Category Archive for: Monetary Policy [Return to Main]

Sunday, November 07, 2010

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:

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:


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%.


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.


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.


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.


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.


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%.


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.


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.


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.


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.


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.


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:


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:


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. ...


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.

Monday, September 27, 2010

Paul Krugman: Structure of Excuses

Arguments that we can't do anything about the unemployment problem are structurally unsound:

Structure of Excuses, by Paul Krugman, Commentary, NY Times: What can be done about mass unemployment? All the wise heads agree: there are no quick or easy answers. There is work to be done, but workers aren’t ready to do it — they’re in the wrong places, or they have the wrong skills. Our problems are “structural,” and will take many years to solve. ...
Who are these wise heads I’m talking about? ...Narayana Kocherlakota, the president of the Federal Reserve Bank of Minneapolis,... has attracted a lot of attention by insisting that dealing with high unemployment isn’t a Fed responsibility: “Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs,” he asserts, concluding that “It is hard to see how the Fed can do much to cure this problem.”
Now, the Minneapolis Fed is known for its conservative outlook, and claims that unemployment is mainly structural do tend to come from the right... But some people on the other side of the aisle say similar things. For example, former President Bill Clinton recently told an interviewer that unemployment remained high because “people don’t have the job skills for the jobs that are open.”
Well,... what should we be seeing if statements like those of Mr. Kocherlakota or Mr. Clinton were true? The answer is, there should be significant labor shortages somewhere... — major industries that are trying to expand but are having trouble hiring, major classes of workers who find their skills in great demand, major parts of the country with low unemployment even as the rest of the nation suffers.
None of these things exist. Job openings have plunged in every major sector, while the number of workers forced into part-time employment ... has soared. Unemployment has surged in every major occupational category. Only three states, with a combined population not much larger than that of Brooklyn, have unemployment rates below 5 percent.
Oh, and where are these firms that “can’t find appropriate workers”? The National Federation of Independent Business has been surveying small businesses for many years, asking them to name their most important problem; the percentage citing problems with labor quality is now at an all-time low...
So all the evidence contradicts the claim that we’re mainly suffering from structural unemployment. Why, then, has this claim become so popular?
Part of the answer is that this ... always happens during periods of high unemployment — ...pundits and analysts believe that declaring the problem deeply rooted, with no easy answers, makes them sound serious.
I’ve been looking at what self-proclaimed experts were saying about unemployment during the Great Depression; it was almost identical to what Very Serious People are saying now. Unemployment cannot be brought down rapidly, declared one 1935 analysis, because the work force is “unadaptable and untrained. It cannot respond to the opportunities which industry may offer.” A few years later, a large defense buildup finally provided a fiscal stimulus adequate to the economy’s needs — and suddenly industry was eager to employ those “unadaptable and untrained” workers.
But now, as then, powerful forces are ideologically opposed to ... government action on a sufficient scale to jump-start the economy. And that, fundamentally, is why claims that we face huge structural problems have been proliferating: they offer a reason to do nothing about the mass unemployment that is crippling our economy and our society. ...
We aren’t suffering from a shortage of needed skills; we’re suffering from a lack of policy resolve. As I said, structural unemployment isn’t a real problem, it’s an excuse — a reason not to act on America’s problems at a time when action is desperately needed.

Tuesday, September 21, 2010

The Fed Remains in “Wait and See” Mode

I have some comments on the Press Release from today's FOMC meeting at MoneyWatch:

The Fed Remains in “Wait and See” Mode

Sunday, September 19, 2010

Tyler Cowen: Can the Fed Offer a Reason to Cheer?

Tyler Cowen hopes to convince you that you need to be convinced:

Can the Fed Offer a Reason to Cheer?, by Tyler Cowen, Commentary, NY Times: ...Optimism, or lack thereof, may seem the province of psychology, not macroeconomics. But ... a deficit of optimism has much to do with why the United States economy remains stalled today.
The Federal Reserve, pondering what to do to stimulate the economy, has a number of tools at its disposal. But if it could just convince Americans that it was committed to monetary expansion and economic growth, it would help the economy pick up speed.
Yet that is easier said than done. ... If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year. ... Of course, if no one believes the Fed’s commitment to price inflation, spending and employment will not go up. The plan will fail, and people will view their skepticism as vindicated.
In other words, one of our economic problems can be solved, but only if we are willing to believe it can. ... Sadly, although Mr. Bernanke clearly understands the problem, the Fed hasn’t been acting with much conviction. This is understandable, because if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence. It would be a long time before the Fed was trusted again, and the Fed might even lose its (partial) political independence. ...
The Fed lost some of its political independence during the financial crisis. It undertook major rescue operations in conjunction with the Treasury, and these bailouts proved extremely unpopular. ... When it comes to inflation, the Fed cannot easily turn to Congress and simply ask to be trusted.
This is the sad side story of our financial crisis: especially when it comes to financial matters, a great deal of trust has been lost. There is the prospect of a free lunch right before us, yet it is unclear that we will be able to grab it. ...
In failing to push harder for monetary expansion, is Mr. Bernanke a wise and prudent guardian of the limited discretionary powers of the Fed? Or is he acting like a too-hesitant bureaucrat, afraid to fail and take the blame when he should be gunning for success?
We still don’t know which narrative is more accurate, but the Fed is not receiving enough signals of support from Congress.
As high unemployment continues, more and more people, including top economists, are asking the Fed to promise a credible commitment to a more expansionary monetary policy. This approach will work only if the Fed finds a way to be bold — and if we find a way to believe in it.

This reminds me of an argument I made in June:

As for Tyler's (and others') call for monetary policy instead of fiscal policy, here's the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it's unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you'll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it's hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.

Wednesday, September 15, 2010

Eichengreen: Competitive Devaluation to the Rescue

In response to Japan's intervention on the Yen, Barry Eichengreen reminds us that in March 2009, he argued that coordinated cross-country quantitative easing by monetary authorities would be better than the competitive devaluation we seem to be heading towards since it avoids large, temporary swings in exchange rates:

Competitive devaluation to the rescue, by Barry Eichengreen, Every day it seems more likely that we are destined – or should one say doomed? – to replay the disastrous economic history of the 1930s. We have had a stock market crash to rival 1929. We have had a banking crisis comparable to 1931. With the economic meltdown in eastern Europe we have the prospect of a financial crisis in Vienna, exactly as in 1931. We have squabbling among the major economies over the design of rescue loans, just as when the Bank for International Settlements was hamstrung in its efforts to contain the crisis in Austria. We have the prospect of a failed world economic conference in London to dash remaining hopes for a co-operative response, just as in 1933.
And if all this wasn't enough, now we have the dreaded specter of competitive devaluation. In the 1930s, one country after another pushed down its exchange rate in a desperate effort to export its way out of depression. But each country's depreciation only aggravated the problems of its trading partners, who saw their own depressions deepen. Eventually even countries that valued currency stability were forced to respond in kind.
In the end competitive devaluation benefited no one, it is said, since all countries can't devalue their exchange rates against each another. The only effects were to fan political tensions, heighten exchange rate uncertainty, and upend the global trading system. Financial protectionism if you will.
Now, we are warned, there are signs of the same. The Bank of England is not exactly discreetly encouraging the pound to fall. And just last week the Swiss National Bank intervened in the foreign exchange market to push down the franc. Will Japan, the United States and China be long to follow? Will we all yet again end up shooting ourselves in the foot?
In fact, this popular account is a misreading of both the 1930s and the current situation. In the 1930s, it is true, with one country after another depreciating its currency, no one ended up gaining competitiveness relative to anyone else. And no country succeeded in exporting its way out of the depression, since there was no one to sell additional exports to. But this was not what mattered. What mattered was that one country after another moved to loosen monetary policy because it no longer had to worry about defending the exchange rate. And this monetary stimulus, felt worldwide, was probably the single most important factor initiating and sustaining economic recovery.
It is true that the process was disorderly and disruptive. Better would have been for the countries concerned to co-ordinate their moves to a more stimulative monetary policy without sending exchange rates on a roller-coaster ride. But, not for the first time, they failed to agree. Those in the most precarious positions had no choice but to pursue the new policy unilaterally.
In any case, monetary easing achieved through a process of "competitive devaluation" was better than no monetary easing. ...
This, in a nutshell, is our situation again today. Sterling's weakness reflects, in part, the exceptional severity of the British slump. But it also reflects the fact that the Bank of England has moved further and faster in the direction of quantitative easing than any other central bank. ... Now the Swiss National Bank has followed suit...
Will other central banks, seeing their own currencies strengthen, conclude that the threat of deflation has grown more immediate and also now move quickly to quantitative easing? If so, exchange rates against sterling and the franc will revert to more normal levels. And, with quantitative easing all around, the world will receive the additional dose of monetary stimulus that it desperately needs.
Better of course would be for the major countries to agree to co-ordinate their monetary policy actions. Then exchange rates will not move by large amounts in one direction today and the opposite direction tomorrow. There will not be further disruptions to the global trading system. There will not be international recriminations over beggar-thy-neighbor policy. The G20 countries could even make such co-ordination part of their agreement at the 2 April summit in London. Or not.

Monetary policy works through lowering interest rates and encouraging new investment, but people seem to have forgotten all about the long and variable lags, particularly for monetary policy. The problem of finding "shovel ready" projects in not limited to the public sector. Even projects that are already planned take time to set in motion in response to lower interest rates (if producers are even willing to initiate new projects given the bleak outlook for sales).

We need to remember that policy takes time to work, that the risks are not symmetric, and that the consequences of failing to act in a timely manner could be very costly down the road. We need to take action now, and not just from coordinated monetary policy. A coordinated fiscal intervention is also needed, but, unfortunately for the jobless, that's not going to happen.

Fed Watch: Yen Intervention

Tim Duy:

Yen Intervention, by Time Duy: At the beginning of August, I wrote:

Now, suppose Japanese officials believe that intervention is required regardless of the G-20. Presumably, they will give US Treasury Secretary Timothy Geithner a phone call to at least keep him in the loop, if not to receive his implicit consent. One wonders if Geithner will recognize what he would be consenting to: Japanese intervention, if it occurs, means that Chinese authorities managed to get Japan to acquire their Dollar reserves for them. Instead of buying Dollars, China buys Yen, which in turn induces Japan to buy Dollars. This maintains the artificial capital flows to the US while allowing China to escape accusations of being a "currency manipulator."

Since then, Japan's currency challenge only intensified, culminating in last week's almost comical complaint from Japanese policymakers:

Japan’s government said it will seek discussions with China over the nation’s record purchases of Japanese bonds as an appreciating yen threatens to undermine an economic recovery.
Japan is closely watching the transactions and will seek to maintain close contact with Chinese authorities on the issue, Vice Finance Minister Naoki Minezaki told lawmakers in Tokyo. Finance Minister Yoshihiko Noda suggested at the same hearing that it’s inappropriate for China to buy Japan’s bonds without a reciprocal ability for Japanese to invest in China’s market.

Did policymakers recognize the irony of their situation? It is not exactly a secret that Japan has made frequent excursions into the currency markets. But apparently they feel that intervention should be limited to Dollar purchases. Surely another Asian nation wouldn't play the same game on them?

Alas, the Chinese did - under pressure to "loosen" the renminbi - and pushed the Japanese into intervening last night to tame the surging Yen. In effect, the Chinese managed to get the Japanese to do their Dollar buying for them. Honestly, I have a hard time faulting the Japanese. They are facing a serious deflation problem, and pumping Yen into the system is an appropriate response (although they might simply sterilize the intervention, which would be, in my opinion, a policy error).

What must be going through the head of US Treasury Secretary Timothy Geithner at this point? After all, as far as global imbalances are concerned, if he can't stop central banks from intervening in the Dollar, he really isn't going to be making much progress on reversing the deteriorating US trade deficit. And before anyone gets too excited about the most recent trade numbers, note the trend remains intact. Moreover, CR is tracking the LA ports data, and it looks ugly. Geithner is now out and about trying to jawbone Chinese officials. From his interview with the Wall Street Journal:

WSJ: Are you satisfied with China’s progress on the yuan?
Geithner: Of course not. China took the very important step in June of signaling that they’re going to let the exchange rate start to reflect market forces. But they’ve done very, very little, they’ve let it move very, very little in the interim. It’s very important to us, and I think it’s important to China, I think they recognize this, that you need to let it move up over a sustained period of time.

So, Geithner finally realizes the extent of the Chinese nonevent. Recall the press fanfare that accompanied the initial Chinese currency announcement - journalists falling all over themselves to speak brightly of China's economic maturation. How many of those stories were sourced by Treasury officials crowing about the breakthrough that allowed them to avoid labeling China a currency manipulator? And where does this leave Geithner? Either complicit in trumping up the most minor of policy adjustments, or completely sucker punched by his Chinese counterparts. Honestly, I don't know which is worse.

What it all boils down to is this: There apparently is no motivation for global central banks to stop directing capital inflows at the US in an effort to support mercantilist objectives. If it isn’t China, it will be some other economy. And equally apparent, there is no motivation among US policymakers to address such government directed capital flows. Which will leave politicians falling back on ultimately harmful trade barriers. The absolute inability of US policymakers to seriously address a global financial architecture where a rule of the game is "when in doubt, by Dollars" will ultimately have serious consequences via disruptive adjustment when the system can no longer be maintained, via either external or internal forces.

Monday, September 13, 2010

Fed Watch: The Fair

Tim Duy:

The Fair, by Tim Duy: A man takes his son to the county fair; the lights and sounds of the amusement rides are like a magnet to the boy. The boy, however, is penniless. His father, seeing the longing in his son's eyes, hands the boy a dollar for the rides, but quizzically adds "if it looks like you are about to have any fun with that dollar, I will take it back from you." The boy is puzzled. First, a dollar only buys three tickets, and the least expensive ride is four tickets. Plus, Dad said he would take the dollar back if he went to buy tickets. So what is the point of even trying to buy any tickets?

Consequently, the father and son stand at the edge of the midway, the father wondering why his son simply stands there while the son wonders why his dad doesn't want him to have any fun. They are soon joined by the boy's grandfather, who, assessing the situation, says that the father should never have given the son a dollar in the first place. "He will just buy candy, which will cost you more later when you have to take him to the doctor to treat diabetes." The father neither agrees or disagrees. Along comes a trusted uncle, who says to give the boy another dime, but " then if he looks like he will have any fun, take back a quarter."

The grandfather and uncle start bickering, loudly, in public, about what to do with the boy and his dollar. Soon another uncle rushes into the fray, proclaiming it is pointless to give the boy a dollar because all the workers are already busy helping other fairgoers. "He can't buy anything anyway, and if he tries, he will just drive up prices for all his cousins." The discussion becomes increasingly heated, drawing the boy's cousins away from the rides. The lights and noise of the fair fade as lines dwindle and the rides grow silent.

All the while, the confused boy is wondering why his father just stands there, refusing to criticize the grandfathers and uncles even as the argue increasingly silly positions. Finally, the father, realizing the boy's confusion, turns to him and says "Reaching consensus in the family is always more important than the fair." The arguing continues as employees begin to turn off the rides, one by one.

This, I believe, is an apt analogy of the current state of monetary policy. A policy that is supporting disinflationary expectations simply because it lacks a credible commitment to any other outcome.

Why does policy lack a credible commitment? First, as I think has been clear from day one of the Fed's quantitative easing policy, policymakers eagerly await the opportunity to reduce the balance sheet - the expansion of the balance sheet was never intended to yield a permanent increase in the money supply, and as such should have had little impact on long run expectations. As recently as Federal Reserve Chairman Ben Bernanke's July Congressional testimony, policymakers were stressing the ability of the Fed to reduce the balance sheet, clearly much more concerned about the inflationary potential of their actions than the ongoing disinflationary impact of being stuck at a subpar equilibrium. Only recently has attention turned to the possibility of additional action, and then only under critical pressure. When additional action is taken, it will almost certainly be in the context of a temporary action, the Fed will stand ready to withdraw the stimulus should it look like economic agents are having any fun with that infusion of cash.

Moreover, I do not believe the swelling of the balance sheet - albeit massive in the eyes of policymakers - sufficed to convince market participants that the Fed was committed to maintaining inflation expectations. St. Louis Federal Reserve Chairman James Bullard, in his "Seven Faces" paper, claims that the suggestions that the appropriate Federal Funds target should have been negative 6% are "nonsensical." And, of course, in a sense they are - zero is indeed the lower bound. But economists also suggested estimates of the quantitative equivalent of negative 6%, perhaps something on the order of a balance sheet expansion to $10 trillion, far beyond what Fed policymakers found tolerable. And I think that big number was important - it gave an indication of the size of monetary commitment consistent with previous policy response. The failure to meet that commitment could reasonably be interpreted by market participants as an indication the Fed was willing to accept the disinflationary impact of the Great Recession, perhaps so far as seeing the event as another opportunity for opportunistic disinflation.

Moreover, any sense that the policy action to date was acceptably insufficient was reinforced by the Fed's own forecasts, which undeniably reveal an expectation that policymakers anticipate an agonizingly long recovery, yet decline to add additional stimulus. Recall that the most recent FOMC decision only prevents premature tightening of policy, not a stimulus boost. Moreover, consider Bullard's remarks Friday:

Continue reading "Fed Watch: The Fair" »

Sunday, September 12, 2010

Williamson: Monetary Policy Issues

Stephen Williamson discusses the Wall Street Journal Symposium on monetary policy. He reacted much as I did, though as noted below I at least found one statement I could support:

Two days ago, the Wall Street Journal published a "symposium," titled "What Should the Federal Reserve Do Next," with short pieces by John Taylor, Richard Fisher (Dallas Fed President), Frederic Mishkin, Ronald McKinnon, Vincent Reinhart, and Allan Meltzer. The WSJ picked a group of conservative economists with a considerable amount of accumulated policy experience among them, and including one sitting Federal Reserve Bank President (Fisher). One would think we could get something useful out of these guys. Well, apparently not.

While I mostly agree with what he says, I have a few quibbles. Stephen Williamson says:

Many central banks focus on "core" measures of inflation. I think that's nonsense. The idea is that we should ignore volatile prices when we think about inflation targeting, which seems akin to ignoring investment and consumer durables expenditures during recessions. Some people draw distinctions between prices that are "sticky" and those that are not, which seems like a related, and equally bad, idea. Since the costs of inflation are related to the fact that we write contracts in nominal terms, which makes inflation uncertainty bad, it seems we should aim for predictability in the rate of change in the broadest possible measure of the price level, which for me is the implicit GDP price deflator.

Monetary policy works with a lag, so we need to know about inflation in the future -- that's the target we are trying to hit. There is evidence core inflation is better than headline inflation at predicting future headline inflation. Here's Mike Bryan of the Cleveland Fed (see here too):

Michael Bryan, an economist at the Cleveland Fed, says the bank’s trimmed mean consumer price index does a better job in the short term at predicting future overall inflation than core inflation does. “It’s really reducing the noise and improving the signal,” Bryan said. “There’s almost no signal in the overall month-to-month CPI.”

The same is true for inflationary expectations. I should add that the evidence is a bit more mixed than this implies, e.g. there is one paper that argues the core inflation rate produces a biased estimate of future inflation, but my point is that there isn't an open and shut case against the use of core inflation even if you think headline inflation is the right quantity to target. We also differ on which price measure to use, I prefer the PCE index rather than the nominal GDP deflator since I think it produces a measure closer to what we have in mind in our theoretical models.

I should also add that the objection to using a weighted price index, perhaps one that includes wages and asset prices in addition to the usual components -- where the weights are based upon the degree of stickiness -- is really an objection to the underlying mechanism used to model price stickiness (the "Calvo Fairy"). If you accept the mechanism, then this approach has theoretical support (see here for a discussion from Woodford on this point).

He also objects to the use of the output gap in the Taylor rule, partly based upon measurement issues, and calls for pure inflation targeting. However, while I agree measurement is always a difficult issue, one that goes beyond concerns about how to measure the gap (e.g. which inflation measure is best?), that concern is not uncommon and not enough to pose an insurmountable objection. More importantly, the literature on divine coincidence (here and here) suggests that there can be advantages to a rule that includes gap measures. That is, a pure inflation target does not do as good a job of maximizing welfare as a rule that includes both inflation target and and output gap components.

But I have no disagreement at all with his (mostly negative) comments regarding the contributions of Fisher, Taylor, and Meltzer. On Fisher he says:

Let's start with the low point. Fisher should win the bad analogy contest with this:
One might assume that with more than $1 trillion in excess bank reserves and significant amounts of cash held by businesses, the gas tank of those who have the capacity to hire is reasonably full. One might also conclude that the Fed, having cut the cost of interbank overnight lending to near zero and used quantitative easing to coax the entire yield curve downward, has driven the cost of gas to virtually nil for businesses that are creditworthy. And yet businesses still aren't hiring.
So, the gas is in the tank, the Fed has done all it can by making the cost of gas zero. So why won't the car go? Fisher says:
If businesses are more certain about future policy, they'll release the liquidity they're now hoarding.
He's talking about fiscal policy:
Fiscal and regulatory authorities share significant responsibility for incentivizing economic behavior through taxes, spending and rule making.
So, apparently the person driving the car, which is full of cheap gas, is paralyzed with fear - he or she might get stopped at the toll both, have to obey speed limits, etc. If Fisher is worried about policy uncertainty, he should probably clean his own house first (to use another analogy). What does the Fed intend to do with the more than $1 trillion in mortgage-backed securities (MBS) on its balance sheet. Will it hold those forever? Will they be sold off slowly? If so, when, and at what rate? What's with that "extended period" language in the FOMC policy statement? How long is that period? How do we know when it is time for the Fed to tighten? When the time comes to tighten, how does the Fed intend to do it - raise the interest rate on reserves, sell Treasuries, sell MBS?

Finally, Williamson doesn't discuss the contributions of Reinhardt, McKinnon, and Mishkin, and while Mishkin and McKinnon deserve to be ignored, I thought Reinhardt had the most reasonable answer, one I could support:

The Fed should promise to purchase government and mortgage-related securities between its regularly scheduled meetings as long as activity is forecast to be subpar and inflation is low or headed down. Purchases of, say, $100 billion every six-to-eight weeks would add up to a number worthy of shock and awe for those with a somber economic outlook.
But those foreseeing a quick return to above-trend growth or expecting a slower trend would similarly be reassured that the Fed would not keep its foot on the accelerator for too long. Most importantly, by linking to economic conditions, the Fed would not be providing an open-ended promise to monetize the federal debt.

Friday, September 10, 2010

Paul Krugman: Things Could Be Worse

Too little too late is better than nothing at all:

Things Could Be Worse, by Paul Krugman, Commentary, NY Times: ...In the 1990s, Japan conducted a dress rehearsal for the crisis that struck much of the world in 2008. Runaway banks fueled a bubble in land prices; when the bubble burst, these banks were severely weakened, as were the balance sheets of everyone who had borrowed in the belief that land prices would stay high. The result was protracted economic weakness.
And the policy response was too little, too late. The Bank of Japan ... was always behind the curve and persistent deflation took hold. The government propped up employment with public works programs, but its efforts were never focused enough to start a self-sustaining recovery. Banks were kept afloat, but were slow to face up to bad debts and resume lending. The result of inadequate policy was an economy that remains depressed to this day.
Yet the picture is grayish rather than pitch black. Japan’s economy may be depressed, but it’s not in a depression. The employment picture has been troubled... But thanks to those government job-creation plans, the country isn’t suffering mass unemployment. Debt has risen, but despite constant warnings of imminent crisis — and even downgrades from rating agencies back in 2002 — the government is still able to borrow, long term, at an interest rate of only 1.1 percent.
In short, Japan’s performance has been disappointing but not disastrous. And given the policy agenda of America’s right, that’s a performance we may wish we’d managed to match.
Like their Japanese counterparts, American policy makers initially responded to a burst bubble and a financial crisis with half-measures. ... The question is: What happens now?
Republican obstruction means that the best we can hope for in the near future are palliative measures — modest additional spending like the infrastructure program President Obama proposed this week, aid to state and local governments to help them avoid severe further cutbacks, aid to the unemployed to reduce hardship and maintain spending power.
Even with such measures, we’ll be lucky to do as well as Japan did at limiting the human and economic cost of the economy’s financial woes. But it’s by no means certain that we’ll do even that much. If the Republicans go beyond obstruction to actually setting policy — which they might if they win big in November — we’ll be on our way to economic performance that makes Japan look like the promised land.
It’s hard to overstate how destructive the economic ideas offered earlier this week by John Boehner, the House minority leader, would be... Basically, he proposes two things: large tax cuts for the wealthy that would increase the budget deficit while doing little to support the economy, and sharp spending cuts that would depress the economy while doing little to improve budget prospects. Fewer jobs and bigger deficits — the perfect combination.
More broadly, if Republicans regain power, they will surely do what they did during the Bush years: they won’t seriously try to address the economy’s troubles; they’ll just use those troubles as an excuse to push the usual agenda, including Social Security privatization. They’ll also surely try to repeal health reform, which would be another twofer, reducing economic security even as it increases long-term deficits.
So I find myself almost envying the Japanese. Yes, their performance has been disappointing. But things could have been worse. And the case Democrats now need to make — the case the president finally began to make in Cleveland this week — is that if Republicans regain power, things will indeed be worse. Americans, understandably, are disappointed over, frustrated with and angry about the state of the economy; but disappointment is better than disaster.

Thursday, September 09, 2010

The WSJ "Symposium" on Monetary Policy

The WSJ asked several people, mostly on the right, about whether the Fed has the power to do more. John Taylor's answer was predictable, the problem is that they aren't following the Taylor rule and the sooner they get back to it, the better, so I'll move on to the next participant, Richard Fisher of the Dallas Fed.

Fisher is predictably hawkish, adopts the GOP line on business uncertainty causing problems, and concludes:

The minutes of the last Federal Open Market Committee (FOMC) meeting noted that "a number of participants reported that business contacts again indicated that uncertainty about future taxes, regulations, and health-care costs made them reluctant to expand their workforces." ... Can the Fed do more to propel job creation? Barring an unforeseen shock, I would be reluctant to expand the Fed's balance sheet... Of course, if the fiscal and regulatory authorities are able to dispel the angst that FOMC participants are reporting, further accommodation may not be needed. If businesses are more certain about future policy, they'll release the liquidity they're now hoarding.

The claim that business uncertainty is holding up the recovery will appear again below, so I'll hold off with the evidence against it.

Next is Frederic Mishkin. I wasn't sure how he'd answer. He's fearful that debt monetization will lead to lack of fiscal discipline, that losses on asset purchases might lead to a loss of Fed independence, and that all roads lead to inflation:

The ... Fed's recent announcement that it will reinvest payments from agency debt and mortgage-backed securities into long-term Treasurys has opened the door to large-scale asset purchases. Should the Fed pull the trigger?
Purchasing long-term Treasurys might suggest that the Fed is accommodating the fiscal authorities by monetizing the debt—thereby weakening the government's incentives to come to grips with our long-term fiscal problems. In addition, major holdings of long-term securities expose the Fed's balance sheet to potentially large losses if interest rates rise.
Such losses would result in severe criticism of the Fed and a weakening of its independence. Both the weakening of its independence and the perception that the Fed is willing to monetize the debt could lead to increased expectations for inflation sometime in the future. That would make it much harder for the Fed to contain inflation and promote a healthy economy.
Expanding the Fed's balance sheet through large-scale asset purchases can be necessary in extraordinary circumstances, such as during the depths of the recent financial crisis. But in relatively normal times, the costs of using this tool are sufficiently high that it should not be used lightly.

Relatively normal times? Now? Ah, he means relatively normal on Wall Street, not Main Street. Anyway, next up, Ronald McKinnon. He wants to "spring the near zero interest rate liquidity trap" by, essentially, increasing interest rates. That's a bad policy, so let's move on.

I didn't expect Vincent Reinhart to be the most reasonable of the bunch, though perhaps given the bunch that was selected it might have been a good bet. I could sign on to something along these lines:

The Fed should promise to purchase government and mortgage-related securities between its regularly scheduled meetings as long as activity is forecast to be subpar and inflation is low or headed down. Purchases of, say, $100 billion every six-to-eight weeks would add up to a number worthy of shock and awe for those with a somber economic outlook.
But those foreseeing a quick return to above-trend growth or expecting a slower trend would similarly be reassured that the Fed would not keep its foot on the accelerator for too long. Most importantly, by linking to economic conditions, the Fed would not be providing an open-ended promise to monetize the federal debt.

Last up is Allan Meltzer, and he follows Taylor in calling for the Taylor rule, and he, like Fisher, adopts the "government policy is creating business uncertainty" line:

When Congress established the Fed in 1913, it gave it a dual mandate: high employment and price stability. In its nearly 100-year history, the Fed has achieved both objectives only rarely: 1923-1928, a few years in the mid-1950s and early 1960s, and from 1985 to 2004, when the Fed followed the Taylor rule that incorporates Congress's mandate. Those 20 years when the Fed followed the rule were the longest sustained period of stable growth and low inflation in Federal Reserve history.
In "A History of the Federal Reserve," I concluded that the principal mistakes the Fed has made have resulted from giving excessive attention to current events... By focusing on the short-term, the Fed neglects the longer-term consequences of its actions. ... A rule would change that. ... At times like the present, a rule helps the Fed to recognize that current problems are mainly the result of mistaken government policies that create massive uncertainty.
The Fed added more than a trillion dollars of excess reserves to respond to the financial crisis. ... Adding a few hundred billion to the trillion dollars already available would ... do little for the economy that banks could not do now.
There is very little that the Fed can do to change the near-term, but it can have important influence on the future. The Fed has sacrificed much of its independence during this crisis by helping the Treasury carry out fiscal policy. Adopting and following a rule, like the Taylor rule, is an effective way to regain independence.

The second to the last paragraph misstates the case that people are making for Quantitative Easing. First, as Ben Bernanke, Joe Gagnon, and others have pointed out, research indicates that the Fed could move long-term rates down a bit with QE. If the Fed does this, it then creates an incentive for more business investment and the purchase of more consumer durables. Yes, banks have plenty of funds to lend, and this would give them more, but the problem is lack of demand, and lower interest rates are intended to boost demand back up a bit. It's the demand side effects that matter, not the increased supply of funds. Now, I happen to think that those effects wouldn't be as strong as we need by themselves, fiscal policy needs to join the effort, but the Fed has a role to play.

As for the business uncertainty claim, here's Paul Krugman:

So I just read the latest speech from Richard Fisher of the Dallas Fed; it’s one of the most depressing things I’ve read lately, and given what I read that’s saying a lot.

Much of the speech is taken up with arguing that it’s not the Fed’s job to help the struggling economy, because the big problem there is business uncertainty about future regulation. Urk. Like others, I’ve tried to point out that there is no evidence for this claim: business investment is no lower than you’d expect given the state of the economy, while surveys say that weak sales, not fear of regulation, are holding back business expansion. Oh, and just to make it perfect, Fisher cites Mort Zuckerman to bolster his case.

Back in April, I said I had given up on policy makers, they weren't going to do anything more for the economy, at least nothing beyond "token help" that they could use to political advantage. Every once in awhile I get my hopes up that monetary or fiscal policy authorities might take action after all, but I shouldn't. Lucy always takes the football away.

Wednesday, September 08, 2010

"The Dramatic Jump in the Actual Unemployment Rate [is] Largely a Cyclical Phenomenon"

Minnesota Fed president Narayana Kocherlakota says once again that there's little that monetary policy can do for the unemployment problem because it's largely structural (here's Brad DeLong's reaction, see here too). However, researchers at the Cleveland Fed say their estimates tell a different story:

The dramatic jump in the actual unemployment rate we have observed since the beginning of the recession is being interpreted in our flows-based analysis as largely a cyclical phenomenon, with little movement in the long-term rate. The long-run trend does appear to have increased from its prerecession level, but by only a small margin.

The natural rate of unemployment is not 9.6 percent, the current unemployment rate. It's not even close to that (the Cleveland Fed says it's "roughly 5.6 percent to 5.7 percent"). But even if it was as high as 7.5 percent (to be clear, this is a hypothetical), are we just going to give up on the other 2.1 percent? I think that the cyclical component is a lot larger than 2.1 percent, and that even if there is a sizable structural problem there are still things we can do to help the structural transition along, including using low long-term interest rates to encourage the investment that helps that structural change happen faster. But even if you think the natural rate has increased quite a bit, and there's nothing the Fed can do for the structurally unemployed, it hasn't gone up as high as 9.6% and there's no reason to give up on those who can be helped.

And they do need help. As the Cleveland Fed notes in the link given above, even though the problem is largely cyclical in their view, it's looking like a long recovery is ahead:

Since we have not seen a big rise in the long-term unemployment rate, we might expect to converge to this “natural” rate soon. Unfortunately, this is not likely to be the case, and there are several reasons to suspect that the adjustment might take a long time. The first is the sheer extent of the gap between the current and long-term unemployment rates, regardless of the specific long-term rate one believes holds (figure 6). ... When the U.S. economy experienced a similar-size gap after the 1981–1982 recession, it took several years for the observed unemployment rate to drop to levels closer to the trend.
And it might be even harder for the labor market to adjust this time around. The rate of adjustment depends on how fast workers are reallocated between unemployment and the available jobs. The slower rates of worker reallocation we have found may act to slow the closing of the unemployment gap.
There are other reasons to believe that unemployment rates may stay well above the long-term rate for an extended period of time. Because of the length of the recession, there is a considerable number of potential workers who are not formally in the labor force. We have seen one of the sharpest drops in the labor force participation rate in the postwar data, as many unemployed workers simply stopped looking for a job. If some of these discouraged workers decide to search for a job as aggregate economic activity picks up, unemployment might decline at an even slower rate because the pool of unemployed workers is being replenished with workers re-entering the labor force.
Another concern raised by our findings is the negative impact of long-term unemployment on the human capital of the workforce. Longer unemployment spells are a problem because unemployed workers who are unemployed for too long can lose industry- and job-specific skills. Losing skills can reduce their odds of finding a job during the recovery as well as lower their productivity when they finally do find one.
Ultimately, an increase in the demand for labor will determine how fast the unemployment stock will be depleted. ...

Continuing the last point, we are simply not doing enough to create the labor demand that is needed. And, unfortunately, the claim that the problem is almost all structural and therefore there's little we can do is one of the things standing in the way of giving labor markets the help that they need.

What is the Role of the State?

When I teach the History of Economic Thought, one thing we focus on is how views on the role of the state have changed over time. It has a natural cycle to it, with eras such as the highly interventionist Mercantilist years followed by Physiocratic and Classical views stressing minimal government intervention. This is followed by a rebound in the other direction, and so it goes with a Keynes followed by a Friedman in the 50s, a rebound back to Keynes in the 60s, to classical ideas following the experience of the 70s, and so on, and so on. We are involved in the same debate, and a smaller version of the grand historical lurches in each direction, yet again today:

What is the role of the state?, by Martin Wolf: It is ... a good time to ask ... the biggest question in political economy: what is the role of the state? This question has concerned western thinkers at least since Plato (5th-4th century BCE). It has also concerned thinkers in other cultural traditions... The perspective here is that of the contemporary democratic west.
The core purpose of the state is protection. This view would be shared by everybody, except anarchists... Contemporary Somalia shows the horrors that can befall a stateless society. Yet horrors can also befall a society with an over-mighty state. ...
Mancur Olson argued that the state was a “stationary bandit”. A stationary bandit is better than a “roving bandit”, because the latter has no interest in developing the economy, while the former does. But it may not be much better, because those who control the state will seek to extract the surplus over subsistence generated by those under their control.
In the contemporary west, there are three protections against undue exploitation by the stationary bandit: exit, voice ... and restraint. By “exit”, I mean the possibility of escaping from the control of a given jurisdiction, by emigration, capital flight or some form of market exchange. By “voice”, I mean a degree of control over, the state, most obviously by voting. By “restraint”, I mean independent courts, division of powers, federalism and entrenched rights.
This, then, is a brief background to ... the problem, which is defining what a democratic state ... is entitled to do. ...
There exists a strand in classical liberal or, in contemporary US parlance, libertarian thought which believes the answer is to define the role of the state so narrowly and the rights of individuals so broadly that many political choices (the income tax or universal health care, for example) would be ruled out a priori. ... I view this as a hopeless strategy...
So what ought the protective role of the state to include? Again, in such a discussion, classical liberals would argue for the “night-watchman” role. The government’s responsibilities are limited to protecting individuals from coercion, fraud and theft and to defending the country from foreign aggression.
Yet once one has accepted the legitimacy of using coercion (taxation) to provide the goods listed above, there is no reason in principle why one should not accept it for the provision of other goods that cannot be provided as well, or at all, by non-political means.
Those other measures would include addressing a range of externalities (e.g. pollution), providing information and supplying insurance against otherwise uninsurable risks, such as unemployment, spousal abandonment and so forth. The subsidization or public provision of childcare and education is a way to promote equality of opportunity. The subsidization or public provision of health insurance is a way to preserve life, unquestionably one of the purposes of the state. Safety standards are a way to protect people against the carelessness or malevolence of others or (more controversially) themselves. All these, then, are legitimate protective measures. The more complex the society and economy, the greater the range of the protections that will be sought.
What, then, are the objections to such actions? The answers might be: the proposed measures are ineffective..; the measures are unaffordable...; the measures encourage irresponsible behavior; and, at the limit, the measures restrict individual autonomy to an unacceptable degree. These are all, we should note, questions of consequences.
The vote is more evenly distributed than wealth and income. Thus, one would expect the tenor of democratic policymaking to be redistributive and so, indeed, it is. Those with wealth and income to protect will then make political power expensive to acquire and encourage potential supporters to focus on common enemies (inside and outside the country) and on cultural values. The more unequal are incomes and wealth and the more determined are the “haves” to avoid being compelled to support the “have-nots”, the more politics will take on such characteristics.
What are my personal views on how far the protective role of the state should go? In the 1970s, the view that democracy would collapse under the weight of its excessive promises seemed to me disturbingly true. I am no longer convinced of this... Moreover, the capacity for learning by democracies is greater than I had realized. The conservative movements of the 1980s were part of that learning. But they went too far in their confidence in market arrangements and their indifference to the social and political consequences of inequality. I would support state pensions, state-funded health insurance and state regulation of environmental and other externalities. I am happy to debate details.
The ancient Athenians called someone who had a purely private life “idiotes”. This is, of course, the origin of our word “idiot”. Individual liberty does indeed matter. But it is not the only thing that matters. The market is a remarkable social institution. But it is far from perfect. Democratic politics can be destructive. But it is much better than the alternatives. Each of us has an obligation, as a citizen, to make politics work as well as he (or she) can and to embrace the debate over a wide range of difficult choices that this entails.
Update: Read Martin Wolf’s response to readers’ comments

Protection, justice, correction of externalities, social insurance, and the provision of public goods (which I would like to have seen emphasized more above) are, in my view, legitimate roles of the state. I have more trouble when it comes to redistribution, I prefer that everyone have an equal chance in life with the chips falling where they may (with insurance against outcomes where individuals end up with too few chips). But redistribution to correct problems associated with, say, uncorrected market failures that redistribute income unfairly, or to compensate for an unequal playing field more generally, is another matter.

Saturday, September 04, 2010

The Fed Can Help, and Should Help, but Fiscal Policy Can Do Even More

The Fed has been under considerable pressure recently by those, me among them, who believe the Fed should use quantitative easing to lower long-term interest rates. 

However, a temporary investment tax credit can provide the same incentives for business investment as a Fed induced fall in the long term interest rate, and then some, and that's not the only thing fiscal policy can do.

The Fed can help, and should help, but fiscal policy can do even more.

Friday, September 03, 2010

"Optimism…Pessimism…and a Bit of Perspective"

Dennis Lockhart, president of the Atlanta Fed, makes it clear that presently he sees no need for more stimulus -- a slow, plodding recovery like we had in the previous two recession is the best we can expect. If we're on track to match those, there's no need to try to do better.

Here's David Altig of the Atlanta Fed discussing Lockhart's speech earlier today:

Optimism…pessimism…and a bit of perspective, by David Altig, macroblog: Here's how I'm tempted to summarize today's release of the August employment report from the U.S. Bureau of Labor Statistics: more of the same. That theme fits nicely with comments this morning from Atlanta Fed President Dennis Lockhart, in a speech at East Tennessee State University. Here he calls for a little perspective:

"Some commentators are reading recent economic data as suggesting the onset of a second recession and deflationary cycle. Quite naturally, business people and consumers aren't sure what to believe.

"At the last meeting of the Federal Open Market Committee (FOMC) in Washington, the committee made a decision that has been widely interpreted as signaling declining confidence in the strength and sustainability of the recovery….

"In my remarks today, I will provide a less alarmist interpretation of recent economic information and the Fed's recent policy decision. I will argue that, generally speaking, there was too much optimism in the early months and quarters of the recovery and now there may be excessive pessimism."

One point is that recoveries are not generally linear affairs:

"Growth at the end of last year and early part of this year was stronger than I anticipated while economic activity in the second and third quarters seems weaker than I expected.

"But such ups and downs are not unusual during a recovery. A little history: following the 2001 recession, gross domestic product (GDP) grew at the annualized rate of 3.5 percent in early 2002. Growth then decelerated to about 2 percent for the next two quarters then fell to almost zero in the fourth quarter. Entering 2003, growth edged up to a little over 1.5 percent and then accelerated from there to a sustained period of relatively strong growth for two years."

...Even in the rapid-growth, pre-1990 recoveries, there was generally a quarter or two of growth that underperformed. ...

But the better benchmarks will likely prove to be the slower-growth, low-employment recoveries post-1990. In addition to the 2001 experience noted by President Lockhart, the expansion that followed the 1990–91 recession stumbled along with quarterly growth rates of 2.7, 1.69, and 1.58 percent, before picking up to above-potential growth rates. Despite that, the eighth quarter after that recession's end clocked in at an anemic 0.75 percent.

So why are we content to match that performance instead of trying to improve? Why do we try to rationalize concerns instead (calling it "a bit of perspective")?:

What is more important is that there is a reasonably good explanation for why we might have hit a soft patch:

"Looking at the 2009–2010 recovery, it seems clear that some of the early strength was promoted by policies that pulled forward spending from the second and third quarters of this year. The recent sharp decline in housing-related indicators following the expiration of homebuyer tax credits is the most obvious example of this effect."

Given that expectation, wouldn't it have been nice to have someone, the Fed say, try to fill this hole until the private sector begins growing robustly on its own?

Back to David Altig:

Essentially, President Lockhart's is a simple message: don't ignore the short-term data, but be careful with getting too carried away with it as well.

"Simply stated, I was expecting a relatively modest recovery...

And he, along with other members of the Fed, is apparently content with that. Finally:

...with respect to that meeting, here is the main policy point:

"At the last meeting there were two important considerations as I saw it. First, as already discussed, some economic data came in weaker than expected, shifting the balance of risks to slower growth in the near term and further disinflation. Second, the Fed's holdings of MBS were projected to decline faster than previously thought because lower rates were generating heavy mortgage prepayments and refinancings.

"So, in the context of a softening economy, the FOMC was confronted with the prospect of unintended withdrawal of support for the recovery through a decline in the level of liquidity provided to the economy….

"That is how I interpret the decision announced following the August meeting—a small tactical change designed to preserve the level of liquidity provided to the system. I supported the committee's decision, but I do not view it as a fundamental change of outlook or strategy. I do not believe this change necessarily heralds the beginning of a period of further expansion of the Fed's balance sheet. Nor do I think the decision precludes a return to a policy of allowing the balance sheet to shrink on its own.

"I think the decision has been over-interpreted in some quarters."


So, again, the recovery is expected to plod along like we've seen in the past, at least that's the hope, and though the downside risk has increased and the Fed has the tools to try to help, it doesn't think it should use them.

My view is different.

"What Role Did the Fed Play In the Housing Bubble?"

David Beckworth pushes back against some posts that have appeared here and elsewhere recently (my view is that low interest rates played a role, as did regulatory failures, but these were not the only causes of the crisis):

What Role Did the Fed Play In the Housing Bubble?, by David Beckworth: I really did not want to revisit this question since I have already covered it here many times before. Folks, however, are talking about it again given its coverage at the Fed's Jackson Hole conference. Mark Thoma, for example, has posted several pieces on it in the past few days. Most of this renewed discussion has taken a less critical view of the Fed's role during the housing boom, specifically the role played by the Fed's low interest rate policy. I feel compelled to rebut this Fed love fest since there are compelling reasons to believe the Fed did play an important role in creating the housing boom. To be clear, I do not see the Fed as the only contributor--far from it--but it does appear to be one of the more important ones. Here is my list of reasons why:

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period. It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative. Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential). There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007). Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa. This figure shows that monetary policy was unusually accommodative during this time. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate.

(2) Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way--via financial innovation, lax governance (both private and public), and misaligned incentives--into the housing market. Housing market activity was further reinforced by "the search for yield" created by the Fed's low interest rates. The low interest rates at the time encouraged investors to take on riskier investments than they otherwise would have. Some of those riskier investments end up being tied to housing. Thus, the risk-taking channel of monetary policy added more fuel to the housing boom.

(3) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom. The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area. From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s. Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

For these reasons I believe the Fed played a major role in the credit and housing boom during the early-to-mid 2000s. Let me close by directing you to Barry Ritholtz who gives more details on how the Fed's policy distorted incentives in financial markets.

Wednesday, September 01, 2010

Christina Romer’s Farewell Address

Here's a summary of:

Christina Romer’s Farewell Address

I also explain one reason I'm so furstrated with fiscal policymakers.

Tuesday, August 31, 2010

Jim Bullard Responds to Tim Duy

Via email, Jim Bullard, President of the St. Louis Fed, responds to Tim Duy:

Hi Tim,

I read your "Fed watch" column this morning in our news clips.  You do an excellent job of summarizing important issues facing the FOMC.  I have three comments, all of which I have made publicly recently, and I think they are critical ones for the direction policy will take:

--on the "raising interest rates" question:  I am not sure if you have looked at my paper, "Seven Faces of the Peril," but if not please take a look at Figure 1 there (web page below) and contemplate the left hand side of the picture.  This convinces me that staying with the near-zero interest rate policy alone--and promising to stay near-zero for a long time without doing anything else--risks a deflationary trap.  To avoid this, I am recommending additional QE as a supplement to the near-zero rate policy as our best option.  You actually have one of the world's experts on the question of the dynamics behind Figure 1 at the U. of Oregon: George Evans.  Rajiv Sethi's summary of this issue as linked in your blog is very good, but citing Howitt--a fine paper, to be sure--is missing the more sophisticated analysis of Evans and Honkapohja that I cite in my paper.  I am not saying I necessarily agree with the Evans and Honkapohja policy conclusions, but they have good analytics for framing these issues.

--on the effectiveness of QE:  I do not agree that asset purchases are somehow ineffective.  I talk about this in my CNBC interview at Jackson Hole (also posted on my web page).  The direct empirical evidence on the effectiveness of QE both in the U.S. and the U.K. is fairly strong.  For example, see the paper by Chris Neely of our staff cited in the "Perils" paper.
--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.  Concerning the data itself, your colleague Jeremy Piger will update his recession probabilities shortly so I will be anxious to see how that comes out.

I hope these comments are not too confused, I enjoyed your blog and I think you do a fine job of tracking the issues in the Fed.

Best regards,


I am about to do a video with George Evans who will explain the issues involved with dynamics at the zero bound, how Howitt fits in, how learning changes things, etc., so please stay tuned...

Fed Watch: No Clothes

Tim Duy is "anything but" reassured by Ben Bernanke's recent speech outlining the Fed's possible policy actions, and what it will take to put them into action:

No Clothes, by Tim Duy:

Unless every able American pitches in, Congress and I cannot do the job. Winning our fight against inflation and waste involves total mobilization of America's greatest resources—the brains, the skills, and the willpower of the American people. --- President Gerald Rudolph Ford, "Whip Inflation Now" Speech (October 8, 1974)

Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. --- Federal Reserve Chairman Ben Bernanke, "The Economic Outlook and Monetary Policy" Speech (August 27, 2010)

Rereading Federal Reserve Chairman Ben Bernanke's recent speech and measuring it against the incoming data leaves me with a pit in my stomach. I sense Bernanke reveals in this speech he is the proverbial emperor without clothes, short on policy options but long on hope. A last ditch attempt to persuade us that as long as we don't believe deflation will be a problem, it will not be a problem. But he faces the same challenge as did then President Gerald Ford. All hat and no cattle. You need to be ready to back up your talk with credible policy options. While Bernanke outlined possible policy options, reading between the lines makes clear he lacks conviction in the viability of any of those options. Simply put, Bernanke is not ready to embrace the paradigm shift bold action requires.

First, it is worth considering the economic context of the policy environment via the lens of July Personal Income and Outlays report. Real gains fells short of what I believe to be already diminished expectations, with a clearly suboptimal trend in place:


When Bernanke expresses concern for the near term pace of economic growth, he is concerned with failing to track the current path of economic activity, as illustrated by the path of consumption since July of last year. This already is a substantial lowering of the bar, and appears to be a resignation that previous trends are unattainable. That is a problem in many respects, the most important of which is that previous trends were consistent with full employment. The failure to acknowledge the importance of re-achieving the previous path is, in my opinion, an admission of the willingness to accept a protracted period of high unemployment. This, of course, has been essentially admitted by Bernanke:

Although output growth should be stronger next year, resource slack and unemployment seem likely to decline only slowly. The prospect of high unemployment for a long period of time remains a central concern of policy. Not only does high unemployment, particularly long-term unemployment, impose heavy costs on the unemployed and their families and on society, but it also poses risks to the sustainability of the recovery itself through its effects on households' incomes and confidence.

As I have already commented, if unemployment is a concern, and there is no conflict between the Fed's dual mandate, then why is the Fed waiting for further evidence of disinflation before acting? Indeed, Scott Sumner saw a line in the sand in Bernanke's speech of a one percent inflation rate. The most recent PCE data suggests we are perilously close to testing that line already:

Continue reading "Fed Watch: No Clothes" »

Monday, August 30, 2010

Did I Hear that Right? You Want to Raise Interest Rates?

Let me explain, as simply as I can, the underlying reason for the strong reaction to Minnesota Fed president Narayana Kocherlakota's suggestion that raising interest rates would be helpful.

When a Federal Reserve president calls for an increase in interest rates while the economy is still struggling to recover, something that repeats the errors of 1937-38, all of his buddies in academia should expect a reaction. It comes with the job. The fact that he can point to a model that failed to provide much help with the situation we're in to justify the statement isn't of much comfort, and there are serious questions about the validity of the claim in any case.

This isn't just a theoretical exercise where finding novel, counter-intuitive results that may or may not have real world applicability draws the admiration of peers, people's livelihoods are at stake. Real people in the real world are depending on the Fed to get this right, and suggestions that the Fed raise interest rates to help with the recession go against every intuitive bone I have in my body. More importantly, for those who think those bones might be broken, it goes against the existing empirical evidence. This is not a game, actual policy is at stake that will affect people's lives, and we cannot be careless in how we approach it.

If I reacted strongly, it's because I don't want us to repeat the mistakes we made in the past, mistakes that would hurt people who have suffered enough already. Do the advocates of this policy really believe, way down deep, that raising interest rates is the right thing to do in this situation? Perhaps, but I sure don't, and I can't let it pass without comment.

Sunday, August 29, 2010

"America’s Leaders are Letting the Country Down"

Clive Crook:

It falls to the Fed to fuel recovery, by Clive Crook, Commentary, Financial Times: The US recovery is stalling. As a matter of economics the balance of risks strongly favors further fiscal and monetary stimulus. Politics appears to rule out the first, and a divided Federal Reserve is hesitating over the second. America’s leaders are letting the country down. ...
Unlike most other advanced economies, the US could undertake further fiscal stimulus at acceptably low risk. Global appetite for its debt is undiminished. The risk, such as it is, could be all but eliminated if Congress could commit itself to stimulus now, restraint later – an easy thing, you might suppose, but evidently beyond its grasp. The administration could and should be pushing for just such a package, but it is not.
The political problem is that US voters ... have wrongly decided that the first stimulus was an expensive failure. The administration is partly to blame. It oversold the ... first package...
One cannot know how many jobs the stimulus saved, but it is absurd to see high unemployment as proof that it was ineffective. More likely this shows how powerful the recession’s downward pull has been, and still is. Most economists think the stimulus helped a lot. Yet, as in other areas, President Barack Obama’s defense of his policy has been strangely diffident. ...
Meanwhile, there is monetary policy. At the end of last week,... Ben Bernanke, Fed chief, acknowledged the faltering recovery, and reminded his audience that the central bank has untapped capacity for stimulus. ... Mr Bernanke and his colleagues are understandably nervous about extending the radical measures they have already taken. ... But the balance of risks has moved. They need to go further. ...

A Question for the Kansas City Fed

This has annoyed me for several years now. Why won't the Kansas City Fed make the papers for the Jackson Hole conference available until after the conference is over? What's the purpose of this? None that I can think of, other than making themselves special, but that's no way for a public agency to behave.

This is the opposite of transparency. I can understand waiting until the final versions are submitted, but at that point, why not post the papers so we can read them prior to the conference and give more informed commentary on the event? As it stands, I have to rely upon reporters to accurately tell me what's in the papers and, while I do trust some of them to mostly get things right (but not all), I'd like to be able to check the papers for myself. Sometimes participants will give a report after the event is over, but that's a bit late and even then I'd like to be able to come to my own conclusions, or at least verify the reports from reading the papers themselves. What's the point in locking them up? (As far as I can tell, the authors aren't even allowed to post the papers on their own sites.)

The pdfs will also be copy protected when they are posted, another step that places unnecessary hurdles in the way of commenting on the papers. Under the KC Fed's policy, which extends to speeches by the president of the KC Fed but isn't followed by other district banks, reproducing a graph or a few paragraphs then becomes tedious. The copy protection doesn't stop anyone who really wants to post a paragraph or two as you are permitted to do, it's simply harder and hence discouraging (and the speeches themselves are supposed to be in the public domain and hence fully reproducible). But why discourage conversation about these papers? Why make it so that we can't actually read the papers and comment on them until the conference is over and people have lost interest in the event. Why make it as hard as possible to even take small excerpts? How is that helpful?

Creating an exclusive event like this does give the people involved power, it makes them special, it gives them the power to include and exclude people, and so on. But their duty is to serve the public interests, not create a special little club that only some can participate in, and then dribble out the important information in a way that maintains their exclusivity and power.

I can live with the copy-protection, but the attempts to discourage access to the conference papers is puzzling when viewed through the Fed's mission to serve the public interest.

[Maybe I've missed something obvious, it certainly wouldn't be the first time that's happened, and there's a good reason for this policy. If someone at the KC Fed wants to explain why they can't do what most conferences do and make the papers available prior to or at the beginning of the conference, or at the very least at the time of or right after a session is over, I will post the explanation. It would be nice if the explanation also included the reasons for trying to lock up other documents such as Fed speeches, something no other Fed tries to do.]

"Can Interest Rates Explain the US Housing Boom and Bust?"

Did low interest rates cause the financial crisis as John Taylor and others contend? (I've argued that the low interest rate policy contributed to the crisis, but by itself was not the major factor. That is roughly consistent with their conclusion, though their numbers on the degree to which interest rates mattered are lower than I would have predicted):

Can interest rates explain the US housing boom and bust?, by Edward Glaeser, Joshua Gottlieb, and Joseph Gyourko: Between 2001 and the end of 2005, the Standard and Poor’s/Case-Shiller 20 City Composite House Price Index rose by 46% in real terms. By the first quarter of 2009 the index had dropped by about one-third before stabilizing. The volatility of the Federal Housing Finance Agency (FHFA) repeat-sales price index was less extreme but still severe. That index rose by 53% in real terms between 1996 and 2006 and then fell by 10% between 2006 and 2008. As many financial institutions had invested in or financed housing-related assets, the price decline helped precipitate enormous financial turmoil.

Much academic and policy work has focused on the role of interest rates and other credit market conditions in this great boom-bust cycle.

  • One common explanation for the boom is that easily available credit, perhaps caused by a “global savings glut,” led to low real interest rates that boosted housing demand (Himmelberg et al. 2005, Mayer and Sinai 2009, Taylor 2009).
  • Others have suggested that easy credit market terms, including low down payments and high mortgage approval rates, allowed many people to act at once and helped generate large, coordinated swings in housing markets (Khandani et al. 2009).

Those easy credit terms may have been a reflection of agency problems associated with mortgage securitization (Keys et al., 2009, 2010, Mian and Sufi, 2009 and 2010, Mian et al. 2008).

If correct, these theories would provide economists with comfort that we understood one of the great asset market gyrations of our time; they would also have potentially important implications for monetary and regulatory policy. But economists are far from reaching a consensus about the causes of the great housing market fluctuation. For example, Shiller (2003, 2006) long has argued that mass psychology is more important than any of the mechanisms suggested by the research cited above.

Re-evaluating the missing link

Motivated by this question, we re-evaluate the link between housing markets and credit market conditions, to determine if there are compelling conceptual or empirical reasons to believe that changes in credit conditions can explain the past decade’s housing market experience.

Continue reading ""Can Interest Rates Explain the US Housing Boom and Bust?"" »