 2008. Yes, exactly. This is why I'm not an old-fashioned quantity theorist. What has to be going on here is a large increase in the world demand for US currency during the financial crisis. All the more reason to be worried about inflation, as the crisis-driven demand goes away.

[The Fed has no way to remove currency or bank reserves from the system once the crisis is over and the economy starts recovering? This relies on the idea that the Fed won't be aggressive in fighting inflation, which in turn relies upon Williamson's contention about Bernanke's character. More on this below.]

what has been happening to (the log of) M2 (the monetarists' favorite measure of money -- he does call himself a New Monetarist after all)?

No, New Monetarists don't care about broader monetary aggregates. Neil Wallace taught us that.

[So his preferred monetary aggregate for predicting inflation is currency in circulation? I find that a bit strange. If it's not his preferred monetary aggregate, then what is it and why didn't he present that as evidence instead of the graph on currency in circulation? Perhaps because it doesn't make the case he wanted to make?]

I also like the contention that calling Bernanke a "wuss" is not "disparaging Bernanke's character."

This seems a bit strange. I'm not sure how Mark comes by all this respect for authority. In this context, I think it's healthy to be skeptical about what these central bankers are telling us. They have a penchant for secrecy, and I don't think we should take everything they say at face value, or necessarily trust them. We've given them an important job, and I think they are taking some big risks. If they screw up, we'll all suffer for it.

[It's possible to question authority without using the word "wuss" or turning it into a character issue, so his reply misses the mark. But this has nothing to do with questioning authority -- I have no problem with that -- and it's not about the particular words that are used. He's trying to turn this into a complaint about language when the underlying issue is that Williamson used a supposed character defect to justify his claim that we should be worried about inflation. He chose to hang his hat largely on Bernanke's character rather than try to make the case with economics, but seems unwilling to own up to this (even above, his main argument is that Bernanke and other Fed officials could be intentionally lying to us so we shouldn't trust them). I am not a big fan of Bernanke for reasons that precede his tenure at the Fed, and we should be skeptical and ask questions, but I think I would at least admit it when I attacked his character as a means of buttressing relatively weak economic arguments and to justify my arguments about inflation. Maybe he's right about Bernanke's character, maybe not, but as I said before nobody should mistake what Williamson is doing for economics. It's just as easy to use the character issue to argue that Bernanke will tighten too soon rather than too late, and debating Bernanke's inner soul gets us nowhere.]

[I'll end by simply noting that while I was pleased to see his first post today acknowledge the inconsistency in his original argument that I pointed out, he still hasn't answered one of the questions I asked, how inflation occurs in a recession when the unemployment rate is 10%. This was something he said we should be very worried about but how, exactly, does this occur? He said this was his last comment, so I guess we'll never know.]

Just for completeness, here is the same graph with the growth in currency (taken from the Bank of Japan web site) just underneath for comparison:

The Resetting of Clocks and Monetary Neutrality

This is mostly for Nick Rowe who says:

...Why does money have real effects? It's just bits of paper. It's not real. We are still stuck on David Hume's puzzle. If we double the number of bits of paper each one should be worth half as much. It should be a purely nominal change. Nothing real should change. If we switch from meauring turkeys in pounds to measuring them in kilograms, the price per unit weight should be divided by 2.2, but the same turkey should cost exactly the same in pounds or kilograms, and we should buy exactly the same number of turkeys as before.

Metrification was a nominal change that had negiligible real effects, as far as I know. Daylight Savings Time is a nominal change that has real effects. Some monetary changes, like currency reforms where we knock a couple of zeroes off the old currency and call it the new currency, are like metrification, where nothing real changes. And maybe all monetary changes are like metrification in the long run. But some monetary changes are like Daylight savings Time, and have real effects, at least in the short run.

If we understood Daylight Savings Time better, and how it works, we might understand monetary policy better. ...

This is a bit on the wonkish side, but here's an example along these lines from David Romer's graduate macro text (pgs. 295-296):

An analogy may help to make clear how the combination of menu costs with either real rigidity or insensitivity of the profit function (or both) can lead to considerable nominal stickiness: monetary disturbances may have real effects for the same reasons that the switch to daylight saving time does.[16] The resetting of clocks is a purely nominal change -- it simply alters the labels assigned to different times of day. But the change is associated with changes in real schedules -- that is, the times of various activities relative to the sun. And there is no doubt that the switch to daylight saving time is the cause of the changes in real schedules.
If there were literally no cost to changing nominal schedules and communicating this information to others, daylight saving time would just cause everyone to do this and would have no effect on real schedules. Thus for daylight saving time to change real schedules, there must be some cost to changing nominal schedules. These costs are analogous to the menu costs of changing prices; and like the menu costs, they do not appear to be large. The reason that these small costs cause the switch to have real effects is that individuals and businesses are generally much more concerned about their schedules relative to one another's than about their schedules relative to the sun. Thus, given that others do not change their scheduled hours, each individual does not wish to incur the cost of changing his or hers. This is analogous to the effects of real rigidity in the price-setting case. Finally, the less concerned that individuals are about precisely what their schedules are. the less willing they are to incur the cost of changing them; this is analogous to the insensitivity of the profit function in the price-setting case.

The question Romer is trying to answer is how it is possible for small menu costs (i.e. small costs of changing prices) to have large effects on the real economy.

I used to get mad at losing an hour of daylight and having it get dark before 5:00 pm, and for many, many years I refused to change my clock (I also hate changing it back in spring and losing an hours sleep). I still had to adjust my schedule to everyone else's so it didn't do much good, but somehow leaving my clocks an hour off made it a tiny bit better. I was surprised at how fast I was able to adjust each fall to the clock being wrong by an hour, though there were several instances when people in my office would get quite confused and panic after looking at the clock and thinking it was an hour later than it actually was. I found that amusing, they found it weird, and I did eventually turn the office clock so that visitors couldn't see it. These days, most of my clocks adjust automatically and I don't bother to change them back, but last year there were a couple of non-self adjusting clocks that I never got around to changing. I doubt I'll bother to change them this year either.

Williamson Responds to "Grumpy Thoma"

I was kind of grumpy. Here's Steven Williamson's response to my post:

Grumpy Thoma, by Steven Williamson: Apparently Mark Thoma didn't like my last piece on QE2. I've had a fairly peaceful time here for a while. Thankfully my fellow bloggers have not been paying much attention to me, and my readers are typically thoughtful and helpful in the comment box.

Now, as my mother (rest her soul) would have said, "Mark, did you get out of the wrong side of the bed this morning?" Hopefully my mother is not reading Thoma's blog, wherever she is, or she would think I had turned into a nasty piece of work.

Thoma was right about a couple of things, though. First, I did not lay out all the details of my arguments. Most of those are in previous posts, and obviously I can't assume everyone is reading all these things. Second, there is an inconsistency in there.

First, the details. What causes inflation? I'm with Milton Friedman on this one. Inflation is everywhere and always a monetary phenomenon. I'm not with Milton Friedman in the sense that I don't think the demand for an asset is anything like the demand for potatoes. Trying to find stable demand functions for monetary quantities is a waste of time. Think of the price level as being the terms on which the private sector is willing to hold the stock of outside money - currency and reserves. The Fed determines the total stock of outside money, and the private sector determines how that total gets split up between currency and reserves. What makes the price level go up? That would be anything that increases the supply of outside money relative to the demand.

Now, what is QE2 about? Under the current circumstances, with a large stock of excess reserves held in the financial system, it seems clear that a conventional exchange of reserves for T-bills cannot matter at all in the present. The Fed swaps one interest-bearing short-term asset for another, and nothing much should happen, short of some minor effects due to the somewhat different roles played by T-bills and reserves in the financial system. On the other hand, swapping reserves for long-maturity Treasuries, as in the QE2 plan, is a different story. We're now swapping a short-term interest-bearing asset for a long-term one. But what will the effects be? Unfortunately there is no good theory to tell us. To the extent that this matters in the present, for example by moving asset prices in the way that Bernanke seems to expect, this depends on some kind of financial market segmentation. Private financial intermediaries cannot be capable of undoing what the Fed is about to do.

Now, what I discussed in the previous paragraph is just about the current effects of the QE2 open market operations. What about the medium-term effects? There are two important points to note here about QE2. The first is that, while interest-bearing reserves, when they are held by banks, look essentially like T-bills, they have one feature that is very different from T-bills. This is that they can be converted one-for-one into currency. For a bank, a reserve account is a transactions account, and currency can be withdrawn from that account in the same way that you withdraw cash from the ATM. Thus, in contrast to T-bills, interest-bearing reserves can be converted into an asset that can be used in retail transactions.

Therefore, the more reserves that the Fed floods the financial system with, the more potential there is for inflation. As the economy recovers, other assets will become more attractive to banks relative to reserves, the demand for outside money will fall, and the price level must rise. Further, there could simply be a net increase in the supply of outside money relative to the demand at the outset of the QE2 operation. What I have in mind here is that, in spite of the fact that a QE2 open market operation simply swaps one consolidated-government liability for another, there may be some friction that implies that, on net, banks will not want to hold the extra reserves at market prices. Surely this is part of what the Fed has in mind. They think that long bond yields will fall. However, part of the adjustment should be an increase in the price level as well.

Now, if the inflation rate starts to rise, what happens then? There are three forces here that are going to make inflation control difficult. First, QE2 will have lengthened the maturity of the Fed's asset portfolio, so that the Fed has a lot more to lose from an increase in short-term interest rates. To tighten, the Fed will have to increase the interest rate on reserves (thus increasing all short rates), which results in a capital loss on its portfolio that will be larger the longer the average maturity of the Fed's assets. If the Fed continues to hold those assets, its income will fall, and if it sells the assets it will be selling them at a loss. If the Fed does not tighten, then inflation rises. None of these outcomes is very appealing. The second force at play is that Bernanke in particular thinks that monetary policy matters for real activity in a big way, and he will be very reluctant to tighten as he will think that he risks another recession. Third, and I may be wrong about this, but I think Bernanke is probably a wuss. He does not want to bear the short term pain associated with people screaming at him if tightening occurs.

Finally, on the inconsistency, I said here, by implication, that I did not think that QE2 would have much in the way of real effects. But I also said that it is costly to bring inflation down. Seems a little goofy, right? Some people think they understand nonneutralities of money well, but I don't feel like I do. Keynesians (new and old) have not convinced me that sticky wages and prices imply that a monetary expansion gives aggregate output a big kick in a positive direction. Some people, including me, made a case that market segmentation could imply a substantial redistributive effect of monetary policy, but this seemed to matter more for asset prices and allocation than for aggregate activity. New Monetarist ideas may give us short-run nonneutralities of money associated with asset trading and liquidity, and with credit market activity, but we haven't worked all of that out. Given what we know, my forecast is that the net real effects of QE2 will be insignificant. Now, what if inflation takes off, Bernanke is not a wuss, and substantial monetary tightening occurs? Do we have to suffer a lot to bring inflation down, or not? The "Volcker recession" was severe, but in the early 1980s inflation came down over a relatively short period from about 15% to 5%. There were plenty of people at the time who thought that the consequences of tightening would be much more severe. Possibly with the benefit of our 1970s and 1980s experience we can manage this inflation better. Who knows?

I'm happy to see that he acknowledges the inconsistency I pointed out, but I don't think this fully answers one of my questions. Saying that inflation is always and everywhere a monetary phenomena, and that prices depend upon the amount of outside money in the system, doesn't answer the question about how we get inflation before aggregate demand kicks up. That is, how do we get inflation in the scenario in his previous post where inflation begins increasing to worrisome levels even if there is an unemployment rate of 10% and aggregate demand remains depressed? As Williamson acknowledges, money that piles up in the banks as excess reserves does not increase inflation, it's only "potential" inflation. Exactly how the excess reserves leave banks in a depressed economy is not explained other than through reference to some vague friction that says banks won't want to hold reserves. But who will buy the reserves they no longer want to hold? The story above assumes that banks can loan money if they want, that there is plenty of demand if banks are willing to meet it, but is that really the case right now? Is the supply of credit the main constraining factor or is it the demand? And how much will that demand change if long-term rates fall by a small amount through quantitative easing? I understand the statement that "the more reserves that the Fed floods the financial system with, the more potential there is for inflation. As the economy recovers, other assets will become more attractive to banks relative to reserves, the demand for outside money will fall, and the price level must rise." This statement is conditional upon the economy recovering. But I still don't see how excess reserves are converted into real investments in plants and equipment on a significant scale, or converted into other components of aggregate demand, in a stagnating economy. Perhaps this can be clarified (I'm not saying this can't happen, there are historical instances of high inflation in stagnating economies, but the the mechanism Williamson has in mind and why the mechanism should be operable in this case is not yet clear.)

Finally, if claiming someone is a "wuss" is a key component of your argument, I suppose that's fine, but we shouldn't pretend that an opinion about someone's character is based upon any sort economic reasoning. It's a convenient opinion/assumption that helps Williamson's story about why we should worry about inflation hold together, but it runs contrary to what Bernanke has said he will do. It's just as easy to assert that Bernanke is very, very concerned about Fed credibility at this point, that he will therefore keep his word, and that he may even begin tightening too soon (and I don't think worries about losses on its portfolio will affect the Fed's decision much if at all). He may be too much of a "wuss" to risk inflation and the Fed's credibility, and his statement that "We're not in the business of trying to create inflation" lends credence to this view. Thus, making assertions about Bernanke's personality to support an argument doesn't get us anywhere useful, one can assert whatever is convenient for the argument at hand. In any case, an inflation problem from a booming economy would be welcome right now -- it's a problem I wish we had -- and if and when that occurs, I remain convinced the Fed has the tools and the will to keep the problem under control.

Saturday, November 06, 2010

"Federal Reserve Reflects on its History"

Bernanke says he's not trying to create inflation as a means of stimulating the economy:

After its big move to boost economy, Federal Reserve reflects on its history, by Neil Irwin, Washington Post: ...Fed Chairman Ben S. Bernanke and a long list of past and present Fed officials gathered this weekend for a conference on the history of the central bank...
That conversation, particularly a Saturday panel discussion featuring Bernanke, his predecessor, Alan Greenspan, and former New York Fed president Gerald Corrigan... Speaking at the "Return to Jekyll Island" conference sponsored by the Atlanta Fed, Bernanke argued that the steps are not as revolutionary as many observers in the financial markets and the news media have suggested.
"There's a sense out there that, quote, quantitative easing or asset purchases are some completely foreign, new, strange kind of thing and we have no idea what . . . is going to happen," Bernanke said, sitting on stage in a conference space that was once J.P. Morgan's indoor tennis court. "Quite the contrary - this is just monetary policy. . . . It will work or not work in much the same way that ordinary, more conventional, familiar monetary policy works."
Corrigan, who was a key lieutenant of Fed Chairman Paul A. Volcker and now a Goldman Sachs managing director, acknowledged some "uneasiness" with that approach.
"If you seek to nudge up the inflation rate," he said, "even with very, very low rates of capacity utilization in the labor market . . . is there a risk that getting inflation to 2 percent may turn out to be easier than capping it at 2 percent?" "That's the source of uneasiness that I wanted to register," Corrigan added.
Bernanke defended the action. "I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy," he said. "We're not in the business of trying to create inflation," Bernanke said. Rather, he said, the Fed is trying to avoid a further drop in inflation. ...

Since an increase in inflationary expectations is one potential way to stimulate the economy, Bernanke is "blocking one of the main channels through which his policy might actually work."

The "Greenspan Put" also came up:

To many Fed critics, a central failure over the past three decades has been the perceived willingness of the central bank to take action to prop up financial markets whenever they are faltering, a phenomenon known as the "Greenspan Put," which uses the term for an option that protects against an asset losing value.
The criticism is that by standing in to prevent precipitous declines in financial markets, the Fed made it appear that one could invest without risk...
Given that his own policies have helped prop up stock prices in the past year, Bernanke echoed the phraseology of some of his critics and referred to the phenomenon, almost sheepishly, as the "Greenspan/Bernanke Put."
Greenspan was unrepentant.
"If in effect the Greenspan Put is the notion which says you're stabilizing the system, then I hope so - that's what we're here for," the former Fed chairman said. "I don't really have an understanding of why that has become a pejorative term. . . . If I understand it, what we're doing is what we should be doing." ...

In looking through past comments on the Greenspan put, I found this from 2005:

...the broader question of whether the perception that the Fed will protect asset markets is causing overconfidence and excessive risk taking among investors is an interesting issue.  For some reason, I’ve been reminded lately of the overconfidence among policymakers in the early 1960s.  After the discovery of the Phillip’s curve and the belief that it represented a permanent inflation-unemployment tradeoff, policymakers were very confident in their ability to pick a particular point on the Phillip’s curve and it was widely believed that the stabilization problem was largely solved.  History teaches us that such overconfidence in any discipline is generally a bad idea, and the 1970s showed economists that humility is always a valuable trait.  Has a run of good luck caused a misperception of the risk of losses so that such overconfidence has emerged again?

I think it's safe to say now that it had. As for the Greenspan put, I had always argued there was no such thing, based partly on quotes like this:

Neither Mr. Bernanke nor his closest colleagues, some of whom served under Mr. Greenspan, believe there ever was a "Greenspan put," a reference to a contract that protects an investor from loss. Yet officials acknowledge the perception that the Fed has bailed out investors in the past. When the stock market crashed in 1987, Mr. Greenspan, then on the job for just two months, used aggressive open-market operations -- buying and selling government securities -- to pump banks full of cash...

What's best for the stock market isn't always what's best for the economy, and when there is a tension between the two, the economy should come first. While this is what I *think* Greenspan is saying above by redefining the Greenspan put to mean "stabilizing the system," it's disappointing to see him embrace the term without cautioning that the Fed shouldn't always try to prevent a fall in the stock market, and that it sometimes has to temper a stock market boom, e.g. by raising interest rates to prevent the economy from overheating, or by popping asset bubbles.

"Bernanke And The Shibboleths"

Paul Krugman:

Bernanke And The Shibboleths, by Paul Krugman: Everyone hates quantitative easing. The inflationistas believe that it’s the end of Western civilization (but as a correspondent points out, we want them to believe that; similar beliefs about the end of the gold standard helped recovery in the 1930s); meanwhile, the rest of the world is furious at the Fed’s actions.
Clearly, Bernanke must be doing something right. As Greg Ip says, all the objections currently being offered to QE would apply equally well to conventional monetary policy — and given high US unemployment and sagging inflation, how can you argue that monetary expansion is unjustified?
But what we’re seeing worldwide right now is an inability to think clearly about economics. In particular, the unconventional nature of our situation is making it clear how many people rely not on any model of how the economy works but rather on what the late Paul Samuelson called shibboleths — by which he meant slogans that take the place of hard thinking.
The basic situation of the world economy is simple: we have an excess of desired saving over desired investment, even at a zero interest rate. ...
How did this happen? The answer, mainly, is that over-borrowing in the past has left large parts of the world credit-constrained, forced to deleverage by cutting spending; and even a zero interest rate isn’t enough to persuade the unconstrained players to increase spending by enough to offset these cuts.
Yet interest rates can’t go below zero; which poses a problem. For the world as a whole, savings must equal investment, or, equivalently, spending must equal income. So this incipient excess of savings leads to a depressed world economy, in which income falls to match the amount people are able/willing to spend.
So what can policy do?
1. It can try to achieve negative real interest rates by creating expectations of inflation. ...
2. Alternatively, governments can step in and spend while the private sector won’t.
3. Finally, central banks can try to circumvent the zero lower bound by buying long-term debt. The point here is that we only have zero rates at the short end, and it’s possible, though not certain, that you can get at least some traction by buying those longer-term bonds.
But now that we’re in this situation, VSPs around the world are objecting to all of these possible actions. Inflation targets are horrible because we must have price stability. Fiscal policy is unacceptable because we must have balanced budgets. QE is outrageous because that’s not what central banks are supposed to do.
Notice that in each case the objection is based on a shibboleth. Price stability is treated as an absolute virtue, without any model to explain why. The same with budget balance. And those who are horrified at the idea of expansionary monetary policy have been inventing concepts on the fly to justify their position.
The simple fact is that we have a global excess supply of savings, which is doing terrible things to workers. The reasonable thing is to do something about it; it’s deeply unreasonable, and deeply irresponsible, to invent reasons not to act because you’re clinging to simplistic slogans.

Here's an example of someone worried that QEII will result in uncontrollable inflation. Steven Williamson has trouble being civil -- I suspect it's the frustration from thinking he's built a better theoretical mousetrap yet the world keeps beating a path to someone else's door -- so I'm sure this will bring some response about how stupid I am for not understanding this or that, and how stupid anyone who might disagree with him is. But his objections are hard to understand or, as Krugman predicted, left unexplained.

His first fear is that:

One possibility is that economic growth picks up, of its own accord, reserves become less attractive for the banks, and inflation builds up a head of steam. The Fed may find this difficult to control, or may be unwilling to do so.

If  the economy begins growing so robustly that inflation breaks out, and as posited by Williamson, QEII has nothing to do with that growth ("growth picks up, of its own accord"), why, exactly, would the Fed be reluctant to remove reserves from the system? If the system is overheating due to high rates of growth, what harm will the Fed fear? If adding the reserves didn't stimulate the economy, how will removing them harm it? QEII didn't help, but ending it will harm the economy? I suspect Williamson has an asymmetric loss function of some sort -- creating inflation, or the expectation of it in the future, doesn't stimulate the economy but lowering it does harm -- but we aren't told what that story is. We're simply told the Fed "may find this difficult" or "may be unwilling." There are certainly stories one can tell about the harmful effects of reducing inflation, e.g. a standard Phillips curve model, but what story does he have in mind? I doubt very much that it's the New Keynesian Phillips curve story, but can't really say -- it's hard to evaluate an objection when you aren't told what it is.

(The reason I am saying that Williamson is assuming QEII will do no good at all is that he only identifies costs and objects on that basis. If there are benefits, then they ought to be weighed against the costs if you are doing an economic analysis. But he doesn't do that. That means he either thinks there are no benefits, as I've assumed, or that he is presenting a one-sided, misleading argument based only on costs to make his case.).

His second objection is that:

Even worse is the case where growth remains sluggish, but inflation well in excess of 2% starts to rear its ugly head anyway. Bernanke is telling us that he "has the tools to unwind these policies," but if the inflation rate is at 6% and the unemployment rate is still close to 10%, he will not have the stomach to fight the inflation.

But how does inflation pick up if aggregate demand remains stagnant? If the reserves are simply piling up in banks, how, exactly does the inflation occur? (Does he mean asset price inflation perhaps? Worried about a bubble maybe?). Waving your hands and saying the economy is sluggish, but there's inflation without explaining how that inflation happens is simply assuming the bad results you want. Maybe Williamson has a story in mind about how prices get driven upward without an increase in aggregate demand, and I expect a (less than civil) response detailing this, but we aren't told what that story is.

Williamson's final paragraph says:

My concern here is that, given the specifics of the QE2 policy that was announced, the FOMC will be reluctant to cut back or stop the asset purchases, even if things start looking bad on the inflation front. Once inflation gets going, we know it is painful to stop it...

This completely ignores Bernanke's clear statement that the Fed will reevaluate the program in light of changing economic circumstances. The Press Release announcing the QEII program was very clear about that, and Bernanke made sure to repeat it in his Washington Post editorial the next day. Williamson clearly does not believe the Fed will actually do what it says it will do since he thinks the costs of ending the QEII program prematurely or reversing it would be so large. But, again, what are those costs? To summarize my questions, why is it painful to stop inflation when the economy is overheating due to excessive demand? We're told the Fed may be "reluctant," but why would they be reluctant to temper inflation in an overheating economy? Why would reducing inflation be so harmful in the Fed's eyes in this case? And if the economy is not overheating, if demand remains stagnant, how exactly does the inflation occur to begin with?

Let me add one more thing. This statement made me chuckle:

Predictably, Krugman and this two buddies DeLong and Thoma think the asset purchase program should have been larger.

First, anytime anyone wants to put me in the same group with DeLong and Krugman, that's fine with me, even if it is to claim we're all idiots. I don't mind being told I'm as dumb as those two. If the phrase "Krugman, DeLong, and Thoma" catches on, as opposed to, say, just "Krugman and DeLong," no problem here. But the funny part to me is that in his desire to put the three of us into the same group so he can summarily dismiss two of us as nothing more than Krugman echoes, he seems to have missed that the three of us don't agree on how well QE will work. I guess pointing out that "predictably" we disagree on some aspects of quantitative easing sort of ruins his effort to undermine us, but at least it would be accurate.

Update: Please see my follow-up post on this: Williamson Responds to "Grumpy Thoma".

Friday, November 05, 2010

"An Open Letter to the President"

Michael Perelman:

An Open Letter to the President, by Michael Perelman: This letter was sent to the President, who failed to heed the warning, which turned out to be correct.

You have made yourself the Trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office.

I wish I had the foresight to have written this letter, but it was sent to the new president in 1933. The author was John Maynard Keynes. Although the letter is old, it is absolutely on target in predicting, “If you fail, rational change will be gravely prejudiced throughout the world.”
Wake up Obama before you do more damage by imagining that cooperation with the Right rather than leadership is the way forward.
By the way, in 1938 Keynes also warned the president that because of the 1937 austerity, “the present slump could have been predicted with absolute certainty.” Brad DeLong reprinted that letter.

Here's a shortened version of the letter from the first link above. The letter is organized by numbered points. I found point 18 interesting in light of recent calls to use quantitative easing to bring down the long end of the yield curve. Keynes is talking about changing the average maturity of the Fed's bond holdings by trading short-term for long-term bonds rather than purchasing long-term bonds through an expansion of the Fed's balance sheet, so he isn't calling for quantitative easing. But he does "attach great importance" to movement at the long end of the yield curve. I also found point 8 interesting since World War II -- which came after this letter -- is generally credited with validating Keynes' ideas:

An Open Letter to President Roosevelt
By John Maynard Keynes

Dear Mr President,
1. You have made yourself the Trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office. This is a sufficient reason why I should venture to lay my reflections before you, though under the disadvantages of distance and partial knowledge.
2. At the moment your sympathisers in England are nervous and sometimes despondent. We wonder whether the order of different urgencies is rightly understood...
3. You are engaged on a double task, Recovery and Reform;--recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range Recovery, that you will have the driving force to accomplish long-range Reform. On the other hand, even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place. It may over-task your bureaucratic machine, which the traditional individualism of the United States and the old "spoils system" have left none too strong. And it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once.
4. Now I am not clear, looking back over the last nine months, that the order of urgency between measures of Recovery and measures of Reform has been duly observed, or that the latter has not sometimes been mistaken for the former. ...
5. My second reflection relates to the technique of Recovery itself. The object of recovery is to increase the national output and put more men to work. In the economic system of the modern world, output is primarily produced for sale; and the volume of output depends on the amount of purchasing power... Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out o their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse. ...
8. Thus as the prime mover in the first stage of the technique of recovery I lay overwhelming emphasis on the increase of national purchasing power resulting from governmental expenditure which is financed by Loans and not by taxing present incomes. Nothing else counts in comparison with this. In a ... slump governmental Loan expenditure is the only sure means of securing quickly a rising output at rising prices. That is why a war has always caused intense industrial activity. In the past orthodox finance has regarded a war as the only legitimate excuse for creating employment by governmental expenditure. You, Mr President, having cast off such fetters, are free to engage in the interests of peace and prosperity the technique which hitherto has only been allowed to serve the purposes of war and destruction. ...
10. I am not surprised that so little has been spent up-to-date. Our own experience has shown how difficult it is to improvise useful Loan-expenditures at short notice. There are many obstacle to be patiently overcome, if waste, inefficiency and corruption are to be avoided. There are many factors, which I need not stop to enumerate, which render especially difficult in the United States the rapid improvisation of a vast programme of public works. I do not blame Mr Ickes for being cautious and careful. But the risks of less speed must be weighed against those of more haste. He must get across the crevasses before it is dark.
11. The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the Quantity Theory of Money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor. ...
15. If you were to ask me what I would suggest in concrete terms for the immediate future, I would reply thus.
16. In the field of gold-devaluation and exchange policy the time has come when uncertainty should be ended. ...
17. In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months. ... You can at least feel sure that the country will be better enriched by such projects than by the involuntary idleness of millions.
18. I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest. The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term Government Bonds to 2½ per cent or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.
19. With these adaptations or enlargements of your existing policies, I should expect a successful outcome with great confidence. How much that would mean, not only to the material prosperity of the United States and the whole World, but in comfort to men's minds through a restoration of their faith in the wisdom and the power of Government!

With great respect,

Your obedient servant
J M Keynes

Thursday, November 04, 2010

Bernanke: What the Fed Did and Why

In the discussion earlier today of the Fed's announcement that it intends to purchase $600 billion in government bonds, I used the term "communications strategy" to describe some of the language in the Press Release. The language in the Press Release does attempt to communicate a commitment from the Fed to meet its inflation and employment targets, but the term "communications strategy" implies something beyond what the Fed announced it is doing (see here for a discussion). Using the term implies the Fed is taking bolder steps than it is actually taking.

The purchase should be much larger, and it should involve longer term Treasury securities (the plan is for 5 to 6 year bonds). The language in the Press Release about maintaining stable expectations is also disappointing to those who have been advocating a higher inflation target. This is not, by any means, a bold plan.

That's unlikely to change. Even if the economy continues to struggle, it's hard to imagine the Fed doing anything more than moving at a "measured pace," a pace too slow to do much except chip away at the margins.

With fiscal policy out the window and a timid, tip-toeing Fed, we're likely headed for an agonizingly slow recovery.

Here's Ben Bernanke's explanation of the Fed's policy and the reasoning behind it:

What the Fed did and why: supporting the recovery and sustaining price stability, by Ben S. Bernanke, Commentary, Washington Post: ...The Federal Reserve's objectives - its dual mandate, set by Congress - are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.
Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. ...
The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. ...
While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.
Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.
Our earlier use of this policy approach had little effect on ... broad measures of the money supply... Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.
The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.

Wednesday, November 03, 2010

The Fed Will Purchase $600 Billion in Treasury Securities

The Federal Reserve has decided to purchase $600 billion in Treasury securities through the end of the second quarter of 2011. As they note, this is around $75 billion per month. That is not enough to do much by itself (update: see here on this point), but this is an important addition to the policy:

The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed

The intent is to communicate a commitment to do whatever is necessary to hit inflation and employment targets, and the commitment is intended to impact expectations and hence impact expected inflation and real interest rates. The statement that we should expect "exceptionally low levels for the federal funds rate for an extended period" is part of this communications strategy.

As I've said many times, I'm skeptical about this doing much, but it could help some -- though a higher level of purchases each month would have been much better (update: and the bonds should be of longer duration than the 5-6 years bonds the Fed is planning to purchase). But with fiscal policy all but off the table, with tax cuts being the possible exception, it's the best we can hope for right now.

Here's the entire statement:

Press Release, November 3, 2010, For immediate release: Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate. 
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.
Voting against the policy was Thomas M. Hoenig. Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy. [Statement from Federal Reserve Bank of New York]

Also posted at MoneyWatch.

Update: I may not have been clear enough -- I agree with this assessment.

Monday, November 01, 2010

Will QEII Work?

As a follow up to the post below this one on whether QEII will work, here's Paul Krugman:

If I Were King Bernanke, by Paul Krugman: I’ve been asked by various people what I would do if I were Bernanke, and/or if I were in charge of the Fed. Those aren’t the same thing: Ben Bernanke isn’t a dictator, and the evidence suggests that he’d be substantially more aggressive in both his actions and his rhetoric if he weren’t constrained by the need to bring his colleagues with him.
So I don’t know what I’d do in his place. What I’d do if I were really in charge of the Fed, however, is the same thing I advocated for Japan way back when: announce a fairly high inflation target over an extended period, and commit to meeting that target.
What am I talking about? Something like a commitment to achieve 5 percent annual inflation over the next 5 years — or, perhaps better, to hit a price level 28 percent higher at the end of 2015 than the level today. (Compounding) Crucially, this target would have to be non-contingent — not something you’ll call off if the economy recovers. Why? Because the point is to move expectations, and that means locking in the price rise whatever happens.
It’s also crucial to understand that a half-hearted version of this policy won’t work. If you say, well, 5 percent sounds like a lot, maybe let’s just shoot for 2.5, you wouldn’t reduce real rates enough to get to full employment even if people believed you — and because you wouldn’t hit full employment, you wouldn’t manage to deliver the inflation, so people won’t believe you. Similarly, targeting nominal GDP growth at some normal rate won’t work — you have to get people to believe in a period of way above normal price and GDP growth, or the whole thing falls flat.
As I wrote way back, the Fed needs to credibly promise to be irresponsible — at least from the point of view of the VSPs.
The sad truth, of course, is that the chance of actually getting anything like this are no better than those of getting an adequate fiscal stimulus — at least for now. QE as currently contemplated is mild mitigation at best. What one has to hope is that as the reality that we’re in a liquidity trap sinks in (amazing how long that’s taking), as the fact that we’re doing worse than Japan starts to finally penetrate our arrogance, we’ll eventually get there. But it’s not going to happen this month.

Donald Kohn, who knows more than a little about the inside workings of the Fed, has something to say about whether the Fed is willing to promise to be irresponsible. He says the Fed is not about to let inflation get out of control, or even rise much:

The DNA of the FOMC [Federal Open Market Committee] is very focused on preventing a rise in inflation and inflation expectations that would be bad for the economy. I’m not worried about inflation getting out of control. Even if [the Fed] waits too long [to raise interest rates] when the time comes, they’ll be very alert and if necessary they’ll tighten up faster than they would have.

How is this policy going to generate an increase in expected inflation to the degree that is needed?

QEII: Even if Real Rates Fall and Expected Inflation Increases, Will Firms and Households be Induced to Increase Consumption and Investment?

It seems to me that everyone fighting today over whether QEII will work are worried about whether the Fed can affect real rates, but are forgetting about the second step in the process. Once real rates rates fall, firms and households then have to be induced to borrow more, then consume or invest (I'm including the response to expected inflation in this). Even if we manage to change real rates, and I have never quarreled with the Fed's ability to do this (though the extent depends upon their ability to affect expectations), why do people think it will bring about a strong consumption and investment response in the current environment? As Paul Krugman notes today, firms are already sitting on mountains of low opportunity cash and they aren't investing, and loans to consumers are already pretty cheap and they aren't increasing their consumption [Update: Or maybe you are hoping for a boom in exports as other countries allow the dollar to depreciate against their currency?]. Can the Fed create a enough expected of inflation (which it would have to validate later, or it will lose credibility and this will never work again) to change the behavior of firms and consumers enough to really matter?

The Stagnation Regime of the New Keynesian Model and Current US Policy

My colleague George Evans has an interesting new paper. He shows that when there is downward wage rigidity, the "asymmetric adjustment costs" referenced below, the economy can get stuck in a zone of stagnation. Escaping from the stagnation trap requires a change in government spending or some other shock of sufficient size. If the change in government spending is large enough, the economy will return to full employment. But if the shock to government spending is below the required threshold (as the stimulus package may very well have been), the economy will remain trapped in the stagnation regime.

(I also highly recommend section 4 on policy implications, which I have included on the continuation page. It discusses fiscal policy options, quantitiative easing, how to help to state and local governments, and other policies that could help to get us out of the stagnation regime):

The Stagnation Regime of the New Keynesian Model and Current US Policy, by George Evans: 1 Introduction The economic experiences of 2008-10 have highlighted the issue of appropriate macroeconomic policy in deep recessions. A particular concern is what macroeconomic policies should be used when slow growth and high unemployment persist even after the monetary policy interest rate instrument has been at or close to the zero net interest rate lower bound for a sustained period of time. In Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010), using a New Keynesian model with learning, we argued that if the economy is subject to a large negative expectational shock, such as plausibly arose in response to the financial crisis of 2008-9, then it may be necessary, in order to return the economy to the targeted steady state, to supplement monetary policy with fiscal policy, in particular with temporary increases in government spending.
The importance of expectations in generating a “liquidity trap” at the zero-lower bound is now widely understood. For example, Benhabib, Schmitt-Grohe, and Uribe (2001b), Benhabib, Schmitt-Grohe, and Uribe (2001a) show the possibility of multiple equilibria under perfect foresight, with a continuum of paths to an unintended low or negative inflation steady state.[1] Recently, Bullard (2010) has argued that data from Japan and the US over 2002-2010 suggest that we should take seriously the possibility that “the US economy may become enmeshed in a Japanese-style deflationary outcome within the next several years.”
The learning approach provides a perspective on this issue that is quite different from the rational expectations results.[2] As shown in Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010), when expectations are formed using adaptive learning, the targeted steady state is locally stable under standard policy, but it is not globally stable. However, the potential problem is not convergence to the deflation steady state, but instead unstable trajectories. The danger is that sufficiently pessimistic expectations of future inflation, output and consumption can become self-reinforcing, leading to a deflationary process accompanied by declining inflation and output. These unstable paths arise when expectations are pessimistic enough to fall into what we call the “deflation trap.” Thus, while in Bullard (2010) the local stability results of the learning approach to expectations is characterized as one of the forms of denial of “the peril,” the learning perspective is actually more alarmist in that it takes seriously these divergent paths.
As we showed in Evans, Guse, and Honkapohja (2008), in this deflation trap region aggressive monetary policy, i.e. immediate reductions on interest rates to close to zero, will in some cases avoid the deflationary spiral and return the economy to the intended steady state. However, if the pessimistic expectation shock is too large then temporary increases in government spending may be needed. The policy response in the US, UK and Europe has to some extent followed the policies advocated in Evans, Guse, and Honkapohja (2008). Monetary policy has been quick, decisive and aggressive, with, for example, the US federal funds rate reduced to near zero levels by the end of 2008. In the US, in addition to a variety of less conventional interventions in the financial markets by the Treasury and the Federal Reserve, including the TARP measures in late 2008 and a large scale expansion of the Fed balance sheet designed to stabilize the banking system, there was the $727 billion ARRA stimulus package passed in February 2009.
While the US economy has stabilized, the recovery has to date been weak and the unemployment rate has been both very high and roughly constant for about one year. At the same time, although inflation is low, and hovering on the brink of deflation, we have not seen the economy recording large and increasing deflation rates.[3] From the viewpoint of Evans, Guse, and Honkapohja (2008), various interpretations of the data are possible, depending on one’s view of the severity of the initial negative expectations shock and the strength of the monetary and fiscal policy impacts. However, since recent US (and Japanese) data may also consistent with convergence to a deflation steady state, it is worth revisiting the issue of whether this outcome can in some circumstances arise under learning.
In this paper I develop a modification of the model of Evans, Guse, and Honkapohja (2008) that generates a new outcome under adaptive learning. Introducing asymmetric adjustment costs into the Rotemberg model of price setting leads to the possibility of convergence to a stagnation regime following a large pessimistic shock. In the stagnation regime, inflation is trapped at a low steady deflation level, consistent with zero net interest rates, and there is a continuum of consumption and output levels that may emerge. Thus, once again, the learning approach raises the alarm concerning the evolution of the economy when faced with a large shock, since the outcome may be persistently inefficiently low levels of output. This is in contrast to the rational expectations approach of Benhabib, Schmitt-Grohe, and Uribe (2001b), in which the deflation steady state has output levels that are not greatly different from the targeted steady state.
In the stagnation regime, fiscal policy, taking the form of temporary increases in government spending, is important as a policy tool. Increased government spending raises output, but leaves the economy within the stagnation regime until raised to the point at which a critical level of output is reached. Once output exceeds the critical level, the usual stabilizing mechanisms of the economy resume, pushing consumption, output and inflation back to the targeted steady state, and permitting a scaling back of government expenditure.

Here is the section on policy options recommended above (it is relatively non-technical):

Continue reading "The Stagnation Regime of the New Keynesian Model and Current US Policy" »

Friday, October 29, 2010

"Friedman was All Wrong about Japan ... and the Great Depression"

As I've noted before, one thing I've learned from this recession is that it's not as easy to increase the money supply as I thought. It's easy to create additional bank reserves and increase the monetary base, but if the new reserves simply pile up in the banking system, then they don't have much of an effect on the supply of money:

More On Friedman/Japan, by Paul Krugman: ...So: David Wessel quoted what Milton Friedman said about Japan in 1998, and interpreted it as meaning that Friedman would favor quantitative easing now. I think that’s right. And just to be clear, I also favor QE — largely because it might help some, and seems to be just about the only policy lever still available in the face of political reality.

But I think it’s also important to note that Friedman was all wrong about Japan — and that you can argue that he was also wrong about the Great Depression, for the same reason.

For what Friedman argued, both for Japan in the 1990s and America in the 1930s, was that all the central bank needed to do was more — push out those reserves into the banking system. This would raise the money supply, and a higher money supply would have the usual effects.

But the Bank of Japan tried that — and found that pushing more reserves into the banks didn’t even lead to rapid growth in the money supply, let alone end the problem of deflation. Here’s a chart of growth rates of the monetary base and of M2, Friedman’s preferred monetary aggregate:

DESCRIPTION
Bank of Japan

So, after 2000 the Bank of Japan engineered a huge increase in the monetary base; this was the original quantitative easing. And it didn’t even translate into a surge in the money supply! This is why I’m so skeptical of people who say that all the Fed has to do is target higher nominal GDP growth — in liquidity trap conditions, the Fed doesn’t even control money, so how can you blithely assume that it controls GDP?

And this also calls very much into question Friedman’s famous claim that the Fed could easily have prevented the Depression, which gradually got transmuted into the claim that the Fed caused the Depression. Yes, M2 fell — but why should we believe that the Fed had any more control over M2 in the 30s than the BOJ had over M2 more recently?

Again, that doesn’t mean that I oppose having the Fed engage in unconventional asset purchases. I’m just trying to be realistic about the likely results. We really, really need expansionary fiscal policy along with Fed policy; and we’re not going to get it.

Wednesday, October 27, 2010

Fed Watch: Too Little

Sudeep Reddy reports on the Fed's plans for another round of quantitative easing:

The Federal Reserve is likely to announce a new bond-buying program next week structured around smaller purchases that can be adjusted over time, rather than the shock-and-awe approach it employed in 2009. It’s a cautious strategy that considers the uncertainty around both the pace of the recovery and the costs of embarking on another round of purchases.

He also notes that an old speech from Bernanke helps us to understand why the Fed is adopting a gradual approach:

...Then he [Bernanke] gets into miniature golf:
“Imagine that you are playing in a miniature golf tournament and are leading on the final hole. You expect to win the tournament so long as you can finish the hole in a moderate number of strokes. However, for reasons I won’t try to explain, you find yourself playing with an unfamiliar putter and hence are uncertain about how far a stroke of given force will send the ball. How should you play to maximize your chances of winning the tournament?
“Some reflection should convince you that the best strategy in this situation is to be conservative. In particular, your uncertainty about the response of the ball to your putter implies that you should strike the ball less firmly than you would if you knew precisely how the ball would react to the unfamiliar putter. This conservative approach may well lead your first shot to lie short of the hole. However, this cost is offset by the important benefit of guarding against the risk that the putter is livelier than you expect, so lively that your normal stroke could send the ball well past the cup. Since you expect to win the tournament if you avoid a disastrously bad shot, you approach the hole in a series of short putts (what golf aficionados tell me are called lagged putts). Gradualism in action!”
Bernanke tends to spend much of his free time watching baseball, not golf, so give him some credit for this one

But is gradualism always best? If the putt is up a steep hill and the flag is just over the crest, and there is a large flat spot behind it, gradualism is the wrong approach. In this case, you'd want to be sure to clear the crest of the hill. There's still a sense in which you would play conservatively, especially after clearing the hill, but the point is that the first shot should guard against undershooting. The putter may be deader than you expect, and to guard against this you'd want to give the putt a little extra force so as to be sure to clear the hill. If the putter turns out to be lively instead of dead and you overshoot, that's still better than an outcome where the ball rolls all the way back down the hill and you have to try it all over again.

This has come up before. As I noted in January 2009 during the debate over the size of the fiscal stimulus package:

the stimulus package is like driving up an icy hill. If you don't have enough momentum from the start and fail to provide enough "stimulus" to get the car over the crest of the hill, you can slide all the way back to the bottom, crashing into things along the way and end up worse off than when you started. Maybe you can give it more gas along the way if needed without spinning out, and perhaps you can hold your position if you don't make it to the top, and then start again from the higher level. But that's not a chance I want to take when I'm sitting at the bottom wondering if I can make it to the top without wrecking my car. The possibility of falling all the way back to the bottom and ending up worse off would make me want to start with sufficient momentum and then some.

Gradualism is not always the best approach (even in miniature golf). As Paul Krugman said recently in response to a Bernanke speech indicating that the Fed is likely to be cautious in implementing unconventional policies such as quantitative easing, "half-hearted measures are a good way of guaranteeing that unconventional policy fails."

A defense of the gradualist approach comes from Jim Bullard, president of the St. Louis Fed, in an email responding to Tim Duy's opposition to a "disciplined" QE program:

...on the "disciplined" QE program: The quote from Vince Reinhart, who is a great guy, gives the "shock and awe" view of QE. I do not think this is remotely correct. We know how monetary policy works: through the expected future path of policy, not through the actual move on a particular day. When we make 25 basis point moves on the federal funds rate, those are small viewed in isolation, but they have important effects for macroeconomic stabilization because they imply an expected interest rate path over the coming years. The same is true for QE. A move on a particular day may seem small, but it implies a path for future policy, and a series of smaller moves may add up to a very large move if the incoming data are consistent with such an outcome. The "shock and awe" view, if applied to interest rate targeting, would suggest very large interest rate movements in response to relatively small changes in incoming data, a policy that most would view as destabilizing for the macroeconomy. The same is true for QE. So the point is that QE moves should be commensurate with the incoming data (a.k.a. "state contingent"). Of course we can argue about the incoming data--and I know you have strong views on that--but I think my position on a "disciplined" QE program is correct and that the dangerous policy is to make destabilizing moves out of line with the incoming data.

Here's the Reinhart quote Bullard refers to:

I think Chairman Bernanke probably disagrees [that the Fed is out of ammunition] on two main counts. One is there's still communication. The Fed could convey they're going to keep interest rates low for a very long time. They've probably done as much as they can on that front. They maybe could do a little bit more. But that leads to one other option, which is buying stuff, buying Treasury securities. Now, Alan Binder I think, believes that that effect isn't that great, but the way you get around that is to buy in very large volume..., it will have to do very large purchases of Treasury securities.

And here's Tim Duy's latest Fed Watch, which addresses this issue:

Too Little, by Tim Duy: Federal Reserve policymakers must be pleased with themselves. Market participants have fallen in line like lemmings off a cliff pursuing the obvious trades as the excitement over quantitative easing builds. Equities, bonds, commodities are all up. Dollar is down. Perhaps more importantly, measured inflation expectations have trended higher. Psychology is a powerful thing. Like leverage.

But like leverage, psychology can turn against you. The psychology of market participants forms on the back of expectations, which in this case is for the Fed to announce a significant expansion of the balance sheet on November 3. If the Wall Street Journal is correct, the Fed is poised to disappoint those expectations with an announcement of "a few billion dollars over several months." This looks like a clear effort to temper expectations.

How can Federal Reserve Chairman Ben Bernanke not view this as anything but yet another major policy error? The first supposedly "shock and awe" balance sheet expansion failed to reflate the economy. What kind of expectations should we have for the "shock and disappoint" strategy? And the stakes are even greater. Market participants already dutifully followed the first reflation attempt, and have eagerly embraced the second. Just exactly how many bites at the apple does Bernanke expect he is going to get? Fool me once….

Moreover, the Fed's communication strategy will almost certainly become more muddled in future months. A reminder from the Wall Street Journal:

In the next few months, internal opposition to Mr. Bernanke's approach could intensify as presidents of three regional Fed banks who have expressed skepticism about the plan—Narayana Kocherlakota of Minneapolis, Richard Fisher of Dallas and Charles Plosser of Philadelphia—take voting positions on the Fed's policy-making body.

To be sure, Fed policymakers will argue that they are trying to preserve flexibility. Why is it that "flexibility" means the ability to scale up? Why can't "flexibility" mean the ability to scale down? Seriously, it is not as if the Fed is in any danger of hitting either of the objectives in the dual mandate anytime soon. And does Bernanke really believe that it will be any easier to offer a credible commitment to scale up once Dallas Federal Reserve Chairman Richard Fisher is a voting member of the FOMC?

And to what extent does a smaller than anticipated QE reflect a concern about a precipitous fall in the Dollar? Is this part of the G20 "agreement" to end currency battles? Taking currency effects off the table will greatly reduce the effectiveness of any QE strategy. Does Bernanke expect to win this battle on expectations alone, without actually having to live up to those expectations?

Bottom Line: Right now, I have more questions than answers. The US economy is operating below potential to the tune of about a trillion dollars give or take. The Obama Administration is poised to turn its attention to deficit reduction, seemingly oblivious to the historical errors of Japanese fiscal policy, not to mention the US experience in the Great Depression. For better or worse, that leaves monetary policy to bear the burden. But the Federal Reserve is signaling they are poised to deliver far less than necessary to meet expectations, expectations that already were likely overly optimistic. Truly, it boggles the mind, and suggests that Bernanke is far more worried about the specter of inflation than the real pain of unemployment.

Tuesday, October 26, 2010

The Dangers of Gridlock in Economic Policy

At MoneyWatch, I have a new post:

The Dangers of Gridlock in Economic Policy

It gives three reasons to worry if Republicans make significant gains in the midterm elections.

How Quantitative Easing Can Help State and Local Governments

I have a new column explaining how quantitative easing can help state and local governments:

Stimulus from the Fed Can Yield a High Return to Taxpayers

The column also discusses how the federal government might be be induced to give state and local governments help in solving their budget problems.

Tuesday, October 19, 2010

Stiglitz: It is Folly to Place All our Trust in the Fed

Since I've been making similar arguments, I can hardly disagree:

It is folly to place all our trust in the Fed, by Joseph Stiglitz, Commentary, Financial Times: In certain circles, it has become fashionable to argue that monetary policy is a superior instrument to fiscal policy – more predictable, faster, without the adverse long-term consequences brought on by greater indebtedness. Indeed, some advocates wax so enthusiastic that they support recent drives for austerity in many European countries, arguing that if there are untoward effects they can be undone by monetary policy. Whatever the merits of this position in general, it is nonsense in current economic circumstances. ...
It should be obvious that monetary policy has not worked to get the economy out of its current doldrums. The best that can be said is that it prevented matters from getting worse. So monetary authorities have turned to quantitative easing. Even most advocates of monetary policy agree the impact of this is uncertain. ...
By contrast, if we extend unemployment benefits we know, not perfectly but with some degree of precision, how much of that money will be spent. Doubters of the effectiveness of fiscal policy worry that such spending will simply crowd out other spending, as government borrowing forces interest rates up. There may be times when such crowding out occurs – but this is not one. ... (There are other, even less convincing arguments: that taxpayers offset future liabilities by reducing consumption. It would have been nice if this had happened when the Bush tax cuts of 2001 and 2003 were enacted; instead, the savings rate fell ever lower until it reached zero.)
A final argument invoked by critics of fiscal policy is that it is unfair to future generations. But monetary policy can have intergenerational effects every bit as bad. There are many countries where loose monetary policy has stimulated the economy through debt-financed consumption. This is ... how monetary policy “worked” in the past decade in the US. By contrast, fiscal policy can be targeted on investments in education, technology and infrastructure. Even if government debt is increased, the assets on the other side of the balance sheet are increased commensurately. Indeed, the historical record makes clear that returns on these investments far, far exceed the government’s cost of capital. ...

Monday, October 18, 2010

Mary Daly of the SF Fed: We are at Risk of a Long period of Sustained Disinflation

Mary Daly, vice president at the Federal Reserve Bank of San Francisco, gives her views on the economy. The outlook presents a strong case for another round of quantitative easing, and whatever other help we can give the economy.

Would the help be effective? That is, is the unemployment problem mainly structural and hence hard to change, or is there a large cyclical component that policy can address? She notes that "Even if structural unemployment has increased, the unemployment rate is still far above the highest survey estimate of the natural rate," implying that a substantial cyclical component to unemployment is present:

Frbsf--01

Fed Views, by Mary Daly, FRBSF: On September 20, the National Bureau of Economic Research's Business Cycle Dating Committee officially called an end to the recession. It will go into the history books as the longest and deepest downturn since the Great Depression. The recession officially lasted 18 months from December 2007 to June 2009. Over that time, the U.S. economy shed 7.3 million jobs, GDP fell by 4.1%, and household net worth declined by 21%.

Frbsf--02

Despite the official announcement, the public thinks the recession is ongoing. According to a CNN/Opinion Research Corporation Poll in September, more than 70% of those surveyed thought the U.S. economy was still in a recession.
One reason for that view is that the economic recovery is proceeding at a very slow pace and has lost momentum since the spring. The effects of this downshift are visible in consumer confidence, which has fallen from earlier in the year.

Frbsf--03

The September jobs report highlights one of the difficulties—the reluctance of businesses to add jobs. Payroll employment declined by 95,000 as large cuts in government staffing levels more than offset modest private job gains.

Frbsf--04

Sluggish job growth left the unemployment rate for September unchanged at 9.6%. Data on initial claims for unemployment insurance also have remained elevated, suggesting that the pace of layoffs has yet to return to a level consistent with a solid recovery.
With consumer confidence low, labor markets weak, and households still working to trim debt and boost savings, consumption growth remains modest. Federal Reserve Bank of San Francisco business contacts say retailers are working to keep inventories lean in anticipation of continued modest consumption growth going forward.

Frbsf--05

Data on housing continues to disappoint. Despite low mortgage interest rates, housing markets have shown little ability to move forward now that the federal first-time homebuyer tax credit has expired. With continued weakness in home sales and prices, residential building remains virtually nonexistent.
Business investment remains a bright spot, although the pace of expansion in this category appears to be slowing. The Institute for Supply Management purchasing managers index suggests that the manufacturing sector is expanding. That said, the index has been falling in recent months, indicating a less robust pace of expansion than earlier in the year.

Frbsf--06

Consistent with the disappointing data, we have marked down our GDP forecast for the remainder of 2010 and 2011. We currently project that real GDP will expand around 2½% in 2010, below its potential of about 3% annually. We expect the recovery to gain momentum over the course of next year and that real GDP growth for 2011 will reach about 3½%.

Frbsf--07

One reason for our more modest outlook is that no sector of the private economy stands ready to drive a robust recovery. As federal fiscal stimulus wanes and state and local government cutbacks accelerate, the private sector has failed to pick up the slack. With only modest gains in private economic activity, the overall pace of growth has slowed.

Frbsf--08

The slow pace of growth projected over the forecast horizon suggests it will take a long time to return to normal. Based on our forecasts of real GDP growth and our estimates of potential GDP, we project that considerable economic slack, known technically as an output gap, will remain at least into 2013.

Frbsf--09

With this sizeable output gap hanging over the economy, we expect both core and headline inflation to be restrained for some time. We project personal consumption expenditures (PCE) inflation to be around 1% in 2011 and 2012.
The September 21, 2010, Federal Open Market Committee (FOMC) statement noted: "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability." This was a stronger statement on the Federal Reserve's dual mandate than had previously been made.

Frbsf--10

To understand what the Committee was referring to when it said it was failing to achieve its mandates—maximum sustainable employment and price stability—it is useful to look at the unemployment rate relative to its natural rate and core inflation relative to the preferred range cited by Committee members.
The Survey of Professional Forecasters places the natural rate of unemployment—the lowest sustainable rate consistent with stable inflation—between 5% and 6.75%. The higher values and increased range of estimates for this rate, often called the non-accelerating inflation rate of unemployment (NAIRU), since the recession began reflect the view that there has been an increase in structural unemployment caused by skill or geographical mismatches between workers and available jobs. Even if structural unemployment has increased, the unemployment rate is still far above the highest survey estimate of the natural rate. This implies there is a way to go before achieving maximum employment.

Frbsf--11

Relative to the preferred level of inflation among FOMC members, as reflected in their calculations from the June 2010 FOMC forecasts of the central tendency of the long-run level of inflation under appropriate monetary policy, core PCE inflation is running low. This low level of inflation, combined with the sluggish GDP forecast and large amount of slack in the economy, suggests that further disinflation is possible.

Frbsf--12

Japan's experience beginning in the early 1990s underscores the risk of getting into a long period of sustained disinflation. Japan fell into deflation in the mid-1990s and has yet to recover.

The Fed should have had a new policy in place long ago instead of waiting for the election to be over before altering course. But it does finally seem to be headed in the right direction. The question now is whether the additional quatitative easing will be "shock and awe" or "gradualism," and what type of assets the Fed will purchase. I expect the Fed will be its usual overly cautious self and choose gradualism, and it will only purchase very safe assets, i.e. Treasury bills or mortgage backed securities insured by Fannie and Freddie. It will be better than nothing, but not by a wide margin.

Sunday, October 17, 2010

"Brad Delong and Mark Thoma Do Not Like the Communications Vehicle"

Just a brief response to this. I haven't argued that the Fed is powerless to affect long-term real interest rates. I think the Fed can lower rates through quantitative easing, though I don't think the effect will be large.

My doubts are about how much people and firms will respond to lower interest rates, i.e. whether they will increase consumption and investment in response. For example, firms are already sitting on piles of cash they aren't spending, and it's just not clear to me that a small downward tick in real rates will motivate them to buy a new delivery truck or build a new factory.

I also think that all of the focus on the Fed has led people to believe the Fed has more power to affect the economy than it actually has right now. Expectations for monetary policy are too high, and it lets fiscal policy authorities -- who actually have the ability to provide significant help the economy -- off the hook. Yes, it's probably true that Congress wouldn't have done anything further even if the administration and its allies had put more pressure on Congress. But we should be making it absolutely clear that monetary policy is a second best alternative right now, our expectations for it shouldn't be overly inflated, and we are turning to the Fed only because Congress has fallen down on the job.

Given the size of the problem we face, and the uncertainties over how effective any type of policy will be, we need both monetary and fiscal policy authorities working together to try to give the economy the lift it needs. Unfortunately, Republicans and a few misguided Democrats have taken further fiscal action off the table, and monetary policy is the only hope we have left, however meager that hope might be.

Friday, October 15, 2010

Bernanke’s Speech: How Does Quantitative Easing Work? Will It Work?

I agree with Brad DeLong's reaction to Ben Bernanke's speech:

Ben Bernanke's Speech Was... Disappointing, by Brad DeLong: I am still surprised at the Fed Chair we have. Where is the Fed Chair who was willing to try to get ahead of the problems in late 2008? Or the "Helicopter Ben" of 2003? Or the student of big downturns in Japan in the 1990s and the U.S. in the 1930s.
It's a very different animal we have today. And this speech didn't do much to convince me that he is going to do what ought to be done.
Bernanke forecasts that growth next year "seems unlikely to be much above its longer-term trend"--that is, that unemployment is likely to rise in the near term and then stay essentially stable through the end of 2011 before it even starts to think about heading down.
In this environment, now is not the time for Bernanke to talk about the costs and risks of expanding the Federal Reserve balance sheet.
And it is also not the time to talk about how monetary policy can be carried out via the Federal Reserve's communications strategy.

Since I have been fairly skeptical of how much this can help the economy --  don't expect it to have a large impact on its own -- let me outline the channels through which this might work:

1. By reducing the quantity of financial assets trading in the private sector, the Fed can lower the rate of return on these assets (which is the same as raising the price of the assets since the price of a financial asset and the interest return are inversely related). The fall in the interest rate creates an incentive for more investment and more consumption of durables, which in turn increases o0utput and employment.

2. Quantitative easing may increase expected inflation. The increase in expected inflation lowers the real interest rate (the real interest rate = nominal interest rate - the expecte4d rate of inflation). The fall in the real interest rate would have the effects outlined above, i.e. create an incentive for more investment and consumption of durables, which then spurs output and employment.

3. The increase in the price of the financial asset due to the inverse relationship between the price and the rate of return noted above. This makes people feel wealthier, and the wealth effect can spur more spending generating an increase in output and employment.

4. The Fed can also lower the risk premia on financial assets, which is another way of lowering the interest rate. Though I don't expect them to do this, the Fed could buy highly risky private sector financial assets, thereby moving them off private sector balance sheets and onto the government's. With fewer risky assets in the marketplace, average risk falls driving down interest rates, and that would, once again, have the effects on consumption, investment, output, and employment described above.

5. [update] It can also cause the dollar to weaken, i.e. change the exchange rate, which would encourage exports and discourage imports (though this assumes that other countries don't respond and offset the fall in the exchange rate).

As I said many times, I don't expect any of these to have particularly powerful effects, they create incentives for businesses and consumers to increase spending, but there's no guarantee that they will act on those incentives given the negative outlook for the economy (so fiscal policy authorities should not assume that the Fed "has this"). Again, as I've said before, you can lead the horse to low interest rate water, but there's no guarantee it will drink consumption and investment. In addition, as Brad notes, it's not clear that the size of the quantitative easing will be sufficient. However, in combination the factors listed above could, perhaps, be helpful. It's certainly better than doing nothing.

[Dual posted at MoneyWatch.]

Tuesday, October 12, 2010

Eichengreen and Irwin: How to Prevent a Currency War

Eichengreen and Irwin say aggressive domestic monetary policy is the key to avoiding a trade war:

How to Prevent a Currency War, by Barry Eichengreen and Douglas Irwin, Commentary, Vox EU: Three years into the financial crisis, one might think that the world could put Great Depression analogies behind it. But they are back, and with more force than ever. Now the fear is that currency warfare, leading to tariffs and retaliation, could cause disruptions to the international trading system as serious as those of the 1930’s.
There’s good reason to worry, for the experience of the 1930’s suggests that exchange-rate disputes can be even more dangerous than deep slumps in terms of generating protectionist pressures. ...
In the 1930’s, the countries that raised their tariffs and tightened their quotas the most were those with the least ability to manage their exchange rates – namely, countries that remained on the gold standard. ... But trade restrictions were a poor substitute for domestic reflationary measures, as they did little to arrest the downward spiral of output and prices. They did nothing to stabilize rickety banking systems. By contrast, countries that loosened monetary policies and reflated not only stabilized their financial systems more effectively and recovered faster, but also avoided the toxic protectionism of the day.
Today, the United States is in the position of the gold-standard countries in the 1930’s. It can’t unilaterally adjust the level of the dollar against the Chinese renminbi. Employment growth continues to disappoint, and fears of deflation will not go away. Lacking other instruments with which to address these problems, the pressure for a protectionist response is growing.
So what can be done to address the situation without getting into a beggar-thy-neighbor, retaliatory free-for-all? In the deflationary 1930’s, the most important way that countries could subdue protectionist pressure was to use monetary policy actively to push up the price level and stimulate economic recovery. The same is true today. If fears of deflation were to recede, and if output and employment were to grow more vigorously, the pressure for a protectionist response would dissipate.
The villain..., then, is not China, but the US Federal Reserve Board, which has been reluctant to use all the tools at its disposal...
Of course, with China pegging the renminbi to the dollar, the Fed would, in effect, be reflating not just the US but also the Chinese economy. ... China might not be happy with the result. Inflation there is already too high for comfort. Fortunately, the Chinese government has a ready solution to this problem: that’s right, it can let its currency appreciate.

Monday, October 11, 2010

Woodford: Bernanke Needs Inflation for QE2 to Set Sail

Michael Woodford is calling for the Fed to create the expectation of more inflation by clarifying its exit strategy and making it clear it has no immediate plans to tighten policy even if inflation rises above the target rate:

Bernanke needs inflation for QE2 to set sail, by By Michael Woodford, Commentary, Financial Times: Debate is raging within the Federal Reserve about whether to do more to stimulate the US economy. ...Ben Bernanke ... knows that a cut in rates, his usual tool, is currently infeasible. Therefore, speculation has turned to a return to quantitative easing (QE2), or large purchases of long-term Treasury bonds.
This would be a dramatic move. But we must not kid ourselves. It would have at best a modest effect in a large, liquid market such as Treasury bonds and, therefore, is unlikely to dig the US economy out of its current hole. There is, however, another option: for the Fed to clarify its “exit strategy”... This would mean making clear that the Fed has no plans to tighten policy through increases in the federal funds rate, even if inflation temporarily exceeds the rate regarded as consistent with the Fed’s mandate. In short, the Fed should allow a one-time-only inflation increase, with a plan to control it once the target level of prices has been reached.
Such a move would be controversial within the Fed. But such a statement would merely be designed to help reduce expectations regarding ... the path of short-term interest rates over the next few years and to increase the expected rate of inflation. Changes in these expectations would stimulate current spending..., giving the US economy a much-needed boost.
This proposal is different from that made in some quarters (and rejected by Fed officials) for an increase in the Fed’s inflation target. In order to obtain the benefits just cited, it is not necessary to make people expect a continuing high rate of inflation. Indeed, that would be counterproductive. ... Instead,... the Fed should commit to make up for current “inflation shortfalls” due to its inability to cut interest rates. ... Once the shortfall has been made up, the Fed would return to its previous, lower target.
Critics will say this will undermine the Fed’s credibility on price stability. They are wrong because the price increases allowed under this “catch-up” policy would be limited in advance. ...
Others argue the opposite case: that a modest increase in prices would have too small an effect to boost the recovery. But the true value of such a commitment would be precluding a disinflationary spiral, in which expectations of disinflation without any possibility of offsetting interest-rate cuts lead to further economic contraction and hence to further declines in inflation. ...

I'm on board, though changing expectations may be harder than it seems even if the Fed clarifies it won't tighten policy until inflation spends some time above the long-run target. To be a broken record on this point, both monetary and fiscal policy are needed -- neither alone is enough -- but if I had to choose one or the other, I'd rather see the infrastructure spending Obama talked about today come to fruition rather than trying to create expected inflation.

But new fiscal policy is unlikely to happen due to considerable opposition from Republicans and a few misguided Democrats in Congress. Monetary policy is not certain either, there is resistance from some members of the Fed, but the prospects for QEII are looking good presently, and the exit strategy can be clarified, so at least there's hope. As I've said many times, I don't expect the impact of a new monetary policy initiative would be large, but it's a whole lot better than the nothing we are likely to get from fiscal policy.

Fed Watch: The Final End of Bretton Woods 2?

Tim Duy:

The Final End of Bretton Woods 2?, by Tim Duy: The inability of global leaders to address global current account imbalances now truly threatens global financial stability. Perhaps this was inevitable - the dollar has not depreciated to a degree commensurate with the financial crisis. Moreover, as the global economy stabilized the old imbalances made a comeback, sucking stimulus from the US economy and leaving US labor markets crippled. The latter prompts the US Federal Reserve to initiate a policy stance that will undoubtedly resonate throughout the globe. As a result we could now be standing witness to the final end of Bretton Woods 2. And a bloody end it may be.

Of course, the end of Bretton Woods 2 has been long prophesied. Back in October 2008, Brad Setser foresaw its imminent demise:

I increasingly suspect that the combination of falling oil prices and falling demand for imported goods will produce significant fall in the US trade and current account deficit in the fourth quarter, with a corresponding fall in the emerging world’s combined surplus. The Bretton Woods 2 system – where China and then the oil-exporters provided (subsidized) financing to the US to sustain their exports – will come close to ending, at least temporarily. If the US and Europe are not importing much, the rest of the world won’t be exporting much….
And rather than ending with a whimper, Bretton Woods 2 may end with a bang….
….If Bretton Woods 2 ends in 2009 – if US demand for imports falls sharply in the last part of 2008 and early 2009, bringing the US trade deficit down – it won’t have ended in the way Nouriel and I outlined back in late 2004 and early 2005. We postulated that foreign demand for US debt would dry up – pushing up US Treasury rates and delivering a nasty shock to a housing-centric economy... it didn’t quite play out that way. The US and European banking system collapsed before the balance of financial terror collapsed.

But Bretton Woods 2 was soon reborn, as the steady improvement to the US current account deficit was soon reversed:

Fedwatch1010101

Bretton Woods 2 simply morphed forms. Rather than a reliance on US financial institutions to intermediate the channel between foreign savers and US households, a modified Bretton Woods 2 - Bretton Woods 2.1 - relied on the US government to step into the void created by the financial mess and become the intermediary, either by propping up mortgage markets via the takeover of Freddie and Fannie, or the fiscal stimulus, or a dozen of other programs initiated during the financial crisis.

In essence, a nasty surprise awaited US policymakers - after two years of scrambling to find the right mix of policies, including an all out effort to prevent a devastating collapse of financial markets and a what Administration officials believed to be a substantial fiscal stimulus, the US economy remains mired at a suboptimal level as stimulus flows out beyond US borders. The opportunity for a smooth transition out of Bretton Woods 2 was lost.

How has it come to this? To understand the challenge ahead, we need to begin with two points of general agreement. The first is that the US has a significant and persistent current account deficit, which implies that domestic absorption of goods and services, by all sectors, exceeds potential output. In other words, we rely on a steady inflow of goods and services to satisfy our excess demand, a situation we typically find acceptable during a high growth phase when domestic investment exceeds domestic saving. The second point of agreement is that high unemployment implies that actual output is far below potential output. We clearly have unused capacity.

Points one and two appear that they should be mutually exclusive, but they are not. The fact that they are not begs an explanation. Paul Krugman sends us to Paul Samuelson to provide that explanation:

Here’s what he [Samuelson] wrote in his 1964 paper “Theoretical notes on trade problems”: “With employment less than full and Net National Product suboptimal, all the debunked mercantilist arguments turn out to be valid.” And he went on to mention the appendix to the latest edition of his Economics, “pointing out the genuine problems for free-trade apologetics raised by overvaluation”.

I think Samuelson is correct; an excessively high dollar is the explanation for the simultaneous existence of a sizable current account deficit and excessive unemployment. Indeed, there appears to be a externally determined downward limit to real value of the Dollar, and we are close to pushing against it:

Fedwatch1010102

The US appears to have little control over that minimum level. Foreign central have repeatedly acted to limit Dollar depreciation. Over the years, US policymakers have happily accepted this state of affairs (the steady financial inflow certainly helped support structural fiscal deficits), all the while ignoring the very real structural outcomes of blind adherence to the idea of a strong Dollar. spencer at Angry Bear succinctly lays out the structural impact:
The first chart is of imports market share, or imports as a share of what we purchase in the US. In the second quarter of this year imports market share rebounded to about where it was at the pre-recession peak, or about 16% of consumption. Since the early 1980's when the US started borrowing abroad to finance its two structural deficits -- federal and foreign--trades share of consumption has risen from about 6% to some 16%. Normally this has a small negative impact on the US economy, but sometimes you get quarters like the last quarter. Last quarter real domestic consumption rose at a 4.9% annual rate. That was an increase of $162.6 billion( 2005 $). But real imports also increased $142.2 billion (2005 $). That mean that the increase in imports was 87.5% of the increase in domestic demand.
To apply a little old fashion Keynesian analysis or terminology, the leakage abroad of the demand growth was 87.5%. It does not take some great new "freshwater" theory to explain why the stimulus is not working as expected, simple old fashioned Keynesian models explain it adequately.

Years of current account deficits - deficits induced not by the decisions of private savers looking to maximize returns but by foreign public sector entities seeking to maintain export growth - has literally resulted in a US economy that, on net, is unable to produce the goods its citizens want to consume. Hence a blast of stimulus flows overseas , the rising trade deficit heralded as a sign of strong US demand despite the inconvenient truth of little net job creation.

Which brings us to this observation by Simon Johnson:

The main reason the U.S. isn’t bouncing back so fast is because of exports and the dollar. South Korea, Russia, and other emerging markets that go through severe crises usually undergo a sharp depreciation in the inflation-adjusted value of the currency, making them hypercompetitive, at least for a while. This makes it easier to replace imports with domestic goods and services and much more attractive to export.
In contrast, the global financial crisis actually strengthened the U.S. dollar as it was seen as a haven, although the dollar has fallen somewhat from its recent peak against major trading partners.

Currency depreciation - of substantial magnitude - is a mechanism by which economies recover from financial crisis. But we shouldn't underestimate that challenges that accompany such an adjustment. If it happens to quickly - a sudden stop of capital - the most likely short run outcome is that the current account deficit will be resolved with import compression via a sharp drop in demand. This would be painful, to say the least. It is not the optimal path.

Neither, though, is the current path - a painstakingly slow Dollar depreciation. The result so far is persistently high US unemployment, with no relief in sight. In frustration, policymakers lash out against the wrong target, free trade. Krugman's frustration rises to the level that he supports the Levin bill as the only remaining option:

Finally, the idea that what we need is a mature discussion of global rebalancing strikes me as reasonable — if you have been living in a cave the past three or four years. We’ve been reasoning, and reasoning, and reasoning, and nothing changes. Clearly, China does not want to act — not out of national interest, but because of the political influence of its export industries. It won’t change its behavior unless it faces an additional incentive — like the prospect of countervailing duties.

But I don't want to make this piece about China. It is more than China at this point. It became more than China the instant US Federal Reserve policymakers woke up one morning and decided they needed to take the dual mandate seriously. And seriously means quantitative easing. Brad DeLong suggests that when the Fed actually acts on November 3, it will be too little too late. But if it is too little, more will be forthcoming.

Put simply, the Federal Reserve is positioned to declare war on Bretton Woods 2. November 3, 2010. Mark it on your calendars.

So perhaps Bretton Woods does not end because foreign governments are unwilling to bear ever increasing levels of currency and interest rate risk or due to the collapse of private intermediaries in the US, but because it has delivered the threat of deflation to the US, and that provokes a substantial response from the Federal Reserve. A side effect of the next round of quantitative easing is an attack on the strong dollar policy.

The rest of the world is howling. The Chinese are not alone; no one wants it to end. From Bloomberg:

Leaders of the world economy failed to narrow differences over currencies as they turned to the International Monetary Fund to calm frictions that are already sparking protectionism….
….Days after Brazilian Finance Minister Guido Mantega set the tone for the gathering by declaring a “currency war” was underway, officials held their traditional battle lines. U.S. Treasury Secretary Timothy F. Geithner and European Central Bank President Jean-Claude Trichet were among those to signal irritation that China is restraining the yuan to aid exports even as its economy outpaces those of other G-20 members.
“Global rebalancing is not progressing as well as needed to avoid threats to the global economic recovery,” Geithner said. “Our initial achievements are at risk of being undermined by the limited extent of progress toward more domestic demand- led growth in countries running external surpluses and by the extent of foreign-exchange intervention as countries with undervalued currencies lean against appreciation.”
At the same time, officials from emerging economies including China complained that low interest rates in the U.S. and its developed-world counterparts mean investors are pouring capital into their markets, threatening growth by forcing up currencies and inflating asset bubbles. The MSCI Emerging Markets Index of stocks has soared 13 percent since the start of September...
...“Near-zero interest rates and rapid monetary expansion are geared at stimulating domestic demand but also tend to produce a weakening of their currencies,” Mantega said Oct. 9. As a result, developing countries will continue to build up reserves in foreign currency to avoid “volatility and appreciation.”

Consider the enormity of the situation at hand. The Federal Reserve is poised to crank up the printing press for the sake of satisfying their domestic mandate. One mechanism, perhaps the only mechanism, by which we can expect meaningful, sustained reversal from the current set of imbalances is via a significant depreciation of the dollar. The rest of the world appears prepared to fight the Fed because they know no other path.

Bad things happen when you fight the Fed. You find yourself on the wrong side of a whole bunch of trades. In this case, I suspect it means that Bretton Woods 2 finally collapses in a disorderly mess. There may really be no other way for it to end, because its end yields clear winners and losers. And the losers, in this case largely emerging markets, and not prepared to accept their fate.

Moreover, there is no agreement on what should be the post-Bretton Woods 2 rules of the game for international finance. Is there even a meaningful policy discussion? Perhaps a little hope via Bloomberg:

Suggestions for how to resolve currency differences were vague in Washington, with French Finance Minister Christine Lagarde proposing better coordination and more diversification, while Canada’s Jim Flaherty suggested that new “rules of the road” be outlined.

Of course, in the next sentence hope is dashed:

European Central Bank Executive Board member Lorenzo-Bini Smaghi suggested the G- 20 may be too big to find a compromise.
Unless checked in South Korea, the discord may snap the G- 20’s united front formed to fight the financial crisis and recession.

And don’t expect that the International Monetary Fund is prepared to deal with this crisis:

Unable to find common ground themselves, governments agreed the IMF should serve as currency cop by preparing reports which show how the policies of one economy affect others. The studies will focus on the U.S., China, the U.K. and the euro area.
“The need to have this kind of spillover report has been discussed for months and now it’s part of our toolbox,” IMF Managing Director Dominique Strauss-Kahn said.

Well, thank the Heavens above, the IMF stands ready to produce a report. Now I can sleep easy.

Bottom Line: The time may finally be at hand when the imbalances created by Bretton Woods 2 now tear the system asunder. The collapse is coming via an unexpected channel; rather than originating from abroad, the shock that sets it in motion comes from the inside, a blast of stimulus from the US Federal Reserve. And at the moment, the collapse looks likely to turn disorderly quickly. If the Federal Reserve is committed to quantitative easing, there is no way for the rest of the world to stop to flow of dollars that is already emanating from the US. Yet much of the world does not want to accept the inevitable, and there appears to be no agreement on what comes next. Call me pessimistic, but right now I don't see how this situation gets anything but more ugly.

Wednesday, October 06, 2010

"Interview with Laurence Meyer"

Larry Meyer, former Governor of the Federal reserve Board, on macro modeling and on Fed policy during the crisis:

Interview with Laurence Meyer, by Mark Sniderman, FRB Cleveland: ...Mark Sniderman, executive vice president and chief policy officer at the Federal Reserve Bank of Cleveland, interviewed Meyer on June 9, 2010, in Cleveland. ...
...Sniderman: What does that tell us about the state of macro modeling?
Meyer: It tells us something very important—something we certainly should have learned—that macro modeling should not be static. It has to evolve over time, and we’re continuously learning. We found holes, and we try to close those holes.
But we know in the future there will be crises coming, or shocks in areas that we didn’t anticipate. We’ll find new holes that we have to fill. In this case, there were really so many. This notion of the financial accelerator wasn’t just a cute idea that the [Federal Reserve] chairman [Ben Bernanke] came up with. It was central to our understanding of how the macro-economy works, particularly when there are intense changes in financial conditions. So you do get these adverse feedback loops that the financial accelerator is all about.
Most of us as macro modelers came out of a tradition in which the transmission of monetary policy, the financial sector, is about real interest rates, about equity values, about the dollar, with virtually no variables that we would call credit variables—they just weren’t there. In milder times, that was OK. That probably got the job done. But when the situation was the drying up of credit markets, dysfunctional credit markets, you simply had to give the model more information than otherwise.
Two things seem valuable that we’ve tried to integrate into our models. First would be “willingness to lend variables” from the senior loan officer survey. Imprecise as it may be, it is a measure of lending terms beyond rates. That’s very important and that wasn’t there, and I think we can integrate that. And the other is credit spread variables—Baa corporate rate relative to, say, a Treasury rate. The reason that’s important is that a risk variable gives an indication of the risk appetites and risk aversion that come into the system when there are financial crises. And that variable tends to be very important in spending equations as well.
Sniderman: Should we expect to be living with our mainstream workhorse macro models for some time, and should we feel good about that? Is there enough progress there?
Meyer: I love that question! So I think we have two kinds of modeling traditions. First there is the classic tradition. I was educated at MIT. I was a research assistant to Franco Modigliani, Nobel laureate, and the director of the project on the large-scale model that was used at the time at the Federal Reserve Board. This is the beginning of modern macro-econometric model building. That’s the kind of models that I would use, the kind of models that folks at the Board use.
There’s also another tradition that began to build up in the late seventies to early eighties—the real business cycle or neoclassical models. It’s what’s taught in graduate schools. It’s the only kind of paper that can be published in journals. It is called “modern macroeconomics.”
We didn’t see the fundamental connection between property busts and collateral in the banking system, bringing the banking system toward insolvency, toward the edge of the abyss. Put on top of that the buildup of leverage in the system—this acts as a multiplier.
The question is, what’s it good for? Well, it’s good for getting articles published in journals. It’s a good way to apply very sophisticated computational skills. But the question is, do those models have anything to do with reality? Models are always a caricature—but is this a caricature that’s so silly that you wouldn’t want to get close to it if you were a policymaker?
My views would be considered outrageous in the academic community, but I feel very strongly about them. Those models are a diversion. They haven’t been helpful at all at understanding anything that would be relevant to a monetary policymaker or fiscal policymaker. So we’d better come back to, and begin with as our base, these classic macro-econometric models. We don’t need a revolution. We know the basic stories of optimizing behavior and consumers and businesses that are embedded in these models. We need to go back to the founding fathers, appreciate how smart they were, and build on that.
Sniderman: Wouldn’t inflation expectations be a counter-example? That has become an important variable in many classical macro models that policymakers use to help them construct their inflation forecasts. Isn’t that at least one place where we see this interplay between the research agenda in macro modeling and the practical use of models?

Continue reading ""Interview with Laurence Meyer"" »

Monetary versus Fiscal Policy

Joseph Stiglitz says that, for the most part, monetary policy has been a failure:

The Federal Reserve’s Relevance Test, by Joseph E. Stiglitz, Commentary, Project Syndicate: With interest rates near zero, the US Federal Reserve and other central banks are struggling to remain relevant. The last arrow in their quiver is called quantitative easing (QE), and it is likely to be almost as ineffective in reviving the US economy as anything else the Fed has tried in recent years. Worse, QE is likely to cost taxpayers a bundle, while impairing the Fed’s effectiveness for years to come.
John Maynard Keynes argued that monetary policy was ineffective during the Great Depression. Central banks are better at restraining markets’ irrational exuberance in a bubble – restricting the availability of credit or raising interest rates to rein in the economy – than at promoting investment in a recession. That is why good monetary policy aims to prevent bubbles from arising. ...

The best that can be said for monetary policy over the last few years is that it prevented the direst outcomes that could have followed Lehman Brothers’ collapse. But no one would claim that lowering short-term interest rates spurred investment. ...
They still seem enamored of the standard monetary-policy models, in which all central banks have to do to get the economy going is reduce interest rates. ... So, while bringing down short-term T-bill rates to near zero has failed, the hope is that bringing down longer-term interest rates will spur the economy. The chances of success are near zero.
Large firms are awash with cash, and lowering interest rates slightly won’t make much difference to them. ... In short, QE – lowering long-term interest rates by buying long-term bonds and mortgages – won’t do much to stimulate business directly.
It may help, though, in two ways. One way is as part of America’s strategy of competitive devaluation. Officially, America still talks about the virtues of a strong dollar, but lowering interest rates weakens the exchange rate. ... The fact is that a weaker dollar resulting from lower interest rates gives the US a slight competitive advantage in trade. ...
The second way that QE might have a slight effect is by lowering mortgage rates, which would help to sustain real-estate prices. So QE would produce some – probably weak – balance-sheet effects. But potentially significant costs offset these small benefits. ...

Not the anyone paid much attention, but I've been worried about the ability of monetary policy to stimulate the economy as much as needed for several years now, and have called for aggressive fiscal policy as an important complement to attempts to revive the economy through monetary policy. I was making this point at a time when others who get credit today as strong proponents of fiscal policy were saying let's wait to see if monetary policy works, and if not, we can turn to fiscal policy. I thought that was a mistake, and still do. For example, from January 2008:

Monetary policy is very good at slowing down an overheated economy, but it is not always so good, for the reasons just stated, at stimulating a lagging economy. It might do the trick, lower interest rates and other measures might provide the needed stimulus, but it wasn't all that long ago that some of the smartest people in this business argued that money had little if any effect on the real economy - some still do - and there are still uncertainties about the extent to which monetary policy can revive a lagging economy, especially an economy in a fairly steep downturn. I don't think it's a given that monetary policy will work.
Unfortunately, a serial approach won't work either. If we wait to see if monetary policy will work, and if it doesn't then turn to fiscal policy, it will be too late for fiscal policy to do much good...
So why not shoot with both barrels? Implement both monetary and fiscal policy measures as soon as possible, hope like heck one of the two works because there's no guarantee either will do enough to matter, and if the economy recovers and begins to overheat due to the dual stimulus, use monetary policy to cool things down. As I said, using monetary policy to temper an overheated economy seems to be the one place we are pretty sure policy can be effective, and monetary policy can be reversed fairly quickly... And even if we do provide too much stimulus for a time, if we put extra people to work, build a few more roads and bridges, give rebates to struggling families when less would have sufficed, measures such as that, well, I can think of worse mistakes to make. So the danger of overstimulating the economy isn't as large as the danger of failing to provide adequate stimulus, thus, why not use both types of policies?

Or, more than three years ago, before the recession officially started, in March 2007:

Recall Keynes' contention that monetary policy may be ineffective in a depression. Keynes said "there's many a a slip twixt the cup and the lip" meaning lots can go wrong with monetary policy - a change in the money supply must lower interest rates, which must then stimulate investment, which in turn must stimulate output. If, for example, interest rates don't fall when the money supply is increased (as in a liquidity trap), or if people are unwilling to invest even if interest rates do fall, monetary policy is ineffective. Keynes noted that fiscal policy, by contrast, operates directly on aggregate demand so it can work even in severe depressions where monetary policy has too many slips twixt cup and lip to be effective.

As I said, that was before the recession officially began, and interest rates weren't yet at zero (federal funds rate=5.25% at this time), so unconventional policy tools weren't considered. I made the same point about monetary versus fiscal policy the other day as well, and Krugman makes the same point today:

why did some of us emphasize the need for fiscal stimulus, rather than just calling for more expansionary monetary policies? ... I wanted and still want fiscal expansion because it’s relatively certain in its effect: if the government goes and buys a trillion dollars’ worth of stuff, that will create a lot of jobs. On the other hand, if the Fed goes out and buys a trillions dollars’ worth of long-term bonds, the effect is quite uncertain, with many possible slips between the cup and the lip.
The truth is that it’s very hard for central banks to get traction in a zero-rate world. This doesn’t mean that they shouldn’t try. But nobody is sure how much effect quantitative easing will have on long-term rates; even a decade ago, I thought Ben Bernanke was too optimistic on that front, which is why I was more of an advocate of inflation targeting — yet I was also aware that making inflation targets credible is itself tricky. Furthermore, even if long rates can be reduced, how much effect will they have? Business investment is relatively insensitive to interest rates, mainly because equipment doesn’t have all that long a lifetime. Housing is the place where the rubber usually meets the road; but not in the aftermath of a huge bubble and vast overbuilding.
So I didn’t and don’t think that we can count on monetary policy to do the job; blithely declaring that the Fed should target nominal GDP misses the difficulties. And that means we need fiscal policy.
Of course, at this point, with the loss of political will, it looks as if we’re going to see an attempt to do the trick with quantitative easing alone. I hope it works, but I wouldn’t bet on it.

I appreciate Stiglitz' shining the spotlight on the ineffectiveness of monetary policy in a recession, but I think fiscal policy is where the biggest mistakes were made and I wish he would have talked about that as well.

Tuesday, October 05, 2010

"Bernanke Breaks Promise, Discusses Fiscal Issues"

CR is blunt:

Bernanke breaks promise, discusses fiscal issues, by Calulated Risk: This speech isn't worth reading for substance (Ben Bernanke is clueless on budget issues), but it reveals something about Bernanke.

From Fed Chairman Ben Bernanke speaking at the Rhode Island Public Expenditure Council meeting tonight: Fiscal Sustainability and Fiscal Rules

Bernanke never mentioned "PAYGO" when he was head of the Council of Economic Advisors in 2005. In fact Bernanke barely mentioned the deficit in 2005 - except in postive terms - even though the structural deficit was in place and the cyclical deficit was coming (because of the housing bubble). I wonder why? Well, he missed the housing bubble completely - but what about the structural deficit?

Today he said:

Our fiscal challenges are especially daunting because they are mostly the product of powerful underlying trends, not short-term or temporary factors. Two of the most important driving forces are the aging of the U.S. population, the pace of which will intensify over the next couple of decades as the baby-boom generation retires, and rapidly rising health-care costs.
Weren't the baby boomers going to get older in 2005? Oh my ...

This is an issue that 1) is outside of Bernanke's area of responsibility, 2) he has promised not to discuss, and 3) he has zero credibility on. Enough said.

On fiscal policy issues, I believe Bernanke should explain the choices the Fed would face under various fiscal scenarios, and how the Fed would be likely to react -- that's information Congress and the president need to make informed fiscal choices. But he shouldn't recommend one budget path over the other except as it affects monetary policy choices (search the speech for "money" or "monetary" and see how many times they come up, or try "inflation" -- try to find anything at all in the speech about the consequences of the current projected budget path for monetary policy). And he certainly shouldn't be trying to dictate how a particular budget choice should be achieved (e.g. he identifies "a top priority" that includes reduced "government health spending"). Why politicize the Fed unnecessarily by talking using examples such as changing the retirement age for Social Security -- people might wonder why you didn't choose to mention, say, raising the income cap instead -- especially at a time like now when the Fed has a critical role to play in the economy?

Monday, October 04, 2010

What are the Risks to a Long Period of Economic Stagnation?

The Economist asks:

What are the risks to a long period -- say, a decade -- of economic stagnation? Are policymakers underestimating these risks? What threat is most underappreciated?

My answer, which shouldn't be too surprising, is here. There are also responses from Ricardo Caballero ("There is no risk for most rich countries") and Jesper Koll ("Government may cause the stagnation"). Additional responses may be posted later, but so far I seem to be the only one who sees risks ahead, and thinks government can help to reduce them. [All Responses]

Saturday, October 02, 2010

"A Perspective on the Future of U.S. Monetary Policy"

Charles Evans, President of the Federal Reserve bank of Chicago:

A Perspective on the Future of U.S. Monetary Policy, by Charles Evans, FRB Chicago: ...I think we face two key issues in the near and medium term. First, to what extent do structural factors explain the very high unemployment rate we currently have? Some have suggested that the financial crisis and the accompanying recession precipitated a seismic shift in the structure of labor markets, raising the natural rate of unemployment significantly above its pre-crisis level. If, as they suggest, labor market frictions rose dramatically over the past two years, then monetary policy is not the appropriate tool to address the ramifications of such a change. If, on the other hand, structural factors can only explain a modest part of the rapid rise in the unemployment rate, and aggregate demand deficiencies account for remainder, then monetary policy may be able to play a constructive role.
This brings me to the second key issue facing policymakers. If further monetary policy accommodation is desirable, what is the appropriate policy action when short-term interest rates are already at zero? Has extreme risk aversion by businesses and consumers put us in what can be described as a liquidity trap? And if so, what can we do about it?
Let me first elaborate on the unsatisfactory progress in employment gains, and what it implies for monetary policy. There are several reasons to think that the natural rate of unemployment has risen over the last couple of years. It is possible that the extension of unemployment insurance benefits during the recession, while cushioning unemployed workers from the adverse effects of lost income, might have reduced some workers’ job search intensity, or kept others from leaving the labor force. To the extent that such incentives are present, the natural rate of unemployment would increase while the extended benefits are in effect. However, reasonable estimates of the effect of the extension of unemployment benefits range one-half to one percentage points – far from sufficient to explain the nearly 5 percentage point increase over the past two years. Moreover, given the current schedule for the expiration of these benefits, the resulting increase in the natural unemployment rate will fade away over the next two years – leaving us still with an unsatisfactorily high rate of unemployment at the end of my forecast horizon.
It is also possible that the shocks that reverberated through the economy created a mismatch between the skills sought by employers and the skills the unemployed workers have. For instance, it is conceivable that the recession affected the different regions and sectors of the economy unevenly. Moreover, the recession may have severed an unusually large number of long-term employment relationships, making for an especially difficult transition for affected workers. The unusually long spells of unemployment experienced during the recent recession and potential erosion of skills during that time are additional factors that might have magnified labor market frictions. The sharp decline in home values and tight credit conditions might have reduced the ability of unemployed workers to sell their homes and move to regions where jobs are available. Taken together, these developments might have eroded the efficiency of matching between workers and jobs, and raised the natural rate of unemployment.[1]
The key question is: Are these possible structural changes in the labor market sufficient to explain the current unemployment rate? The Beveridge curve that describes the relationship between the unemployment rate and the job vacancy rate is a useful tool for addressing this question. The unemployment-vacancy relationship through the end of 2009 is captured very well by a simple, stable Beveridge curve and a constant-returns Cobb-Douglas matching function. So, the relationship between job openings and unemployment through the end of 2009 has been relatively stable, and does not suggest a dramatic increase in labor market frictions. It is only recently that we have seen an improvement in job openings that was not matched by a correspondingly large reduction in unemployment. Based on these data, some have suggested that most of the increase in the unemployment rate over the past two years is due to skills mismatch.
However, it seems likely that much of the apparent conflict between unemployment and vacancy data may be purely an issue of timing. At this stage of an economic recovery, it is not unusual for the vacancy rate to increase ahead of reductions in the unemployment rate – we have often seen such loops in the Beveridge curve at the end of past recessions.
But even if we take the job openings data at face value, it doesn’t suggest an increase in the natural rate to anything like the current rate of unemployment, which stands at 9.6 percent. Making some plausible assumptions, my staff estimates that the typical level of unemployment associated with a stable Beveridge curve passing through the recent data is likely to be about 7 percent. This includes the effects of increased unemployment insurance benefits that I already discussed.[2] 
I am not suggesting that 7 percent is a good estimate of the current natural rate. As I said, there are reasons to discount some of the recent improvement in the vacancy data. Rather, I want to point to out that, even if one takes the vacancy data at face value and accepts that the natural rate has risen to 7 percent, we are still left with a very large amount of slack relative to the current rate of unemployment and the rate most analysts expect to see at the end of 2012.[3]
The size of the unemployment gap, combined with the fact that inflation has been running below the level I consider consistent with long-term price stability, suggests that it would be desirable to increase monetary policy accommodation to boost aggregate demand and achieve our dual mandate.
Should the FOMC judge that further monetary policy accommodation is appropriate based on our economic outlook, what is the optimal level of additional accommodation and what policy tools should be employed to deliver the additional stimulus?
During a typical period of policy accommodation, the answers to these questions would be straightforward. The FOMC would lower the target federal funds rate based on our economic outlook and the historical relationship between policy actions and their impact on the economy. For instance, were the current fed funds rate at 3 percent, my forecast would call for a substantial decline in the target rate. Such a reduction in the nominal fed funds rate would be consistent with several versions of the Taylor rule, which would call for negative interest rates.[4] However, at roughly zero, the fed funds rate is as low as it can go.
As a result, the current economic environment poses unusual challenges to policymakers. In assessing the current state of the economy and considering the optimal policy response, a key issue that concerns me is the possibility that we might be in a liquidity trap.
As I assess the incoming data and talk to my business contacts, I see that executives are very cautious in their outlook and spending plans. They appear to be content to post strong profits generated by unprecedented cost-cutting, rather than growing their top-line revenues by expanding capital investments and hiring. Very conservative attitudes reign and cash is still king – even after the improvements in financial markets and strong bond issuance by businesses. Firms are sitting on the cash generated by profits and funds raised in capital markets. Very few are planning to grow their workforce. Although some contacts point to uncertainties raised by regulatory actions and government policies to explain their reluctance to invest, most admit that they would increase spending if stronger demand conditions prevailed.
Households are similarly cautious and gun-shy in their spending. Given the millions of jobs lost during the recession, the job insecurity faced by those employed, trillions of dollars in lost wealth and the balance-sheet repair that households have undertaken, consumers are displaying significant risk aversion. They have raised their savings rate, even though those savings earn very little interest income.
These are the classic symptoms associated with a liquidity trap: the supply of savings that outstrip the demand for investment even when short-term nominal rates are at zero.
The modern economic theory of liquidity traps indicates that the optimal policy response at zero-bound is to lower the real interest rate, almost surely by employing unconventional policy tools. Theory also indicates that, in the absence of such policy stimulus, the factors that generate high risk aversion could very well stifle a meaningful recovery, keep unemployment high and reinforce disinflationary pressures – clearly an undesirable equilibrium.
So, in the coming weeks and months, as I assess the incoming data, update my forecast and deliberate on the best monetary policy approach, I will be pondering two key issues: How much more should monetary policy do to reduce the shortfalls in meeting our dual mandate responsibilities for employment and price stability; and what tools should we use? Thank you.

I mostly agree with this analysis, but I am still left wondering how much demand can be increased with monetary policy tools. As I've said many times, I am convinced the Fed can bring down long-term interest rates, what I am uncertain about is how strong the reaction to this incentive will be. Lowering the real interest rate creates an incentive for firms to invest more, and for households to purchase more consumer durables, but how much consumption and investment will actually increase as a result of the fall in the real interest rate is an open question. Given the amount of excess capacity that exists, the poor outlook for the future for both firms and labor, the amount of cash firms are sitting on already, etc., etc., it's not at all clear to me that the response to a relatively small decline in real interest rates will be very strong. We can lead the horse to the low interest rate water, but will it drink more consumption and investment? To the extent that we can get something out of monetary policy, great, let's give it a shot -- I'm not worried about inflation -- but monetary policy by itself isn't enough.

That's why I think the demand shock needs to come from the fiscal side rather than the monetary side, and why -- to repeat another longstanding complaint -- I've been disappointed that people have focused so much on the Fed and let Congress off the hook. As the midterms approach, there has been hardly any effort to make the case that Congress should take a large share of the blame for the shape that the economy is in, particularly the shape of employment markets, all we are hearing about is the Fed, and it's disappointing to think that politicians will escape responsibility for their failure to provide people the help that they need.

Friday, October 01, 2010

Is the Fed Waiting for the Election to be Over Before Making a Decision on QEII?

There is news today that the Fed is moving closer to what has come to be known as QEII (QEI was the expansion of the Fed's balance sheet from around 800 billion to 2.3 trillion, and QEII would increase the size of the balance sheet even further -- though if they do move to QEII, how much and how fast that balance sheet would be extended is not known).

Just a quick thought on why they are waiting until November 3, the day after the midterm election, to make a formal announcement (the next FOMC meeting is a two day meeting on the 2nd and 3rd, and the press release will come on the 3rd). I have always believed that the Fed is reluctant to be viewed as taking policy positions that might influence national elections. Thus, when an election is coming, the Fed is hesitant to make large, activist changes in policy since one side of the political fence or the other will see the move as working against their interests. (Prior to 1980 the Fed often eased slightly before elections, probably showing an abundance of caution in an attempt to avoid being accused of doing anything that would make the economy worse in the pre-election time-period -- though some people tell a political business cycle story about the pre-election easing. But, in any case, there's no evidence of a consistent tendency in the run-up to elections after 1980 when the Fed changed its operating procedures).

So we probably should have expected all along that the Fed wouldn't even consider making a large change in policy until the election is over. I think it's a mistake for the Fed to put political considerations ahead of what is best fopr the economy, but it seems to me that is what they are doing.

I'm wondering, though, do you think this is right? Or is there some other reason the Fed has waited so long to make this decision? Is it just a coincidence that the announcement will come the day after the election, a coincidence that is due to accumulating data finally overcoming foot dragging and reluctance at the Fed to admit more help is needed from monetary policy?

Thursday, September 30, 2010

Federal Reserve Board Nominations Confirmed

Brad DeLong reports:

Finally..., by Brad DeLong: At least one year late and many dollars short:

Nominations Confirmed: September 29: These nominees were confirmed by Voice Vote:

Sarah Bloom Raskin, of Maryland, to be a Member of the Board of Governors of the Federal Reserve System for the unexpired term of fourteen years from February 1, 2002

Janet L. Yellen, of California, to be a Member of the Board of Governors of the Federal Reserve System for a term of fourteen years from February 1, 2010

Janet L. Yellen, of California, to be Vice Chairman of the Board of Governors of the Federal Reserve System for a term of four years

We need a very different senate.

Will this change the balance of power enough to make a big difference? I hope so, but I'm not so sure that it will.

Wednesday, September 29, 2010

"Employers Aren’t Trying Hard to Hire"

Mark Whitehouse at Real Time Economics notes that if the unemployment problem is mainly structural rather than cyclical, hiring intensity ought to be going up, not down::

Employers Aren’t Trying Hard to Hire, by Mark Whitehouse: Unemployed workers have a point when they complain that companies aren’t really trying to fill open jobs, a new study suggests.
In recent months, policy makers have puzzled over the inadequate rate at which job searchers and job vacancies are coming together. ...
Explanations have tended to focus on workers. Extended unemployment benefits could make people less willing to take jobs that pay poorly or don’t quite fit. Mortgage troubles and employed spouses could make it harder for people to move for work. People might not have the right qualifications for the jobs available.
A new paper, though, suggests employers themselves are at least part of the problem. The authors — Steven Davis of Chicago Booth School of Business, R. Jason Faberman of the Philadelphia Fed and John Haltiwanger of the University of Maryland — take a deep dive into Labor Department data and come up with an estimate of what they call “recruiting intensity,” a measure of employers’ vacancy-filling efforts including advertising, screening and wage offers.
Their finding: Employers haven’t been trying as hard as they usually do. Estimates provided by Mr. Davis suggest that over the three months ending July, recruiting intensity was about 12% below the average for the seven years leading up to the recession. Their lack of effort probably accounts for about a quarter of the shortfall in the hiring rate.
Depressing as it might seem, the finding is in some ways encouraging. It suggests that the trouble with hiring might be more a “cyclical” function of low business confidence than a chronic, “structural” ailment that will last for years to come.

In other news, some members of the Fed are finally waking up:

Fed's Kocherlakota revises down forecast, by CalculatedRisk: Minneapolis Federal Reserve President Narayana Kocherlakota spoke in London today. He has been one of more optimistic Fed presidents, and he revised down his forecast today ...

Kocherlakota ... still seems too optimistic, but he is moving in the right direction.

And on the coming QE2:

My own guess is that further uses of QE would have a more muted effect on Treasury term premia. Financial markets are functioning much better in late 2010 than they were in early 2009. As a result, the relevant spreads are lower, and I suspect that it will be somewhat more challenging for the Fed to impact them.

...It is interesting that certain Fed presidents are now revising down their overly optimistic forecasts - all but guaranteeing QE2 (even if he thinks it will have little impact).

If only they'd listen:

...presently the Fed does not feel the benefits [of further action]outweigh the costs, and it remains in “wait and see” mode.
My first question for the Fed would be this. To date, you have overestimated the strength of the recovery at every step. ... Given the forecasts to this point, all of which have been too rosy, I would place more weight on the downside, quite a bit more...
So, in my view, the Fed should drop its relatively rosy forecast for the recovery and take more account of the downside risks, the Fed should place more weight on the unemployment problem, and have less fear of inflation — the risk right now is in the other direction. Making these adjustments that would compel the Fed to action instead of “waiting and seeing,” a policy that, to date, has kept the Fed from getting out in front of the economy’s problem.
It’s time for the Fed to stop playing catch-up as it waits and sees that its forecasts were wrong, and and take the steps needed to boost the economy. ...

and:

People need jobs, or more social support until jobs appear, and both the Congress and the Fed are failing to do all that they can do to help. Apparently, imagined fears of deficits and inflation are more important than the real struggles of the unemployed.