Category Archive for: Monetary Policy [Return to Main]

Wednesday, September 21, 2011

FOMC Decides to Implement Operation Twist

Here's the FOMC statement. The big news is the attempt to lower long-term interest rates by shifting $400 billion of the Fed's portfolio from short-term to long-term assets (i.e. what has been described as a "twist"):

Press Release, Release Date: September 21, 2011: Information received since the Federal Open Market Committee met in August indicates that economic growth remains slow. Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has been increasing at only a modest pace in recent months despite some recovery in sales of motor vehicles as supply-chain disruptions eased. Investment in nonresidential structures is still weak, and the housing sector remains depressed. However, business investment in equipment and software continues to expand. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action were Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who did not support additional policy accommodation at this time.

On the run, so very quick reaction:

1. This shifts the duration of the balance sheet, but it does not change its size. I would have preferred balance sheet expansion, i.e. QE3, as that would have a much better chance of helping the economy. But the inflation hawks on the committee will not tolerate further expansion in the balance sheet due to worries about inflation.

2. It's not big enough.

3. Even if it causes rates to fall, will consumers and businesses respond?

That is, this might help some, but not enough to solve our employment crisis -- not by any means. Thus, this does not alleviate the need for Congress to implement serious job creation programs as soon as possible.

The unemployment crisis needs to be attacked vigorously, and we need aggressive action from both monetary and fiscal policymakers. But neither the Fed nor Congress has the will to do more than half-hearted measures at this point, and even that might be too much for Congress.

I wish the people making these decisions had to face what households struggling to find a job endure daily -- the world policymakers see from their insulated shell is very different from the world of the unemployed. Maybe then they'd finally get it and, more importantly, do what needs to be done.

Update: Tim Duy reacts to the decision.

Update: Via Daniel Indiviglio:

...But the other action announced by the Fed shouldn't be overlooked. Previously, it was reinvesting its maturing mortgage securities in new Treasuries. By instead targeting agency mortgage securities, it will more directly push down mortgage interest rates. The size of this effort is not provided, in large part because its size will depend on external factors.

As prepayments from mortgage refinancing increase, so will the amount of money the Fed will reinvest. And with mortgage rates heading towards historical lows due to this campaign, you should expect to the Fed provided lots of principal with which to reinvest. It wouldn't be surprising to see $40 to $45 billion per month in reinvested in agency mortgage securities through this effort. That's about the amount of monthly maturing principal reinvestment from mortgage securities we saw last year as rates were dropping. So this effort could actually outweigh Operation Twist.

McConnell, Boehner, Kyl, and Cantor's Letter to the Fed

This letter from Senators McConnell, Boehner, Kyl, and Cantor crosses a line that shouldn't be crossed:

Dear Chairman Bernanke,
It is our understanding that the Board Members of the Federal Reserve will meet later this week to consider additional monetary stimulus proposals. We write to express our reservations about any such measures. Respectfully, we submit that the board should resist further extraordinary intervention in the U.S. economy, particularly without a clear articulation of the goals of such a policy, direction for success, ample data proving a case for economic action and quantifiable benefits to the American people.
It is not clear that the recent round of quantitative easing undertaken by the Federal Reserve has facilitated economic growth or reduced the unemployment rate. ...
We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems or further harm the U.S. economy. ...
Sen. Mitch McConnell, Rep. John Boehner, Sen. Jon Kyl, Rep. Eric Cantor

I think speaking out individually is fine, e.g. a member of Congress stating his or her views on monetary policy in a speech is not a problem. That's part of the public dialogue.

But an official letter from members of the House and Senate to the Fed is more official, and more threatening to the Fed's independence than a speech from an individual member of Congress. Robert Reich explains the objections:

The Republican’s Latest Ploy to Keep the Economy Lousy through Election Day, by Robert Reich: ...To say it’s unusual for a political party to try to influence the Fed is an understatement.
When I was Secretary of Labor in the Clinton Administration, it was considered a serious breach of etiquette — not to say potentially economically disastrous — even to comment publicly about the Fed. Everyone understood how important it is to shield the nation’s central bank from politics.
If global investors suspect the Fed is responding to political pressure of any kind, investors will lose trust in the nation’s monetary policies. Even if the pressure is to tighten the money supply and keep interest rates high, it’s still politics. And once politics intrudes, lenders of all stripes worry that it will continue to intrude in all sorts of ways. The inevitable result: Lenders charge more for lending us money.
The letter puts Bernanke and his colleagues in a huge bind. If they decide against another round of so-called “quantitative easing” to lower long-term rates and boost the economy, they may look like they’re caving to congressional Republicans. If they decide to go ahead notwithstanding, they’re bucking the Republicans and siding with Democrats. Either way, they’re open to the charge they’re playing politics.
Congressional Republicans evidently don’t care. They want Obama out, whatever the cost. Besides, they’ve never met a government institution they don’t mind trashing.

There's more to it than higher interest rates. History tells us that politicizing monetary policy is a bad idea -- giving control of the money supply to politicians generally leads to high inflation -- and for this reason most countries have a monetary authority with some degree of independence. Thus, the GOP's politicization the Fed in the name of preventing inflation is puzzling (unless of course, inflation hawkery is cover for another agenda).

Tuesday, September 20, 2011

Fed Watch: Not the 1970s

Tim Duy:

Not the 1970s, by Tim Duy: Today former Federal Reserve Chairman Paul Volker pulled out the specter of the 1970’s to rail against those suggesting room for a higher inflation target, holding special contempt for the obviously insidious President of the Chicago Federal Reserve Charles Evans:

So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.

It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.

Not so remarkably given that this idea has been making the rounds for some time – Olivier Blanchard suggested a 4% inflation target early last year, and Greg Mankiw wrote this in early 2009:

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.

Of course, Volker’s amazement that someone might suggest a higher inflation target is a consequence of his conviction that the 1970’s was the worst economic decade ever:

…Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability…

…Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth…

…It is precisely the common experience with this inflation dynamic that has led central banks around the world to place prime importance on price stability. They do so not at the expense of a strong productive economy. They do it because experience confirms that price stability — and the expectation of that stability — is a key element in keeping interest rates low and sustaining a strong, expanding, fully employed economy.

Note the conviction that high inflation is not compatible with strong growth. Now take a quick look at some of the economic outcomes of periods beginning with 1970 and 2000:





I don't want to romanticize the 1970s. I think we all recognize that the 2.5% unemployment rate at the end of the 1960’s was below the natural rate and thus incompatible with low inflation. The subsequent decade of economic mismanagement did permit both inflation and unemployment to rise, although certainly some of the latter can be attributed to the unusually low unemployment at the beginning of the decade. That said, the above numbers stack up pretty impressively compared to the 2000s. Arguably in recent years productivity did accelerate, at least temporarily, but didn’t appear to translate into better job or wage growth. But overall, I am thinking the inflationary 1970s look pretty good right now relative to the price stability of the last decade.

Of course, in the background, the unexpected inflation of the 1970s drove a redistribution of wealth, and it is this that is probably Volker’s real complaint. My first undergraduate economics professor told a story of how all the student loans he took out in the late 60s and early 70s evaporated in real terms a decade later. Perhaps Volker would have preferred that he had been weighed down by those debts instead - a situation not unlike today, were the debt overhang is a weight on household spending.

What is even more sad is that Volker fails to recognize why some argue for higher inflation:

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

I don’t think I have heard anyone who believes that inflation is a cure to sluggish productivity. Indeed, see above – during the recession productivity was anything but sluggish. No one thinks that higher inflation will spark higher productivity, only that higher inflation can be a tool to lift the economy from the lower bound allowing output to rise to the productivity-enhance level of potential output. Excessive leverage is a real problem, and in fact one that can be addressed via inflation. A commenter on an earlier piece notes that even what I perceive as lower levels of inflation could quickly erode the debt overhang, albeit not as quickly as I might like. How a central banker cannot recognize that unanticipated inflation erodes real debt loads is simply unfathomable.

And Volker uses the general term “economic imbalances,” but offers no explanation to what he is referring. Arguably, the major economic imbalance is the foreign central bank-induced trade deficit, which has contributed to a global imbalance in patterns of production and consumption. Recall that he appears to recognize the role of the dollar in any rebalancing:

If the dollar is weakened, that’s a good thing; it might even help close the trade deficit.

But seems to lose sight of this later:

At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

I thought the purpose of the Federal Reserve was to promote the economic interest of the United States – that is its primary responsibility. And how can any economic imbalances be resolved if we remain dependent on borrowing from abroad? Wouldn’t we be better off discouraging those capital flows and allowing for export and import-competing industries to expand? And wouldn’t the rest of the world be better off if the US helped ease their inflationary pressures by providing additional goods and services to the global economy rather than attempting to absorb the excessive production of other nations? (And if you believe that those capital inflows represent confidence in the US economy, I have a bridge to sell you. Take out the purchases by foreign central banks and see what happens.)

Bottom Line: The constant comparisons to the 1970s are increasingly tiresome. At the end of the day, in the 1970s we were not in a liquidity trap. Today we are. The world is simply different. And we need policymakers that recognize that difference, not dinosaurs who refuse to do anything but live in a narrow view of their youth.

Monday, September 19, 2011

Fed Watch: Rearranging the Deck Chairs

Tim Duy says he has "trouble seeing the FOMC doing anything really big at this point":

Rearranging the Deck Chairs, by Tim Duy: Here we are, again staring down the barrel of an FOMC meeting while deeply entrenched in a subpar equilibrium, with output well below the pre-recession trend and unemployment stuck in the high single digits. What will the Fed bring to the table this time around? Considering the magnitude of the economic challenge, expectations are low: A modification of the FOMC statement to reflect an increasingly pessimistic outlook couple with some version of “Operation Twist,” an effort to reduce longer-term interest rates by extending the duration of the Fed’s portfolio of Treasury securities. There is an outside change the Fed lowers interest on reserves, but I view that as unlikely at this juncture. Even more unlikely is another round of quantitative easing. I don’t think there is much appetite at the Fed for additional asset purchases given the inflation numbers and the stability of longer-term inflation expectations relative to the events that prompted last fall’s QE2.

Will additional Fed action accomplish much if anything? I admit to being increasingly skeptical that the Fed is doing much more than pushing on a string. Interest rates on are less than 1 percent out to five year, which pretty much means whatever the Fed is doing at that horizon is just shifting around the composition of risk free assets. There is some room as you move to the 10-year horizon – at least there you have 200 basis points to play with. But even with some room to maneuver, in order to have significant impact, I think they need to be throwing around some big numbers when it comes to Operation Twist. Via Marketwatch, former Federal Reserve Vice-Chair Alan Blinder:

Blinder agreed that “some version of twist” is “the likely next step.” The Federal Open Market Committee will meet for two days next week to determine whether and how to ease further.

Blinder said the program needed to be large to have a meaningful impact.

“The twist is a sufficiently weak instrument so to do it in tiny amounts it almost becomes laughable,” he said.

Likewise, the same holds for another round of quantitative easing. Recall that estimates of the interest rate effect of QE2 were relatively modest, on the order of 20bp. I am not sure that any of us believe that another 20bp will be the bullet that pulls us out of the slump.

So if the Fed wants to have any meaningful impact, it needs to do something really, really big, and even then, a “meaningful” outcome is not assured. And, in any event, I have trouble seeing the FOMC doing anything really big at this point – it seems the center of the Fed questions the basic effectiveness of policy to do much more than raise inflation given what are increasingly perceived as structural impediments to growth. It could be the Fed is inclined to take additional actions only to look like they are doing something.

Moreover, there is this ongoing concern the Fed is doing nothing more than aggravating the lending situation by crushing down longer-term yields. The logic is that banks need some interest rate spread to justify lending. In the current environment, they see no reason to take on additional lending to any but the safest clients – not enough margin to justify the risk of a loan default.

What can be done to steepen the yield curve and this induce additional lending while at the same time holding long term rates low to encourage borrowers to line up at the bank? Override the zero lower bound to induce negative short-term interest rates. Blinder again:

Blinder said the Fed could first cut the interest rate on excess reserves to zero “just to make sure that there are not some unintended consequences that are horrendous,” he said.

The rate could then be pushed into negative territory.

The notion is strongly opposed by banks, who view it as a tax.

Blinder doesn’t disagree with that characterization.

“The whole notion is you should tax things you don’t like people to do, and subsidize things that are essential,” he said.

“One thing we don’t like is banks just piling up idle reserve,” he said. “We would like to push that money out of the banks and have them do something with it.”

Although some money will undoubtedly go into super-safe money funds, “the hope is that some fraction goes into increased lending,” he said.

You get the idea – whatever money the Fed has injected into the economy via QE2 has been reabsorbed by the Fed in the form of excess reserves rather than supporting loan growth in the economy. To solve that problem, charge banks for holding reserves at the Fed, thus inducing them to get their acts together and start lending.

Will it work, or will there be some serious, negative unintended consequences? Consider this story of soaring bank deposits (hat tip to CR):

Americans are pumping money into bank accounts at a blistering pace this year, sending deposits to record levels near $10 trillion on escalating fears that the U.S. economy is on the verge of another implosion.

There's no sign that the flood into checking, savings and money market accounts is slowing down. In the last three months, accounts at U.S. commercial banks have increased $429 billion, or 10%, almost double the increase for all of last year.

The money is coming in fast! Good news? No:

There's one big problem: Banks don't want your money.

"Banks and credit unions are doing everything they can to get rid of the cash except make loans," said Mike Moebs, a Lake Bluff, Ill., banking consultant.

He said banks are driving away deposits by refusing to renew CDs at higher rates and by imposing fees on checking accounts for depositors who don't use other, profitable financial services as well.

The banking sector is reacting to a flood of money by trying to push back the tide, not by opening up the loan spigot. If the Fed pushes the interest on reserves into negative territory, will that be enough to spur lending? Or will banks simply do more of what they are already doing? The path of least resistance is to keep doing more of the same.

And if consumers are only charged for money they hold in the bank, effectively earning negative interest rates themselves, will they spend more money, or just start stuffing their mattress? And maybe start stuffing it twice as fast. You know its bad when banks won’t take your money. Time to dust off the Roubini portfolio – dried food, ammunition, and gold. I guess that is how gold can go off the charts in both an inflationary or deflationary environment.

In short, it is not evident that more monetary policy will make its way down to the heart of the problem:

Bankers such as Robert H. Smith, former chairman of L.A.'s Security Pacific Corp., say the industry is being throttled by a combination of the weak economy and regulations that were tightened in the aftermath of the financial crisis.

"What little demand that is out there for loans is regarded very skeptically [by the banks] because of the pressures from the regulators," said Smith, who sold Security Pacific to Bank of America 20 years ago and is now a founding director of Commerce National Bank in Newport Beach.

Which came first, the chicken or the egg? Is the economy weak because lending is tepid, or vice-versa? The lack of potential borrowers with sufficient cash flow who actually want to borrow money clearly hampers the effectiveness of monetary policy through either traditional or nontraditional channels.

So what is left? I keep coming back to the same conclusion. That to be effective at this juncture, additional monetary policy must be coordinated with additional fiscal policy. The Fed creates the money, fiscal policymakers ensure it gets into the hands of someone who will spend it, boosting demand until interest rates rise and the pool of ready and willing borrowers swells. At that point the banking sector has someone to loan to and a spread to work with.

Bottom Line: When the Fed meets this week, will they accommplish anything more than rearranging the deck chairs? I increasingly see the need for dramatic action to decisively lift the economy off the zero bound. The comparisons to Japan and getting a little too close for comfort; it is easy to how the US economy limps along for the next decade characterized by rock-bottom interest rates and never-ending fiscal deficits.

Wednesday, September 14, 2011

"How to Do More"

Adam Posen urges central banks to take aggressive action:

How to do more, by Adam Posen, External Member of the Monetary Policy Committee, Bank of England: We do want more, and when it becomes more, we shall still want more. And we shall never cease to demand more until we have received the results of our labor. - Samuel Gompers, May 2, 1890

Something's better than nothing, yes! But nothing's better than more.
- Stephen Sondheim, Sung by Madonna in the movie, Dick Tracy, 1990

Both the UK and the global economy are facing a familiar foe at present: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the US and elsewhere in the 1930s, or in Japan in the 1990s, every major financial crisis-driven downturn has been followed by premature abandonment—if not reversal—of the macroeconomic stimulus policies that are necessary to sustained recovery. Every time, this was due to unduly influential voices claiming some combination of the destructiveness of further policy stimulus, the ineffectiveness of further policy stimulus, or the political corruption from further policy stimulus. Every time those voices were wrong on each and every count. Those voices are being heard again today, much too loudly. It is the duty of economic policymakers including central bankers to rebut these false claims head on. It is even more important that we do the right thing for the economy rather than be slowed, confused, or intimidated by such false claims.

Make no mistake, the right thing to do right now is for the Bank of England and the other G7 central banks to engage in further monetary stimulus. If anything, it is past time for us to do so. The economic outlook has turned out to be as grim as forecasts based on historical evidence predicted it would be, given the nature of the recession, the fiscal consolidations underway, and the simultaneity of similar problems across the Western world. Sustained high inflation is not a threat in such an environment, and in fact the inflation that we have suffered due to temporary factors in the UK is about to peak.1 If we do not undertake the stimulative policy that the outlook calls for, then our economies and our people will suffer avoidable and potentially lasting damage. I will recap the argument for doing more in a moment.

My main purpose in speaking to you today is to explain how the Bank of England, and by extension other central banks, should do more to ease monetary policy at this juncture. I hope to convince you that doing more would be not only desirable, but constructive for the economy as a whole, effective as stimulus, and feasible without political compromise. A large part of this argument rests on asking you as sensible listeners to see through the distortions and falsehoods that have cropped up again in the aftermath of this crisis as in the past. Some common sense can be just as useful in appraising monetary policy as in evaluating the overall worth and likely success of other services for which the public contracts with technical experts. After such appraisal, I hope that you will agree with my arguments that:

  • More monetary ease will lead to greater restructuring of the economy in the right and necessary direction;
  • More of the same Quantitative Easing [QE] program that the Bank already undertook would be where to start, especially if done on sufficient scale;
  • More cooperation between the Bank and HM Government to promote investment and credit to small and medium business should be the beneficial next step.

Monetary policymakers must also free themselves from unfounded concerns and take these necessary actions. There are too many excuses for passivity being offered, none of which stand up to scrutiny or to the data. In essence, central banks can improve matters by doing more, even if we have to act alone. In so doing, we would make constructive actions by other policymakers in the fiscal and financial arenas outside of our remit more – not less – likely, and those actions more likely to succeed when undertaken.

Almost certainly, even if we were to do everything right on monetary policy (and we certainly will not get everything right, despite the best of intentions), there will still be suffering and ongoing problems from economic adjustment. And the benefits of our right policies may not turn out to be self-evident. But it is our responsibility and our duty to make things better if we can. Central bank officials have wasted too much time over the last year worrying about how their institutions would appear to markets, to politicians, and to the public, were we to undertake more stimulus. Sometimes you have to do the right thing even if it may be misperceived. I believe that by explaining how doing more would work, as I am trying to do today, the chances may increase that we will do the right thing on monetary policy now, and that it will be recognized as right later if not immediately.

1 Unless there is a sufficiently persistent supply shock to energy prices to more than offset the influence of declining rates of global growth on those prices for the next couple of years – something oil futures markets do not price in at present (in fact, they price in the opposite). ...[continue reading]...

Monday, September 12, 2011

Fed Watch: A Modest Monetary Proposal

Tim Duy:

A Modest Monetary Proposal, by Tim Duy: I have been reading and rereading Raghuram Rajan’s piece questioning the effectiveness of proposals to raise inflation targets. I tend to be pretty sympathetic to such proposals; traditional monetary policy obviously hit it limit long ago, and active commitments to higher inflation to depress real rates seems to be a logical next step. That said, Rajan has a number of good points questioning both the implementation and efficacy of higher inflation targets. Can the Federal Reserve credibly commit to higher inflation? Can they credibly commit to regain control over inflation at some later time? Most striking, I think, was Rajan’s reflection, that a small inflation increase really will not do much good at all:

Moreover, the central bank needs rapid, sizeable inflation to bring down real debt values quickly – a slow increase in inflation (especially if well signaled by the central bank) would have limited effect, because maturing debt would demand not only higher nominal rates, but also an inflation-risk premium to roll over claims.

A mechanism to rapidly accelerate the process of household rebalancing would be extremely helpful. It is not clear that an inflation target of 3 percent is such a mechanism. Something more dramatic is required.

Would that something more dramatic be QE3? I see that over the weekend, St. Louis Federal Reserve President James Bullard came out in favor of QE3 should more easing be necessary. From the Wall Street Journal:

In an interview with the Business News Network, James Bullard said “I still think our most potent weapon is to do more QE3 if necessary,” in a reference to the QE2 bond buying program that ended in the summer.

He goes on to undermine the policy that Fed seems to be coalescing around:

Bullard said the experience of the 1960s-era “Operation Twist,” when the Fed and Treasury together worked to try to push down long-term borrowing rates, should be cautionary. Bullard said that effort was not particularly effective, which is why more outright purchases would most likely be the way to go.

My sense is that Bullard prefers whatever policy option produces the biggest headline for him. That said, he is probably right on this one – a portfolio rebalancing is a move in the right direction, but don’t expect miracles. But could any miracles really be expected from more quantitative easing? As Rajan notes:

Start with the question of whether central banks that have spent decades establishing and maintaining anti-inflation credibility can generate faster price growth in an environment of low interest rates. Japan tried – and failed: banks were too willing to hold the reserves that the central bank released as it bought back bonds.

To be most effective, monetary policy needs to push on some variable that will have a substantial impact on demand. Trading safe assets for cash at near zero interest rates just doesn’t accomplish that. But it’s the only biggish lever we seem to have left, but it simply is not direct enough. What is needed is to get the money in the hands of someone who will use it, rather than just sloshing around banks as excess reserves. If it is stuck in the banking system, it can’t create demand that at least causes a big shift in the prices of both goods and wages.

Maybe at this point we need to be thinking about something a little more direct – one of the proposals floating around is to use Fannie and Freddie to purchase nearly all the outstanding mortgages and refinance them at lower interest rates regardless of loan to value ratios. Better yet, to apply some consistent system of principle reduction for everyone, not just underwater mortgages. Lift the entire boat at once, rather than trying to discern between the most and least deserving lifeboats.

Something like this is not a new idea, but it gets held up by, among other things, by the issue of the cost. So maybe the Treasury needs to issue a class of bonds the Federal Reserve agrees to purchase and hold – essentially monetizing the rebuilding of household balance sheets and freeing future tax payers from the burden of repaying the debt.

I suspect that this entails a sharp, one time increase in the price level, and this is the tricky part. The Fed would have to both accept that increase and make clear they are committed to return to their 2 percent target. I don’t think this is impossible, but it might be difficult to accomplish quickly. Also note that once we can lift up off the zero-bound, traditional monetary policy can come back into play to manage inflation. Moreover, they have room to reduce the remainder of the balance sheet, but, when all is said and done, they should not expect to return to the pre-crisis trend, and instead acknowledge the one-time shock to the balance sheet.

Bottom Line: Rather than the more indirect approaches left to monetary policy, maybe there is room for a one-time effort to monetize the rebalancing of household balance sheets, which perhaps can be viewed as a more “modest” alternative to monetization of general government spending. Perhaps the former can be more credibly contained to a one-time event.

Friday, September 09, 2011

Fed Watch: Ben Speaks

Tim Duy:

Ben Speaks, by Tim Duy: Federal Reserve Chairman Ben Bernanke took the stage today, providing few hints about the path of monetary policy in the months ahead. Market participants were hoping for more specific details on what the Fed has up its sleeve at the next meeting, but got more of the same:

In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. My FOMC colleagues and I will continue to consider those and other pertinent issues, including, of course, economic and financial developments, at our meeting in September and are prepared to employ these tools as appropriate to promote a stronger economic recovery in a context of price stability.

More interesting was his extended comments on inflation:

However, inflation is expected to moderate in the coming quarters as these transitory influences wane. In particular, the prices of oil and many other commodities have either leveled off or have come down from their highs. Meanwhile, the step-up in automobile production should reduce pressure on car prices. Importantly, we see little indication that the higher rate of inflation experienced so far this year has become ingrained in the economy. Longer-term inflation expectations have remained stable according to the indicators we monitor, such as the measure of households' longer-term expectations from the Thompson Reuters/University of Michigan survey, the 10-year inflation projections of professional forecasters, and the five-year-forward measure of inflation compensation derived from yields of inflation-protected Treasury securities. In addition to the stability of longer-term inflation expectations, the substantial amount of resource slack that exists in U.S. labor and product markets should continue to have a moderating influence on inflationary pressures. Notably, because of ongoing weakness in labor demand over the course of the recovery, nominal wage increases have been roughly offset by productivity gains, leaving the level of unit labor costs close to where it had stood at the onset of the recession. Given the large share of labor costs in the production costs of most firms, subdued unit labor costs should be an important restraining influence on inflation.

A couple of points. First, he takes the inflation boogeyman off the table for the time being. Not only are temporary factors easing, but long-term expectations remain stable and wage gains are subdued. Focus more, however, on the inflation expectations story – clearly Bernanke is not phased by the deterioration in the five and ten year-forward breakevens. The ten year in particular still hovers well above the levels that triggered QE2.

So where are we at? The deterioration in the real economy coupled with moderating inflation suggests more easing is at hand. Indeed, we know there is a growing dovish FOMC group that desires more aggressive policy. But how aggressive? Chicago Federal Reserve President Charles Evans desires a relatively aggressive stance that includes allowing inflation to drift up to 3% at least temporarily. But I don’t think we will get something like that. And I can’t see a return to quantitative easing short of a real deflation threat – I don’t see the core of the FOMC or Bernanke himself supportive of such a step at this time. Ditto for allowing the inflation target to drift upward.

If higher inflation targets and an open-ended program of quanitative easing are off the table, what’s left? As I noted earlier this week, the usual suspects, with the extending the duration of the Fed’s portfolio high on the list of market expectations. See Neil Irwin's piece at the Washington Post.

What I have trouble seeing is a strong commitment about the path of monetary policy. More soft commitments, yes. But not a locked in stone, willing to endure higher inflation commitment. Consider, for example, this week’s speech by San Francisco Federal Reserve President John Williams. He seems open to additional policy:

Despite these efforts, the recovery slowed to a crawl this year. But what does this mean for monetary policy? After all, monetary policy cannot cure all that ails our economy, which in large measure involves the aftereffects of the mortgage lending boom, the housing crash, and the resulting financial crisis. But, monetary policy can help limit the damage and provide support to other areas of the economy.

Williams sounds supportive of additional action, which he made more clear in comments. Via Reuters:

"There's still considerable room for monetary accommodation to improve financial conditions," San Francisco Federal Reserve Bank President John Williams told reporters after a speech to the Rotary Club of Seattle. "My main concern is really not the concern that inflation is going to be too high over the medium term. I think my main concern really is the pace of recovery and the high degree of unemployment."

"If anything more monetary accommodation seems appropriate than not," he added.

Still, something dramatic, moving into the relm of Evans? Note the mixed message. Yes, there is more we can do to prevent the patient (his analogy later) from deteriorating further, but the medicine is limited. How does this play into monetary policy? He continues:

The monetary policy situation is similar. Like the hospital patient, the economy took a turn for the worse and faces heightened risks. In addition, inflation is expected to drift down. These circumstances called for additional monetary easing. At our August meeting, the FOMC took a step in that direction, issuing a statement that we are likely to keep the federal funds rate at exceptionally low levels at least through mid-2013.

Arguably, if data continues to disappoint heading into the next meeting, the same logic will hold true, and the Fed will embrace some additional easing. So far, so good. But then he undermines the FOMC statement, first by dismissing it relevance:

In one respect, this wasn’t such big news. Even before the announcement, financial market participants generally didn’t expect the Fed to raise rates much earlier than mid-2013.

Then he backtracks and claims:

But it was news in the sense that it removed uncertainty and helped financial markets better understand our intentions.

I like that, removing uncertainty is a good thing. But then he puts the uncertainty right back into the mix:

Note also that we are not tying our hands by making this announcement. We haven’t made a guarantee. We will alter our policy as appropriate if circumstances change.

When is a commitment not a commitment? When made by the Federal Reserve. Which makes me wary of any supposed policy guidelines. Most policymakers - even increasingly dovish ones such as Williams - don’t want to have their hands tied, and few other than Evans are interested in seeing inflation drift above 2%. Williams on inflation, via Bloomberg:

When asked by reporters whether he would be willing to tolerate higher inflation if it brought down unemployment, Williams said, “I don’t think there’s a tradeoff. I don’t think that’s really a choice we can make over the long term.”

“We have to focus on keeping inflation relatively low over the medium term and again keeping employment as close as we can to the maximum sustainable level,” he said.

Still others don’t believe additional policy will do much good. And quite frankly, I am sympathetic with that view. If the Fed is going to have an impact, policymakers need to go big time. 20 basis points on the long-end of the yield curve through a maturity extension just is not going to cut it. Allowing inflation to drift up to 3% is not going to cut it. Chopping the interest rate on reserves in half is not going to cut it. Half commitments to policy paths are not going to cut it. I am not even confident committing to a rate of 1% on the ten year will cut it, unless fiscal policymakers take advantage of such a gift and step up government spending. I am not sure the private sector will want to make many 1% loans – financial institutions need some spread to make a profit. These are all things that probably won’t hurt and should be tried, but don’t expect miracles either.

What would work? I am sympathetic to the notion that if fiscal policymakers can address the mortgage mess, then lower interest rates that encourage refinancing can help. But this isn't something the Fed can do alone. I am also sympathetic to targeting an asset price that you are very confident will stimulate demand. And that brings you to the hand played by the Swiss National Bank – commit to currency depreciation. Set a target for the dollar, and purchase foreign assets in unlimited quantities to achieve that goal.

Bottom Line: Bernanke continues to hold his cards close to his chest. The data flow, and the subsequent forecast implications, justifies additional easing. Indeed, Bernanke’s inflation view appears to take out one impediment to such easing. That said, the lack of concern about the path of longer-term inflation expectations still suggests additional easing will fall short of what we saw during last year's deflation scare. The composition of the portfolio seems high on the list, although I am hesitant to believe there is a lot of traction to be gained when the ten year rate is hovering around 2%. Steps in the right direction, to be sure, but, as Federal Reserve officials continue to emphasize, nothing that will rapidly restore economic vibrancy.

Wednesday, September 07, 2011

The Fed's Dual Mandate: Responsibilities and Challenges Facing U.S. Monetary Policy

It's nice to see that at least one member of the FOMC gets it, and is willing to act:

The Fed's Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy, by Charles Evans, President, FRB Chicago: In the summer of 2009, the U.S. economy began to emerge from its deepest recession since the 1930s. But today, two years later, conditions still aren’t much different from an economy actually in recession. GDP growth was barely positive in the first half of the year. The unemployment rate is 9.1%, much higher than anything we have experienced for decades before the recession. And job gains over the last several months have been barely enough to keep pace with the natural growth in the labor force, so we’ve made virtually no progress in closing the "jobs gap".

The Federal Reserve has responded aggressively to the deep recession and weak recovery, cutting short-term interest rates to essentially zero and purchasing assets that expanded its balance sheet by a factor of three. But since undertaking the so-called QE2 round of asset purchases last fall, the Fed’s aggressive policy actions have been on hold.

Some believe that this pause is entirely appropriate. They claim that the economy faces some kind of impediment that limits how much more monetary policy can do to stimulate growth. And, on the price front, they note that the disinflationary pressures of 2009 and 2010 have given way to inflation rates closer to what I and the majority of Fed policymakers see as the Fed’s objective of 2%. These considerations lead many to say that when adding up the costs and benefits of further accommodation, the risk of over-shooting our inflation objective through further policy accommodation exceeds the potential benefits of speeding the improvement in labor markets.

I would argue that this view is extremely, and inappropriately, asymmetric in its weighting of the Fed’s dual objectives to support maximum employment and price stability.

Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.

In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.

The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment. ...[continue reading]...

Tuesday, September 06, 2011

Fed Watch: Questions and Answers

Tim Duy:

Questions and Answers, by Tim Duy: I thought this might be an easier way to get back into the game after an extended hiatus.

Does the economy need more stimulus?

Always good to start with a softball question - YES! The US economy is two years into an economic expansion, and yet the unemployment rate remains above 9 percent. National output growth averaged just 0.7 percent in the first two quarters of the year. Job growth was zero in August, albeit with some downward pressure from the Verizon strike. Output is $1 trillion below CBO potential – and the gap is expanding. The 30-year inflation indexed Treasury bond just traded at 90 basis points. None of which should be happening two years into an expansion. Yet here we are.

Will the private sector provide the needed stimulus?

Federal Reserve President Dennis Lockhart summarizes the situation:

It is necessary that the process of deleveraging plays itself out, which may take several more years. When economies are deleveraging they cannot grow as rapidly as they might otherwise. It is obvious that as consumers reduce spending they divert more of their incomes to paying off debt. This shift in consumer behavior increases the amount of capital available for financing investment. But higher rates of business investment are not likely to fully offset weakness in consumer spending for some time, as businesses continue to grapple with uncertainties about the future.

Lacking the equity wealth provided by the housing bubble, households are simply unable to sustain the debt loads of years past. Hence, deleveraging continues. Without anyone else to pick up the slack, it is tough to see how we eek out anything other than subpar growth, trend growth (2.5 - 3.0%) at best. Not enough to quickly lift the economy back to trend output.

Will the government provide the needed stimulus?

On the fiscal side, the answer is no, or at least not yet. As Paul Krugman points out, fiscal policy is already contractionary, while the recently passed budget deal promises only more austerity. And, via Brad DeLong, Macroadvisors predicts that President Barack Obama’s impending jobs plan is not likely to provide much if any of an economic boost. That leaves monetary policy as the only game in town. And here we can anticipate that more easing is coming. But will it be enough to pull the economy from its slump? At this point, almost certainly not.

Why will monetary policy fall short?

Here again it is useful to refer back to Lockhart’s recent speech:

Given the weak data we've seen recently and considering the rising concern about chronic slow growth or worse, I don't think any policy option can be ruled out at the moment. However, it is important that monetary policy not be seen as a panacea. The kinds of structural adjustments I've been discussing today take time, and I am acutely aware that pushing beyond what monetary policy can plausibly deliver runs the risk of creating new distortions and imbalances.

Lockhart is not ruling out additional policy responses, but makes obvious his view the Fed is nearly, if not already, out of bullets to deal with a balance-sheet recession. Moreover, he shows his sympathy with the camp, I think best identified with the views of Kansas City Federal Reserve President Thomas Hoenig, that the Fed at this point risks doing more harm than good. This, I believe, represents the center of FOMC thought at the moment. This group is simply not inclined to initiate a new large scale easing in the absence of clear deflationary pressures. The five and ten-year TIPS breakevens are 1.81 and 2.05 percent, respectively. Combined, I believe they argue, at least from the Federal Reserve point of view, for more easing, but nothing dramatic.

But didn’t the most recent FOMC minutes reveal a more dovish constituency?

Yes. From the minutes:

A few members felt that recent economic developments justified a more substantial move at this meeting, but they were willing to accept the stronger forward guidance as a step in the direction of additional accommodation

Chicago Federal Reserve Bank President Charles Evans is a good example of this group. Via a recent CNBC interview:

In his view, QE needs to stay in place until unemployment plunges to 7 percent or if inflation gets past 3 percent. Core inflation, which strips out food and transportation, is about 1.8 percent, though the number is 3.6 percent including the more volatile measures.

Evans is a voting member on the fed Open Market Committee and traditionally has been among its more dovish members when it comes to interest rates and inflation.

"Strong accommodation needs to be in place for a substantial period of time," he said. "If we could sort of make everybody understand that this is going to be in place for a longer period of time, we could knock out some of that restraint that comes about when people talk about premature tightening."

As far as I am concerned, he is preaching to the choir. There has been a remarkably irresponsible tendency of Fed policymakers to turn hawkish at the slightest hint of economic improvement. I think this belies their discomfort with the expansion of the balance sheet, and renders the rest of us unsure of their commitment to the dual mandate. And I believe the Fed needs to accept the possibility of higher inflation.

What can the Fed do at this point?

The usual suspects: Reduce the interest paid on reserves, extend the maturity of the Fed’s portfolio, expand the balance sheet further, shift the portfolio in favor of mortgage-backed securities to support the housing market, make a firm commitment to zero interest rates regardless of the inflation outcome, or raise the inflation target from 2 percent to 3 or 4 percent. I suspect the first three are most likely in play, although the magnitude of an additional balance sheet expansion will likely fall short of what is needed.

Wait a second. Didn’t the Fed already commit to zero interest rates until 2013?

No – they just said that given current forecasts, they anticipated an extended period on low interest rates. This does have some value in marginalizing the hawks. That said, the minutes make clear this is only a soft commitment:

Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.

What we really need is a hard commitment that can weather a period of higher inflation.

Where is Federal Reserve Chairman Ben Bernanke is this mix?

It appears that Bernanke is right of the dovish contingent revealed in the most recent FOMC minutes. I think this first became evident in his June press conference, when he made clear the bar to QE3 was high. The bar was high because inflation expectations had rebounded, and inflation was the only clear target the Fed had control over. This basic idea was evident in Bernanke’s Jackson Hole speech:

The Federal Reserve has a role in promoting the longer-term performance of the economy. Most importantly, monetary policy that ensures that inflation remains low and stable over time contributes to long-run macroeconomic and financial stability. Low and stable inflation improves the functioning of markets, making them more effective at allocating resources; and it allows households and businesses to plan for the future without having to be unduly concerned with unpredictable movements in the general level of prices.

Once inflation is close to the Federal Reserve’s target, Bernanke apparently sees little else monetary policy can do to relieve the cyclical pressures on the economy:

Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.

I think the Bernanke’s focus on the 2 percent inflation target will severely limit the magnitude of additional easing to support job growth. It is increasingly my opinion that to lift the economy beyond the zero bound, we need a commitment by the Fed to lift inflation above 2 percent to allow nominal spending to return to the pre-recession trend. This is policy the Fed Chair appears dead set against, leaving only half-measures.

Note, however, the above only applies when inflation and inflation expectations are near the Fed’s target. I do believe Bernanke will press for more dramatic action should deflationary pressures become evident. I just don’t think we are there yet.

Would a shift to additional mortgage-backed assets help?

It wouldn’t hurt, and could push mortgage rates down further and thus encourage additional refinancing. Back in the day I would have been worried that the Fed risked looking like it was trying to sustain bubble-level prices, but I think we are beyond that. Still, note the problem in mortgage markets is deeper than interest rates – the problem is the inability to finance due to tougher underwriting standards and underwater mortgages. I am not confident that lower rates would alleviate these challenges. This seems more like the purview of the US Treasury, which could push for all federally guaranteed mortgages to be refinanced at a lower interest rate, regardless of the loan to value ratio.

Are we headed for recession?

I would not discount the possibility of recession given the US economy was clearly operating near stall-speed in the first half of the year. That said, it would be easier to embrace the recession story had the US economy ever returned to trend output during the recovery. As noted earlier, the economy is operating well below trend, and typical sources of strong downdrafts in demand – housing and autos – remain below pre-recession levels. Indeed, the absence of any rebound in housing is striking. Under these circumstances, I find it easier to embrace the “Japan” scenario, a sustained period of choppy and low growth. Recession or not, a tragedy by any measure.

What’s going on in Europe?

The Europeans are vexed with a political establishment that is not conducive to maintaining a single currency (of course, we too in the US are vexed with a dysfunctional political establishment, just a different one). In particular, they lack a mechanism to make sizable fiscal transfers within the Euro area. This is simply an important element of running a “one size fits all” monetary policy. As it stands, Euro-policymakers are attempting to enforce IMF-style austerity packages on troubled economies without the usual currency depreciation that helps offset the resulting fiscal contraction. It is obvious this approach is not working – Greek two-year debt is trading at 50 percent and the spread on Italian and Spanish debt widens. Paul Krugman asks where is the ECB? Where indeed? Perhaps they see their earlier debt-buying efforts as a failure, thus concluding the problem is a solvency problem, not a liquidity problem. And there is no European solution for a solvency problem, other than more austerity for troubled economies. Where does this end? Either the Euro-area comes together as a strong fiscal union or the periphery is jettisoned from the Euro. It really looks like the smart money is on the latter outcome. Drachmas anyone?

Update:  10:09PM PST

I see the ECB was not completely asleep at the wheel and was buying bonds. From the Wall Street Journal:

The ECB purchased Italian and Spanish government bonds Monday in a bid to keep 10-year borrowing costs from rising further above 5%—a threshold analysts say is key to their ability to finance their high debt loads. The ECB has purchased over €50 billion in bonds since reactivating the program four weeks ago.

Friday, September 02, 2011

How Will the Fed Respond to Today's Bad News on Employment?

There is a lot of discussion on how the Fed will react to the jobs report in its meeting this month, e.g. here and here. My view is that if the Fed is moved to action by the report -- and it is not at all certain that they will be -- they will do the least they possibly can while still looking like they are doing something about the problem.

What is the least they can do while still satisfying the demand for action? One option is to change the average duration of the assets they hold on their balance sheet by trading short-term for long-term assets (i.e. lengthen the average duration of the portfolio). This could bring down the long end of the yield curve a bit -- not much as there isn't all that much room for long-term rates to fall -- and perhaps stimulate economic activity. However, it's hard to see how a fall in long-term interest rates of such a small magnitude will produce a change in investment and a change in the consumption of durables such as cars and refrigerators of the magnitude that is needed. If there is a response from consumers and businesses to a small drop in the long-term rate, it will be far, far short of what we need.

Another option would be to cut the rate the Fed is paying on reserves held in banks. Ben Bernanke has stated this would disrupt the overnight federal funds market, so I think this is unlikely, but it could be cut, say in half from its current level of 0.25%, or even to zero. Any change in this rate can be reversed quickly if needed, so it's not a very risky option -- that's why I think it is one potential response -- but again I don't think it would do a lot of good. The problem isn't the supply of loans, it's the demand, and this wouldn't do much to stimulate new demand.

The Fed has already used up another option that doesn't require much actual action -- committing to low interest rates for an extended period of time -- but so far that hasn't seemed to have helped much. The options after that such as QE3 or adopting (and then trying to hit) a higher inflation target require much more action from the Fed and are likely to be resisted.

But things are much worse than the Fed thought they would be, the green shoots they keep pointing to whither away as soon as they depend upon them, and it's time -- way past time actually -- to quit hoping things improve and take the possibility of an extended period of stagnation seriously. I blame fiscal policymakers more than the Fed, fiscal policy is our best hope for job creation and we should have had a large job creation program in place long ago. But we need both policy barrels pointed at this problem, it's too large to solve without both policies working together, and it's time for the Fed to quit hoping a miracle saves them from the hard decisions they need to make and to move forward with more aggressive policy.

[Also posted at MoneyWatch.]

Wednesday, August 31, 2011

Posen: No Excuse for Inaction from Central Banks

Adam Posen says there's no excuse for inaction from the Fed and other central banks:

No excuse for inaction, by Adam Posen, Reuters: It is past time for monetary policy to be doing more to support recovery. The Jackson Hole conference has come and gone, and no shortage of excuses was provided for central banks to hold their fire — even though most economists acknowledged the grim outlook for the advanced economies. ...
It is also past time to stop fearing inflationary ghosts. There is no credible threat of sustained higher inflation in the advanced economies that should restrain central bank action. ...
The evidence is clear that the Bank of England’s and the Federal Reserve’s asset purchases had a positive significant effect on consumption, on the relative prices of riskier assets, on credit availability, and on liquidity in the financial system. If the improvement was insufficient, because the response to a given injection was less than some hoped, increase the dose.
There are no negative side-effects to speak of from greater asset purchases, beyond some politically induced nausea (which central bankers simply have to suffer through). ...

The Balanced Budget Multiplier: Job Creation without Increasing the Deficit

[Here is an op-ed I started, and then abandoned in favor of another topic (so it hasn't been thoroughly edited and is several hundred words too long). I decided to post it because I want to at least raise the possibility of using the balanced budget multiplier as a way of using budget neutral policies to stimulate the economy. As explained below, those policies would work best if we ask the wealthy to finance job creation programs. It's not as powerful as deficit spending, but it's better than nothing at all:]

Despite the advice from many economists urging the Fed to do more to help the economy, and despite hopes in the business community that the Fed would follow this advice, Ben Bernanke made it clear in his speech at Jackson Hole last Friday that policy is on hold. He noted they will discuss this at their September meeting, but I am not very hopeful that policy will change at that time. I disagree strongly with the Fed's decision to remain on hold, we need to attack the employment crisis with all the policy tools at our disposal, but the Fed disagrees.

With the Fed unlikely to ease policy any further, what about fiscal policy? Would another round of fiscal policy be helpful, or would it do more harm than good? There are very clear political problems involved with fiscal policy, more on that below, but what about the economics? Would further stimulus be beneficial?

The economics does provide a further case for intervention. As I’ve explained previously on these pages, not all recessions are alike. They have different causes, e.g. recessions can be caused by oil price shocks, productivity shocks, monetary policy shocks, and bursting asset price bubbles. When a bubble bursts wiping out household retirement, education, and other savings households rely upon for security it is known as a balance sheet recession. Recovering losses from this type of recession, i.e. rebuilding the balance sheet, are notoriously difficult and “lost decades” such as Japan experienced in the 1990s are not uncommon.

What to do? The slow recovery can be attributed in large part to the fact that households must reduce consumption and increase savings in order to recover their losses, and so long as consumption remains low the economy will continue have problems. In ordinary, mild recessions monetary policy is the best approach, and it can generally handle the problem on its own. But in a deep balance sheet recession monetary policy alone isn’t enough. In large recessions fiscal policy that targets the problem – balance sheets in this case – has an important role to play.

How can fiscal policy be used to attack the type of recession we are having?  Mortgage relief, and debt relief more generally, is first on the list. Debt relief improves household balance sheets, and hence directly targets the problem. There were a few half-hearted attempts to do something like this, but nothing like what is needed.

Thus, fiscal policy directed at two goals, balance sheet repair and job creation, would do a lot to ease current conditions and to allow us to exit the recession sooner.

But is there any way at all to get more fiscal policy through Congress? Probably not. But the problem is important enough, and the crack in the door is open just enough (and opening more with each new piece of information indicating a sluggish recovery at best), that it’s worth it to at least try.

We do have a long run debt problem to bring under control, but in the short-run we need more, not less deficit spending. But the political atmosphere will not allow any further increase in government debt. If anything, it will move in the other (and wrong) direction. However, there is something called the balanced budget multiplier that could still be useful and would perhaps -- emphasis on perhaps -- find political support.

How could, say, an increase in government spending of $100 on new goods and services financed by a $100 increase in taxes stimulate the economy? The $100 purchase by the government increases aggregate demand by the same amount. But the increase in taxes does not fully offset the increase in demand because the tax bill will be paid, in part, from savings. For example, suppose that the household pays its tax bill by reducing consumption by $80 and reducing saving by $20. Then the net impact on aggregate demand will be the $100 in government spending minus the $80 reduction in consumption for a net change of $20. That’s not as large as the $100 we could get from deficit spending, i.e. increasing government expenditures without increasing taxes, but it’s better than not doing anything at all (and this is just the impact effect, the $20 will create more than $20 in spending due to standard multiplier effects).

This also tells us who should be asked to pay these taxes if we want to have the maximum impact on the economy. If more of the bill is paid from saving, e.g. $30 instead of $20, then the net impact will be bigger. Thus taxes that are levied on those most likely to pay out of saving, the wealthy, will have the largest impact on aggregate demand (e.g. if it is paid fully out of saving, there is no offset at all). I don't have any illusions about the difficulty of getting a tax increase on the wealthy through Congress, but it could be done -- perhaps -- by closing loopholes, credits, deductions, exclusions, etc. which seems to have a bit more support.

On the other side, what should the government spend its money on? The usual answer is infrastructure since it stimulates the economy in the short-run and also helps with long-run growth. But one thing we learned from the previous round of infrastructure spending is that infrastructure construction has a relatively low labor intensity per dollar spent. But long-run growth is not the only goal of this spending, job creation is just as important. In addition emphasizing employment keeps people connected to the labor market, and this can also have positive effects on long-run growth (by, for example, keeping people from permanently dropping out of the labor force). The first round of spending emphasized long-run growth, but I would like to see this round concentrate spending in areas where it is likely to have the most effect on employment.

The spending programs should end once the economy improves, e.g., I would link the spending to the unemployment rate and end it once unemployment falls below some threshold (and include automatic, distasteful cuts in the legislation if the two sides do not reverse the spending to help to ensure it is temporary -- that will help to mollify the concerns of those who worry about using stabilization policy to increase the size of government). But the tax increases/closed loopholes, credits, deductions, etc. on the wealthy should continue so that in the long-run the tax increase can help with deficit reduction.

I don’t have any doubt about the need for such initiatives, nor do I have any illusions about politicians endorsing this or any other stimulus plan – raising taxes on the wealthy is most likely a non-starter. But taxes on the wealthy are going to go up, if not sooner than later. Our long-run budget picture demands it and recent polls show that the public is behind this. So why not do it now when it can help with the employment, household debt, infrastructure problems immediately and improve our long-run debt outlook instead of waiting until we can only help with a subset of those problems? The answer, of course, is that helping households overcome debt problems and helping the unemployed would cause taxes on the wealthy to go up, and that is very unlikely to happen. And the dismal chances of providing help to middle and lower class households struggling with debt problems and high unemployment by asking the wealthy to pay more says a lot about who has power in Washington.

[Update: I probably should have noted that both Robert Shiller and Joe Stiglitz, among others, have suggested the same thing.]

Tuesday, August 30, 2011

More Dovish Than We Thought?

There is news from the Fed. First, from Narayana Kocherlakota of the Minneapolis Fed:

Fed’s Kocherlakota Suggests Dissent Won’t Be Repeated, by Michael S. Derby, WSJ: One member of the troika who opposed the Federal Reserve‘s recent decision to keep rates at rock bottom levels for two years suggested he won’t be repeating his disagreement at coming central bank gatherings.
In a speech, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said Tuesday “I see no reason to revisit the decisions” made last month, and added “I plan to abide by the August 2011 commitment in thinking about my own future decision.”
The reason? With the Fed having made its pledge, “I believe that undoing this commitment in the near term would undercut the ability of the Committee to offer similar conditional commitments in the future.” ...
That said, the official spent a considerable amount of his speech — his comments came from remarks prepared for delivery before the National Association of State Treasurers in Bismarck, N.D. — explaining why he did not think the Fed made the right decision on its forward interest rate commitment. He indicated there was even a case to be made for going the other way on policy and tightening it. ...

Brad Delong comments here, and also notes (approvingly) remarks by Charles Evans of the Chicago Fed:

Fed official makes plea for more stimulus, by Robin Harding, FT: A leading Fed policymaker made an aggressive call for more monetary stimulus on Tuesday as it emerged that staff of the US central bank have permanently cut their growth forecasts. In an interview with CNBC, Charles Evans of the Chicago Fed said that he would “favour more accommodation” and became the first policymaker on the rate-setting Federal Open Market Committee to explicitly countenance letting inflation rise above the Fed’s target of 2 per cent in the short-term. ...

I don't think it's a secret that I favor more accomodative policy as well. Finally, the minutes from the last FOMC meeting were released today, and they showed a divided committee, but more dovishness than most people expected:

Participants discussed the range of policy tools available to promote a stronger economic recovery should the Committee judge that providing additional monetary accommodation was warranted. Reinforcing the Committee's forward guidance about the likely path of monetary policy was seen as a possible way to reduce interest rates and provide greater support to the economic expansion; a few participants emphasized that guidance focusing solely on the state of the economy would be preferable to guidance that named specific spans of time or calendar dates. Some participants noted that additional asset purchases could be used to provide more accommodation by lowering longer-term interest rates. Others suggested that increasing the average maturity of the System's portfolio--perhaps by selling securities with relatively short remaining maturities and purchasing securities with relatively long remaining maturities--could have a similar effect on longer-term interest rates. Such an approach would not boost the size of the Federal Reserve's balance sheet and the quantity of reserve balances. A few participants noted that a reduction in the interest rate paid on excess reserve balances could also be helpful in easing financial conditions. In contrast, some participants judged that none of the tools available to the Committee would likely do much to promote a faster economic recovery, either because the headwinds that the economy faced would unwind only gradually and that process could not be accelerated with monetary policy or because recent events had significantly lowered the path of potential output. Consequently, these participants thought that providing additional stimulus at this time would risk boosting inflation without providing a significant gain in output or employment. Participants noted that devoting additional time to discussion of the possible costs and benefits of various potential tools would be useful, and they agreed that the September meeting should be extended to two days in order to provide more time.

The last part where they say they need more time to discuss "the possible costs and benefits of the various potential tools" is a bit worrisome. We all know what the policy options are, and they should have been prepared with that information coming in. I think what they're really saying is that thay've gone as far as they're willing to go for now, and they want to wait to see what happens to the economy and then discuss it further. Should things get worse, they want to make sure that they have enough time to thoroughly review their options. But they're hoping things stabilize or get better so they don't have to seriously confront the question.

The release of the minutes seems to have raised the expectation that more action is coming, so it will be interesting to see if Fedspeak tries to reduce expectations in coming days.

DeLong: Ben Bernanke’s Dream World

Brad DeLong is unhappy with Ben Bernanke:

Ben Bernanke’s Dream World, by Brad Delong, Commentary, Project Syndicate: US Federal Reserve Board Chairman Ben Bernanke is not regarded as an oracle in the way that his predecessor, Alan Greenspan, was before the financial crisis. But financial markets were glued to the speech he gave in Jackson Hole, Wyoming on August 26. What they heard was a bit of a muddle. ...[continue reading]...

Monday, August 29, 2011

Fed Watch: Brief Hiatus

Tim Duy:

Brief Hiatus, by Tim Duy: I remained under the radar for the past two weeks. Summer finally got the best of me, perhaps just as well, as I did not have the opportunity to backtrack from my last assessment of Fed policy:

All in all, this is pretty weak medicine given the condition of the patient. I would have preferred to see an open-ended commitment to asset purchases - buying up anything not nailed to the floor at a rate of $10 or $15 billion a week until achieving the dual mandate is in clear sight. But policymakers, on average tend to think they have relatively weak ammunition to stimulate growth. Their tools are more effective against deflation. And until the former turns into the latter, expect the Fed to do little more than modifications of the basic zero interest rate / hold balance sheet constant policy combination.

As was widely noted, Federal Reserve Chairman Ben Bernanke emphasized the Fed’s “wait-and-see” position, offering only an extended September meeting to consider the available options. Nothing specific to hang our hats on, no clear guidance as to the next move – suggesting the next "move" is likely to be more of the same, especially if financial markets stabilize and growth lifts off the first and second quarter floors. I believe we need to see even weaker growth, coupled with a steeper drop in long-term inflation expectations to prompt additional action.

The failure of Bernanke to push for more aggressive action is even more puzzling in the wake of this speech. According to the Fed chair, the situation is becoming urgent:

Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.

I suppose I should be happy that someone in Washington considers unemployment to be a crisis, both near and long term. That said, Bernanke follows up with this:

Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank. We have heard a great deal lately about federal fiscal policy in the United States, so I will close with some thoughts on that topic, focusing on the role of fiscal policy in promoting stability and growth.

So he passes the ball to fiscal policy. With good reason, to be sure. Congress and the Administration are failing miserably at macroeconomic policy. The debt debate was an unnecessary, destabilizing, pointless disaster. Does this mean the Fed should be let off the hook? Consider that question in the context of Bernanke’s speech on February 3 of this year:

Although large-scale purchases of longer-term securities are a different monetary policy tool than the more familiar approach of targeting the federal funds rate, the two types of policies affect the economy in similar ways…By easing conditions in credit and financial markets, these actions encourage spending by households and businesses through essentially the same channels as conventional monetary policy, thereby supporting the economic recovery.

A wide range of market indicators supports the view that the Federal Reserve's securities purchases have been effective at easing financial conditions. For example, since August, when we announced our policy of reinvesting maturing securities and signaled we were considering more purchases, equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation as measured in the market for inflation-indexed securities has risen from low to more normal levels…Interestingly, these developments are also remarkably similar to those that occurred during the earlier episode of policy easing, notably in the months following our March 2009 announcement of a significant expansion in securities purchases. The fact that financial markets responded in very similar ways to each of these policy actions lends credence to the view that these actions had the expected effects on markets and are thereby providing significant support to job creation and the economy.

Funny that additional quantitative easing yielded “significant support to job creation” in February, when Bernanke wanted to justify QE2, yet now “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.” Sometimes I think the only person who doesn’t read Bernanke’s past speeches is Bernanke himself. In any event, it seems the key difference between then and now, from the perspective of the Federal Reserve, is that the recent burst of inflation spooked them badly, raising in their minds the possibility of any central banker’s worse fear, an inflation spiral.

The bottom line: We are playing a data game as we approach the next FOMC meeting – lacking a more extensive collapse of growth forecasts and or inflation expectations, the Fed looks likely to stay the course.

As to my absence alluded to earlier, this summer finally caught up with me. My son being out of school was no small issue – parents are well aware with the requirements of summer camps. New schedule, new location each week. A bit different than I recall of my summers growing up, which were much more of the “go away and try not to wind up in the hospital” variety.

In addition, my wife was in trial in late July. For those of you married to a litigator, you understand what happened to July, and by my recollection, half of June (although I am confident the latter claim will be subject to family debate for years). Household production shifted to my corner.

Most importantly, my father passed away ten days ago after a sixteen-month battle with leukemia. I feel compelled to put a something in words, but none of you should feel compelled to keep reading (the Fed Watch part is obviously done for the day). The battle began at the end of winter term 2010 when I drove him to OHSU for an initial diagnosis and ended on August 18 at his home with his immediate family (my mother, my sister, and myself). As I am sure any of you who have faced the illness of a family member understand, the process is draining. I surely have a greater appreciation of both the possibilities and limitations of modern medicine. We were sure we lost him last September, when he fell into a coma during the first round of treatment. It is tough to forget my mother and I trying to understand the difference between “life-supporting” and “life-extending” treatments when one doctor wants to push forward yet another, just before moving onto dialysis, assured us that no one ever walks away at that point.

As it turns out, at least one person walked away, and my Dad recovered to dictate his own treatment for the next year, right up to the point when he knew he ran out of options and the end was near. We were lucky that my family moved to Eugene after my first child was born, giving us the opportunity to support each other through this ordeal. Still, throughout the year, my mother and sister were the real heroes. It was a year of sorrow, pain, uncertainty, and unexpected opportunities. My father passed on his woodworking skills to my sister as they completed projects such as a beautiful maple coffee table:


Moreover, there was a furious effort to produce a large quantity of end-grain cutting boards as “goodbye presents” to friends and family:


We had some very good times even during the last week. That week he managed to convince me to take a trip to introduce his friend and former business associate to cask conditioned ale (you do need to have your priorities straight). An unambiguously fun night regardless of the circumstances. Another night with just the two of us. And a final trip to the family cabin. Good memories to add to a long list.
In short, more nights with family left fewer nights for blogging. And I will most likely sink below the radar again for the next week. My calendar tells me I am supposed to be walleye fishing in Canada – a trip planned by my father after he recovered from the coma – but instead we will be taking our traditional summer-end vacation near home. For the next few days we will disappear into Central and Eastern Oregon where, much to my wife’s dismay, I have planned a rock-hunting trip in the desert. Moreover, not one of her carefully planned (and almost certainly successful) trips; more one of my “vague, have-car-will-travel, sort of know where the campgrounds are, hope I can get 3G reception as a backup” kind of trip. This is really for my son, who became interested in rocks after a presentation in his kindergarten class. Supporting that interest is a small price to pay given the teacher managed to get him reading at a third grade level after just nine months. Any attempt by his parents to accomplish the same were worse than pulling teeth. That and Oregon is a vast and diverse state, and I want to get to a few places I have yet to see.
Enjoy the end of summer, and look forward to all the possibilities of the next year.

Saturday, August 27, 2011

How Long Will It Take for the Economy to Recover?

I don't think we'll attain the growth rates the CBO is forecasting -- an average of 3.6% from 2013 to 2016 is a lot to ask for (especially if there is substantial deficit reduction over that time period). But even the CBO's optimistic estimates imply we won't fully recover until 2017. And if growth is a bit slower, well, yikes!:

Lots of ground to cover: An update, David Altig: ...There are two pieces of information that emphasize the economy's recent weakness and potential slow growth going forward. The first is this week's revised forecasts and potential for gross domestic product (GDP) from the Congressional Budget Office (CBO), and the second is today's revision of second quarter GDP from the U.S. Bureau of Economic Analysis (BEA). Though estimates of potential GDP have not greatly changed, the CBO's downgrade in forecasts and BEA's report of much lower than potential growth in the second quarter have the current and prospective rates of resource utilization lower than when macroblog covered the issue just about a month ago.

Key to the CBO's estimates is a reasonably good outlook for GDP growth after we get past 2012:

"For the 2013–2016 period, CBO projects that real GDP will grow by an average of 3.6 percent a year, considerably faster than potential output. That growth will bring the economy to a high rate of resource use (that is, completely close the gap between the economy's actual and potential output) by 2017."

The margin for slippage, though, is not great. Assuming that GDP ends 2011 having grown by about 2.3 percent—as projected by the CBO—here's a look at gaps between actual and potential GDP for different, seemingly plausible growth rates:

Attaining 3.5 percent growth by next year moves the CBO's date for closing the output gap up by about a year. On the other hand, a fall in output growth to an average of 3 percent per year moves the date for eliminating resource slack back to 2020. If growth remains below that—well, let's hope it doesn't.

Maybe policymakers should do something to try and improve the odds?

Friday, August 26, 2011

Bernanke: We'll Wait and See

Here's a quick response to Bernanke's speech:

Bernanke: We’ll Wait and See, but No Changes in Policy for Now

Paul Krugman: Bernanke’s Perry Problem

I came to the same conclusion:

Bernanke’s Perry Problem, by Paul Krugman, Commentary, NY Times: As I write this, investors around the world are anxiously awaiting Ben Bernanke’s speech at the annual Fed gathering at Jackson Hole, Wyo. They want to know whether Mr. Bernanke ... will unveil new policies that might lift the U.S. economy out of what is looking more and more like a quasi-permanent state of depressed demand and high unemployment.
But I’ll be shocked if Mr. Bernanke proposes anything significant... Why...? In two words: Rick Perry. ... I’m using Mr. Perry — who has famously threatened Mr. Bernanke with dire personal consequences if he pursues expansionary monetary policy before the 2012 election — as a symbol of the political intimidation that is killing our last remaining hope for economic recovery.
To see what I’m talking about, let’s ask what policies the Fed actually should be pursuing right now. ... Well, in 2000 ... Ben Bernanke offered a number of proposals for policy at the “zero lower bound.” True, the paper was focused on policy in Japan... But America is now very much in a Japan-type economic trap, only more acute. ...
Back then, Mr. Bernanke suggested that the Bank of Japan could get Japan’s economy moving with a variety of unconventional policies...: purchases of long-term government debt (to push interest rates, and hence private borrowing costs, down); an announcement that short-term interest rates would stay near zero for an extended period, to further reduce long-term rates; an announcement that the bank was seeking moderate inflation, “setting a target in the 3-4% range for inflation, to be maintained for a number of years,” which would encourage borrowing and discourage people from hoarding cash; and “an attempt to achieve substantial depreciation of the yen”...
So why isn’t the Fed pursuing the agenda its own chairman once recommended for Japan?
Part of the answer is internal dissension..., with three inflation hawks on the committee... The larger answer, however, is outside political pressure. Last year, the Fed actually did institute a policy of buying long-term debt, generally known as “quantitative easing”... But it faced a political backlash out of all proportion...
Now just imagine the reaction if the Fed were to act on the other and arguably more important parts of that Bernanke 2000 agenda, targeting a higher rate of inflation and welcoming a weaker dollar. With prominent Republicans like Representative Paul Ryan already denouncing policies that allegedly “debase the dollar,” a political firestorm would be guaranteed.
So now you see why I don’t expect any substantive policy announcements at Jackson Hole. ... In effect, it has been politically intimidated into standing by while the economy stagnates. And that’s a very, very bad thing.
Political opposition has already crippled fiscal policy; instead of helping to create jobs, the federal government is pulling back, acting as a drag on output and employment.
With the Fed also intimidated into inaction, it’s hard to see any end to the ongoing economic disaster.

Thursday, August 25, 2011

Why is the Fed Hesitant to Do More for the Economy?

I try to explain why the Fed is unlikely to do more to help the economy:

Why is the Fed Hesitant to Do More for the Economy?

"Rules-based Keynesian Policy?"

Is John Taylor anti-Keynesian?:

Rules-based Keynesian Policy?, Twenty Cent Paradigms: John Taylor, who is one of the most prominent academic critics of administration and Fed policy over the past several years, grapples with the label "anti-Keynesian" that was pinned on him by The Economist. He writes:

In a follow-up to the Economist article, David Altig, with basic agreement from Paul Krugman, argued that it was a misnomer because I developed and used macro models (now commonly called New Keynesian) with price and wage rigidities in which the government purchases multiplier is positive (though usually less than one), or because the Taylor rule includes real variables in addition to the inflation rate. In my view, rigidities exist in the real world and to describe accurately how the world works you need to incorporate such rigidities in your models, which of course Keynes emphasized. But you also need to include forward-looking expectations, incentives, and growth effects—which Keynes usually ignored.

In my view the essence of the Keynesian approach to macro policy is the use by government officials of discretionary countercyclical actions and interventions to prevent or mitigate recessions or to speed up recoveries. Since I have long been critical of the use of discretionary policy in this way, I think the Economist is correct so say that I am anti-Keynesian in this sense of the word. Indeed, the models that I have built support the use of policy rules, such as the Taylor rule for monetary policy or the automatic stabilizers for fiscal policy, which are the polar opposite of Keynesian discretion. As a practical prescription for improving the economy, the empirical evidence is clear in my view that discretionary Keynesian policy does not work and the experience of the past three years confirms this view.

"Keynesian" means different things to different people - at its broadest, it means accepting that there are frictions in the economy which mean that aggregate demand matters and policy can have real effects. This is in contrast to the pure classical view, in which Say's law holds, demand is irrelevant, and output depends on technology and preferences. In the version of Keynesian economics in our undergraduate textbooks - the IS-LM/AS-AD framework - the frictions are nominal rigidities and the Keynesian model deals with "short run" fluctuations around a "long run" equilibrium determined by the classical model. In this setting, both monetary and fiscal policy matter (by shifting the LM and IS curves, respectively), though early Keynesians emphasized fiscal policy and "monetarists" (most prominently Milton Friedman), gave primacy to monetary policy. The version of Keynesian economics in our graduate textbooks and academic journals - "New Keynesian" - combines dynamic optimization with sticky prices, and explicitly addresses the lack of "forward looking expectations" in the traditional textbook version. Furthermore, some argue that both the IS-LM and New Keynesian incarnations really miss the point and gloss over more fundamental irrationality and instability Keynes saw in the capitalist system.

As Taylor describes his views of the economy (and from what I know of his academic work), it seems consistent with mainstream New Keynesian economics (though his version has been less favorable to fiscal policy than some others). His criticism of recent fiscal and monetary policy grows out of another longstanding conundrum in macroeconomics, "rules versus discretion." He is not claiming that countercyclical fiscal and monetary policy are fundamentally impossible, which is what I would say is the true "anti-Keynesian" view. Rather, he is arguing that discretionary policy may do more harm than good, and policy should be based on stable, predictable rules.

A primary argument for rules is that discretionary "fine tuning" is impractical based on "long and variable" lags associated with (i) recognizing the state of the state of the economy, (ii) designing and implementing a policy and the (iii) the policy's impact reaching the economy. Often lurking behind this argument is a political philosophy that is skeptical of government (no coincidence that Milton Friedman was the most famous proponent of rules - Brad DeLong recently argued this is how he resolved the contradiction between an economics that said monetary policy can be effective with a libertarian political philosophy).

Taylor is careful to say that he opposes "discretionary Keynesian policy" - I think "anti-discretion" might be a better characterization of his critique than "anti-Keynesian." Of course, that only matters if it is possible to be "anti-discretion" without being "anti-Keynesian." I think it is.

I don't share the political philosophy, but the experience of the last several years has underscored the practical difficulties of discretionary policy. The early-2009 Obama administration with large congressional majority is about as close to government by center-left mainstream Keynesian technocrats as the American political system is likely to ever give us. In retrospect, it is clear they misjudged the scope and duration of the downturn and were not able make adjustments as that became apparent.

Monday morning quarterbacking in April, I suggested that the stimulus should have been designed in a "state-contingent" fashion to remain in place until the recovery reached certain benchmarks. It is a small step from there to a "rules based" countercyclical fiscal policy - policies like aid to state governments, extended unemployment benefits, payroll tax cuts and even increased infrastructure spending could be designed to kick in and ramp down automatically based on the state of the economy (e.g., with triggers based on the unemployment rate). To me, that's very "Keynesian", but also "rules-based", and its easy to imagine that might have worked better than the actual policies that were put in place.

Monday, August 22, 2011

Krugman: Stop Worrying and Learn to Love Inflation

Paul Krugman is taking a break from his column today (Arrrr!), so here's a summer rerun. Can you guess when he wrote this?:

Stop worrying and learn to love inflation, by Paul Krugman: ...depression economics - the kinds of problems that characterized much of the world economy in the 1930s but have not been seen since - has staged a stunning comeback.
Five years ago hardly anybody thought that modern nations would be forced to endure bone-crushing recessions for fear of currency speculators; that a major advanced country could be persistently unable to generate enough spending to keep its workers employed; that even the Federal Reserve would worry about its ability to counter a financial market panic. The world economy has turned out to be a much more dangerous place than we imagined. For the first time in two generations, failures on the demand side of the economy - insufficient private spending to make use of the available productive capacity - have become the clear and present limitation on prosperity for much of the world.
Economists and policymakers weren't ready for this. The specific set of silly ideas known as 'supply-side economics' is a crank doctrine, which would have little influence if it did not appeal to the prejudices of wealthy men; but over the past few decades there has been a steady drift in thinking away from the demand side to the supply side of the economy. The truth is that good old -fashioned demand-side macroeconomics has a lot to offer in our current predicament - but its defenders lack all conviction.
Paradoxically, if the theoretical weaknesses of demand-side economics are one reason we were unready for the return of depression-type issues, its practical successes are another. Central banks have repeatedly managed demand - cutting rates to keep spending high - so effectively that a prolonged slump due to insufficient demand became inconceivable. Except in the very short run, then, the only limitation on economic performance was an economy's ability to produce - that is, the supply-side. ...
The question of how to keep demand adequate to make use of the capacity has become crucial. Depression economics is back. ... The free-market faithful tend to think of Keynesian policies - deliberate efforts by governments to stimulate demand - as the enemy of what they stand for. But they are wrong. For in a world where there is often not enough demand to go around, the case for free markets is a hard case to make. ...
The right perspective is to realize how very much good free markets and globalization have done; the point is to preserve those gains. One cannot defend globalization merely by repeating free-market mantras as economy after economy crashes. If we want to see more nations making the transition from abject poverty to the hope of a decent life, we had better find answers to the problems of depression economics. ...
I don't like the idea that countries will need to interfere in markets - to limit the free market in order to save it. But it is hard to see how anyone who has been paying attention can still insist that nothing of the kind needs to be done, that financial markets will always reward virtue and punish only vice.
One of the most important obstacles to sensible action, however, is prejudice -by which I mean the adherence of too many influential people to orthodox views that are no longer relevant to our changed world. ...
This brings us to the deepest sense in which depression economics has returned. The quintessential economic sentence is supposed to be 'There is no free lunch'; it says that there are limited resources; to have more of one thing you must accept less of another. Depression economics, however, is the study of situations where there is a free lunch, if we can figure out how to get our hands on it, because there are unemployed resources that could be put to work.
In 1930, John Maynard Keynes wrote that 'we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand'. The true scarcity in his world - and ours - was therefore not of resources, or even virtue, but understanding.
Originally published, 6.20.99

Then, as now, he points to inflation as the answer to a liquidity trap:

So what should we be doing differently? ... Japan, having fallen in its liquidity trap - unable to recover by means of conventional monetary policy, because even a zero interest rate is not low enough - and having exhausted its ability to spend its way out with budget deficits, must now radically expand its money supply. It must convince savers and investors that its current deflation will turn into sustained, though modest, inflation. Once the Japanese make up their mind to do this, the results will startle them. ... There is no economic evidence suggesting that inflation at the ... 4 per cent rate I believe Japan should target, does any noticeable harm; and the things advanced countries need to do to counter depression economics do not involve any compromise of the commitment to free markets. ...

Thursday, August 18, 2011

"Defending the Dollar"

David Glasner:

Defending the Dollar, Uneasy Money: After administering a pro-forma slap on the wrist to Texas Governor Rick Perry for saying that it would be treasonous for Fed Chairman Bernanke to “print more money between now and the election,” The Wall Street Journal in today’s lead editorial heaps praise on the governor for taking a stand in favor of “sound money.” First there was Governor Palin, and now comes Governor Perry to defend the cause of sound money against a Fed Chairman who, in the view of the Journal editorial page, is conducting a massive money-printing operation that is debasing the dollar.

Well, let’s take a look at Mr. Bernanke’s record of currency debasement. The Bureau of Labor Statistics announced the latest reading (for July 2011) of the consumer price index (CPI); it stood at 225.922. Thirty-six months ago, in July 2008, the index stood at 219.133. So over that entire three-year period, the CPI rose by a whopping 3.1%. That is not an annual rate, that it the total increase over three years, so the average annual inflation rate over the whole period was less than 1%. The last time that the CPI rose by as little as 3% over any 36-month period was 1958-61. It is noteworthy that during the administration of Ronald Reagan — a kind of golden age, in the Journal‘s view, of free-market capitalism, low taxes, and sound money — there was no 36-month period in which the CPI increased by less than 8.97%, or about 3 times as fast as the CPI has risen during the quantitative-easing, money-printing, dollar-debasing orgy just presided over by Chairman Bernanke. Here is a graph showing the moving 36-month change in the CPI from 1950 to 2011. If you can identify which planet the editorial writers for The Wall Street Journal are living on, you deserve a prize. ...

“Mr. Perry,” the Journal continues, “seems to appreciate that the Federal Reserve can’t conjure prosperity from the monetary printing presses.” A huge insight to be sure. But the Journal is oblivious to the possibility that there are circumstances in which monetary stimulus in the form of rising prices and the expectation of rising prices could be necessary to overcome persistent and debilitating entrepreneurial pessimism about future demand. How else can one explain the steady decline in real (inflation-adjusted) interest rates over the past six months? On February 10 the yield on the 10-year TIPS bond was 1.39%; today the yield has dropped below zero. For the Journal to attribute the growing pessimism to the regulatory burden and high taxes, as it reflexively does, is simply laughable now that Congressional Republicans have succeeded in preserving the Bush tax cuts, preventing any new revenue-raising measures, and blocking any new regulations that were not already in place 6 months ago. ...

Wednesday, August 17, 2011

Richard Green: I am a Big Fan of Stein's work

Richard Green says I should support Jeremy Stein's appointment to the FOMC (this also gives me a chance to note that Richard Clarida has removed himself from consideration):

Jeremy Stein for Fed Governor, by Richard Green: Mark Thoma writes that the administration is considering nominating Richard Clarida and Jeremy Stein for the Federal Reserver Board. He cites an encouraging Clarida speech, but writes, "I know less about Stein, so I'll withhold judgment for the moment."

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

  • Herd Behavior and Investment
  • A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets
  • Rick Management: Coordinating Investment and Financing Policies
  • Bad News Travels Slowly: Size, Analyst Coverage and the Profitability of Momentum Strategies
  • Internal Capital Markets and the Competition for Corporate Resources.
Stein has spent his career trying to figure out how capital markets really work instead of pledging fealty to models that don't work very well. I can't think of a better intellectual qualification for a Federal Reserve Board member.

I have done a bit of reading since, and I agree.

Thinking of the Fed's recent commitment to keep interest rates low though mid-2013, the membership rotates among the regional Feds every January. Will changes in the composition of the committee make any difference? If you look at the composition of the FOMC next year (it changes every January), not much will change. Presently the regional bank representation is (ignoring New York since it doesn't change, the D, N, SH, and H designations stand for dove, neutral, soft-hawk, and hawk, and are taken from here):

Chicago - Evans (D)
Philadelphia - Plosser (H)
Dallas - Fisher (H)
Minneapolis - Kocherlakota (SH)

Come January it will change to:

Cleveland - Pianalto (N)
Richmond - Lacker (H)
Atlanta - Lockhart (SH)
San Francisco - Williams (D)

Most of these are a wash:

Williams for Evans (D for D)
Lacker for Fisher (H for H)
Lockhart for Kocherlakota (SH for SH)
Pianalto for Plosser (N for H)

Pianalto for Plosser should tilt the Committee a bit toward easing, but for the most part the hawkishness/dovishness of the FOMC won't change all that much. Thus, if the committee is going to change noticeably any time soon, it will have to come from new appointments rather than the rotation of the regional Fed presidents. But with new appointments all but blocked, especially those that would lean toward dovishness, that's unlikely.

Tuesday, August 16, 2011

The Not Ready for Prime-Time Players

Steve Benen:

Republican presidential candidate Rick Perry raised a few eyebrows yesterday with borderline-violent rhetoric about the Federal Reserve and Ben Bernanke. “If this guy prints more money between now and the election, I don’t know what y’all would do to him in Iowa, but we would treat him pretty ugly down in Texas,” the Texas governor said. “Printing more money to play politics at this particular time in American history is almost treacherous, or treasonous, in my opinion.”

The comments have drawn bipartisan criticism, but as of this morning, the Perry campaign isn’t backing down.

A spokesman for Mr. Perry said Tuesday the governor “got passionate” in his remarks about the Federal Reserve, but he did not disavow the comments.

“He is passionate about getting federal finances under control,” the spokesman, Ray Sullivan, said in an interview here. “They shouldn’t print more money, they should cut spending and move much more rapidly to a balanced budget.”

Apparently he thinks the Fed has the ability to cut spending and balance the budget. What a clown.

Friday, August 12, 2011

Clarida on Monetary and Fiscal Policy

This is from an old post (March 2009, Clarida and DeLong on Fiscal Policy). It should give you a bit of perspective on potential Fed Governor Richard Clarida's views on monetary and fiscal policy:

A lot of bucks, but how much bang?, by Richard Clarida, Vox EU: “We have involved ourselves in a colossal muddle, having blundered in control of a delicate machine, the workings of which we do not understand” - John Maynard Keynes, “The Great Slump of 1930”, published December 1930.

I recently had the privilege of participating on a panel that was part of the Russia Forum, an annual conference held in Moscow that brings together market makers, policymakers, and academic experts... The topic assigned to our panel, not surprisingly, was the global financial crisis – causes, consequences, and policy responses. Although each speaker had his own, unique perspective, a cohesive, urgent theme did emerge, or so it seemed to me...

That theme suggests the title I’ve chosen for this column; there are, at last, a ‘lot of bucks’ now committed by policymakers to address the global recession and the global financial crisis, but there is real doubt about how much ‘bang’ we can expect from these bucks.

In the US, President Obama has just signed a nearly 800 billion dollar stimulus package and the Fed has cut the Federal Funds rate to zero. Monetary policy in the rest of the G7, while lagging behind the US, will follow the US lead and soon come close to zero. (In the case of the ECB, the policy rate may end up at 1%, but the effective interbank rate has been trading well below the official policy rate in recent weeks so a policy rate of 1% could translate into an effective interbank rate of nearly zero). Likewise for fiscal deficits – they are rising globally and headed higher, propelled by a combination of discretionary actions and automatic stabilisers.

To date, however, these traditional policies have been insufficient for the scale and scope of the task. Recall that the Obama stimulus package is actually the second such US effort in the last 12 months. The 2008 edition was deemed to be a failure because a big chunk of the rebate checks were saved or used to pay down debt and not spent. The Obama package includes tax cuts and credits that will provide a boost to disposable income, but how much of these will be spent rather than saved or used to pay down debt? The package also includes a substantial increase in infrastructure spending, as well as transfers to the states, but the infrastructure spending is back-loaded to 2010 and later, and the transfers to states will most likely just enable states to maintain public employment, not expand it appreciably.

Bucks without bang

What is the source of this concern that the US fiscal package will not deliver a lot of ‘bang’ for the ‘bucks’ committed? Because of the severe damage to the system of credit intermediation through banks and securitisation, policy multipliers are likely to be disappointingly small compared with historical estimates of their importance. Recall the Econ 101 idea of the Keynesian multiplier – the impact traditional macro policies are ‘multiplied’ by boosting private consumption by households and capital investment by firms as they receive income from the initial round of stimulus. It important to remember why and how policy multipliers actually come about. Policy multipliers are greater than 1 to the extent the direct impact of the policy on GDP is multiplied as households and companies increase their spending from the increased income flow they earn from the debt-financed purchase of goods and services sold to meet the demand from the initial round of stimulus.

Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001, the economy was in recession, but households took advantage of zero-rate financing promotions – as well as ready access to home equity withdrawal from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts and income earned from government spending on goods and services will not be leveraged by the financial system to nearly such an extent, resulting in (much) smaller multipliers.

There is a second reason while the bang of the fiscal package will likely lag behind the bucks. Even if the global financial system soon restores some semblance of order and function, the collapse in global equity and housing market values has so impaired household wealth that private consumption (which represents 60% to 70% of GDP in G7 countries) is likely to lag – not lead – economic growth for some time, as households rebuild their balance sheets the old-fashioned way – by boosting their saving rates. Just in 2008 alone, I estimate that the net worth of US households fell by some 10 trillion dollars, with much of this concentrated in older demographic groups who, in our defined contribution world, must now be focused on building back up their wealth to finance retirement, which is not that far away. This means more saving, less consumption, and smaller multipliers. ...

Will the Fed pull it off?

So where does this leave us? A LOT is riding on the efforts of the Fed and other central banks to stabilise the financial system and restore the flow of credit.

Officials recognising these challenges are now seriously considering “non-traditional” policies that combine monetary and fiscal elements. Cutting rates to (near) zero has not been a mistake, but it has been ineffective – really the most striking example of ‘pushing on a string’ I have witnessed in my lifetime. The reason, again, is the impaired credit intermediation system. The private securitisation channel, which at its peak was intermediating nearly 50% of household credit in the US, has been destroyed. Banks are hunkering down in the bunker, hoarding capital as a cushion against massive losses yet to be recognised on the trillions of dollars of ‘legacy’ assets that they have been unable or unwilling to sell at the deep discount required to attract private investors. For this reason, the Fed and Bank of England – with many other central banks likely to follow suit in some form or fashion – are filling the vacuum by directly lending to the private sector. The Fed aims to purchase 600 billion dollars worth of mortgage-backed and agency securities this year and, via the soon to be launched Term Asset-Backed Securities Loan Facility (TALF), to finance without recourse up to one trillion dollars worth of private purchases of credit cards, auto loans, and student loans. Since last fall, the Fed has also been supporting the commercial paper market via the Commercial Paper Funding Facility (CPFF).

Altogether, between the MBS, CPFF, and TALF programs, the Fed is committing nearly 2 trillion dollars of financing to the private sector. While these sums may be necessary to prevent an outright economic collapse that extends and deepens into 2011 and beyond, it is not clear to me that they are sufficient to turn the economy around so that it returns to robust growth. Moreover, based on the Fed’s just released economic forecast and Chairman Bernanke’s recent testimony to the Senate Banking committee, the Fed is also not convinced that these policies are sufficient to turn the economy around. On 24 February, knowing that an 800 billion stimulus had passed, that the Fed has committed nearly 2 trillion dollars of lending to the private sector, and that the Treasury’s Public Private Investment Fund will aim to support up to one trillion dollars of private purchases of bank legacy assets, Chairman Ben Bernanke said,

If actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability – and only if that is the case, in my view – there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,

As I said in my remarks at the conference, I think of myself as an optimist, and that outlook on life has served me well. However, the last nine months have severely tested that mindset, at least as it pertains to my professional endeavours. But old habits are hard to break, so I am casting aside the contrary evidence and putting my ‘bucks’ on the Fed. But it is a close call.

Jeremy Stein and Richard Clarida Identified as Potential Nominees to Fed

Some news:

The Obama administration has identified two economists, one Democrat and one Republican, for two empty seats on the seven-member Federal Reserve Board, according to several people familiar with administration deliberations.
The two are Jeremy Stein, a Harvard University specialist in finance, and Richard Clarida, an executive vice president at money manager Pimco and professor of economics and international affairs at Columbia University.
Mr. Stein did a stint in the White House at the beginning of Barack Obama's presidency. Mr. Clarida was a Treasury official in the early years of the George W. Bush administration.
The administration coalesced around the two names a few months ago, hoping that pairing a Republican with a Democrat would smooth the way for Senate confirmation. But the White House has yet to nominate either formally and could change course depending on the political environment and the individuals' circumstances.
Although the two men have different political views, both are well-credentialed economists who have done scholarly work on central banking and would bolster the economic expertise on the Fed board. Only two of the five current Fed governors are Ph.D. economists, Mr. Bernanke and Vice Chairwoman Janet Yellen.

More here and here. Clarida is a good choice. I know less about Stein, so I'll withhold judgment for the moment.

What Was Kocherlakota Thinking When He Dissented on Monetary Policy?

Narayana Kocherlakota makes it clear that the rate at which the recovery is proceeding is just fine with him. No more accommodation from the Fed is necessary given that "Since November, inflation has risen and unemployment has fallen."

But he doesn't acknowledge that the November date is cherry-picked to some extent. Since January -- just two months from when he starts his measurement -- unemployment has actually risen. He's happy with that? As for inflation -- the worry that is stopping him from endorsing a more aggressive policy -- using his preferred time period from last November until now, core PCE has risen from 1.0% to 1.3%. And it didn't move at all between May and June, it was 1.3% in both months. Uh oh, hyperinflation! Assuming a target of 2.0%, at this rate the Fed will reach it's inflation target in about a year and a half. Sounds kind of like the guidance they issued (and there is a good argument that the Fed should overshoot its target in the short-run). Perhaps lag effects can explain his response, if we tighten now we may not feel it until a year later, but that doesn't seem to be his argument:

In its August 9 meeting, the Committee changed this “extended period” language to say instead that it “currently anticipates economic conditions … are likely to warrant extraordinarily low levels of the federal funds rate through mid-2013.” This statement is designed to let the public know that the fed funds rate is likely to stay between 0 and 25 basis points over the next two years, not just over the next three to six months. Hence, the new language is intended to provide more monetary accommodation than before.
I dissented from this change in language because the evolution of macroeconomic data did not reflect a need to make monetary policy more accommodative than in November 2010. In particular, personal consumption expenditure (PCE) inflation rose notably in the first half of 2011, whether or not one includes food and energy. At the same time, while unemployment does remain disturbingly high, it has fallen since November. I can summarize my reasoning as follows. I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.

Again, "well-calibrated" should include both the direction and pace of change. Even if the direction is correct, is he satisfied with the pace of change for employment? I realize he thinks we will have to tighten in 3-6 months, but it's hard to see how a data-based projection takes you to this outcome (even more so if you believe, as I do, that the risks are asymmetric, i.e. that unemployment is more costly than inflation).

Finally, this is not a rock solid commitment from the Fed. This is their view of the most likely path for the federal funds rate, they have not said this is what they will do independent of how the data evolve. All they have said is that economic conditions are likely to warrant this outcome. The dissenters seem to believe that another outcome is more likely, the view is that economic conditions will force the Fed into a different posture -- you know, that high inflation and rapid recovery we've been seeing to date -- in as soon as 3-6 months. Anything is possible, but again, it's hard to see how recent data point to this outcome.

Update: See Matt Rognlie: Macroeconomics in Action (I've made this point several times in the past, and should have mentioned it here as well).

Update: Here's the view from the right.

Wednesday, August 10, 2011

Fed Watch: Weak Medicine

Tim Duy:

Weak Medicine, by Tim Duy: The Federal Reserve pronounced on the state of the economy, and the assessment wasn't pretty. I think this was pretty much the only good news:

However, business investment in equipment and software continues to expand.

We'll see if that holds up given the downdraft in the economy. Speaking of that downdraft, the growth outlook pushes back the return to full employment:

The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased.

And that hawkish inflation story is falling apart:

The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further.

In response to these clear and present dangers to the economy, policymakers offered this:

The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Not exactly shock and awe. And this takes some of the fun out of Fed watching. What will become of us if the Fed starts telling everyone the policy path for the next two years? I imagine we will preoccupy ourselves with this:

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.

We can do more, but we won't. And why not? I think the answer was back up in the first paragraph:

Longer-term inflation expectations have remained stable.

The story from the Treasury rally is more of a low growth than a deflation story. In what world would anyone foresee that real 5 year yields would be negative, real 10 year yields would be zero, and the real 30 year yield just 1.06 percent? If this really represents annual potential growth over the long run, the next few decades are going to be no fun at all.

Now, I think it is perfectly reasonable to argue that low growth will eventually work its way into substantially lower inflation expectations, and it would be better to get ahead of that curve. The Fed doesn't see it that way. They will need to see inflation expectation numbers turn more solidly south to bring out another round of QE3. I think that takes some additional weakness on top of what we are currently experiencing.

As far as the expectation of near zero rates for two years, is this weak or strong medicine? My initial reaction was similar Paul Krugman's:

The Fed didn’t announce a new policy. And despite what some press reports said, it didn’t even commit to keeping rates low; all it did was say that if the economy stays weak, rates will stay low — well, duh...

The Fed did not actually promise to keep rates low (whether market participants caught that nuance is another matter). They only said that based on what they see now, they would anticipate zero rates for another two years. And so what? We were going to figure that out sooner than later. The expected date of the first rate hike of the cycle has been repeatedly pushed back "another six months." And, sure, with mere words the Fed can flatten the near term portion of the yield curve to nearly zero, but there wasn't a lot of room to play around there to begin with.

Still, upon reflection, I see some additional upside from this psuedo-commitment. In effect, the FOMC publicly marginalized the hawks. You know who I am taking about:

Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.

Awfully convenient to have a block of three dissenters - the names "Larry, Moe, and Curly" come to mind. But I digress. One complaint over the past two years is that Fedspeak turns prematurely hawkish. The instant one good month of data rolls through the door, the more hawkish policymakers rush to let market participants know the end of easy money is near, talk that induces a tightening as agents hedge their dovish bets. Now we know not to be distracted by such talk, that while the bar to QE3 might be high, so too is the bar to actually raising rates. In other words, while not a promise, the Fed's outlook works to entrench expectations against any misunderstandings caused by Fed hawks.

Bottom Line: All in all, this is pretty weak medicine given the condition of the patient. I would have preferred to see an open-ended commitment to asset purchases - buying up anything not nailed to the floor at a rate of $10 or $15 billion a week until achieving the dual mandate is in clear sight. But policymakers, on average tend to think they have relatively weak ammunition to stimulate growth. Their tools are more effective against deflation. And until the former turns into the latter, expect the Fed to do little more than modifications of the basic zero interest rate / hold balance sheet constant policy combination.

Tuesday, August 09, 2011

The Fed Says Rates Likely to Remain Low Through Mid-2013

Here's my reaction to today's the FOMC meeting:

The Fed Says Rates Likely to Remain Low Through Mid-2013

"For once, I'd like to see the Fed get out in front of the problem, and with the recent emergent signs of weakness on so many fronts, now would have been a great time for the Fed to show it can do more than look in the rear view mirror."

Monday, August 08, 2011

Fed Watch: The Unpleasantness Continues

Tim Duy:

The Unpleasantness Continues, by Tim Duy: Lots of moving pieces tonight as financial centers around the world prepare for the impact of the S&P downgrade of US debt and the ongoing Eurozone debt crisis. The list:

ECB Finally Ready to Come to the Table. The ECB is signaling they are prepared to buy up massive quantities of Italian and Spanish debt, hoping to put a firewall around the European debt crisis. Of course, this isn’t the first firewall European leaders have set, to no avail. Perhaps this time will be different. Paul Krugman argues, I think correctly, that at least for Italy the issue is seemingly a liquidity crisis, not an insolvency crisis. The ECB could effectively act as a lender of last resort in such a case, and bring about stability with only minor fiscal adjustment. My concern is that if this was just a liquidity crisis, then why did the ECB posture that significant fiscal adjustments were necessary? Just to look tough? As to whether or not the ECB is actually prepared to follow through with big bond purchases, I refer you to Yves Smith:

My readers of European press tell me that the signals this weekend was that the ECB wants to nibble only and is trying to prevent panic sales. If this reading is correct, this is a variant on the Paulson “bazooka” strategy of July 2008 with Fannie and Freddie, that if the markets knew he had a bazooka in his pocket, he would not have to use it. We know how that one turned out.

The G7 Communiqué. The G7 finances ministers and central bankers met over the weekend and more or less confirmed their commitment to fiscal austerity:

We are committed to addressing the tensions stemming from the current challenges on our fiscal deficits, debt and growth, and welcome the decisive actions taken in the US and Europe. The US has adopted reforms that will deliver substantial deficit reduction over the medium term. In Europe, the Euro area Summit decided on July 21 a comprehensive package to tackle the situation in Greece and other countries facing financial tensions, notably through the flexibilisation of the EFSF. We are now focused on the quick and full implementation of the agreements achieved. We welcome the statement of France and Germany to that effect. We also welcome the statement of the Governing Council of the ECB.

Whether the US has adopted a credible medium term plan for fiscal reform is debatable, even more so given ongoing economic weakness likely to be exacerbated by near-term fiscal austerity. What the US needs is near-term stimulus and long-term consolidation, or at least a political system capable of producing this.

Regarding the rapid implementation of the EFSF, I think this means the someone in Europe is going to have to cut their vacation short and actually get on this before the end of the month. A key paragraph:

We are committed to taking coordinated action where needed, to ensuring liquidity, and to supporting financial market functioning, financial stability and economic growth.

I think this gives the Fed cover to move this morning; more later. I like this part:

These actions, together with continuing fiscal discipline efforts will enable long-term fiscal sustainability. No change in fundamentals warrants the recent financial tensions faced by Spain and Italy. We welcome the additional policy measures announced by Italy and Spain to strengthen fiscal discipline and underpin the recovery in economic activity and job creation.

On one hand, nothing warrants the pressure on Spain and Italy – just a liquidity crisis. On the other hand, they welcome additional policy measures. Less reassuring, has the feel of a solvency problem. Honestly, I think I would be more confident if the ECB had just stepped up to the plate and not demanded a quid pro quo. Finally:

The Euro Area Leaders have stated clearly that the involvement of the private sector in Greece is an extraordinary measure due to unique circumstances that will not be applied to any other member states of the euro area.

This is a clear line in the sand. Expect more fiscal austerity.

The Federal Reserve. As I argued last week, the usual guides to monetary policy, a combination of Fedspeak and data flow, are not conducive to a near-term policy shift. An overriding factor, however, would be financial crisis, and the G7 statement seems to raise the current circumstances to crisis level. This should give the Fed a green light to act. I still think the best option is to come in before the market opens and announce they are buying $100 billion of Treasuries. Just get ahead of this. The problem is that so many Fed policymakers have come out seemingly dead set against any additional bond purchases that action just a day before the next FOMC meeting seems like a big leap. Still, a financial crisis is a good time for a big leap.

The S&P Downgrade. Lot’s of speculation on the competence of S&P. They obviously messed up on the math. And let’s not forget the role they played during the financial crisis – aren’t any mortgage backed assets investment grade? They are if you want to keep earning your fees. But Ezra Klein and Felix Salmon argue that the circus of US politics warrants a debt downgrade. After all, a small but apparently vocal contingent thinks the debt-ceiling is no big deal, and is actually willing to press the button to prove their point.

Should the downgrade have significant economic consequences? I fear the answer is yes. First, if you believe confidence is important, that confidence has surely been shaken, as evidenced by wild ride of financial markets. Second, the political response could be a full-court press for more fiscal austerity. Finally, we don’t completely know the knock-off effects on the rest of the financial system. From the Wall Street Journal:

The downgrade late Friday had implications for a range of entities with links to the U.S. government or holdings of its debt, running the gamut from mortgage giants Fannie Mae and Freddie Mac to large insurers to securities clearinghouses—not to mention rates on consumer loans such as mortgages that are linked to Treasury yields.

The risk for all these borrowers is that the downgrade to double-A-plus, even though by just one of the three major rating firms, could result in slightly higher interest rates. Those costs might be small for each borrower, but in total could essentially mean a tightening of credit in the country at a time when a weak economy can ill afford higher rates.

The world needs more safe assets. The safest asset just became a little bit less safe. That can’t be good. The sad part is that there really shouldn’t be any doubt the US can and will repay its debt in full. Any way you cut it, this is a self-inflicted wound.

Good luck today.

Saturday, August 06, 2011

Fed Watch: Jobs Report and the Fed

Tim Duy:

Jobs Report and the Fed, by Tim Duy: The jobs report was somewhat better than expectations. Admittedly, this isn't saying much. But it was "good" enough to give the Fed pause before rushing into a fresh round of easing.

The headline NFP gain of 117k jobs was a combination of a not-terrible 154k gain in the private sector and a 37k loss on the public side of the ledger. Overall, simply a sideways movement. From the perspective of policymakers, however, the numbers will suggest that recession fears are overblown. And the 10 cent gain in hourly wages will suggest to some FOMC members that a renewal of deflation fears are also equally overblown.

It is true that, as Calculated Risk notes, the survey period was before agents turned cautious as the debt farce deepened. But, then again, the Fed would simply argue they need to see how much of that caution is quickly reversed.

Now, they could turn their attention the the household survey, and note that both labor force participation rates and the employment to population ratio continue to decline. But they could attribute these effects to largely structural causes, and as such beyond their purview. This too would also argue against any significant change in policy.

The implied inflation expectations from the TIPS market is 193bp and 225bp at the 5 and 10 year horizons, respectively. Still well above last summer's lows. The Fed has repeatedly argued they can't do anything about growth, but can fight deflation. But this doesn't appear to be a strong deflationary signal. This too argues against significantly policy shifts.

Financial market chaos argues for a shift in policy, but traditionally the Fed has resisted until the impact on actual economic activity becomes more evident. Again, an argument against looser policy.

On net, and with the benefit of the labor report in our back pocket, I think Neil Irwin at the Washington Post is most likely correct:

The Fed is holding its regular meeting on monetary policy next week, and leaders of the central bank will surely discuss the weakening outlook, whether they should do anything in response and what such a response might consist of. Their public statement following the meeting will likely reflect the worsening outlook for the economy, but they appear inclined not to make any policy changes until more evidence has become available and there has been more time to weigh it.

They will offer the possibility of further action, but none will be forthcoming next week. Now, all that said, I think the Fed should get ahead of this one - failure to do so has not yielded positive results in the past. But what the Fed should do and will do are two different things.

Friday, August 05, 2011

Fed Watch: That. Was. Unpleasant.

Tim Duy:

That. Was. Unpleasant., by Tim Duy: The rapidity with which confidence can shift is nothing short of a wonder of nature. I am not sure there was any terribly new news today. The evidence the US economy is weakening has been mounting for weeks. That equities had not sold off yet was something of a testament to the underlying profit situation.

But now fear grips financial market participants as the rush to cash or cash equivalents accelerated. A rush to judgment on the US economy? Felix Salmon tries to paint a positive picture:

Firstly, this is not necessarily a Bad Thing. If you’re saving for retirement, stocks are cheaper now, and your 401(k) contribution goes further than it did a few weeks or months ago. That’s good.

Secondly, if there ever were serious doubts about the USA’s creditworthiness, they’re gone now. The 10-year bond is yielding less than 2.5%: there are no worries in evidence there.

Put those two things together, and you can even be quite happy about today’s sell-off. If you’re a debtor rather than a saver, then falling interest rates are good for you. If you want to buy a house, then falling mortgage rates — not to mention falling home prices — are also good news. And if you want to invest in some wonderful future income stream, then money’s cheap right now to do so.

This seems to me to be a point in the recovery where you do not want the 10-year Treasury plunging to 2.41 percent. Felix offers a bit more pessimism:

Still, the future of the global economy is very uncertain, and southern Europe in particular is still far from any kind of sustainable resolution. The US economy has no particular exposure to Greece — but Italy is another matter entirely. This is a global sell-off, with European markets down just as much as those in the US; Asia’s sure to follow suit when it opens. Now that the Fed has stopped dropping dollar bills on the US economy, it’s hard to see where confidence and optimism are going to come from in the coming months.

Yes, will the Fed come to the rescue? Ryan Avent:

The good news is this: the Fed can't help but act. On Tuesday, I worried that the Fed would stand pat at its meeting next week, leaving the economy to dip into recession before it finally reacted in late August or following its September meeting. That no longer seems like the most likely outcome to me; events are moving too fast. Ben Bernanke may not announce a new policy next week, but I believe he will hint at new Fed easing—potentially at new purchases, but perhaps also at other available tools. The drop in inflation expectations should force the Fed's hand.

Inflation expectations are coming down, with the 5 year TIPS measure less than 2 percent but the 10 year TIPS measure is still 2.23 percent (down just 4bp from yesterday). Looking at the past week, I think Avent is on the right track – the Fed should be ready to get ahead of this mess, and next week is an opportune time. That said, the Fed has tended to be late in the game throughout the past few years. You have a lot of policymakers that need to fundamentally shift their intellectual framework to come to terms with a rapid shift in policy. And they could easily point to the 10 year implied inflation expectation and say it need to fall further before we will act. Same with the 5 year implied inflation expectation – it was bouncing along near 1.2 percent by late August last year.

In other words, it took considerably greater worries on the deflation front to prod the Fed into action last year.

In my view, Avent’s policy prescription is correct. For goodness sake, get ahead of this thing. Does another $200 billion on the balance sheet really matter that much? But the history of the last few years it this: They get to the right solution, but it takes some time. Now, one would think they learned some lessons in the last few years, and would tighten up the timeline. At the same time, though, one would have thought they learned their lesson from last years ill-timed turn toward hawkishness. Yet, they once again eagerly walked into that track this year as well.

The slow learning curve on Constitution Ave. argues against action next week. The reality of the world argued for action last month. Go figure.

Of course, the slowest learning curves are in Europe. Via the Wall Street Journal:

The euro zone’s inflation outlook has remained largely unchanged since the European Central Bank‘s July policy meeting, ECB President Jean Claude Trichet said Thursday, noting that he would not rule out further rate increases despite the ECB broadening its efforts to support fragile financial markets.

Speaking in a television interview with Dow Jones Newswires, Trichet said “our judgment is very much the same as in the previous meeting a month ago. We consider that we’re still in a situation where the risks are more on the upside… and that we will have to monitor the situation very closely.”

It speaks for itself. With policymakers across the Atlantic seemingly oblivious to their own dire situation, the fear gripping financial markets is completely understandable.

Bottom Line: The market nosedive does not yet guarantee Fed action in the near future. History has shown the Fed tends to react with a lag. They should have learned better by now, but if they had learned anything, they would not have pushed forward with hawkish rhetoric earlier this year. Arguably, they will hold firm, let the markets think they are out of the game and further bid down implied inflation expectations, and then, once the damage is done, up the level of stimulus. Terrible way to run an economy, I know. Still, it would be remiss to declare anything is certain before the employment report is released. A downside surprise could promt the Fed into more rapid action. I am now entirely speechless on the European situation – with Trichet's ongoing hawkish stance, it has truly devolved into one of those slow-motion train wrecks that one only sees in the movies.

Thursday, August 04, 2011

Fed Watch: On The Edge. Again.

Tim Duy:

On The Edge. Again., by Tim Duy: Market participants turned their attention away from Washington politics to the actual economy, and didn’t like what they saw. Incoming data has too many hints of recession to leave anyone optimistic about the second half. And while corporate profits have held up despite weak growth, it is difficult to see how they could retain recent gains in an outright recession.
Moreover, the reality of the budget deal is starting to set in. What the economy needed was near-term stimulus and long-term consolidation. What Washington delivered was just consolidation, both near and long-term. Now market participants are scratching their heads around three basic questions: Is recession imminent? How deep would it be? When will Washington come to the rescue?
The story I take away from the data is this: The US economy quickly lost any momentum developed in the back half of 2010 as the impact of higher commodity prices rippled through the economy. To be sure, this was compounded by the impact of the Japanese disruption, but that episode should have had little impact. The disruption was expected to be short-lived, and largely has been.
The commodity shock left a deeper mark on the economy. Not only did it directly impact households via higher energy prices, but I sense that firms where eager to try to push through higher prices. I also think one can argue that firms where goaded into higher prices by certain Fed officials who fanned the flames of inflation fears. The combination was that real consumption spending hit a wall:
And once again we return to the story of a new normal – not only is consumer spending at a lower trend line, but a lower growth rate as well:

Continue reading "Fed Watch: On The Edge. Again." »

Monday, August 01, 2011

Fed Watch: On Pins and Needles

The second of two from Tim Duy:

On Pins and Needles, by Tim Duy: Here we are, one month into the second half. Expectations, or, perhaps more accurately, blind hope, is that the back half of 2011 is better than the first half. We can only hope this is true. The revised GDP data reveal the US economy flirted with recession in the first six months of the year, raising the real concern that we are at stall speed. We need those confidence fairies sooner than later – because it looks like fiscal and monetary policymakers are still on the sidelines. Worse, in the case of the former, near, medium, and long-term policy are all looking contractionary at the moment.

Will the economy tumble into recession, or simply continue to limp along? Bets are all over the place at this point. Optimists are looking for a stronger second half as the temporary factors (Japan, oil price shock, etc) fade, giving a boost to at least one sector, autos. Karl Smith sees room for optimism in the manufacturing survey data – we will see the ISM number this morning for further insight. Rebecca Wilder, however, sees weakness in the high frequency data, although the most recent initial claims numbers fell below 400k. That said, Brad DeLong noted unusual seasonal effects in past Julys, and 2011 could be the same. Bloomberg sees trouble signs in container shipping rates:

Plunging rates for chartering container vessels that carry sneakers, furniture and flat-screen TVs may signal a U.S. consumer slowdown and losses for shipping lines in what is traditionally their busiest time of the year.

Fees for hiring vessels have fallen 9.3 percent since the end of April, according to the Howe Robinson Container Index, which tracks charter rates for a range of vessels. Last year, the index surged 56 percent in the period, as lines added ships on demand from U.S. and European retailers restocking for the back-to-school and holiday shopping periods.

“The troubling part is that charter rates are falling in the peak season,” said Johnson Leung head of regional transport at Jefferies Group Inc. in Hong Kong. “Sentiment among consumers and retailers isn’t very strong.”

I think you can tell a story of growth in the 2.0 to 2.5 percent range in the second half of this year, consistent with the low-end of consensus. Weak, weak, weak relative to the depth the recession – too weak to push down unemployment rates, perhaps too weak to prevent joblessness from increasing. As far as faster growth is concerned, I am still held up by the issue that the last two expansions were tied up in massive asset bubbles. What will provide that wealth-effect source of demand this time around? What will take its place? It certainly isn’t fiscal stimulus. If not, then what?

Moreover, while all eyes where on the debt-ceiling debate, the European debt crisis continues essentially unabated. So while the US economy is dragging itself into the second half at stall speed, it faces the certain shock of fiscal contraction and the increasingly likely shock emanating from Europe.

Where is the Federal Reserve in the midst of this turmoil? Out of sight. Well, not entirely, San Francisco Fed John Williams offered conditional support:

Looking ahead, we at the Fed will keep a very close eye on incoming data and adjust our policy as needed to work towards our two policy goals. If the recovery stalls and inflation remains low or deflationary pressures reemerge, then we may need to keep our very stimulatory policies in place for quite some time or even increase stimulus. On the other hand, assuming growth picks up and inflation doesn’t fall too low, then at some point we’ll need to start gradually removing stimulus.

We need to see both low growth – in the second half of the year, the first is irrelevant – and a reversal of recent inflation trends. Note the GDP revisions where not kind on that front:

Chicago Federal Reserve President Charles Evans would be willing to push for additional stimulus, again, dependent on the third quarter growth numbers – see the Wall Street Journal. Still, he would be more likely to ease even in the face of recent inflation trends, as he sees those as largely transitory. Note the same article highlights the opposite view of Philadelphia Fed President Charles Plosser. He expects stronger growth, and is looking to tighten policy ASAP.

Richmond Federal Reserve President Jeffrey Lacker sees more easing as simply inflationary:

This circumstantial evidence suggests that the additional monetary stimulus initiated last November raised inflation and did little to improve real growth. Last year, raising inflation was a desirable policy objective, but that clearly is not the case today. Given current inflation trends, additional monetary stimulus at this juncture seems likely to raise inflation to undesirably high levels and do little to spur real growth.

I suspect Federal Reserve Chairman Ben Bernanke is not far from this outlook as well. And, finally, we also have the wisdom of St. Louis Federal Reserve President James Bullard:

Now, “you’ve got rising inflation, and headline inflation is pretty high compared to a year ago. It could even go even higher,” Bullard said, noting “in that case you have be very circumspect” about doing more to help the economy, even in the face of anemic growth.

Sounds like a no vote to me.

Bottom Line: Pins and needles time for the US economy. The general expectation is for a stronger second half – but how much stronger? Seems like a lot of swords are still hanging over our heads to expect much more than anemic growth. That said, monetary policymakers expect something better and won’t budge either way until the tea leaves become clearer. And even if growth surprises on the downside, the inflation issue remains. Just can’t see monetary policy shifting in such an environment. The growth/inflation nexus needs to make a clean break one way or the other to prompt Fed action. For market participants, the mix of growth, inflation and policy is in something of a perverse sweet spot. Consider that corporate profits have held strong – revised upward even – helping sustain equity markets. Not sure that this should change in the absence of outright recession. Indeed, Wall Street is ready to ignore weak data, instead expected to rally hard this morning on the news that a debt-ceiling solution is at hand. Meanwhile, the Fed is effectively sidelined by weak growth, keeping interest rates low and freeing investors from imminent tightening fears. Impending fiscal contraction only locks in that outlook. And inflation is sufficiently high such that the Fed won’t loosen policy. No need to fret about that for the time being, and instead just enjoy the ride.

Wednesday, July 27, 2011

Fed Watch: Is Structural Change the Primary Challenge?

Tim Duy:

Is Structural Change the Primary Challenge?, by Tim Duy: Given that thoughts of high structural unemployment continue to emerge in Fed thinking, the topic bears ongoing scrutiny. Especially so for me personally, as I have long seen the need for structural shifts that address the US current account deficit - but should such adjustments require persistently high unemployment rates? Some affirmation of my general story comes via David Altig, who recently posted this chart:


Note the shift in relative growth patterns – less consumption, more investment, and net exports at least a less negative drag. This seems consistent with a shift away from the externally supported pattern of household consumption so evident in the past decade. And in discussing the general disappointment with the strength of the recovery, Altig says:

The undeniable (and relevant) human toll aside, the current recovery seems so disappointing because we expect the pace of the recovery to bear some relationship to the depth of the downturn. That expectation, in turn, comes from a view of the world in which potential output proceeds in a more or less linear fashion, up and to the right. But what if that view is wrong and our potential is a sequence of more or less permanent "jumps" up and down, some of which are small and some of which are big?

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

Why might we believe that potential output has suffered some sizable, negative downward shock? Altig did not provide an explanation, but one can find the same idea in the most recent FOMC minutes:

Continue reading "Fed Watch: Is Structural Change the Primary Challenge?" »

Friday, July 15, 2011

The Fed's Exit Strategy

Thursday, July 14, 2011

Seasonal Adjustment and New Unemployment Insurance Claims

Brad DeLong makes a good point about interpreting this morning's news that new claims for unemployment insurance fell a bit to 405,000 (though last week's number was revised upward):

Economagic Economic Chart Dispenser

New Unemployment Insurance Claims, by Brad DeLong: In both July 2009 and July 2010 the BLS's seasonal adjustment algorithm overestimated the extent of the seasonal jump in new unemployment insurance claims in July. Thus both in 2009 and 2010 the seasonally-adjusted series "saw" a July fall in unemployment insurance claims that was not really there.

Is the same thing happening this year? Perhaps. Thus I am not as pleased with this week's decline in seasonally-adjusted UI claims as I would be normally...

Leaving the microphone in Brad's hands, in another post he notes that:

worrying about deficit reduction right now stops us from worrying about things we could do something about--like high unemployment, idle capacity, slow growth, and crumbling infrastructure.

But instead of doing anything about it, the Fed watches and waits -- by Bernanke's own admission -- and hope's that, unlike all the other times it watched and waited to see if things got better and they didn't, this time is different (Bernanke said today that "We are uncertain about the near-term developments in the economy. We’d like to see if, in fact, the economy does pick up, as we are projecting."). And Congress is all but hopeless -- they'll be lucky if they don't wreck the economy over the debt ceiling, let alone take steps to improve it.

Wednesday, July 13, 2011

Fed Watch: A Nod to QE3?

Tim Duy interprets the remarks of Ben Bernanke in his appearance today before the Financial Services Committee, and notes that he hasn't change his position on QE3 as much as many people seem to think:

A Nod to QE3?, by Tim Duy: Financial markets warmly embraced a perceived opening by Federal Reserve Chairman Ben Bernanke, jumping sharply on news that QE3 was still on the table.

But QE3 was never off the table to begin with. It was simply that the bar to QE3 was very, very high. And I have to agree with Calculated Risk; I don’t see that Bernanke lowered it any today. The key sentence from the Congressional testimony:

On the one hand, the possibility remains that the recent economic weakness may prove more persistent than expected and that deflationary risks might reemerge, implying a need for additional policy support.

Note the two conditions – persistent economic weakness coupled with deflation risks. The latter was a focus when the Fed initiated QE2, with the lack of such risks guaranteeing the Fed would cease asset purchases at the end of June. Bernanke made clear the focus on deflation in his most recent press conference.

Are we seeing signs that such deflationary fears are emerging? Not yet, at least not based upon the kinds of market and survey based indicators the Fed is watching:


I would be looking for inflation expectations to plunge well below 200bp to trigger Fed action, like we saw last fall. Nor is it evident in the actual inflation data:


Absent a jarring negative shock, it seems difficult to believe the Fed could forge a consensus to ease further given the recent inflation path. Without a clear risk of deflation, it seems any additional asset purchases (or other easing efforts) would not make it through the FOMC.

Of course such a risk could not emerge quickly – the debt ceiling charades and the European debt crisis stand out as big tail risk events. And it's not really hard to tell a story that more action would be necessary under either scenario. But it shouldn't be a surprise that the Fed would be ready to step in and support financial markets if such events occur.

And don’t forget that Bernanke made clear another story:

On the other hand, the economy could evolve in a way that would warrant a move toward less-accommodative policy.

He doesn't lay down any specific data markers for tightening. In short, policy could tighten, could loosen. They are stuck on hold, waiting and watching the evolution of the data. But absent deflation risks, easing policy further seems very, very unlikely.

Bottom Line: Looking for more from the Fed? Then look to conditions that sharply raise the risk of deflation. And note that the FOMC minutes suggest the Fed is not really looking in this direction, instead focused on the commodity-induced inflation shock passing through the economy.

Fed Watch: A Divided FOMC

Tim Duy:

A Divided FOMC, by Tim Duy: The FOMC minutes were simply fascinating. The discussion of the economic situation was markedly downbeat, even before the latest employment report, yet the final outcome of the meeting – the FOMC statement and Federal Reserve Chairman Ben Bernanke’s subsequent press conference – seemed to clearly indicate that, barring an outright return to the threat of deflation, the Fed saw its job as done. How can we reconcile these two positions? Presumably the faction leaning more toward additional easing is relatively small, while the majority believes either they have already gone too far or that further policy is ineffectual. Bernanke seemed to place himself in the latter category during the press conference. Is that really where he stands? This apparent divergence of views on the FOMC will bring extra attention to Bernanke’s testimony today on Capitol Hill.

Begin with the economic situation as seen from Constitution Ave. A host of “temporary factors” are weighing on the economy:

… including the global supply chain disruptions in the wake of the Japanese earthquake, the unusually severe weather in some parts of the United States, a drop in defense spending, and the effects of increases in oil and other commodity prices this year on household purchasing power and spending.

Still, better times are on the horizon:

Participants expected that the expansion would gain strength as the influence of these temporary factors waned.

I wouldn’t sigh too loudly just yet. It is reasonable to believe that some of these impacts are indeed temporary. For example, Bloomberg reports the Bank of Japan see good progress toward normalizing production conditions:

“Japan’s economic activity is picking up with an easing of the supply-side constraints caused by the earthquake disaster,” the central bank said in a statement. Increasing output has resulted in an “upturn” in exports, and household and business sentiment has improved, it said.

Toyota and Honda said last month they plan to add thousands of workers in Japan as they increase production. Toyota, the world’s largest automaker, said domestic plants were running at 90 percent of planned levels in June, up from 50 percent in April and May, when output was depressed by a shortage of parts from suppliers.

That said, as Bernanke earlier explained, temporary factors are not all that are in play:

Nonetheless, most participants judged that the pace of the economic recovery was likely to be somewhat slower over coming quarters than they had projected in April.

Why the downgrade? The list is long:

This judgment reflected the persistent weakness in the housing market, the ongoing efforts by some households to reduce debt burdens, the recent sluggish growth of income and consumption, the fiscal contraction at all levels of government, and the effects of uncertainty regarding the economic outlook and future tax and regulatory policies on the willingness of firms to hire and invest.

As if this is not enough, the risks are all downside risks:

Moreover, the recovery remained subject to some downside risks, such as the possibility of a more extended period of weak activity and declining prices in the housing sector, the chance of a larger-than-expected near-term fiscal tightening, and potential financial and economic spillovers if the situation in peripheral Europe were to deteriorate further.

Lions and tigers and bears, oh my. Then comes the disappointing jobs numbers:

Meeting participants generally noted that the most recent data on employment had been disappointing, and new claims for unemployment insurance remained elevated. The recent deterioration in labor market conditions was a particular concern for FOMC participants because the prospects for job growth were seen as an important source of uncertainty in the economic outlook, particularly in the outlook for consumer spending.

Note that this was before the most recent employment report. The situation has only deteriorated further. Indeed, the sharp downturn in employment growth is something of a mystery if the primary factors weighing on the economy, primarily the Japanese tsunami, are widely believed to be only temporary. Firms should be willing and able to look through such disruptions. Simply a heightened sense of caution as the memory of the recession still lingers? Or are the back-to-back weak employment reports indicating a more permanent downward shock to growth, perhaps a cascading effect from the commodity price shock that will not be easily relieved unless the shock reverses itself.

Additional risks to the outlook were seen in the European debt crisis and the possibility the US debt ceiling may not be raised (I sure hope Calculated Risk is correct on this one). Given the general downbeat tenor of the discussion, it is tough to see how they did not open the door further for additional easing. Why not? Policy is held hostage to inflation fears:

Most participants expected that much of the rise in headline inflation this year would prove transitory and that inflation over the medium term would be subdued as long as commodity prices did not continue to rise rapidly and longer-term inflation expectations remained stable. Nevertheless, a number of participants judged the risks to the outlook for inflation as tilted to the upside. Moreover, a few participants saw a continuation of the current stance of monetary policy as posing some upside risk to inflation expectations and actual inflation over time.

On the other side were those that argued there were no indications inflation expectations were becoming unanchored, nor would this be likely when labor costs were subdued. Then comes the paragraph that truly reveals the divergence within the FOMC:

Participants also discussed the medium-term outlook for monetary policy. Some participants noted that if economic growth remained too slow to make satisfactory progress toward reducing the unemployment rate and if inflation returned to relatively low levels after the effects of recent transitory shocks dissipated, it would be appropriate to provide additional monetary policy accommodation. Others, however, saw the recent configuration of slower growth and higher inflation as suggesting that there might be less slack in labor and product markets than had been thought. Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, may have temporarily reduced the economy's level of potential output. In that case, the withdrawal of monetary accommodation may need to begin sooner than currently anticipated in financial markets. A few participants expressed uncertainty about the efficacy of monetary policy in current circumstances but disagreed on the implications for future policy.

The group suggesting the need for additional stimulus appears to be relatively small. A more significant group looks at recent data and concludes we overestimated the amount of slack in the system (despite meager wage gains). An apparently nontrivial contingent sees structural issues driving potential output lower, even if only temporarily. And then there are those that are not confident that policy has much impact at this juncture – which implies either do nothing or the next thing they do has to be really, really big. And I doubt there is much support on the FOMC for something really big.

And note that although the group open to additional stimulus caught the attention of the press, it appears they too would wait until it becomes clear that both labor markets remain weak and inflation returns to low levels. I would add that Bernanke raised the stakes further – inflation expectations need to threaten to become unanchored on the downside, a real fear of deflation like last fall. He seems to believe that additional policy would be ineffectual at boosting growth further, and should be reserved for moderating financial disruptions and maintaining inflation expectations. It should be interesting if today he reiterates his point that in the absence of deflation, the tradeoffs of additional policy are not very attractive. If he recants this view, it would signal that he is moving toward additional policy sooner than later. I don't expect such a change.

So what’s the bottom line here? On one hand, the “watch and wait” mode could be viewed as understandable given the multitude of temporary factors in play. That said, temporary factors aside, the overall tenor of the meetings appears to have been very depressing. There is a clear sense the economy is firing on only a handful of cylinders, yet FOMC members cannot completely explain why. And perhaps more importantly, it appears members are operating without consistent theoretical or empirical frameworks. They all seem to be looking at the same set of data through very different lenses. There is no agreement that policy has been effective or ineffective. There is no agreement if inflation risks are high or low. There is no agreement if structural impediments are real or imagined. Given the lack of agreement, it is difficult to see how policy does anything but remain in a holding pattern until a clearer picture emerges. Good news for those worried the Fed would soon tighten. Ongoing weak job reports practically guarantees the Fed will not step on the breaks. Bad news for those looking for more. Until the inflation fears shift back to deflation fears, there looks to remain strong resistance to additional asset purchases.

Monday, July 11, 2011

Paul Krugman: No, We Can’t? Or Won’t?

Excuses, excuses:

No, We Can’t? Or Won’t?, by Paul Krugman, Commentary, NY Times: ...The ... United States economy has been stuck in a rut for a year and a half. Yet a destructive passivity has overtaken our discourse. Turn on your TV and you’ll see some self-satisfied pundit declaring that nothing much can be done about the economy’s short-run problems..., that we should focus on the long run instead.
This gets things exactly wrong. ... Our failure to create jobs is a choice, not a necessity — a choice rationalized by an ever-shifting set of excuses.
Excuse No. 1: Just around the corner, there’s a rainbow in the sky.
Remember “green shoots”? Remember the “summer of recovery”? Policy makers keep declaring that the economy is on the mend — and ... these delusions of recovery have been an excuse for doing nothing as the jobs crisis festers.
Excuse No. 2: Fear the bond market.
Two years ago The Wall Street Journal declared that interest rates on United States debt would soon soar unless Washington stopped trying to fight the economic slump. Ever since, warnings about the imminent attack of the “bond vigilantes” have been used to attack any spending on job creation.
But basic economics said that rates would stay low as long as the economy was depressed — and basic economics was right. ...
Excuse No. 3: It’s the workers’ fault.
Unemployment soared during the financial crisis and its aftermath. So it seems bizarre to argue that the real problem lies with the workers — that the millions of Americans who were working four years ago ... somehow lack the skills the economy needs...: high unemployment is “structural,” they say, and requires long-term solutions (which means, in practice, doing nothing).
Well, if there really was a mismatch..., workers who do have the right skills ... should be getting big wage increases. They aren’t. ...
Excuse No. 4: We tried to stimulate the economy, and it didn’t work.
Everybody knows that President Obama tried to stimulate the economy with a huge increase in government spending, and that it didn’t work. But what everyone knows is wrong.
Think about it: Where are the big public works projects? Where are the armies of government workers? There are actually half a million fewer government employees now than there were when Mr. Obama took office. ... This ... wasn’t the kind of job-creation program we could and should have had. ...
It’s also worth noting that in another area where government could make a big difference — help for troubled homeowners — almost nothing has been done. ...
Listening to what supposedly serious people say about the economy, you’d think the problem was “no, we can’t.” But the reality is “no, we won’t.” And every pundit who reinforces that destructive passivity is part of the problem.

Fall Into the Gap Forever?

Here are three graphs showing the gaps in output, consumption, and employment that have opened up since the recession:

Real GDP

Gap2 Real Consumption

Gap3 Employment

In all three cases, we appear to be growing along a lower growth path than before. The question is whether we are stuck on these lower growth paths forever. Will we ever recover the old growth path, in full or in part? That is, how much of the change in the GDP growth path is permanent, and how much is temporary?

This is important because the level of employment is a function of the level of output. If we stay on the lower growth path, then we will have a permanent gap in employment -- most of the 14+ million unemployed will have little hope of finding work. We can share the jobs that exist, something like that, but we won't ever recover the jobs that were lost.

However, graphs like the next one point to temporary changes as the dominant feature of output fluctuations. Sometimes the deviations from trend are highly persistent, as in the Great Depression, but eventually we recover. The trend has not varied much for over 100 years. It does vary slightly over time, but the variance in the red line is small relative to the overall variance in output:


But as Brad DeLong notes:

I ... find the picture impressive. But the U.S. is exceptional. Other countries do not show the same pattern: for example, the United Kingdom never recovered to trend after its post-World War I recession.
And past performance is no guarantee of future results...

So it's not 100% certain that we will bounce back to the long-run trend. This time could be different (Brad shows that Britain has had permanent shocks).

The argument that variation in GDP, consumption, employment, and other macroeconomic variables is due to permanent shifts in the trend rather than cyclical variation around the trend is precisely the argument used by Real Business Cycle theorists and adherents to the classical school more generally to undermine the case for countercyclical monetary and fiscal policy. The more of the variation in output that can be explained by variation in trend (i.e. by supply-shocks), the less that is left over to be explained by aggregate demand shocks. With less variation caused by demand, there is less need for demand stabilization policies.

(This is also what is at issue in the structural versus cyclical unemployment debate. The more that the variation in unemployment is attributed to structural change, and hence to variation in trend, the less that is left over to be attributed to cyclical factors. With less cyclical variation, the case for policy is weakened.)

Now, none of the above implies that the argument that some of the variation in output is due to variation in the trend is wrong (see here for a summary of the debate). I believe that some of the variation in output is, in fact, due to permanent changes in the trend rate of output. The trend is not a perfectly straight line. The question is the size of the variation in trend relative to the size of the variation due to demand shocks (a question that has not been very decisively answered in the empirical literature, e.g. see the early work on this by Stock and Watson, and Blanchard and Quah). My read of the evidence is that the amount of variation in trend relative to cycle is nowhere near large enough to undermine the case that demand shocks are important components of aggregate fluctuations.

The point I want to make is that the "it's all explained by a new normal" story adopts the conservative point of view that variation in output is mostly due to supply shocks rather than fluctuation in demand. In this case, there's little room for monetary or fiscal policy to help. However, there are good theoretical, empirical, and -- if you are into such things -- ideological reasons to be wary of making the "it's the new normal" or, equivalently, the "shocks are mostly permanent" argument. The persistence of the trend in output is evident in the graph above, and while this time may, in fact, be different, those making the argument -- some of whom are on the left -- should be fully aware of the conservative viewpoint this argument embraces. The argument that we are on a permanently lower growth path is an argument that there's nothing we can do, nothing we need do, and nothing we should do (except, perhaps, measures such as sharing the jobs we have more broadly). This is the new normal and you may as well get used to it.

My view is different. I believe we will eventually recover to a new growth path that is near, but a bit lower than the old one. The recovery will be slow, but we will get there eventually. How long it takes depends, in part, upon how aggressively we attack the problem with monetary and fiscal policy measures ( or how much we make things worse with mistakes in either area such as premature deficit reduction or interest rate hikes).

 There is plenty of evidence in the historical record to suggest it's possible to largely recover from the recession, and I am not ready to accept the conclusion that we must resign ourselves to a growth path so far below the historical norm. If it eventually turns out that we are on such a disheartening long-run path and there's no way to change it, so be it, but I'm not ready to give up just yet.

Friday, July 08, 2011

Fed Watch: Grim

Tim Duy:

The employment report polishes off what was already a depressing week. The turn of events in the budget negotiations was deeply distressing. It just seemed like it should be impossible to imagine that budget cutting is the order of the day when unemployment is over 9%, 10-year Treasuries hover near 3%, and a Democrat is in the White House. Yet possible it is.

The extent to which our leadership seems determined to follow in the path of the Japanese is absolutely stunning. My impression of the last two decades is that Japanese policymakers were never able to keep their eyes on the weak economy, instead always eager to turn their attention back to "normalizing" policy – raising interest rates, raising taxes, cutting spending. Our leadership suffers from the same obsession.

The employment report should be a wake up call. A slap in the face. A bucket of cold water poured over your head. But it won’t. I suspect it will be seen as further evidence that stimulus is pointless, that austerity is the only solution.

Weakness spread far and wide throughout the report. No way to put lipstick on this pig. As others have noted, the labor force fell, the participation rate fell, the employment to population ratio fell, the number of employed plummeted, and the number of unemployed climbed. Private nonfarm payrolls gains a paltry 57k, and the drag from government cutbacks pulled the overall jobs gain to just 18k. Far short of the numbers needed to even hold unemployment steady.

And wages fell. Just a penny an hour, to be sure. But that penny is meaningful given the desperate fears of inflation that appeared to take hold on Constitution Ave. Without sharply rising wages, those fears are simply unfounded. This was the lesson of the post-1984 period. Why monetary policymakers are fixated on the pre-1984 period is a mystery.

What I noticed was the number of short-term unemployed:


A sharp rise in the number of people thrown into unemployment is definitely a red flag. The overall data picture is not pointing at recession yet, but this number reeks of something bad.

We can only hope some of the downward pressure on growth is relieved as the tsunami related disruptions fade and, more importantly in my mind, the sharp rise in oil prices has been arrested, at least for the moment. But even as these restraints lift, what remains? Oil prices have not plummeted like in 2008 to provide a big positive boost to real spending. And interest rates are no longer falling to provide and opportunity for a refinancing boom. So at best we return to trend growth, maybe a little above? Trend growth that was never sufficient in the first place?

Moreover, we still face significant headwinds in the second half of the year. The Europeans are determined to avoid resolution in their ongoing debt crisis. The ECB is determined to raise interest rates. And Congress and the White House are determined to pursue a path of fiscal austerity.

Bottom Line: Simply a weak report – unbelievably weak given the “recovery” is two years old. Weak enough – especially given falling wages – that it should prompt Bernanke & Co. to revisit their commitment to end large scale asset purchases. The next round of Fedspeak will be very interesting. Watch closely for the focus on “temporary” factors - code for watch and wait. At this juncture, they are still out of the game. I think the Fed will need to see another quarter of data before they begin to take seriously the possibility that they once again erred with a premature policy shift.

Sunday, July 03, 2011

The You're On Your Ownership Society

Richmond Federal Reserve president Jeffrey Lacker says the Fed should forget about the unemployed and focus on inflation:

Fed’s Lacker: Central Bank Needs to Focus on Inflation, Not Jobs, WSJ: The Federal Reserve should focus on keeping prices under control, leaving the government to try to boost the U.S. economy and jobs, Richmond Federal Reserve Bank President Jeffrey Lacker said in an interview Friday.
Though frustrated by a recovery that continues to be slow and choppy two years after the recession ended, Lacker said further monetary stimulus by the Fed would likely show up “almost entirely” in inflation, which is already too high. ...
[T]he Fed official urged President Barack Obama and Congress to come up with a credible long-term plan to cut the budget deficit without worrying too much about the short-term effects on growth.

The Fed is worried about inflation, Congress is worried about the deficit, but who is worried about the unemployed? I don't mean worried in the sense of acknowledging it's a problem and saying empathetic things -- oh those poor unemployed, too bad for them -- I mean worried enough to try to do something about it.

Saturday, July 02, 2011

Why the Wealthy Need the Welfare State

We have forgotten what it was like before the welfare state (I prefer the term social insurance state), and why it was put into place:

What history teaches us about the welfare state, by Francois Furstenberg, Commentary, Washington Post: In the wake of the economic crash, which has led to soaring budget deficits, Democrats and Republicans are negotiating “to move forward to trillions of spending cuts,”... unprecedented reductions in the size of the welfare state... Lost in this debate is an appreciation of the historical origins of the American welfare state — long before FDR and the New Deal, after another epochal financial crash.
Much like our time, the Gilded Age was an era of economic booms and busts. None was greater than the financial crisis that began in September 1873... For 65 straight months, the U.S. economy shrank — the longest such stretch in U.S. history. America’s industrial base ground to a near halt... Until the 1930s, it would be known as the Great Depression. ...
As demand collapsed, businesses slashed payrolls and reduced wages, and a ruinous period of deflation began. By 1879, wholesale prices had declined 30 percent. The consequences were catastrophic for the nation’s many debtors and set off a vicious economic cycle.
Neither political party offered genuine solutions. ... With laissez-faire ideas dominant and the political system in stasis, economic decline persisted. The collapse in tax revenue only strengthened calls for fiscal retrenchment. Government at all levels cut spending. Congress returned the country to the gold standard...: “hard money” policies that favored Eastern financiers over indebted farmers and workers.
With neither major party responding to the crisis, new insurgent movements arose: antimonopoly coalitions, reform parties and labor candidates all began to attract support. ... The continued economic misery for the many, juxtaposed against fabulous wealth for the few, generated intense hostility to great fortunes. Workers, suffering the most without a welfare state, responded with ever-greater militancy.
The labor struggles of the age were as epic as the fortunes of the tycoons: the Molly Maguires of the Pennsylvania coal fields; the great railroad strike of 1877 that nearly paralyzed the nation; the Haymarket affair of 1886, in which a bomb killed eight people in a Chicago demonstration; the Homestead strike of 1892, probably the most violent labor conflict in American history. But these were just the most famous episodes...: Between 1881 and 1890, there were 9,668 strikes and lockouts... State and federal militias were repeatedly called out to quash labor unrest. ...
Wealthy Americans began to fear for the stability of the social order. What force, the wealthy asked in desperation, might mitigate the social chaos and misery, and mute what one public official called “the antagonism between rich and poor”? ...
Today, new fortunes have been accumulated that rival those of the Gilded Age. Some of that wealth, possessed by people like Charles G. Koch and David H. Koch or Peter G. Peterson, has been used to promote cuts to social spending. Before ...  dismantling of the welfare state, however, they might think harder about the reasons such policies were put in place.
The Gilded Age plutocrats who first acceded to a social welfare system and state regulations did not do so from the goodness of their hearts. They did so because the alternatives seemed so much more terrifying.

Though it doesn't fit precisely, I keep thinking of the ultimatum game. When the distribution of gains crosses some threshold of unfairness, people become willing to sacrifice in order to make a larger point. For example, in a strike they are willing to impose costs on themselves in order to impose even larger costs on someone else and hopefully bring about desired change.

I don't know how close we are to the boiling point, the point where people become willing to go on strike, sabotage production, etc., etc. in protest over intolerable levels of inequality in the distribution of the nation's output. But I fear we are closer to that point than we think, and attempts to dismantle the welfare state will make the tipping point come sooner rather than later.

Friday, July 01, 2011

Austerity Can Wait

I have a comment at the Financial Times:

Austerity can Wait

It's at the end of the Gavyn Davies article.

Thursday, June 30, 2011

The End of QE2: Did It Work? What Will Happen Next?

At MoneyWatch:

The End of QE2: Did It Work? What Will Happen Next?

[This borrows from an op-ed in the local paper: Interest rates not the only way the Fed boosts economy, by Tim Duy and Mark Thoma.]

Wednesday, June 29, 2011

Feldstein: What’s Happening to the US Economy?

Martin Feldstein sounds worried:

What’s Happening to the US Economy?, by Martin Feldstein, Commentary, Project Syndicate: The American economy has recently slowed dramatically, and the probability of another economic downturn increases with each new round of data. ...
Monetary and fiscal policies cannot be expected to turn this situation around. The US Federal Reserve will maintain its policy of keeping the overnight interest rate at near zero; but, given a fear of asset-price bubbles, it will not reverse its decision to end its policy of buying Treasury bonds – so-called “quantitative easing” – at the end of June.
Moreover, fiscal policy will actually be contractionary in the months ahead. The fiscal-stimulus program enacted in 2009 is coming to an end, with stimulus spending declining from $400 billion in 2010 to only $137 billion this year. And negotiations are under way to cut spending more and raise taxes in order to reduce further the fiscal deficits projected for 2011 and later years.
So the near-term outlook for the US economy is weak at best. Fundamental policy changes will probably have to wait until after the presidential and congressional elections in November 2012.

Sarah Raskin is also worried, and seems to be one of the few Federal Reserve Board willing to "underscore" the employment part of the dual mandate (though I think Feldstein's right about further easing, that won't happen unless the outlook darkens considerably, and even then there's no certainty the Fed would take action):

Fed’s Raskin Paints Grim Picture of Recovery, by Luca Di Leo, Real-Time Economics: Federal Reserve Board governor Sarah Raskin Wednesday painted a grim picture of the U.S. economy and signaled support for the central bank’s easy-money policies aimed at boosting jobs.

In a speech to the New America Foundation, Raskin said the jobs market is actually in worse shape than what’s indicated by the headline 9.1% unemployment rate. ...Raskin told the audience “we should pause to underscore the promotion-of-maximum-employment imperative of the Federal Reserve’s dual mandate.” ...

Though statistics show that about 13.9 million Americans were out of work in May, an additional 8.5 million workers had to settle for part-time jobs or were forced to cut back on their work hours, Raskin said.

“It is necessary for the strength of our nation’s recovery that low- and moderate-income Americans be able to more fully participate in the economy,” the Fed official said. ...

Monday, June 27, 2011

"No Pain, No Gain?"

In this Slate column from 1999, Paul Krugman discusses (and dismisses) the "pain is good" economic argument from the 1920s, and then says "one hears exactly the same argument now." Twelve years later, not much has changed.

This also buttresses an argument I've made recently. Some people argue that the problem with the economy is mostly structural rather than cyclical, and that monetary and fiscal policy can do little to help. I disagree on both counts. I think most of the problem we face today is cyclical, not structural, and to the extent we do face a structural problem it's still important to institute "short-run palliatives" that allow us to "keep the work force employed":

No Pain, No Gain?, by Paul Krugman, Slate, Jan. 15, 1999: Once upon a time there was a densely populated island nation, which, despite its lack of natural resources, had managed through hard work and ingenuity to build itself into one of the world's major industrial powers. But there came a time when the magic stopped working. A brief, overheated boom was followed by a slump that lingered for most of a decade. A country whose name had once been a byword for economic prowess instead became a symbol of faded glory.
Inevitably, a dispute raged over the causes of and cures for the nation's malaise. Many observers attributed the economy's decline to deep structural factors--institutions that failed to adapt to a changing world, missed opportunities to capitalize on new technologies, and general rigidity and lack of flexibility. But a few dissented. While conceding these factors were at work, they insisted that much of the slump had far shallower roots--that it was the avoidable consequence of an excessively conservative monetary policy, one preoccupied with conventional standards of soundness when what the economy really needed was to roll the printing presses.
Needless to say, the "inflationists" were dismissed by mainstream opinion. Adopting their proposals, argued central bankers and finance ministry officials, would undermine confidence and hence worsen the slump. And even if inflationary policies were to give the economy a false flush of artificial health, they would be counterproductive in the long run because they would relax the pressure for fundamental reform. Better to take the bitter medicine now--to let unemployment rise, to force companies to purge themselves of redundant capacity--than to postpone the day of reckoning.
OK, OK, I've used this writing trick before. The previous paragraphs could describe the current debate about Japan. (I myself am, of course, the most notorious advocate of inflation as a cure for Japan's slump.) But they could also describe Great Britain in the 1920s--a point brought home to me by my vacation reading: the second volume of Robert Skidelsky's biography of John Maynard Keynes, which covers the crucial period from 1920 to 1937. (The volume's title, incidentally, is John Maynard Keynes: The Economist as Savior.)
Skidelsky's book, believe it or not, is actually quite absorbing: Although he was an economist, Keynes led an interesting life--though, to tell the truth, what I personally found myself envying was the way he managed to change the world without having to visit quite so much of it. (Imagine being a prominent economist without once experiencing jet lag, or never taking a business trip where you spent more time getting to and from your destination than you spent at it.) And anyone with an interest in the history of economic thought will find the tale of how Keynes gradually, painfully arrived at his ideas--and of how his emerging vision clashed with rival schools of thought--fascinating. (Click here for an example.)
But the part of Skidelsky's book that really resonates with current events concerns the great debate over British monetary policy in the 1920s. Like the United States, Britain experienced an inflationary boom, fed by real estate speculation in particular, immediately following World War I. In both countries this boom was followed by a nasty recession. But whereas the United States soon recovered and experienced a decade of roaring prosperity before the coming of the Great Depression, Britain's slump never really ended. Unemployment, which had averaged something like 4 percent before the war, stubbornly remained above 10 percent. There is an obvious parallel with modern Japan, whose "bubble economy" of the late 1980s burst eight years ago and has never bounced back.
Almost everyone who thought about it agreed that Britain's long-run relative decline as an economic power had much to do with structural weaknesses: an overreliance on traditional industries such as coal and cotton, a class-ridden educational system that still tried to produce gentlemen rather than engineers and managers, a business culture that had failed to make the transition from the family firm to the modern corporation. (Keynes, never one to mince words, wrote that "[t]he hereditary principle in the transmission of wealth and the control of business is the reason why the leadership of the Capitalist cause is weak and stupid. It is too much dominated by third-generation men.") Similarly, everyone who thinks about it agrees that modern Japan has deep structural problems: a failure to move out of traditional heavy industry, an educational system that stresses obedience rather than initiative, a business system that insulates big company managers from market reality.
But need structural problems of this kind lead to high unemployment, as opposed to slow growth? Is recession the price of inefficiency? Keynes didn't think so then, and those of us who think along related lines don't think so now. Recessions, we claim, can and should be fought with short-run palliatives; by all means let us work on our structural problems, but meanwhile let us also keep the work force employed by printing enough money to keep consumers and investors spending.
One objection to that proposal is that it will directly do more harm than good. In the 1920s the great and the good believed that an essential precondition for British recovery was a return to the prewar gold standard--at the prewar parity, that is, making a pound worth $4.86. It was believed that this goal was worth achieving even if it required a substantial fall in wages and prices--that is, general deflation. To ratify the depreciation of the pound that had taken place since 1914 in order to avoid that deflation was clearly irresponsible.
In modern times, of course, it would, on the contrary, seem irresponsible to advocate deflation in the name of a historical monetary benchmark (though Hong Kong is currently following a de facto policy of deflation in order to defend the fixed exchange rate between its currency and the U.S. dollar). But orthodoxy continues to prevail against the logic of economic analysis. In the case of Japan, there is a compelling intellectual case for a recovery strategy based on the deliberate creation of "managed inflation." But the great and the good know that price stability is essential and that inflation is always a bad thing.
What really struck me in Skidelsky's account, however, was the extent to which conventional opinion in the 1920s viewed high unemployment as a good thing, a sign that excesses were being corrected and discipline restored--so that even a successful attempt to reflate the economy would be a mistake. And one hears exactly the same argument now. As one ordinarily sensible Japanese economist said to me, "Your proposal would just allow those guys to keep on doing the same old things, just when the recession is finally bringing about change."
In short, in Japan today--and perhaps in the United States tomorrow--behind many of the arguments about why we can't monetize our way out of a recession lies the belief that pain is good, that it builds a stronger economy. Well, let Keynes have the last word: "It is a grave criticism of our way of managing our economic affairs, that this should seem to anyone like a reasonable proposal."

Thursday, June 23, 2011

Fed Watch: FOMC Reaction

Tim Duy reacts to the FOMC meeting:

FOMC Reaction, by Tim Duy: The two-day FOMC meeting ended largely as expected, with the Fed reaffirming the current policy stance. If you were looking for signs that QE3 is on the horizon, you were sorely disappointed. If anything, the FOMC statement shifted in a slightly hawkish direction, setting the stage for the next policy move to be a tightening. The Fed is trying to make it as straightforward as possible – in the absence of clear and convincing evidence that deflation is again a threat, they have nothing else to offer.

The statement itself made clear the Fed interprets much of the current data flow as reflecting temporary factors, either the impact of higher commodity prices or the disaster in Japan. Interestingly, though, temporary factors alone are not sufficient to explain the slowdown, as the 2012 GDP forecast was downgraded. Federal Reserve Chairman Ben Bernanke admitted this during his subsequent press conference. In response to a request for the forecast he brought to the meeting, he suggested that he was on the low side of expectations:

[The] “slowdown is at least partly temporary….can’t explain the entire slowdown…Growth at least in the near term might be a little bit less than we anticipate.”

Still, despite the slowdown, the Fed removed the “employ its policy tools as necessary to support the economic recovery” language, presumably because they have no intention of providing any additional support. Moreover, inflation trends are no longer “subdued.” Instead, they see a “subdued outlook for inflation,” another signal that they are not thinking about easing, but instead restraining themselves from tightening now.

As Mark Thoma notes, Bernanke made clear that the shift away from deflation concerns effectively ends the possibility of another dose of quantitative easing. So what happened to the Bernanke of a decade ago, when he chastised the Bank of Japan for inaction? Brad DeLong laments:

Those of us Democrats who were happy when Barack Obama reappointed Ben Bernanke as Fed Chair thought that we were getting the Ben Bernanke we knew--the student of the Great Depression and of Japan's Lost Decade dedicated to doing whatever was necessary to stabilize the time path of nominal GDP, up to and including dropping bales of money out of helicopters.

Whatever happened to him?

My first thought is that we forgot or overlooked the fact that Bernanke is a child of the Bush Administration, which should have been a red flag that he was not all that he was thought to be. My second thought is that I don’t see Bernanke as terribly out of line with the current Administration itself. Third, Bernanke made clear in his response to a Japanese reporter that he sees himself as exactly the Bernanke of a decade ago. His comments then meant that:

“…a determined central bank can always do something about deflation.”

Like inflation, deflation is a monetary phenomenon, and, as such is within the control of the monetary authority. He acted on that belief last fall with the Fed’s second large-scale asset program – a policy that had more to do with eliminating deflationary expectations than the path of growth. Those deflationary concerns have now been replaced by the more traditional inflationary concerns. To be sure, the growth forecast leaves much to be desired, and the unemployment outlook should arguably be seen as a crisis. But – and I think this is key – the Fed believes that they have little traction over growth at this juncture. Thus, additional policy yields no improvement on the employment outlook, but potentially adds to an already uncomfortable inflation tradeoff.

Simply put, from the Fed’s point of view, the balance of risks is clear. And that means we should expect nothing more from Constitution Ave.

Despite the clear direction from Bernanke, Bill Gross of PIMCO doubled-down on his failed bet that this statement would hint at QE3. Via Reuters:

Gross, the co-chief investment officer of PIMCO, the world's top bond manager, on Wednesday said on Twitter: "Next Jackson Hole in August will likely hint at QE3 / interest rate caps."

Consider the timeline. Today, the FOMC and Bernanke himself only further distanced themselves from another dose of easing in this cycle. That means he need a full 180 degree turn by August, less than two months away. Consider too that we would need a deflation threat to create such a turnaround. But, even if commodity prices stabilize, or even decline, the pass-through from previous price increases is still likely to be working its way through the core data. And it defies belief that, given the current attitude among FOMC members, they would entertain the thought of deflation with such inflationary pressure in the pipeline, even if you believe it to be temporary pressure.

Moreover, any commodity price declines are likely to provide a boost to growth. Moreover, so too will an easing of Japanese related supply issues. Which means a reasonable chance that growth looks stronger in comparison to recent weakness. Not terrific, mind you, but the level is unimportant. What is important is simply that growth does not deteriorate, and instead improves, however modestly.

All of this argues against Gross’s outlook. Which means you need a vastly contrarian actual outcome, and it needs to fall into place quickly. That outcome, as far as I can see, is some combination of a shift to deflation concerns, a dramatic downward shift in the 2012 growth forecasts, or massive financial contagion from the European crisis (best guess on this is that Europe kicks this can down the road for a few months anyway).

Which, in sum, means to need to ask yourself this question if you are going to jump into the Bill Gross camp: “Do you feel lucky, punk?” It seems like an awful lot needs to go wrong in the next few weeks to get QE3 at Jackson Hole. I am not saying that it can’t go wrong, and if it does I will happily give credit to Gross for his wisdom and insight. That said, the time horizon is remarkably short, and will shrink rapidly, to generate the kind of change of heart at the Fed necessary to prod officials into another round of easing. It would seem that financial crisis is the only event that could prompt such a shift in just two months.

Bottom Line: The Fed believes they are done easing, and policymakers now look toward tightening. I know, I know – they have said this before, which is reason enough to take their tough talk with a grain of salt. But the shift in the inflation outlook looks very much to represent the high water mark for policy. The data will need to dramatically deteriorate to shift the Fed’s focus away from tightening.

Wednesday, June 22, 2011

The Fed's Monetary Policy Meeting: Policy Stays on Hold

Here's my reaction to the Fed's press release from the FOMC meeting that ended today:

The Fed's Monetary Policy Meeting: Policy Stays on Hold

The statement was expected, but not at all what I wanted to hear.

I just added some comments on Bernanke's press conference.

Update on Bernanke's Press Conference: Bernanke all but ruled out QE3. In response to a question about whether the Fed is considering further easing, Bernanke noted that this is a committee decision, it's not his to make alone, but he gave two main reasons why the Fed is reluctant to pursue additional asset purchases. First, when the Fed decided to put QE2 in place, there were substantial worries about deflation. Thus, the Fed was missing both elements of its dual mandate by a wide margin, and further easing would help to increase inflation and stimulate output. Now, however, although the output gap is still large, the Fed is starting to see signs of inflation. Bernanke stated that most people underestimate the negative impact inflation can have on growth and employment, and this indicates the Fed will not be willing to increase the risks that inflation will become a problem.

The other reason he gave for being wary of further easing is that the Fed is starting to increases in wages. Thus, the Fed is worried about an emerging wage-price spiral, and it is determined to stop this from happening. A wage-price spiral was a big problem in the 1970s and the beginning of the 1980s, and memories of this episode make the Fed unlikely to do anything that might cause it to happen again.

In the past, Bernanke has also stated that the Fed is in unfamiliar territory with the inflated balance sheet from QE1 and QE2, and that creates a lot of uncertainty about how much inflation risk the Fed has created. This also works against further easing.

Finally, in his presentation of the Committee's forecasts of where the economy is headed, Bernanke noted that most committee members expect relatively strong output growth next year, and that is another reason why the committee is thinking more about when to begin tightening than it is about further easing.

There were many questions about this, i.e. when the Fed might begin tightening policy, but Bernanke was very careful not to tip his hand. He said it will depend on how the recovery progresses, but as noted above most Committee members expect relatively strong growth next year.

If the economy weakens considerably, anything is possible, but there's no indication at this time that the Fed has any inclination toward further easing.

One more thing. As I've said a couple of times recently, I think it's a mistake for the Fed to look past the current slowdown in the recovery (it should ask itself how often it has had to downgrade its forecasts in the past). This is a critical point in the recovery, and if the Fed makes the wrong choice, it could make things worse than they need to be. I didn't expect to hear news of further easing at this meeting, but I did hope to hear a bit more willingness to consider it.