Category Archive for: Monetary Policy [Return to Main]

Thursday, March 31, 2011

Why Do Central Banks Have Discount Windows?

The names of the banks that borrowed from the Fed during the financial crisis will be released today by court order. It's probably just a coincidence that this post on the history of the discount window and the stigma of being identified as needing to use it appeared on the new blog from the NY Fed:

Why Do Central Banks Have Discount Windows?, by João Santos and Stavros Peristiani, Liberty Blog: Though not literally a window any longer, the “discount window” refers to the facilities that central banks, acting as lender of last resort, use to provide liquidity to commercial banks. While the need for a discount window and lender of last resort has been debated, the basic rationale for their existence is that circumstances can arise, such as bank runs and panics, when even fundamentally sound banks cannot raise liquidity on short notice. ... In this post, we discuss the classical rationale for the discount window, some debate surrounding it, and the challenges that the “stigma” associated with borrowing at the discount window poses for the effectiveness of the discount window. ...

While the discount window is an important tool for central banks dealing with liquidity problems that may threaten financial stability, its effectiveness depends critically on the willingness of banks to borrow from central banks. Banks are often reluctant to borrow from central banks not only because this source of liquidity tends to be expensive but also because of the “stigma” that is associated with discount window borrowing. ...
If a bank worries that borrowing from the discount window will lead other banks to doubt its fundamental solvency, it may avoid the discount window even if the discount window provides the cheapest funds available.  Instead, the bank may liquidate marketable assets or try to borrow in the interbank market at onerous terms, further straining these markets and making it even more difficult for other banks to obtain funding or sell assets.  Thus, central banks typically disclose only a limited amount of information about discount window activity to avoid branding healthy (but illiquid) banks as weak.  The Federal Reserve, for example, has historically published the total amount of borrowing from the discount window on a weekly basis, but not information on individual loans.[1]  By allowing banks to borrow confidentially, this policy aims to make healthy institutions more willing to use the discount window during periods of market stress. It should be emphasized that confidentiality is not meant to protect the identities of individual banks per se, but rather to make the discount window more effective in dealing with market disturbances.
Central banks have long recognized the challenges that stigma creates for the effective operation of the discount window during crisis. Donald Kohn, former Vice Chairman of the Fed, has discussed the stigma problem in past speeches. “The problem of discount window stigma is real and serious. The intense caution that banks displayed in managing their liquidity beginning in early August 2007 was partly a result of their extreme reluctance to rely on standard discount mechanisms,” Kohn noted in a 2010 speech.  In fact, the need to mitigate stigma influenced the design of some of the lending facilities, such as the Term Auction Facility, created by the Fed during the financial crises.[2]
In sum, the discount window is a vital tool to maintain the uninterrupted functioning of the banking system, but its effectiveness may be limited by the stigma associated with using it. This explains why policies that aim at dealing with the stigma of discount window borrowing are so important. Admittedly, the existence of the discount window may create some moral hazard, but of course, the Federal Reserve limits moral hazard by restricting discount window access to depository institutions that are closely regulated and supervised by federal banking authorities.

Wednesday, March 30, 2011

Fed Watch: Running the Fed Like an Economics Department

Tim Duy:

Running the Fed Like an Economics Department, by Tim Duy: My central complaint with Federal Reserve Chairman Ben Bernanke is his penchant for what is often described as running the Fed like a university economics department. Internally, I do not see this as a challenge, and for the Fed’s culture may be an effective management style. Externally, I see this a potential communications disaster always in the making. The recent uptick in inflation heightens my unease at this approach, and I think Ryan Avent hits the nail squarely on the head:

…An increase in inflation is only worrying to the extent that it undermines the Fed's efforts to satisfy those mandates, and the above clearly doesn't count. Yet the simple fact of increasing inflation sends writers running to speculate on and, in many cases, demand central bank action.

And central bankers often play along. You have a number of regional Fed presidents warning that they may be ready to end the latest round of asset purchases ahead of schedule. I don't know whether there's any communications strategy within the Fed—whether Ben Bernanke is tacitly approving of these comments or upset by them—but it's fairly certain that the comments themselves represent a tightening of monetary to the extent that they shape actual market expectations (and there does seem to have been some impact).

That's no way to make policy. It's a poor means of communication and a poor decision to tighten. And these poor choices are encouraged by writing that misrepresents the extent of current inflation and its consistency with Fed mandates.

It seems to me that the Fed lacks a coherent communication strategy – there is no willingness on the part of the leadership to enforce talking points. As a consequence, there is enormous pointless chatter from Fed officials that might be interesting in some sense, but provide misleading guidance about policy direction. Recent talk about scaling back the size of the large scale asset program, for instance. Almost certainly not going to happen – so why talk about it? Sadly, it appears to be an almost deliberate effort to create uncertainty among market participants at a time when the opposite is so important.

Of the frequent Fed speakers, I think Chicago Fed President Charles Evans and Atlanta Fed President Dennis Lockhart are particularly good. And not because they tend to say things that I agree with, but because they say things that I think reflects the majority view of the monetary policymakers. I suspect incoming San Francisco Fed President John Williams will fall into that same category. The so-called hawks Philadelphia Fed President Charles Plosser and Richmond Fed President Jeffrey Lockhart are interesting, but one needs to discount their tendency toward inflation/balance sheet concerns. And, I hate to say it about a Fed official, but I wouldn’t take much stock in the words of Dallas Federal Reserve President Richard Fisher. He may talk tough, but I believe he would always fall in line with the majority decision of the FOMC.

Hopefully, regular press conferences by Bernanke will foster a more consistent voice among Fed officials, or at least a guidepost by which market participants can more easily identify and dismiss the loose talk of policymakers and the fringes of policy.

Tuesday, March 29, 2011

Inflation vs. Jobs: Fed’s Move Can Seal Its Fate

Haven't had a chance to write much the last few days, but here's something you can yell at me about in comments (or not):

Inflation vs. Jobs: Fed’s Move Can Seal Its Fate

Update: I forgot to mention that CBS MoneyWatch asked me to write about a similar topic yesterday (I tried to say something different, but there's still a bit of repetition):

Bernanke’s New Quarterly Press Conferences

Fed Watch: Quick PCE Notes

Tim Duy:

Quick PCE Notes, by Tim Duy: The February Personal Income and Outlays report revealed the drag of higher food and energy costs as a 0.3 percent gain in nominal disposable personal income was knocked back to a 0.1 percent loss in real terms. Similarly, the 0.7 percent gain in nominal spending turned into a just 0.3 percent real gain. While better than the flat reading in January, the relatively weak performance of PCE this quarter will lead analysyst to knock down Q1 growth forecasts. I try not to read too much into any one quarter, and tend to view the consumer slowdown in light of the acceleration at the end of last year. Overall, the trend in PCE growth since the middle of last year is consistent with annual gains of around 3% a year. The footing is firming, and it is sustainable, but it is still far short of what is needed to rapidly return consumption to its pre-recession trend.
Since the recession ended, real PCE gained at a rate of 0.18 percent per month:

By a year into the recovery, household spending accelerated, and since July of 2010 has grown at 0.23 percent per month, just about the prerecession trend:

Continue reading "Fed Watch: Quick PCE Notes" »

Sunday, March 27, 2011

Ron Paul's Money Illusion: The Sequel

David Andolfatto continues his battle with Ron Paul supporters:

Ron Paul's Money Illusion (Sequel), by David Andolfatto: As I promised to do here, I am posting a sequel to my original column: Ron Paul's Money Illusion. ... I ... hope that the nature of my criticism will be more clearly understood.

The purpose of my original post was to critique a statement I've heard Fed critics repeat ad nauseam. The statement can be found in Paul's book End the Fed (p. 25):

One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy.

I think that the first part of this statement is true, so I do not wish to dispute this fact. ... As for the final sentence in the quote above, well, I think it is just plain false. Now let me explain why...

Let me begin with the picture most popular with end-the-fed types--a graph depicting the declining purchasing power of the USD. I use postwar data without loss of generality, since most of US inflation has happened since then.

This picture plots the inverse of the price-level (as measured by the consumer price index). I have normalized the price-level to $1.00 in 1948. It falls to roughly $0.11 in 2010. This corresponds to roughly a nine-fold increase in the price-level or about a 4.6% annual rate of inflation. (Note that the rate of inflation has slowed considerably since 1980).

The picture above is used by some end-the-fed types to great effect in generating anger and fear among some members of the population. Anger via the claim that the Fed has stolen 90% of (the purchasing power) of your money; and fear through the prospect of this purchasing power approaching zero in the not-too-distant future. ...

Let me draw you another picture. This one plots the inverse of the U.S. nominal wage rate (total nominal wage income divided by aggregate hours worked).
This graph plots the purchasing power of the USD, where purchasing power is now measured in terms of labor, rather than goods. This graph shows that you need a lot more money today than you did in 1948 to purchase 1 hour of labor. Another way of saying this is that the average nominal wage rate in the U.S. has increased by a factor of 25 since 1948. ...

Let me now combine the two graphs above into one picture, with both series inverted, and with both the price-level and nominal wage rate normalized to $1.00 in 1948 (the actual nominal wage rate was $1.43).

According to these (publicly available) data, the price-level (CPI) has increased by about a factor of 10 since 1948. But the average nominal wage rate has increased by a factor of 25. (There is, of course, considerable disparity in wage rates across members of the population. But I am aware of no study that attributes significant wage or income heterogeneity to monetary policy. Of course, if readers know of any such studies, I would be grateful to have them sent to me.)

The figure above implies that the real wage (the nominal wage divided by the price-level) has increased by a factor of 2.5 since 1948. This is undoubtedly a good thing because it implies that labor (the factor we are all endowed with) can produce/purchase more goods and services. More output means an increase in our material living standards (Though again, I emphasize that this additional output is not shared equally. ...)

Now, an interesting question to ask is how the picture above might have been altered if the price-level had instead remained more or less constant. ...

I suggested, in my original post, that there is reason to believe that under an hypothetical regime of price-level stability, the nominal wage rate in the graph above would instead have ended up increasing only by a factor of 2.5 (more or less)--the factor by which real wages actually rose. This is what I meant by my claim of long-run neutrality of the price-level increase; and it is also what I meant by Ron Paul's Money Illusion (which is subtly different than claiming the superneutrality of money expansion; more on this later).

Some evidence in favor of my "long-run neutrality view" is to be found in the time-path of labor's share of income (GDP):

I see no evidence in the data here that our higher price level today has whittled the share of income accruing to labor. Moreover, I see no evidence suggesting that episodes of high or low inflation are related in any systematic way to the resources accruing to labor. (In fact, I see some evidence of a rising labor share during the high inflation decade of the 1970s.) But perhaps other data tells a different story. If so, I'd like to see the data (i.e., instead of a short email claiming that I am wrong). ...
To conclude, I think that the ... assertion that "the Fed has stolen 95 cents of every dollar" I view as absurd. There are legitimate criticisms one could level at the monetary institutions of this country, but these are not some of them. ...

Monday, March 21, 2011

Fed Watch: Intervention Thoughts

Tim Duy:

Intervention Thoughts, by Tim Duy: It is worth pointing out some interesting reporting regarding last week’s G7 intervention. I think this summary via the Wall Street Journal is basically correct:

The Group of Seven’s coordinated efforts Friday to weaken the value of the Japanese yen are likely designed more to temper panicked markets than targeting a specific currency level, economists say….

“This is a short-term measure that has more the goal of stabilization and averting a short-run panic than taking a view about how global imbalances might evolve and what the right value of the yen is against other currencies,” said Ralph Bryant, a former director of the U.S. Federal Reserve‘s international finance division, now a fellow at the Brookings Institution.

I have a hard time reading anything more than the obvious into the G7 intervention. In response to the earthquake and subsequent tsunami the Yen was appreciating rapidly in what appeared to be a disruptive fashion. The Japanese authorities would have acted on their own sooner or later, but secured the backing of their G7 partners to provide evidence that efforts to stabilize the Yen should not be confused with attempts to direct the value of the Yen to achieve a trade advantage. It will work as a break on speculative activity, but will have limited impact, if any, on any long-run, fundamental forces driving the value of the currency. To fight the latter requires a committed, repeated effort on the part of the Ministry of Finance, something that at the moment does not appear to be on the table.

The Wall Street Journal also has a more curious piece relating the currency intervention to the Federal Reserve’s balance sheet that reads like it was rushed on a Friday afternoon. (which I can identify with, as most pieces I rush fall short of where they should be). The piece begins:

Continue reading "Fed Watch: Intervention Thoughts" »

Sunday, March 20, 2011

(Don't) Raise Rates to Boost the Economy

David Frum tweets:

If there were a prize for the most foolish op-ed of the week, we wouldn't have to wait till next Friday to award it.


Raise Rates to Boost the Economy, by Andy Kessler, Commentary, WSJ: The chairman of the Federal Reserve is stuck between a rock and a hard place—well, more like a house and a gas tank. How to escape? Mr. Bernanke, raise interest rates now. ...
It's all counterintuitive, but it will work. Ending quantitative easing and raising short-term rates will surely cause the stock market to crater. 1,000 points? 2,000? Who knows? But a selloff will ensue. Does that mean a negative wealth effect? I doubt it. Who really thought they were wealthier at Dow 12,000 versus Dow 10,000?
Some banks will sputter, and maybe even fail, even the big boys. ... Hopefully the FDIC is ready to dive in and remove the remaining toxic mortgage assets of any failing banks, along with their managements, and then refloat the institutions. ...
But along with a likely lower stock market and failing banks will be several positive effects that will finally kick-start the economy. Oil and wheat and commodities will see a 20%-30% drop in price as speculators run for the hills. This will be a de facto tax cut for consumers. Hiring should restart when businesses see normal short-term rates, most likely 2%. ...

The key to recovery begins with a Fed induced stock market crash, followed by failing banks -- perhaps even systemically important ones? This may win more than "the most foolish op-ed of the week".

Friday, March 18, 2011

DeLong's Law

Say's Law:

This says that there cannot be a general excess demand or excess supply of goods, i.e. that the sum of the excess demands (excess supply if negative) across all goods must equal zero. There can be no "general gluts."

Walras says, not so fast. We also have to consider money demand and money supply. If there is an excess demand for money, there can be an economy-wide excess supply of goods. Walras Law:


Thus, if there is an excess supply of goods, the imbalance can be cured by increasing the supply of money.

Brad DeLong says, not so fast, we also need to consider the supply and demand of "high-quality interest bearing assets." Delong's Law:

This says that there can be a general gluts of goods offset by either an excess demand for money or an excess demand for assets (or some combination of the two that nets out correctly, and sometimes -- like now -- the assets in A and M are perfect substitutes). What is the cure for an excess supply of goods in this case? In Brad's own words:

I would say that the right way to think about the current situation is to move from a two-commodity model--money and goods--to a three-commodity model: goods, money, and "high-quality interest bearing assets." When there is an excess demand for high-quality interest bearing assets the interest rate goes to zero, in which case money becomes a perfectly good high-quality interest bearing asset. Then money gets swapped out of the "transactions" balance account into the "speculative" (or "insurance") balance account, and all of a sudden you have an excess demand for transactions-balance account money and so by Walras's Law a deficient demand for currently-produced goods and services.

I'm happy to call that a "monetary phenomenon" if it will make Nick Rowe happy.

But might it not be more illuminating to call it a financial phenomenon? A Minkyite or Kindlebergian or Bagehotian phenomenon?

Elsewhere, Brad adds:

Hicks and Wicksell would say that you also have to include the supply and demand for bonds--for interest-yielding savings vehicles. And, of course, at the ZLB money becomes a perfectly good savings vehicle and a perfectly good safe asset: it is no longer dominated by the other assets for those wanting a savings vehicle or safety because interest rates are zero.

Thursday, March 17, 2011

Mankiw and Weinzierl: An Exploration of Optimal Stabilization Policy

I haven't had a chance to ready beyond the introduction and conclusion of this paper by Greg Mankiw and Matthew Weinzierl, "An Exploration of Optimal Stabilization Policy," but a couple of quick reactions. First, in the paper, in order for there to be a case for fiscal policy at all, the economy must be at the zero bound and the monetary authority must be "unable to commit itself to expansionary future policy." This point about commitment has been made in other papers (I believe Eggertsson, for example, notes this), and I think the credibility of future promises to create inflation is a problem. If so, if the Fed cannot credibly commit to future inflationary policy, then this paper provides a basis for, not against, fiscal policy when the economy is stuck at the zero bound.

Second, they note in the paper that tax policy can do a better job of replicating the flexible price equilibrium in terms of the allocation of resources, and hence tax policy should be used instead of government spending. However, since I think that there is a strong case that we are short on infrastructure, and that public goods problems prevent the private sector from providing optimal quantities of these goods on its own, I don't see the distributional issues as an important objection to government spending at present.

Here's the introduction to the paper:

An Exploration of Optimal Stabilization Policy, by N. Gregory Mankiw and Matthew Weinzierl March 8, 20111 Introduction What is the optimal response of monetary and fiscal policy to an economy-wide decline in wealth and aggregate demand? This question has been at the forefront of many economists' minds over the past several years. In the aftermath of the 2008-2009 housing bust, financial crisis, and stock market decline, people were feeling poorer than they did a few years earlier and, as a result, were less eager to spend. The decline in the aggregate demand for goods and services led to the most severe recession in a generation or more.
The textbook answer to such a situation is for policymakers to use the tools of monetary and fiscal policy to prop up aggregate demand. And, indeed, during this recent episode, the Federal Reserve reduced the federal funds rate -- its primary policy instrument -- almost all the way to zero. With monetary policy having used up its ammunition of interest rate cuts, economists and policymakers increasingly looked elsewhere for a solution. In particular, they focused on fiscal policy and unconventional instruments of monetary policy.
To traditional Keynesians, the solution is startlingly simple: The government should increase its spending to make up for the shortfall in private spending. Indeed, this was a main motivation for the $800 billion stimulus package proposed by President Obama and passed by Congress in early 2009. The logic behind this policy should be familiar to anyone who has taken a macroeconomics principles course anytime over the past half century.
Yet many Americans (including quite a few congressional Republicans) are skeptical that increased government spending is the right policy response. They are motivated by some basic economic and political questions: If we as individual citizens are feeling poorer and cutting back on our spending, why should our elected representatives in effect reverse these private decisions by increasing spending and going into debt on our behalf? If the goal of government is to express the collective will of the citizenry, shouldn't it follow the lead of those it represents by tightening its own belt?
Traditional Keynesians have a standard answer to this line of thinking. According to the paradox of thrift, increased saving may be individually rational but collectively irrational. As individuals try to save more, they depress aggregate demand and thus national income. In the end, saving might not increase at all. Increased thrift might lead only to depressed economic activity, a malady that can be remedied by an increase in government purchases of goods and services.
The goal of this paper is to address this set of issues in light of modern macroeconomic theory. Unlike traditional Keynesian analysis of fiscal policy, modern macro theory begins with the preferences and constraints facing households and …firms and builds from there. This feature of modern theory is not a mere fetish for microeconomic foundations. Instead, it allows policy prescriptions to be founded on the basic principles of welfare economics. This feature seems particularly important for the case at hand, because the Keynesian recommendation is to have the government undo the actions that private citizens are taking on their own behalf. Figuring out whether such a policy can improve the well-being of those citizens is the key issue, a task that seems impossible to address without some reliable measure of welfare.

Continue reading "Mankiw and Weinzierl: An Exploration of Optimal Stabilization Policy" »

Wednesday, March 16, 2011

Fed Watch: Policy Still on Autopilot, For Now

Tim Duy:

Policy Still on Autopilot, For Now, by Tim Duy: The Federal Reserve did as expected, leaving policy unchanged. But policymakers tweaked the statement ever to slightly to suggest that indicators are at a minimum not moving away from the objectives of the dual mandate – a critical first step on the road toward normalizing monetary policy.

First, apparently there was some surprise that the Federal Reserve failed to mention the unfolding crisis in Japan. From the Wall Street Journal:

Federal Reserve policy statements are supposed to outline the forces that will drive monetary policy over coming months, so while it wasn’t unexpected, it’s nevertheless puzzling central bankers omitted the biggest risk of all: Japan.

I suspect they did not mention Japan because little information is known about the economic risk or they don’t perceive it to be the primary risk in the US outlook. Indeed, we have been down this road before with Hurricane Katrina - even very large disasters in advanced economies appear to have limited overall economic impact, although the regional impacts could be quite severe. I often wonder if economists have a tendency to initially overestimate the potential impact of such events as they believe the economic impacts must somehow reflect the human impact, or that if they don’t play up the economic impacts they will be seen as downplaying the human impact. I tend to be less concerned about the economic impact (particularly over the longer term; market economies have proven to be remarkably resilient) and instead am much, much more concerned about the very devastating and long-lasting human impact of this tragedy. I recommend the guest post at Econbrowser on this topic. To be sure, policymakers will be watching this and other situations closely, but I suspect they would turn to this kind of research as a guide and conclude for now that the global economic impact will be largely transitory.

Indeed, instead of focusing on the downside risk, policymakers turned their attention largely to on the moderately positive news. First, as has been widely noted, the Fed upgraded the economic assessment – the recovery is not only on “firmer footing,” but labor markets “appear to be gradually improving.” The last bit is important. The lack of any meaningful improvement in labor markets has been a central feature of this recovery, and a major impediment to any change in policy. Signs of improving labor conditions are a welcome relief for policymakers.

Note also that the language regarding commodity prices is focused on the inflationary, not deflationary, implications. I tend to believe the Fed would ultimately be forced to ease policy further in the event of a significant oil price surge, but there is no indication here that this is the concern.

Furthermore, notice the slight change in the language regarding the inflation trend. The Wall Street Journal missed it:

The language on its closely watched measures — core inflation and expectations — is unchanged. The bottom line here is that policy makers aren’t overly concerned about inflation right now.

True, they are not overly worried about inflation. But Calculated Risk spots the small but important change:

Inflation "subdued" instead of "trending downward"

If you are looking for QE3, you need some combination of ongoing labor market stagnation and threat of deflation (the two go hand in hand). Instead, what the Fed sees is improving labor markets and inflation that appears to have hit a floor:


Of course, despite indications data is actually heading in the direction of the dual mandate, the size of the output gap, high unemployment, and weak wage growth all argue against tightening policy in any way, shape, or form. Hence the current large scale asset program continues unabated. I still believe the calendar argues against any deviation from this plan. Even if incoming data strongly surprised on the upside, by the time the Fed was able to assess such data and act, the policy would be nearly at an end. Changes would be essentially pointless.

Bottom Line: Monetary policy continues on autopilot – they still plan that QE2 will end as expected at which time policymakers will turn their attention to policy normalization, setting the stage for a rate hike in 2012. Watch for signs that the downside risks (oil, Japan, Europe, etc.) are evolving in such a way that they are impacting actual data, with the weak reading on consumer confidence being a cautionary tale. But if the data holds up, with steadily improving labor markets and improving inflation measures, the next test for monetary policy will be the end of QE2. Will markets falter in the absence of a steady drip of monetary policy?

Tuesday, March 15, 2011

The FOMC Leaves Fed Policy Unchanged

At MoneyWatch, I have a brief reaction to the Fed's decision to leave policy unchanged:

The FOMC Leaves Fed Policy Unchanged

Why Politics, Ideology and the Fed Don’t Mix

We are, as they say, live. Senator Shelby blocking Peter Diamond's appointment to the Federal Reserve Board of Governors, and this talks about whether there is any justification for doing so, and how the appointment process might be improved:

Why Politics, Ideology and the Fed Don’t Mix

I'm not sure you'll agree with this one.

Update: One thing that doesn't come through very well in the column is that a president's first few appointments to the Board of Governors should be given due deference (and a lot is due). After that scrutiny, even blocking, is justified since a president's ability to stack the Board should be limited -- that's the Senate's role. Scrutiny over Krosner was appropriate since Bush had ample opportunity (and then some) to shape the ideological makeup of the Board. Blocking Diamond as payback for blocking Kroszner is not appropriate since Diamond is clearly qualified and among the first few nominations.

Thursday, March 10, 2011

Should the Fed Respond to Commodity Price Increases?

To answer the question in the title of this post, it's useful to think of an island with only two goods. One of the goods is non-renewable, but highly desirable. The other good is less preferred, but it is renewable (thinking of renewable and non-renewable energy resources, for example). The key is to distinguish between changes in prices that reflect changes in the relative scarcity of the two goods, and changes driven by increases in the money supply.

Over time, as the stock of the more desired good falls due to consumption, the price of this good will rise relative to the renewable good. Consumers will be hit by increases in the cost of living -- the same basket of the two goods purchased last year now costs more.

But is this the kind of increase in prices the Fed should respond to? No, the price increase -- and the increase in the cost of living -- reflects increasing scarcity of the desired good. The price of the two goods are changing to balance the relative supplies of the two goods. Unless the price of the non-renewable resource does not properly take account of the preferences of future generations -- and it may not -- or there is some other market failure, there is no reason for government to intervene to change the prices. If the prices are correct, they will allocate the resources optimally.

Now consider a different case. Suppose the central bank in charge of money -- sea shells of a particular type identified with the central bank's special mark -- and the money supply is being increased at a rapid rate. This will drive the prices of both goods up, but so long as the price of each good rises in proportion to the change in the money supply so that the relative price of the two goods is undisturbed, no problem. The price level will adjust to the number of sea shells in circulation, but since relative values remain intact, nothing will change.

However, suppose one of the two prices is sticky. It does not change very fast when the number of sea shells in circulation increases. In this case relative prices will be distorted as the number of sea shells increases, one price will rise faster than the other, and resources will be misallocated. In this case the Fed would want to do something about the inflation since it is having negative effects on the efficient allocation of the two resources. This is, essentially, the Fed's justification for activist policy.

A couple of notes. First, it's interesting to think about how technological change that improves the quality or lowers the price of the renewable good plays into this. Such a change could offset the increase in the cost of living that households face. Thus improving technology, not Fed policy, is the key to helping people on the island struggling with high prices.

Second, this is about the long-run and growth in demand. The central bank may still want to try to offset temporary price spikes, for example when sticky prices can cause problems that persist beyond the spike in the price of one of the two goods (e.g. a spike in the price of oil that leads to long-lived price distortions). But long-run growth that causes the price of one of the goods to rise by more than the other, i.e. relative price changes, is not something the Fed should try to neutralize.

"The Free-Banking vs. Central-Banking Debate"

David Andolfatto has been "the recipient of hundreds of rather nasty emails lately":

The Ron Paul Thing: I've taken down my post entitled "Ron Paul's Money Illusion" because it seems to have provoked mindless rage rather than thoughtful debate.

A part of this is my fault for saying that, while I respected many of the Congressman's libertarian ideals, I thought that he could be more circumspect at times. Well, I didn't exactly use this language, if you know what I mean. And for that, I want to apologize to the Congressman and all of his ardent supporters.

Having said this, I stand by the substantive point that I was trying to make. That column, however, was written too hastily. So I think I'll rewrite it, this time a little more carefully, and with a little less colorful language...

Here's his next post:

The free-banking vs. central-banking debate: ...As many of you can imagine, I've been the recipient of hundreds of rather nasty emails lately. I don't know any other way to describe it except as "awesome." Oh, I don't especially like being called names and being insulted, but it's no big deal (academics need pretty thick skins to survive). The awesome part is how people are so eager to express their views. ...
Now for a little story--some background, I guess. Long ago, a remarkable debate took place about the optimal way to organize an economy's money and banking system. The proponents of free-banking eventually lost out to those who favored some form of central bank regime. The nature of these debates are nicely summarized by Vera Smith in her book, The Rationale of Central Banking. ...
As an academic who has devoted a considerable amount of time on the subject, I cannot say that I presently fall strongly on either side of the debate. I can see merits (and defects) in both points of view. ...
To make a solid case one way or the other, it is important to keep the facts straight..., not to present data in a misleading light. Now, I do not think everything Ron Paul says is wrong. In fact, as I said in my original post, I appreciate the libertarian philosophy. But if one wants to promote libertarianism based on sound intellectual foundations, it does the cause no good to make and promote misguided statements about money, prices, and the role of central banks. History is replete with examples of  bad government policies in place well before the existence of central banks. In my view, it is wrong to convey the impression that something close to economic nirvana will dawn in the absence of a central bank. ...
It is my belief that Ron Paul promotes a misleading argument concerning the fact that our price-level today is much higher today than it was 100 years ago. His argument implicitly suggests that nominal wages today would be roughly where they are at even in the absence of currency debasement. This is, in my view, just plain wrong.
But for people who believe it (and evidently there are many out there that do), it provokes rage against the Fed. It is as if the Fed has stolen virtually all of their wages and that real material living standards today would be much higher if only the price-level had remained at its 1913 level. This proposition is grossly at odds with the evidence, which shows roughly 2% annual real growth in per capita income and roughly stable income and expenditure shares. There is, of course, considerable discussion about growing income inequality. But almost every paper I read about this phenomenon seems to point either to skill-biased technological change or competition from emerging economies. I'm not sure what Fed policy has to do to with those forces.
I am no defender of inflation. But the US inflation rate has been low and stable for decades now. ... Now, there may be other reasons for abolishing the institution, but if so, then why not emphasize those? As I said in my original post,... it does no service to the libertarian cause to attack the Fed with misleading arguments ... because opponents to the libertarian cause can latch on to the lame arguments and use them to discredit the more worthy ones.
The Fed was established by an act of Congress in 1913. The Fed is operating under the rules established by Congress. If you have a problem with these rules, then I encourage you to lobby your Congressional representatives to change them. Blaming the Fed for following the law as established by Congress  (and other guidelines, such as the dual mandate) seems like a rather strange way to go. But hey--power to the people.

I'm more of a central banking type.

Monday, March 07, 2011

Fed Watch: Ignore Hawkish Rhetoric

Tim Duy:

Ignore Hawkish Rhetoric, by Tim Duy: The Wall Street Journal suggests the Fed is facing a policy conundrum. I would suggest that "conundrum" is an overstatement. Push comes to shove, there will be little debate - if the current oil price shock turns nasty, Fed officials will embrace another round of quantitative easing.

Dallas Federal Reserve President Richard Fisher offers the hawkish view, and remains colorful as always. Today he ranted against QE2:

To be sure, there are some, including me, who worry that the Fed ultimately may have taken out too much insurance against a double-dip recession and slippage into a deflationary spiral. There are some, including me, who argued against the last tranche of insurance we took out in committing to buy $600 billion in U.S. Treasuries between last November and the end of this coming June as we were simultaneously purchasing additional Treasuries to make up for the roll off in our mortgage-backed securities portfolio. There was a strong feeling among those of my policy persuasion that we had already sufficiently refilled the tanks holding the financial fuel businesses needed to drive their job-creating machines. They felt that by being too accommodative, we might run the risk of planting the seeds that could germinate into renewed volatility, speculation and inflation, or give comfort to a government that for far too many congressional cycles has fallen down on the job by spending and borrowing and committing to unfunded programs with reckless abandon.

Am I the only one who sees Fisher as a remarkably irresponsible policymaker? I get the sense that at best he is trying to undermine the effectiveness of monetary policy by repeatedly emphasizing that it doesn’t work. At worst, he is deliberately trying to feed inflation expectations, for what purpose I know not. I think the responsible policy approach would be to exude confidence in the Federal Reserve, particularly during period of turmoil. The policy is in play; no good comes from public derision at this junction. Simply reiterate that the Fed has the tools to remove the accommodation should it become necessary.

Goodness, if anyone took him seriously, he could do some real damage. Luckily, I think by now we have been trained to largely dismiss Fisher. For a more nuanced and thoughtful policy approach, I suggest the competing speech by Atlanta Fed President Dennis Lockhart, with what I think is a key insight:

Where my views might depart from the mainstream to some extent is on the question of the range of plausible economic scenarios from this juncture. In thinking about an appropriate and balanced policy for at least the near term, it seems to me a critical question is whether the range of plausible scenarios is narrowing (that is, is certainty growing) or widening (that is, is uncertainty growing). My view is the range has widened—not dramatically, but somewhat. For some time, my list of headwinds and risks has encompassed European sovereign debt, our own federal, state and municipal fiscal challenges, house prices, and commercial real estate. My sense of the balance of risks has shifted with the addition of unrest in the Middle East and North Africa.

That growing uncertainty has weighed on me in recent weeks. Rather than digging in his heels like Fisher, Lockhart allows policy flexibility in the months ahead:

With the information I have today, my first inclination is to be very cautious about extending asset purchases after June. Given the emergence of new risks, however, I prefer a posture of flexibility as regards policy options. As we have seen, conditions can change rapidly, so I will continue to evaluate the incoming information as much as possible with fresh eyes as I approach each meeting and each decision.

Lockhart’s position will become the dominant view at the Fed. A month ago, the likelihood of additional easing was nearly zero. QE2 would end as scheduled, and the Fed would turn its attention to the timing of policy reversal. The evolving commodity price shock, however, clouds that outlook. To be sure, Lockhart recognizes the potential inflationary impact of recent events:

To recap, one can't help but notice rising inflation anxiety among the business community as well as consumers based on recent experience with highly visible and highly publicized commodity prices. So far, this anxiety has not translated to a loosening of the moorings of inflation expectations….But my concern is that broad inflation worries—even if in reaction to what are probably temporary relative price movements—could shift and cut loose inflation expectations. It goes without saying that we policymakers must watch indications of expectations very carefully and be on guard for an approaching inflection point.

But he recognizes that this should not be the baseline expectation. Instead:

In my opinion, central to the question of the potential for price action becoming broad inflation is the behavior of wages. I remember the early eighties well. I was in a management role in a bank then, and in my organization we were moving salaries around 10 percent a year to retain our people. Wage accommodation of rising prices has the effect of institutionalizing and embedding inflation. However, I do not see widespread wage pressures developing any time soon in the current circumstances of upwards of 20 million people either out of work or working part-time for economic reasons.

The February employment report would appear to support Lockhart’s position – average hourly wages climbed by a mere penny. Indeed, it is hard to see the basis of a wage-price inflation spiral evolving:


Spencer at Angry Bear adds succinctly:

With income growth this weak fears of significantly higher inflation appear to be misplaced. Although headline inflation may be ticking up because of food and energy, the weak income growth implies that the impact of higher food and oil prices will be felt much more in weak consumer spending rather than higher inflation expectations.

Bottom Line: The ongoing commodity price shock argues for further monetary accommodation, not less. In the current environment, efforts to pass through higher prices to consumers will only erode spending power, not provide the basis for additional wage gains. This is not Europe or Asia; dismiss policymakers who suggest otherwise.

Politics Matters

One thing I've learned from the crisis is that the politics of economic intervention to stabilize the economy is far more important than I realized. When you teach stabilization policy out of textbooks, it's easy, you just say that the government cuts taxes or increases spending, that the Fed takes this or that action, and then calculate the result (or, more likely, show it graphically). The politics, e.g. the distributional consequences of the policies, are rarely if ever mentioned.

The importance of the politics started to dawn on me as I began to observe the reaction to the bank bailout and the stimulus package on this blog and elsewhere. For example, I was traveling from Seattle to Victoria by ferry and I overheard a conversation from the group sitting behind me. There were two couples, I'd place pretty good odds they showed up in either a Volvo or a Prius, and the conversation turned to the economic stimulus. They said how worried they were about the debt -- all that spending Congress was going to do -- and how we would pay it off? They were very emphatic, and clearly very worried about this. They said many things that seemed to come out of the anti-stimulus playbook, and at several points it was all I could do not to turn around and try to straighten them out. But I decided there was more value in listening to how they felt about the bank bailout and stimulus packages, and it was an eye opener. They were very much opposed to the actions that had been taken. I heard a similar conversation across the aisle from me on a plane trip not too long after that, with the health care plan at the forefront of worries, and at other times as well, but it really hit home when I was watching a Duck game with some friends who are very liberal, very populist, and very much working class. They hated the bank bailout in particular -- it was seen as a bailout for the wealthy -- and I was quite surprised at the degree to which they opposed this policy. The anger in their voices was evident, and they had no interest at all in listening to my explanations of why the bailout policy was done this way, and how it would help everyone. Where's my bailout I heard again and again. The attitude was that the rich got bailed out -- as always -- but the people who could have actually used the money got nothing but the bills. There was no sense whatsoever that they believed bailing out the banks had saved Main Street from an even worse fate -- this was nothing more than a scam to funnel money to the rich. As far as I could tell, they simply did not believe that the bank bailout would help them in any way. But they would be asked to pay the bills.

The result of this -- and it's something I've written about several times -- was to wonder about this "trickle down" approach to policy. Why not help people pay their bills directly instead of letting them go under and then bailing out the bank when households cannot repay loans? Economically it isn't that much different from the banks' perspective -- they get the money they need to survive either way, it's simply a matter of who gets the money first.

The point I'm making is a simple one. We have a responsibility to make sure that both monetary and fiscal policy are still there for future generations. If we do things now that are economically justified, but political disasters, then the next time policy is needed it won't be there -- the policies won't have the public support that is needed for politicians to get behind them. As we calculate the value of enacting a policy, politics matters. We have to take account of the costs to future generations of potentially not having these policies available due to the political opposition that might come about as a result of our actions to try to stabilize the economy. For that reason, we need to think a bit harder about the distributional consequences of policies that are put in place during a crisis. If, when the next crisis hits, we try to repeat the actions taken this time, the political opposition will likely stand in the way -- there is little support for a repeat of current policy (and I do not believe that resolution authority is enough by itself to prevent the need to bail out banks in a severe crisis). There are alternatives to helping the well off and hoping it trickles down -- there are trickle up alternatives that help middle and lower class households directly -- but we haven't put enough effort into developing these policies. That needs to change.

Sunday, March 06, 2011

How Long Until We Reach Full Employment?: Using the Last Two Recessions as Guides

Comments to this post have pointed out what I tried to acknowledge in the write-up, the forecasts of how quickly unemployment will recover present a relatively optimistic case. Though it didn't come through very well, that was part of the point. Even with an optimistic outlook, the return to full employment will take a long, long time. (See also Brad DeLong's comments.)

However, a more pessimistic outlook is likely warranted. Suppose that instead of looking over the entire sample to make the forecasts, as in the last post, we restrict our attention to just the last two recoveries.

Again, taking a quick, back of the envelope approach, the rate of recovery from the peak unemployment rate of 7.8% in June of 1992 through the trough of 3.8% in April of 2000 was, on average, a -0.04255 change per month. From the peak of 6.3% in June of 2003 through the trough in 4.4% in October of 2006, the average rate of change per month was -0.04750.

Averaged over both periods, the rate of decline was -0.04403 per month. This is the rate used to construct the forecasts shown by the dotted red lines in the figure. (Both the in-sample and out-of-sample forecasts are shown. The out-of sample forecast begins at the peak of 10.1% in November of 2009 to be consistent with the way the rates of change are constructed. In the previous post the forecast began the period after the end of the sample.):


The resulting forecast is truly scary. Here are updated versions of the benchmarks in the previous post:

7% unemployment in August of 2015
6% unemployment in June of 2017
5% unemployment in May of 2019
4% unemployment in April of 2021

Thus, if we recover at the same pace as in the last two recessions, something we certainly can't rule out, it will take more than six years to get to 6% unemployment rate, and until June of 2018 to get to 5.5%, the figure I cited in the last post as my best guess of the long-run natural rate.

So why are we sitting on our hands?

Saturday, March 05, 2011

Greenspan: The Costs of Government Activism

When Alan Greenspan was nearing the end of his time as Chairman of the Federal Reserve System, there was a celebration of his career at the Fed meeting held annually at Jackson Hole, Wyoming. At this meeting he was ordained, for all intents and purposes, as the greatest central bank ever. He must have been on top of the world.

However, since the housing market crash and subsequent deep recession, an event that can be linked to regulatory failures under his watch and to other policies he supported, his reputation has taken a big hit. In response, Greenspan has been doing everything he can to restore his reputation, including writing a book, writing op-eds, and giving interviews laying out his case.

Greenspan would not agree with the charge above that failure to regulate banks adequately caused the crisis. In fact, he argues just the opposite -- that government activism was responsible for the crisis. His latest defense of his anti-regulatory stance continues this argument, and in a new article he blames the severity of the economic recession on "regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism." This activism, in his view, is "crippling our chances of a full long-term recovery":

The costs of government activism, EurekAlert: In an article to be published in the forthcoming issue of International Finance, Dr. Alan Greenspan, former chairman of the Federal Reserve, issues a major analysis of the U.S. government's economic recovery and reform efforts since the collapse of Lehman Brothers in September 2008. ...
Applying a range of analytical and historical lenses, and data-sifting techniques, Greenspan concludes that the primary cause of the malaise is the exceptional level of government activism during the past two years. "Although the actions the government took in the immediate aftermath of the Lehman Brothers shutdown were necessary and appropriate responses to the crisis," he writes, "these actions are not necessary any longer, and could in fact be crippling our chances of a full long-term recovery."
Greenspan argues that the real problems with government activism began with the stimulus package of early 2009 and the failure to phase out the "temporary" actions taken during the last quarter of 2008. He argues that this fostered a degree of risk aversion to investment in illiquid fixed capital, on the part of both corporations and individuals, that was most evident in our longest-lived assets – real estate, both nonresidential and residential. "Without the abnormal weakness in long-lived assets," he writes, "the current unemployment rate would be well below 9%."

Here's the abstract from his article:

The US recovery from the 2008 financial and economic crisis has been disappointingly tepid. What is most notable in sifting through the variables that might conceivably account for the lacklustre rebound in GDP growth and the persistence of high unemployment is the unusually low level of corporate illiquid long-term fixed asset investment. As a share of corporate liquid cash flow, it is at its lowest level since 1940. This contrasts starkly with the robust recovery in the markets for liquid corporate securities. What, then, accounts for this exceptionally elevated level of illiquidity aversion? I break down the broad potential sources, and analyse them with standard regression techniques. I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s. I conclude that the current government activism is hampering what should be a broad-based robust economic recovery, driven in significant part by the positive wealth effect of a buoyant U.S. and global stock market.

He also warns that new regulation will destabilize financial markets:

The degree of complexity and interconnectedness of the global 21st century financial system, even in its current partially disabled form, is doubtless far greater than the implied model of financial cause and effect suggested by the current wave of re-regulation. There will, as a consequence, be many unforeseen market disruptions engendered by the new rules.

I hope it's clear by now that I do not support Greenspan's view of regulation. I think the failure to bring the shadow banking system under the regulatory umbrella that covered traditional banks -- something Greenspan opposed vigorously -- was a big mistake. Thus, the non-activism he supported was a big part of the problem. And, contrary to Greenspan who thinks recent regulation has gone too far, in my view it does not go far enough.

Thursday, March 03, 2011

Fed Watch : Game Changers

Tim Duy:

Game Changers?, by Tim Duy: The strong data flow continues. Following up on its manufacturing counterpart, the ISM’s service sector report extended January’s improvement. Retail sales appeared to bounce higher in February, supporting the contention that January’s weakness in retail sales was weather related. When the roads cleared, consumers realized they had a few extra dollars burning a hole in their pockets. And, most importantly, initial unemployment claims sank, bringing the 4-week average below the 400k mark. We are at levels that typically foreshadow solid labor market improvement, which is undeniably good news.

All in all, incoming data reinforce my sense that the upside and downside risks to the forecast are intensifying, which could make for a very interesting few months. I sense there is a tendency to downplay the upside risk because of the depth of the US employment and output holes. To be sure, there remains significant slack in the economy, enough so that a steady stream of good data should not induce monetary or fiscal authorities to withdraw stimulus anytime soon. This, of course, is the mistake the ECB looks likely to make:

European Central Bank President Jean-Claude Trichet said the ECB may raise interest rates next month for the first time in almost three years to fight mounting inflation pressures.

An “increase of interest rates in the next meeting is possible,” Trichet told reporters in Frankfurt today after the central bank set its benchmark rate at a record low of 1 percent for a 23rd month. “Strong vigilance is warranted,” he said, adding that any move would not necessarily be the start of a “series.”

Overeager ECB policymakers aside, one can see the foundation of a shockingly sustainable recovery forming. I know, it has been so long since we saw good data that the natural inclination is to be dismissive. But at this point, all we really need is to light a little fire under the labor market to entrench a positive feedback loop. And the sharp improvement in initial claims suggests that fire has been lit. It is just a matter of time before it shows up in nonfarm payrolls.

But lighting the fire is not enough to prompt the Fed to make a rapid policy reversal. Some policymakers will focus on what they see as brewing inflation. From the Beige Book:

Manufacturing and retail contacts across Districts reported rising input costs. Manufacturers in many Districts conveyed that they were passing through higher input costs to customers or planned to do so in the near future. Homebuilders in the Cleveland and Atlanta Districts noted rising material costs, but acknowledged little ability to pass through the costs to buyers. Retailers in some Districts mentioned they had implemented price increases or were anticipating such action in the next few months.

Efforts to pass along higher prices, however, should not be enough to unsettle the Fed as a whole. Eyes should be drawn to the next sentence:

There is little evidence of wage pressures across Districts. Wages remained steady in the Boston, Philadelphia, Cleveland, Kansas City, and Dallas Districts, while moderate wage pressures were reported in the Chicago, Minneapolis and San Francisco Districts. Philadelphia, Dallas, and San Francisco noted that most wage increases were for workers with specialized skills.

Until we see enough labor demand, and reduced slack, that we see some widespread upward momentum in wages, it is tough to see how higher input cost do anything but temper demand growth.

Simply put, the baseline scenario should be that labor markets are not going to improve sufficiently quickly to unsettle the Fed’s plans. Still, there is a risk that we are underestimating the degree of slack in labor markets. I think one needs to pay more attention to that risk should we see a string of solid employment reports.

At the same time the economy is showing signs of sustained momentum, thus raising the specter of upside risks, we are faced with the downside risks from the commodity side. Undoubtedly, higher commodity prices are a drag on activity. But the last shock came in the context of waning US economic activity and rock bottom saving rates. This time, the US economy is on the upswing, with positive saving rates to provide cushion, suggesting that for now the commodity shock can be managed. Still, I can outline a scenario where low interest induces a flood of money into commodities to chase a supply induced price shock. And I am more inclined to believe that this would trigger a recessionary rather than inflationary environment.

Bottom Line: We await yet another employment report, facing intensifying risks on both sides of the forecast. The possibility of some real game changing developments is at hand. At this moment, I think the balance of risks are now on the upside, but am very, very conscious of how quickly that balance can change in the wake of a commodity price shock. I would be wary about letting the depth of this recession interfere with your read of the data, just as wary as you should be about letting the data tempt you from thinking it is time to push stimulative policies into reverse.

Long and Variable Lags in Monetary Policy

I am between classes and in a rush, so I don't have time to say much about Scott Sumner's latest misrepresentation of what I've said (I tried to clear it up here, e.g. for just one example, he turns the statement "it would be very unusual for monetary policy to work that fast" into my saying it couldn't possible have happened -- that's not what I said). However, on one point -- the lags in monetary policy -- since Scott claims (based upon his own work on the Great Depression) that "I don’t see any long and variable lags there," and uses this to try to refute my claim about policy lags, and since he makes it sound like I am relying solely on "modern macro" to draw this conclusion, let me quote Milton Friedman as an authority on monetary policy in the Great Depression (and outside of it for that matter). Here's what Friedman said to me on policy lags in a letter on one of my papers:

...Turning to your mathematization of the idea, I am struck that it is extremely ingenious and I have no comments to make on that. In re the conclusions, I am not greatly disturbed that positive money growth shocks do not have a large impact on inflation when the economy is operating at maximum level. We have consistently found that changes in money lead changes in inflation by about two years, and there is no reason why that lag should not be just as operative at upper turning points as elsewhere. You include, as I understand it, a lag of at most six months. True, the impulse response functions implicitly extend the lag, but I suspect that is not the same as allowing for a very much longer lag. Changes in money tend to affect output after something like about six to nine months, and inflation only after another 18 months, by which time the effect on output is negative rather than positive. Hence, it is not surprising that the short-term reaction is on interest rates rather than on inflation. In a frictionless world in which money was completely neutral, the impact of monetary growth would always be solely on inflation. In the real world, given the lags that I have described and taking for granted that positive money growth is not reflected in inflation for a considerable period, it must be reflected somewhere. The obvious candidates are output, interest rates, and buffer money stocks. When the economy is operating below capacity, it is easy for part of the impact to be taken up by real output and a lesser part by interest rates or by buffer stocks. But when the economy is operating at full capacity, it cannot be taken up by output. It will therefore have to have a stronger influence on the two other components. ...

The claim that there are lags before policy takes effect is not at all controversial. I can understand the inclination to argue otherwise when you need short lags -- no lags essentially in this case -- to justify the story you've been telling about policy. But saying it, and acting quite assured in doing so, does not make it true. So, once again, to restate the claim I made, there are long and variable lags in policy. Finding significant employment effects so soon after the QEII policy was announced -- essentially within a quarter, four months at the most -- is difficult to believe given that employment is even slower to respond than output. As I said initially, we don't have the data to sort this out yet, it's too soon to know for sure, but a lag that short would be "unusual."

[Update: I probably should have also clarified what it was that I responded to in the initial post long ago. Scott claimed in a post, without any qualification I can recall, that fiscal policy had failed. Period. No question about it. My point was a simple one -- we don't have the evidence to come to that conclusion yet (and the evidence that does exist points in both directions -- you can support whatever you want by choosing the right study), and due to the timing of various policies, it will be difficult even when we do have all the data we need to do the tests properly. When monetary and fiscal policies are implemented at nearly the same time, as they were, and when they come at or near the trough of cycles, as both QEII and the recent tax cuts did, it is hard to identify them separately. And it will also be hard to separate the effects of policy from the natural recovery. The part about QEII working so soon, or not, drew the most reaction, but it was not the main point being made.]

Wednesday, March 02, 2011

Fed Watch: The Rearview Mirror

Tim Duy:

The Rearview Mirror, by Tim Duy: The rearview mirror is looking pretty good this week. The ISM manufacturing index extended January’s impressive gains, again with improving internals. Note declines in the inventory measures, which suggests manufacturing momentum is set to continue. One can wring their hands over the Personal Income and Outlays report, which revealed a very small 0.1 percent decrease in real spending. This should be taken in context of likely weather-related issues rather than some impending consumer slowdown. Bolstering that view is the 0.4 percentage point gain in the saving rate; bank accounts swelled a bit as weather restrained shopping activity. Moreover, the February spending report will get a boost from autos, with car dealers reporting well-above-expectations sales of 13.44 million units, SAAR. No wonder consumer confidence was up in February. Buying new cars makes people happy.

All told, incoming data continues to be on the bright side. To be sure, it is reasonable to complain about the depth of the hole we are in – the “real” recovery remains nascent, beginning just in the final quarter of 2010. A handful of solid data should not be reason to abandon monetary and fiscal stimulus and threaten building momentum. But the data is solid, so much so that it is surprising to see the comments of Harvard’s Martin Feldstein. Via Bloomberg:

“There is a mixed picture now in terms of how much the economy is on track,” Feldstein said in an interview on Bloomberg Television’s “InBusiness With Margaret Brennan.” Growth “started slowing down toward the end of the fourth quarter. The January numbers are not very good at all.”

Feldstein cited less-than-forecast consumer spending in January, continuing monthly declines in U.S. housing prices and weakness in industrial production. While fourth-quarter growth was bolstered by consumers spending more after a rise in the stock market, those gains came as the personal savings rate fell, he said.

“So this is not a strong economy,” Feldstein said. “There hasn’t been a pull-through from the fourth quarter to the first quarter.”

I disagree; the pull-through has been strong. The industrial production weakness in January was the consequence of the often-volatile mining and utility sectors. Manufacturing production gained 0.3 percent, extending a 0.9 percent gain the previous month. And the ISM reports promise additional strength going forward. I already commented above on the consumer spending picture. Feldstein, however, is correct on housing. But this should not come as a surprise – a housing recovery figures into precious few forecasts this year.

Federal Reserve Chairman Ben Bernanke also does not side with Feldstein. Making his semi-annual trek to Capitol Hill, Bernanke gave a relatively upbeat assessment of the economy:

More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. Notably, real consumer spending has grown at a solid pace since last fall, and business investment in new equipment and software has continued to expand. Stronger demand, both domestic and foreign, has supported steady gains in U.S. manufacturing output.

The combination of rising household and business confidence, accommodative monetary policy, and improving credit conditions seems likely to lead to a somewhat more rapid pace of economic recovery in 2011 than we saw last year.

Enough optimism to change policy in the near term? No:

While indicators of spending and production have been encouraging on balance, the job market has improved only slowly... Until we see a sustained period of stronger job creation, we cannot consider the recovery to be truly established.

It will take a few months of solid jobs data to convince Fed officials that the economy is out of harms way – and by that time, the Fed’s current asset purchase plan will be effectively over. Maybe we will get the first such report on Friday; I am optimistic that nonfarm payrolls will look better than the weather mangled January read. Interestingly, Oregon reported solid numbers for January, a month that was unseasonably warm. No snow to disrupt the jobs picture. 

Given where Bernanke is today, I find it difficult to believe that he will follow the path suggested by St. Louis Fed President James Bullard. From the Wall Street Journal:

“We are still very far away from achieving our dual mandate of maximum sustainable employment and price stability,” Dudley said. “Faster progress toward these objectives would be very welcome and need not require an early change in the stance of monetary policy,” he said.

Bullard sees things a little differently. In his television appearance he explained the Fed is “determined” to get monetary policy back to a more normal profile. He explained he saw the Fed as “possibly finishing the program a little bit shy of where we intended initially, and then go on pause for a while.”

Bullard’s comments need more clarification:

Bullard differs somewhat from that camp in that he’s been a QE2 supporter and was one of its primary advocates before it was launched. His comments Monday suggest a philosophical difference. While many in the Fed see QE2 as an extension of normal monetary policy, Bullard takes that view a step further, and would like the Fed to use bond buying in a fashion similar to the way it used to approach short-term rates. The Fed didn’t always move in a straight line with rate adjustments then, and sometimes paused to take in new data.

Bullard has been suggesting for quite some time that the Fed should use small adjustments in its bond buying program to manage expectations, and this is likely his last chance to see that idea actually implemented. Note that it was not implemented last year; the Fed opted for the announcement of a large scale program with a $600 billion target. The only possible reason to bring an early halt to the program given the early stage of the recovery and, as Bernanke notes, an environment of stable inflations expectations, is to hand Bullard a policy “win.” I just don’t see that happening. But if it does, there would be no question about Bullard’s stature within the Fed.

What could upset Bernanke’s optimism? Commodity prices, of course. If commodity prices work their way deep into inflation expectations in an environment of improving final demand, the Fed will be pushed to reverse policy.  And if inflation truly took hold, forget about fine-tuning and tapering; think outright reversal. That, however, I think is less likely than the recessionary implications of a sharp run up in commodity prices, the odds of which seem more likely by the day.  For now, Bernanke can only sit on the sidelines and see how it plays out. 

Bottom Line:  If the Fed continues to drive by the rear view mirror, they will happily bring the current $600 program to conclusion as expected.  Assuming the data continues to hold, and momentum builds  in the job market, they will shift to "normalizing" policy, with rate hike possible early next year.  But if they turn their attention to the front windshield, they will see the commodity price truck starting to slide out of control.  But until the slide turns into an outright wreck, they just will not know which way to swerve.

Tuesday, March 01, 2011

New President of the San Francisco Fed

Good choice.

Monday, February 28, 2011

The Fed's Hawkish Stance

At MoneyWatch:

The Fed's Hawkish Stance

It tries to explain why, to quote Christina Romer, "Monetary policy makers are all hawks now."

Fed Watch: Commodity Shock

Tim Duy:

Commodity Shock, by Tim Duy: How quickly the world can change. Just a few weeks ago, incoming data suggested room for optimism. And, in large measure, continue to do so. Regional manufacturing reports have been largely solid, while initial unemployment claims declined during the month, ending last week just a hair above the 400k mark. Even consumers appeared a bit brighter, with confidence rising to its highest level in three years (still low, but the right direction). To be sure, there were some setbacks as well. The revisions to 4Q10 GDP were disappointing, although I would still focus on the final demand figure rather than the headline. Non-defense, non-air capital goods declined sharply, almost erasing the previous month’s surge. But an up-and-down pattern has been a persistent feature of that data series in recent months, suggesting little to worry about in the context of other generally positive manufacturing indicators.

The rapidly evolving situation in the Middle East, however, threatens to unsettle this positive momentum as oil prices surge. Unfortunately, the suddenly choppy economic waters catch US monetary policymakers off guard, and it shows in recent Fedspeak. It appears that the Fed is stuck between two narratives, one in which the energy price shock turns inflationary given signs of economic improvement in recent months, and another in which oil undermines a still-nascent recovery. It is an unfortunate debate to have during this period of uncertainty and this early in the recovery.

The usual suspects seize upon recent data to argue for a new evaluation of the Fed’s large scale asset purchases. From the Wall Street Journal:

“Should economic prospects continue to strengthen, I would not rule out changing the policy stance to bring QE2 to an early close,” Federal Reserve Bank of Philadelphia President Charles Plosser said. “If the growth rates of employment and output begin to accelerate or if inflation or inflation expectations begin to rise, then it may be time to begin taking our foot off the accelerator,” he said.

Richmond Fed President Jeffrey Lacker continues along the same argument:

Lacker was asked if he would dissent against continued bond buying if he had a voting slot on the FOMC this year. He declined to say, but added he takes "very seriously" the Fed's pledge to continuously re-evaluate the program. Lacker said recent growth levels should have "tilted things in the direction in modifying the program," adding he believes QE2 has had a "minimal contribution" in driving the current recovery.

And, unsurprisingly Kansas City Federal Reserve President Thomas Hoenig continues to rail against the inflationary implications of Fed policy. More surprising is a bit of hawkishness from Governor Janet Yellen:

Yellen said “any increase that seemed to be sustained in inflation expectations or core inflation, that looked like we were getting pass through [from commodity price gains] that seemed to be sustained, would demand a response” from monetary policy.

She also said the Fed would have to be ahead of the curve and would need to move to tighten policy before inflation became an issue, repeating a mantra common to central bankers. She noted that, in past years, the central bank had enjoyed the “luxury” of unexpected commodity price gains not passing through to inflation in any significant fashion.

This suggests that Yellen is sympathetic to the notion that the recent economic upswing offers a path for commodity price gains to work their way to core inflation. Meanwhile, St. Louis Federal Reserve President Robert Bullard plays all sides of the table. Via (again) the Wall Street Journal, he raises the prospect of additional easing:

But while Bullard, a non-voting Fed member this year, said QE2 could be adjusted, he still said a third bond-buying effort is not totally off the table, given tensions in the Middle East and rising oil prices and ongoing concerns about the euro-zone debt crisis.

Still, this clearly is not the direction he is leaning:

For now though, “looking at the data today and the outlook, the natural thing would be to say either that we should pull back a little bit” on bond-buying, or just follow through with the program if the consensus is the economic outlook is not sufficient enough to end the program before June, he said.

I think it is somewhat silly to be discussing an early end to the LSAP as it only adds another layer of uncertainty on what was already an increasingly uncertain environment. Somewhat pointless as well – the end is fast approaching in any event. Indeed, I find the debate disappointing, albeit expected. Policymakers appear to have learned little from their failed exercise in hawkishness this time last year.

What should be our baseline expectation for policy at this juncture? First, the current LSAP policy concludes as planned, at least in magnitude. They could choose a more gradual end to the policy, but I am hard pressed to see a change in the ultimate amount given the time horizon (June will come faster than we think). Indeed, continuing high unemployment alone argues against meaningful alteration of the policy despite signs of economic health. Second, the oil price shock raises the odds for another round of easing. Simply put, the recent trajectory of commodity prices threatens to shift the story from a benign signal that the economy is on the mend to something much more dire. And much more dire generally induces monetary easing, not tightening.

Continue reading "Fed Watch: Commodity Shock" »

Saturday, February 26, 2011

"The Debate That’s Muting the Fed’s Response"

Christina Romer:

The Debate That’s Muting the Fed’s Response, by Christina Romer, Commentary, NY Times: ...Monetary policy makers are all hawks now. Even those who most emphasize the Fed’s role in fighting unemployment oppose policies that would raise inflation noticeably above the Fed’s implicit target of about 2 percent.
The real division is not about the acceptable level of inflation, but about its causes, and the dispute is limiting the Fed’s aid to the economic recovery. The debate is between what I would describe as empiricists and theorists.
Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal. ...
Theorists, on the other hand, emphasize economic models that assume people are highly rational in forming expectations of future inflation. ... For theorists, any rise in an indicator of expected or future inflation, like the recent boom in commodity prices, suggests that the Fed’s credibility is at risk. They fear that general inflation could re-emerge quickly, despite high unemployment.
Now, not every monetary policy maker fits neatly into these categories. ... But the main division is between the empiricists who say “inflation is unlikely at 9 percent unemployment” and the theorists who say “inflation could bite us at any moment.” ... Although the Survey of Professional Forecasters ... shows virtually no change in long-run inflation expectations since the start of the program, the theorists hold fast to their concerns.
As a confirmed empiricist, I am frustrated that the two sides have been able to agree only on painfully small additional aid for a very troubled economy. For a sense of how much more useful monetary policy could be, one can look to the Great Depression.
By 1933, short-term interest rates were near zero — just as they are today. As I described in a 1992 academic article, Franklin D. Roosevelt took the United States off the gold standard in April 1933, and rapid devaluation led to huge gold inflows and a large increase in the money supply. ... Expectations of deflation, which had been enormous, abated quickly. As a result, with nominal rates at zero, real interest rates ... plummeted. The first types of demand to recover were ones that were sensitive to interest rates. ...
The Fed could engage in much more aggressive quantitative easing, both in size and in scope, to further lower long-term interest rates and value of the dollar. It could more effectively convey to markets its intentions for the funds rate, which would also lower long-term rates. And it could set a price-level target, which, unlike an inflation target, calls for Fed policy to take past years’ price changes into account. That would lead the Fed to counteract some of the extremely low inflation during the recession with a more expansionary policy and lower real rates for a while.
All of these alternatives would be helpful and would retain the Fed’s credibility as a defender of price stability. And any would be better than doing too little just because some Fed policy makers believe in an unproven, theoretical view of how inflation works.

Since my views on monetary policy haven't always been reflected accurately when other people have characterized them, let me make them clear once again. I have never argued that monetary policy won't work at all when the economy is near the zero bound. What I have said is that monetary policy alone cannot close the output and employment gaps in severe recessions, and that fiscal policy has an important role to play in aiding monetary policy in spurring a recovery. I have called for more aggressive QE -- I was very clear that I did not think that QE2 was large enough or that is was done soon enough, e.g. I complained about the Fed waiting until the election was over before announcing the policy -- and I have also called for more aggressive fiscal policy. When I respond to those who call solely for monetary policy, it is not because I think that monetary policy won't work at all, it's because monetary policy alone is likely to be insufficient. We shouldn't take that chance.

From the very start of this crisis, I have called for a portfolio of policies as a response to our considerable uncertainty over both monetary and fiscal policy multipliers. My view is that fiscal policy is more powerful than monetary policy in severe recessions, but we don't know all that much about these multipliers in normal times, and we know even less about how they work in severe recessions (most estimates of monetary and fiscal policy multipliers come from models that don't connect the financial and real sectors very well, and hence miss a key transmission mechanism in this recession, and the studies use data that mostly come from normal times). The portfolio approach is useful when there is so much uncertainty over the effectiveness of policy because if one of the policies doesn't work as well as hoped, perhaps another will fill the void. In addition, to me it was also a case of asking which error is worse, overstimulating the economy and putting too many people to work too fast, or doing too little and enduring an "agonizingly slow recovery" to repeat a phrase I used often. I think the costs are asymmetric, that doing too little is a bigger error, so the response should be aggressive and it should involve all the tools at our disposal, i.e. it should involve both monetary and fiscal policy. We haven't done enough of either type of policy, and what we have done has been put into place much later than would have been optimal.

However, while I don't think we did enough, or did it fast enough, I also believe that what has been done on both the monetary and fiscal policy fronts has helped. The empirical evidence isn't all in and won't be for some time, but my reading of the evidence to date is that these policies helped to avoid a much worse outcome. (Even if, when summed across federal, state, and local levels, the net fiscal stimulus was relatively small, as appears to be the case, things still would have been worse without the federal stimulus offsetting the losses at the state and local level.)

Right now, we could use more of both types of policy, it's not too late to do more given the expectation that full recovery of employment is years away. Thus, I am also frustrated with the "painfully small additional aid for a very troubled economy," but my frustration is not just with monetary policymakers. Fiscal policymakers have also failed to do enough.

Tuesday, February 22, 2011

How Long Will It Be Until the Fed Raises Interest Rates?

How long will it be until the Fed begins increasing the federal funds rate? Answers from Calculated Risk and the SF Fed's Glenn Rudebusch are summarized at MoneyWatch:

How Long Will It Be Until the Fed Raises Interest Rates?

I also give an answer, though we all mostly agree (Glenn Rudebusch comes armed with lots of graphs).

Wednesday, February 16, 2011

Cheap Shots That Miss

Scott Sumner tries do denounce a recent post of mine, but fails:

Cheap shot #2:

I notice that Krugman defends his “no stimulus” argument with a graph showing government expenditures.  I guess that’s OK, as in earlier posts he suggested that tax cuts weren’t very effective stimulus.  On the other hand, Mark Thoma recently made the following claim:

It’s particularly amusing to see people saying that QEII raised employment in January when we know good and well that there are substantial lags in the policy process and it would be very unusual for monetary policy to work that fast. It would be just as easy to point to the recent tax cuts that Congress (surprisingly) put into place and give those credit for recent employment gains.

Keynesians like to act like there is some sort of rigorously scientific model behind their calls for the government to waste hundreds of billions of dollars.  Now we find that two of the top Keynesian commentators don’t even agree on whether tax cuts count as stimulus.  If they don’t, Thoma’s point is flat out wrong.  If they do, Krugman’s post is completely inaccurate.

[BTW, Thoma is doubly wrong about monetary lags.  He confuses peak effect, often estimated at 6 to 18 months, with some effect, which occurs almost immediately after major monetary shocks.  He also fails to mention that the effects should begin when the policy was expected (September/October 2010), not when it was announced (November.)  And finally he ignores the fact that we know from TIPS market responses to rumors of QE2 that the policy does raise inflation expectations.]

It's annoying to have to respond to such a mischaracterization of the evidence, and of what I actually said.

1. First, I didn't confuse peak effects with some effect. Sumner needs to look again at the empirical evidence. There is at least a one quarter lag before policy takes effects (and the delay is particularly long for inflation). You can find estimates saying anything, but there's a good reason Woodford et. al. spent so much time trying to build a policy delay into their models. [Update: I should have given a reference. See Woodford's book Interest and Prices, page 175 where he says "...there is a substantial real effect of the shock. ... Furthermore, the effect occurs with a substantial delay; there is essentially no effect on output until the second quarter following the policy shock" Or, perhaps better, see the section in Chapter 5 called "Delayed Effects of Monetary Policy."]

2. On the timing, no date is actually mentioned in my post, but I relied upon John Taylor's rejection of the earlier dates (i.e. those in August, though Sumner doesn't cite those). Again, I didn't cite a date, but even the earliest of dates Sumner cites, September/October, which is what I had in mind, only leave around 3 to 4 months before the January data. Again, to see real effects in January would be remarkably fast given what the empirical evidence says about the lags in the effects of policy (and even without a delay, the impact would be small at this point since the peak effect is 6-18 months, and most evidence points toward the long end of this distruibution).

3. Sumner twisted my words on tax cuts. I didn't say they were effective, I said that if one made the QE2 argument (which I was denouncing), one could just as easily make the tax cut argument. But I wasn't actually saying the tax cuts had this impact (I also said fiscal policy could be given credit, but I guess Sumner ignored that because it didn't fit the gotcha he wanted for Krugman.)

4. I have made the inflation expectations argument many times, and highlighted it again in a post last night echoing Jim Hamilton. So this has been anything but ignored. If Sumner wants to defend QE2, Hamilton's relatively pessimistic take ought to throw cold water on that notion, though he does talk about the expectations effect. But even if you make the expectations argument, you still have to get past the policy delays to argue the effects were evident in January.

5. There's plenty of evidence that the stimulus led to the employment (new or saved jobs) of one to two million people (the estimates vary, but even the very lowest find a considerable effect). I can't see how giving people struggling with the recession the means to pay their bills is a wasted effort, but apparently there are people who want to characterize it this way.

"Cheap shots" are easy when you don't understand the empirical evidence on the effects of policy, when you assert the earliest possible date for the start of QE2 because if fits your story (and even then the story is implausible), and when you claim someone says something they aren't saying.

If Sumner wants to argue that the empirical evidence for the effectiveness of QE2 on the real economy is out there already (or tht fiscal policy had no effect), as he apparently does, then he ought to present it instead of wasting our time with cheap shots that fall apart under scrutiny.

"'Progress report on QE2"

Jim Hamilton evaluates QE2:

Progress report on QE2, by Jim Hamilton: We're now 3 months into the Fed's new asset purchase program that has been popularly described as a second round of quantitative easing, or QE2. ...
The essence of QE2 is that the Fed buys some longer-term Treasury debt and pays for it by creating reserves on which the Fed pays an overnight interest rate. In my view, in the current environment, interest-bearing reserves are for all practical purposes the same kind of security as a very short-term Treasury bill. The net effect of such a Fed operation is to lower the average maturity of the combined outstanding debt of the Federal Reserve and Treasury. One view of how such an operation might affect the economy is that a big enough drop in the net supply of long-term debt might result in a decline in long-term yields. ...
I noted in December that QE2 as actually implemented ... has primarily been buying debt of intermediate maturity (2-1/2 to 10 years) rather than the longest term debt outstanding. Second, the Fed spread these purchases out over a period of 8 months, during which time we could anticipate significant changes in the composition of debt issued by the Treasury which could potentially offset any effects of QE2. ...
However, since the start of 2008, ... the Treasury has been issuing more long-term debt faster than the Fed has been buying it ...
Our conclusion is that if QE2 made a positive contribution to the improving economic indicators since the program began, it could not have been through the mechanism of shortening the maturity of publicly-held Treasury debt.
This does not rule out the possibility that QE2 had an effect through some other channels. Another possible mechanism is that, by announcing QE2, the Fed successfully communicated that it had a higher inflation target than some observers had assumed, and successfully communicated that the Fed had both the tools and the will to prevent outright deflation. It appears to be quite an accurate characterization that QE2 did have an effect on many people's expectations. Indeed, some observers had quite a passionate response that I find hard to reconcile with the fundamentally modest nature of what the Fed has been doing. Using the tool of QE2 as a device for helping to manage expectations is in fact the main argument I can see for having the Fed rather than the Treasury be the agent responsible for announcing and carrying out the plan. Even so, I doubt that it can make much sense for the Treasury to pull so hard in one direction that it completely undoes any real effects of QE2.
But whether it makes sense or not, that's what's been happening so far.

Friday, February 11, 2011

Paul Krugman: Abraham Lincoln, Inflationist

The GOP's nutty ideas about monetary policy "offer a revealing — and appalling — look at the mind-set of one of our two major political parties":

Abraham Lincoln, Inflationist, by Paul Krugman, Commentary, NY Times: There was a time when Republicans used to refer to themselves, proudly, as “the party of Lincoln.” But you don’t hear that line much these days. Why?
The main answer, presumably, lies in the G.O.P.’s decision, long ago, to seek votes from Southerners angered by the end of legal segregation. ...
But sooner or later, Republicans were bound to notice other reasons to disavow Lincoln. He was, after all, the first president to institute an income tax. And he was also the first president to issue a paper currency — the “greenback” — that wasn’t backed by gold or silver. “There is nothing more insidious that a country can do to its people than to debase its currency,” declared Representative Paul Ryan in one of two hearings Congress held on Wednesday on monetary policy. So much, then, for the Great Liberator.
Which brings me to the story of what went on in those monetary hearings.
One of the hearings was called by Representative Ron Paul ... Mr. Paul’s subcommittee called three witnesses, one of whom was an odd choice: Thomas DiLorenzo, a professor at Loyola University and a senior fellow at the Ludwig von Mises Institute.
What was odd about that choice? Well, Mr. DiLorenzo hasn’t actually written much about monetary policy... His main claim to fame, instead, is as a critic of Lincoln — he’s the author of “Lincoln Unmasked: What You’re Not Supposed to Know About Dishonest Abe” — and as a modern-day secessionist.
No, really: calls for secession run through many of Mr. DiLorenzo’s writings — for example, in his declaration that “healthcare freedom” won’t be restored until “some states begin seceding from the new American fascialistic state.” Raise the rebel flag!
O.K., it’s going to be a while before the G.O.P. as a whole embraces neo-secessionism... But ... Mr. Ryan’s hard-money rhetoric was nearly as bizarre as Mr. DiLorenzo’s.
Start with that bit about debasing our currency. Where did that come from? The dollar’s value in terms of other major currencies is about the same now as it was three years ago. ... But the facts don’t matter, because conservative hard-money mania, the demand that the Fed stop trying to rescue the economy, isn’t really about inflation fears.
Mr. Ryan said as much in Wednesday’s hearing, in which he declared that our currency “should be guided by the rule of law, not the rule of men.” A few years ago, my response would have been, say what? ... Milton Friedman..., who believed that it sometimes makes sense to let your currency depreciate, who urged Japan’s central bank to adopt a policy very similar to what the Fed is doing now, was a leftist by the standards of today’s G.O.P.
Wednesday’s hearings aren’t likely to have any immediate effect on monetary policy. But they offer a revealing — and appalling — look at the mind-set of one of our two major political parties. We’ve always known that the modern G.O.P. wants to take America back to the way it was before the New Deal; but now it’s clear that the party wants to build a bridge to the 19th century, and maybe even to the antebellum era. Backward, march!

Thursday, February 10, 2011

The Slow Recovery of Labor Markets

Ben Bernanke characterizes the unemployment problem:

... As Bernanke sees it, 2.5% gains in gross domestic product are needed simply to create the needed level of economic activity that will absorb new entrants to the labor force. If the 3.2% GDP rate seen for the final quarter of last year were sustained, it would take a decade to bring today’s 9% unemployment rate down to the 5% to 6% range central bankers consider normal. Bernanke said if the economy were to average an “ambitious” 4.5% GDP rate, the natural unemployment rate could be achieved within three to four years. ...

It didn't have to be like this.

Tuesday, February 08, 2011

Can Econometrics Distinguish between the Effects of Monetary and Fiscal Policy During the Crisis?

People are taking victory laps over monetary policy, saying it's now clear that either fiscal policy doesn't work or, even if it does, it will be offset by monetary policy? Or they are making the claim that those who said monetary policy is ineffective at the zero bound have been shown to be wrong? I'm sorry, but it's too soon to do this. I knew this was going to happen, it always does, and tried to warn about it in August 2009:

...Much of the uncertainty in economics derives from our inability to do laboratory experiments, and that includes uncertainty about which model best describes the macroeconmy. 
When the present crisis is finally over, those who advocated fiscal policy, those who advocated monetary policy, and those who advocated no policy at all will all say "I told you so" based upon their reading of the evidence.
Some New Keynesians will cite fiscal policy as the important policy response, and the timing of the policy relative to the recovery will likely support that argument. Other New Keynesians along with Monetarists (e.g. Lucas and others who believe monetary policy can help, but fiscal policy is ineffective) will insist it was monetary policy that saved us. The timing of the monetary policy response will support their position as well.
Still others, those such as Prescott who believe in Real Business Cycle models, will say the economy recovered despite policy, and would have recovered all that much faster if government hadn't gotten in the way. Without a baseline to refer to showing what would have happened without policy, it would be hard to refute this argument.
Once this is all over, there will be ways to tease this out of the data, e.g. the pattern of the response of key macroeconomic variables may be most consistent with one of the policies, but there will still be considerable uncertainty due to the high correlation in the timing of the monetary and fiscal policy responses (cross-country studies could help too since the policy response varied by country, but other differences across countries that are difficult to control for making these estimates uncertain as well).
Ideally, we would go to the lab and run the economy with the same initial conditions, say, 1,000 times with no policy intervention at all to establish the average non-intervention response (and its variance), i.e. the baseline, an important missing piece of information when all you have is non-experimental data. Then, we would run the economy again with a monetary policy response to the crisis 1,000 times (or do several experiments with different monetary policy responses to see which is best), and yet again 1,000 more times with fiscal policy (or, as with monetary policy, perhaps several fiscal polices involving different levels of spending and taxes), then compare the results to see how well each policy attenuates the cycle. (I would also want to run the economy with several combinations of the two polices in case there are important interaction effects the experiments with individual treatments might miss.)
That would probably give us a pretty good idea about which policy works best. However, without the ability to do experiments, the best we can do is to build a model of the economy based upon historical data, and then use the model to simulate the experiments above. That is, estimate the model based upon actual data, then run it with various combinations of monetary and fiscal policy and see how the outcome varies with differences in policy. Unfortunately, the answers you get are only as good as the model used to get them, and considerable uncertainty remains over which macroeconomic model is best (which is why we have Real Business Cycle, New Keynesian, and Monetarist type macroeconomic models along with all their various sub forms, though more recently questions have arisen over whether any of the existing theoretical structures are satisfactory). ...

The evidence about which, if any policies worked best simply isn't there yet, and claims that, say, monetary policy was effective while fiscal policy did nothing simply cannot be supported with the solid econometric results. It's particularly amusing to see people saying that QEII raised employment in January when we know good and well that there are substantial lags in the policy process and it would be very unusual for monetary policy to work that fast. It would be just as easy to point to the recent tax cuts that Congress (surprisingly) put into place and give those credit for recent employment gains. Similarly, the timing works quite well for the argument that the employment gains we've seen recently -- meager as they are -- come from the spending on infrastructure and other projects in the ARRA. If you impose the standard lags for fiscal policy and take good account of when the spending came online, it's just as easy to give fiscal policy credit as it is monetary policy. Or, if you'd like, a case can be made that QEI is responsible for recent upticks in activity. Finally any policies such as QEII and the recent tax cuts that are put into place in the neighborhood of a trough of a recession are going to look effective even if they do nothing. The economy is headed upward anyway, and it's hard to say how the trajectory is affected by policy.

So it is no harder, and perhaps even easier, to make the claim that fiscal policy did it all and monetary policy did nothing. Again, we don't have the evidence yet and won't for some time -- so people can claim whatever and it's hard to agree or disagree based upon solid evidence. We need the full series through the recovery and all the data revisions in place to do this right, and even then the separate effects of monetary and fiscal policy will be difficult to identify for the reasons discussed above. Those who are claiming victory are simply reading the data in a way that supports what they've predicted in the past -- there's no way to decisively make the case based upon the evidence at hand. Conclusions that say otherwise more upon ego than evidence. As I've said recently, I do this too -- my ego leads me to read the data in a way that supports what I've said would happen in the past -- but if I'm honest I have to admit that there's no way to make an evidence based case one way or the other yet, and there may never be a decisive way to sort out the effects of monetary and fiscal stimulus. Both monetary and fiscal policy tended to occur together during the crisis, and the last round occurred near the trough confounding the analysis even more.

One final note. Many people have been pointing to results from simulations showing that monetary policy had some effect on employment and output, though not a huge effect, as a means to support their prior predictions about monetary and fiscal policy. But as noted above, these simulations are based upon models that failed to predict the crisis and that do not have the connections between the real and financial sectors that are needed to properly model the monetary transmission mechanism. Why people would put a lot of weight on the results from models that do not capture that monetary transmission mechanism is puzzling. Until we have models of the crisis that have these connections, such evidence should be regarded with skepticism.

Monday, February 07, 2011

Fed Watch: Acceleration Alert

Tim Duy:

Acceleration Alert, by Tim Duy: For those of us still fretting over a struggling US economy, the first week of February delivered a host of data that should raise red flags. Simply put, the solid activity of 4Q2010 looks to have carried through into the new year. This could be shaping up to be a far more interesting year for monetary policy than I would have imagined just six weeks ago. While I believe the baseline forecast – complete the current asset purchase program and then move to the sidelines for the remainder of 2011 – incoming data suggests a need to be prepared for a fallback position. And that fallback is no longer toward additional easing.
If you believed the 4Q10 GDP report revealed a far stronger economy than the headline number suggested, you would have been looking for some blowout numbers from the ISM reports. And that is just what we got. In addition to the headline gain, the ISM manufacturing report had very strong internals. New orders gained 5.8 percentage points, promising future production. But is the capacity there? Note the 11 percentage point surge in border backlogs. Sustained backlogs would prompt firms to add additional capacity, which would obviously reveal itself in stronger investment spending in the months ahead. Likewise, supplier deliveries were slower. And the pressure on factories is stimulating a desperately needed demand for labor – the sector added 49,000 jobs during January, possibly underestimated given the weather related concerns with the January establishment survey. In short, it was tough to ignore the strength in the ISM report. Moreover, its service sector counterpart revealed similar trends, albeit to a lesser degree.
The manufacturing report also revealed accelerating price pressures, with the prices paid index jumping 9 percentage points to 81.5. All commodities were reported up in price. Via the baseline forecast, these gains should not be cause for worry, as excess slack in labor markets implies a very difficult environment to push through price increases. But should the employment report force us to rethink that story? More on that later.
The Personal Income and Outlays report pointed to a consumer willing to step back up to the plate. Although real income gained a scant 0.1 percent, real spending grew 0.4 percent. Compared to a year ago, real spending is up 2.8 percentage, respectable given the damage done to household balance sheets over the past three years:
Not surprisingly, the saving rate declined – one has to consider the possibility that saving is settling into a new equilibrium around the five percent mark. If so, pessimism on the consumer outlook was overblown and, more importantly for the immediate outlook, the rise in the saving rate is now behind us. Income gains will thus largely translate into spending gains in the months ahead.

Continue reading "Fed Watch: Acceleration Alert" »

Friday, February 04, 2011

John Taylor and Fed Reform: Is Change Required?

Since I'm headed to the NY Fed this morning for a conference, maybe I should be nice and let David Altig of the Atlanta Fed defend Federal Reserve policymakers against charges from John Taylor and others that low interest rates and excess liquidity caused the crisis (I've argued that excess liquidity due to low interest rate policy and inflows from abroad helped to fuel the crisis, but these factors were not the main cause. So I'm nowhere near as critical of the Fed in this regard as John Taylor.):

John Taylor and Fed reform: Is change required?, macroblog: In a Wall Street Journal article this past Friday, Stanford economist John Taylor articulated a two-track plan to restore growth. The first track pertains to fiscal policy, but what always attracts our attention here at macroblog are Professor Taylor's comments on monetary policy, the essential second track in his formulation for economic restoration. Here are the highlights (emphasis mine):

Continue reading "John Taylor and Fed Reform: Is Change Required?" »

Thursday, February 03, 2011

Is QEII Working?

It's great that QEII seems to be working, but let's not get overexcited here. According to this FRBSF Economic Letter, the effect on unemployment will be around 1.5% (and it won't happen overnight).

By 2012, the ... program's incremental contribution is ... 700,000 jobs generated ... by the most recent phase of the program. Increased hiring lowers the unemployment rate by 1½ percentage points compared with what it would have been absent the Fed's asset purchases... Based on other simulations, providing an equivalent amount of support to real economic activity through conventional monetary policy would have required cutting the federal funds rate approximately 3 percentage points relative to baseline from early 2009 through 2012, an obvious impossibility because of the zero lower bound.

That gets us down to 8% in 2012 (Update: as Ryan Avent notes, plus any change that would have happened anyway, but see the note below). We can argue about what "working" means, but if it means reducing unemployment to acceptable levels, to repeat a point I've made again and again, this alone is not nearly enough.

There is also more evidence on QEII beyond the FRBSF research. This paper by Heike Schenkelberg and Sebastion Watzka of the University of Munich finds positive effects of QE for Japan. Here's there introduction:

1 Introduction We study the real effects of Quantitative Easing (QE) in a structural VAR (SVAR) when the short-term interest rate is constrained by the Zero-Lower-Bound (ZLB). Using monthly Japanese data since 1995 - a period during which the Bank of Japan's target rate, the overnight call rate, has been very close to zero - and sign restrictions based on liquidity trap theory, we find that an increase in reserves leads to a significant 0.7 percent rise in industrial production on impact.
This rise lasts for about two years. On the other hand, our results indicate that the same shock has no effect on inflation. Thus our results provide mixed evidence on the successfulness of QE in Japan. Whilst real economic activity does seem to pick up after a QE-shock, this does not seem to affect inflation in such a way that Japan could exit its deflationary period through such a policy shock.
However, this conclusion strictly holds only under the usual caveat in SVAR- analysis that the monetary policy shock we consider must be a small one - one that is not allowed to change the policy regime or any other of the structural relations we estimate. Whilst we argue this is precisely the kind of shock that central banks currently inflict on our economies, we should be careful not to conclude that any more aggressive policy changes by central banks to escape the deflationary period of the liquidity trap are doomed to fail. ...

Finally, Bernanke said today that unemployment is still too high, inflation is still too low, QEII appears to be working (though again, what does working mean in terms of solving the big problem we face?), and that QEII will continue. (Wish I had more time to extract some of this, but I need to go find the gate for my flight, so I'll have to leave it to you.)

Update: Ryan Avent argues that a 1.5% change over such a long time period --around two years -- is, in fact, "working." Again, under my definition of what working means, this (less than 30,000 jobs per month) is far from fast enough and clearly indicates that the unemployment problem could use more help (and that help should already be in place) -- my main point. Ben Bernanke says it will be "several years" yet until unemployment returns to normal even with QEII. That is far from getting people working fast enough under any reasonable definition. Call that "working" if you like, but I don't see it that way.

Update: A few more comments from my oh so comfortable seat on the plane (writing this is supposed to take my attention away from the crying baby and the jabbing elbow next to me -- grrr -- both irritated and distracted as I try to write).

I am not saying that QEII did nothing, was worthless, anything like that. I'm just disappointed to see people patting the Fed on the back for a job well done when the Fed's actions were both far too late and far too small (why settle for 1.5% reduction in unemployment if inflation is not a worry? Why wait until after the election to do this when we knew unemployment was a problem long, long before that?). Furthermore, with the unemployment problem expected to persist for years yet, we have to worry that this optimism will translate into deficit reduction and interest rate increases that come far too early and create yet another headwind working against the millions seeking work. My reactions are partly conditioned on that worry. All along I've been arguing that the Fed could not put the unemployment rate on a satisfactory trajectory by itself, and Bernanke's comments about having years yet until unemployment returns to normal reinforces that view. Like the Fed, but even more so, Congress needed to do more than it has done, and do it much sooner. But that didn't happen. Yes, we got a bit more recently, and I am happy about that -- better than nothing -- but it's much too little and much too late relative to the optimal response.

I am very pleased that 700,000 more people will have jobs as a result of the Fed's actions in QEII (and the total QE affects were even larger, the 700,000 is only for QEII). But with millions and millions out of work still, I am not going to settle for this, say great job, pat the Fed and Congress on the back, and move on to other things (and it's important to realize the forecast for a 1.5% reduction is from model based simulations and hence there is quite a bit of uncertainty surrounding the forecast -- yet another reason not to relax just yet). It's time to keep pushing for more, we have years ahead of us before we are back to normal. If that means I'll have a hard time saying good job when perhaps it's warranted, and I will, so be it.

Ah, the cabin is a bit quieter. Yahoo.

Monday, January 31, 2011

Paul Krugman: A Cross of Rubber

Central bank authorities should not give in to demands for higher interest rates:

A Cross of Rubber, by Paul Krugman, Commentary, NY Times: Last Saturday, reported The Financial Times, some of the world’s most powerful financial executives were going to hold a private meeting with finance ministers in Davos... The principal demand of the executives ... would be that governments “stop banker-bashing.” Apparently bailing bankers out after they precipitated the worst slump since the Great Depression isn’t enough — politicians have to stop hurting their feelings, too.
But the bankers also had a more substantive demand: they want higher interest rates ... because they say that low rates are feeding inflation. And what worries me is the possibility that policy makers might actually take their advice.
To understand the issues, you need to know that we’re in the midst of ... a “two speed” recovery, in which some countries are speeding ahead, but ... advanced nations — the United States, Europe, Japan — have barely begun to recover. ... To raise interest rates under these conditions would be to undermine any chance of doing better; it would mean, in effect, accepting mass unemployment as a permanent fact of life.
What about inflation? High unemployment has kept a lid on the measures of inflation that usually guide policy. ... But food and energy prices — and commodity prices in general — have ... been rising lately. Corn and wheat prices rose around 50 percent last year; copper, cotton and rubber prices have been setting new records. What’s that about?
The answer, mainly, is growth in emerging markets ... — China in particular — ... has created ... sharply rising global demand for raw materials. Bad weather ... has also played a role in driving up food prices.
The question is, what bearing should all of this have on policy at the Federal Reserve and the European Central Bank? First of all, inflation in China is China’s problem, not ours. ... Neither China nor anyone else has the right to demand that America strangle its nascent economic recovery just because Chinese exporters want to keep the renminbi undervalued.
What about commodity prices? The Fed normally focuses on “core” inflation, which excludes food and energy... And this focus has served the Fed well in the past. ... It’s hard to see why the Fed should behave differently this time...
So why the demand for higher rates? Well, bankers have a long history of getting fixated on commodity prices. Traditionally, that meant insisting that any rise in the price of gold would mean the end of Western civilization. These days it means demanding that interest rates be raised because the prices of copper, rubber, cotton and tin have gone up, even though underlying inflation is on the decline.
Ben Bernanke clearly understands that raising rates now would be a huge mistake. But Jean-Claude Trichet, his European counterpart, is making hawkish noises — and both the Fed and the European Central Bank are under a lot of external pressure to do the wrong thing.
They need to resist this pressure. Yes, commodity prices are up — but that’s no reason to perpetuate mass unemployment. To paraphrase William Jennings Bryan, we must not crucify our economies upon a cross of rubber.

Saturday, January 29, 2011

Divine Coincidence and the Fed's Dual Mandate

John Taylor says the Fed should adopt a single mandate. In his view, which seems to be fairly common on the political right, the Fed should abandon targeting the output gap and restrict its attention it keeping the inflation rate stable:

Former U.S. Treasury Department undersecretary John Taylor on Wednesday called for overhauling the Federal Reserve’s dual mandate of ensuring stable prices and maximum employment, saying that the central bank should focus on prices.
“It would be better for economic growth and job creation if the Fed focused on the goal of “long run price stability within a clear framework of economic stability,’” Taylor told the House Financial Services Committee. ...
Taylor said that “too many goals blur responsibility and accountability.” ...

Robert Barbera, a fellow at John Hopkins, sends an email making the case that a single mandate is a bad idea, particularly near the zero bound. It is based upon an IMF paper showing that deflation does not generally occur when there are large output gaps. Instead, downward price and wage rigidities cause inflation to stabilize at low rates, and this is part of the reason for a suboptimal response under a single mandate.

Note that the term "divine coincidence" used in the email refers to a situation where stabilizing inflation is the same as stabilizing output. When particular assumptions are imposed on theoretical NK DSGE models, there is no difference in terms of household welfare between a single and a dual mandate. Unfortunately, the assumptions that are required for the existence of divine coincidence are relatively strict and we shouldn't expect it to hold generally. (The wide adoption of a single mandate in Europe is due, in large part, to the difficulties of targeting output gaps when multiple countries are involved. Thus, it's based more on politics than on economics. Suppose, for example, that Germany is doing well and does not favor expansionary policy, but Ireland is struggling and wants help. Whose interests should prevail?).

Here's Robert's email:

IMF did a bang up working paper on Persistent Large Output Gaps, looking at 20 or so nations over 30 years. A super short version of their conclusions? PLOGS weigh on price pressures for years, even amid strong recoveries--a standard Keynesian conclusion. Two, PLOGS lose much of their deflationary power, the closer inflation gets to zero--a not so common conclusion. It seems slowing pay and price increases is much easier than actually cutting wages and prices...
Now imagine a two nation world near zero inflation amid PLOG circumstances. Imagine further that one nation has a dual mandate and the other is an inflation targeter. What happens?
The dual mandate CB sees high joblessness keeps pedal to the metal till strong growth arrives. The other CB fails to see deflation appear and therefore is less stimulative. As the big ease in nation #1 succeeds, stronger growth lifts it's currency. A touch of adverse terms of trade lifts price pressures in nation #2 just enough to confirm, in the CB inflation nutter one track minds, that they are doing "the right thing". They stick to their guns, and over time cyclical joblessness becomes structural. In other words, they are unwitting agents of hysteresis.
Thus the divine coincidence categorically fails amid near zero inflation. More to the point, single focused CBs are quite likely to pursue suboptimal policy.

The argument is not that the Fed will remain passive under a single mandate. When inflation is below target -- as it would be near the zero bound -- there is still a response from the Fed. The Fed will still try to hit its inflation target and hence should ease up. However, because the Fed pursues a single rather than a dual target, and because of the effects on the terms of trade, the response will be smaller than it would be under a dual mandate, and hence suboptimal (there is a result in the background showing that the variance of output is lower under the dual mandate unless, again, restrictive assumptions are made).

Note: A good description of the special conditions that are needed for divine coincidence comes from this paper by Jordi Gali and Olivier Blanchard:

...In this paper, we show that this divine coincidence is tightly linked to a specific property of the standard NK model, namely the fact that the gap between the natural level of output and the efficient (first-best) level of output is constant and invariant to shocks. This feature implies that stabilizing the output gap the gap between actual and natural output is equivalent to stabilizing the welfare-relevant output gap the gap between actual and efficient output. This equivalence is the source of the divine coincidence: The NKPC implies that stabilization of inflation is consistent with stabilization of the output gap. The constancy of the gap between natural and efficient output implies in turn that stabilization of the output gap is equivalent to stabilization of the welfare-relevant output gap.
The property just described can in turn be traced to the absence of non trivial real imperfections in the standard NK model. This leads us to introduce one such real imperfection, namely real wage rigidities. The existence of real wage rigidities has been pointed to by many authors as a feature needed to account for a number of labor market facts (see, for example, Hall [2005]).We show that, once the NK model is extended in this way, the divine coincidence disappears.
The reason is that the gap between natural and efficient output is no longer constant, and is now affected by shocks. Stabilizing inflation is still equivalent to stabilizing the output gap, but no longer equivalent to stabilizing the welfare-relevant output gap. Thus, it is no longer desirable from a welfare point of view. ...

Suppose, for example, that firms have market power. Then the natural rate of output will be lower than the welfare maximizing level (because market power leads to lower output and higher prices than is socially optimal). So long as the gap between the two stays constant, then divine coincidence will exist. However, it is very easy to make this gap variable and, in fact, realism within our models demands it (divine coincidence can fail for reasons besides a variable gap due to wage rigidities, so this does not exhaust the resons why divine coincidence can fail).

Thus, theory tells us that a single mandate is a bad idea except under conditions that are unlikely to exist. Since the conditions are special, and since inappropriately adopting a single mandate leads to too much unemployment and potential hysteresis, the burden of proof that the special conditions required for a single mandate are present, at least approximately, is on the proponents of the single mandate -- and they simply have not made the case.

Update: I forgot that Paul Krugman wrote about "PLOGS" in August:

The Price Stability Trap, by Paul Krugman: There’s an important new paper from the IMF about inflation in the face of Prolonged Large Output Gaps — yes, PLOGs. You can think of it as a careful, multi-country version of the quick-and-dirty analysis of US experience I did recently, with an assist from Tim Duy. What the analysis shows is that prolonged periods of economic weakness are, with almost no exceptions, associated with falling inflation rates.

The analysis also suggests something else, however: as the inflation rate goes toward zero, it seems to become “sticky”: in the modern world, rapid deflation doesn’t happen, and in fact slight positive inflation often persists in the face of an obviously depressed economy:


The authors discuss several possible explanations, but it does seem as if downward nominal rigidity is playing a role.

And this raises the specter what I think of as the price stability trap: suppose that it’s early 2012, the US unemployment rate is around 10 percent, and core inflation is running at 0.3 percent. The Fed should be moving heaven and earth to do something about the economy — but what you see instead is many people at the Fed, especially at the regional banks, saying “Look, we don’t have actual deflation, or anyway not much, so we’re achieving price stability. What’s the problem?”

And the slump will just go on.

Wednesday, January 26, 2011

The FOMC Keeps the Federal Funds Rate and QEII Unchanged

A quick reaction to the FOMC's decision to maintain current policy objectives. There wasn't much to say -- the Fed did just as expected -- but I said it anyway:

The FOMC Keeps the Federal Funds Rate and QEII Unchanged

Update: From Tim Duy:

Quick FOMC Response, by Tim Duy: The FOMC statement was largely as expected – sticking to the current policy path. That means maintaining the current asset purchase program while holding interest rates low for an extended period. Some specifics:

No Dissents: Kansas City Fed President Thomas Hoenig is no longer a voting member, and none of the new voting members took up his dissent. Completely unsurprising. While some policymakers such as Philadelphia Fed President Charles Plosser believe that QE2 was a mistake, they see the costs –market disruption and loss of credibility – of undoing that mistake as greater than the benefits.

Additional Flexibility: Note the change in the first sentence. From:

Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment.
Information received since the Federal Open Market Committee met in December confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring about a significant improvement in labor market conditions.

A focus on a specific data point – unemployment – was replaced with the more general “labor market conditions.” This could signal a willingness to roll back the balance sheet expansion if nonfarm payrolls were growing rapidly but, as workers return to the labor force, unemployment rates remain persistently high. I have difficulty seeing the Fed raise rates as long as unemployment is high, but a return to allowing the balance sheet to contract naturally or directly would not be out of the question.

Commodity Prices: As expected, the FOMC is not poised to follow the path of ECB Head Jean-Claude Trichet and fret about headline inflation. In contrast, the FOMC will focus on the pass-through to core inflation, if any, and the path of longer term inflation expectations.

Bottom Line: No real surprises in this FOMC statement, with the exception of a slight change in language on labor markets that suggests an effort to create additional flexibility.

Tuesday, January 25, 2011

Fed Watch: The “Recalculating” Debate

Tim Duy:

The “Recalculating” Debate, by Tim Duy: The fundamental nature of the recession continues to be debated – a debate with important policy consequences. Is the recession the consequence of a general aggregate demand deficiency, or is it a structural consequence of the housing bubble? If the former, the policy approach should be to support aggregate demand via a combination of fiscal and monetary policy. If the latter, only time will resolve the challenge, and aggressive policy will only lead to inflation.

David Beckworth and Ryan Avent provide nice summaries of the nature of the debate. Paul Krugman argues that the answer is obviously a demand shortfall, and bemoans:

Now, however, we’re seeing a much more widespread attack on demand-side economics. More than that, it’s becoming clear that many people don’t so much disagree with the idea that demand matters as find it abhorrent, incomprehensible, or both.

Nick Rowe offers an alternative explanation:

For decades my job has been to teach students that, despite the evidence of their senses, and contrary to their hearsay of the heretical teachings of the Keynesian Cross, aggregate output is basically supply-determined. Which it is. Basically. Though short-run fluctuations in demand can and will cause short run fluctuations in aggregate output around an average level that is determined by the supply-side.

And, for once, the memories of their parents are actually supporting me in my job. Look what happened in the 1970's, when demand increased. Printing too much money and increasing demand really did cause inflation. It really didn't make us all richer. It didn't reduce unemployment.

Now, just for once, we have to switch gears. These times are not normal. Just for once, the demand side really is the problem. Just for once, the overly obvious truth your senses are telling you really is the truth. Just for once, your parents' experience of the 1970's doesn't apply. Just for once, it really is OK to have a drink, even though you are a recovering alcoholic.

In some sense, economists diluted the reasoning of demand side macroeconomics with a focus on supply side factors. The Great Moderation only served to entrench the supply side view – after all, by the late-90’s I recall articles suggesting that we had conquered the business cycle. Demand side fluctuations had become a thing of the past.

I would offer another observation. I agree that the issue is a shortfall in demand. And not just for this recession, but arguably the entire last decade. That said, I think it is easy to lose sight of this demand shortfall in light of another feature of the past two business cycles. Both appear to have been inexorably connected to asset price bubbles, first in information technology and then in housing:


Supporting sufficient aggregate demand to maintain full employment looks to have required supporting relative levels of net worth well above a decades-long baseline. And pushing net worth to those levels was a consequence of asset price bubbles. Hence, it appears that the demand generated by that wealth was “fake.” Moreover, that “fake” demand arguably induced a supply side effect by pushing capital first into information technology and then into housing. To be sure, ultimately the impacts of such capital misallocations will fade away. Information technology depreciated rapidly, and the excess housing stock will eventually be absorbed by a growing population. It is not quite obvious, however, why this adjustment needs to extend to such a large portion of the workforce. The answer, I think, is not the housing adjustment itself, but the loss of general demand precipitated by the housing decline and subsequent balance sheet malaise.

The wealth-supported demand surely was not “fake,” as real goods and services were indeed purchased. But it was ephemeral, evaporating with the popping of bubbles. So it should be of little surprise the Federal Reserve is viewed by some as doing nothing more than supporting another round of “fake” demand. Fed officials probably compound this problem by citing the stock market increase as evidence that QE2 is working. Via the Wall Street Journal:

In recent weeks, the Federal Reserve has been turning to an unusual metric to prove the potency of its bond-buying program: the stock market.

Comments from Fed Chairman Ben Bernanke and other officials, as well as research by the central bank, cite rising stock prices as a sign that the central bank’s $600 billion bond-buying program is working to bolster the economy.

Of course, it is perfectly reasonable for officials to note that high equity prices signal improving economic prospects, the latter a consequence of their policy stance. Some, however, may interpret this as further evidence that the Fed is simply trying to create another asset price bubble, which will, if history is any guide, will also prove to be fleeting. The resulting aggregate demand will then be viewed as “fake.” In this light, the Federal Reserve is not really fixing anything, just papering over the underlying problem.

In short, I appreciate hesitation to embrace “more money” as a solution when it appears that “more money” was part of the problem. Indeed, I used to be more sympathetic to that notion than I am now.

But what exactly is the underlying problem? Or is there an underlying problem? I don’t know that we have agreement on that. Why was the US economy dependent on asset bubbles to spur demand over the past decade, and will the same be true for the next decade? Is the Fed’s current policy stance destined to fuel another bubble? I don’t think that is a excuse to forego monetary and fiscal support – the alternative of ongoing high unemployment is not particularly enticing – but I think we would all feel a bit more comfortable if the next decade sees robust growth without an asset price bubble.

Are Low Rates A Subsidy to Banks?

Paul Krugman responds to (and disagrees with) Axel Leijonhufvud:

Are Low Rates A Subsidy to Banks?, by Paul Krugman: Mark Thoma sends us to Axel Leijonhfvud, who declares that

The Fed is supplying the banks with reserves at a near-zero rate. Not much results in bank lending to business, but banks can buy Treasuries that pay 3% to 4%.

This hefty subsidy to the banking system is ultimately borne by taxpayers. Neither the subsidy, nor the tax liability has been voted for by Congress.

This is a common view. But it misses the key point, which is maturity: short-term rates are near zero, while those 3-4 percent Treasuries are long-term.

Here’s a stylized picture:


Short rates will (and should) remain low until the economy recovers substantially; thereafter, they’ll rise as we get closer to full employment. Long-term rates are, to a first approximation, the average future expected short-term rate — because investors choose whether to park their funds short-term or buy long bonds based on which they think will yield more over the next 10 years.

So what can we say about a bank that gets short-term deposits or loans and puts the money into long-term Treasuries? Yes, it’s earning more interest now than it’s paying. But it’s also tying up funds in long-term assets; if and when short rates rise, it will either find itself paying more interest than it receives, or have to sell those long-term bonds at a capital loss. There’s no subsidy here.

Now, there is a question about reported earnings: do rosy numbers on bank earnings take into account the likely future losses on those long-term bonds? I suspect not, or at least not sufficiently — which means that reports of the revival of the financial sector are exaggerated, as are bonuses. But that misreporting is the issue — not the alleged subsidy to the banks.

"Zero-Interest Policies as Hidden Subsidies to Banks"

Axel Leijonhufvud argues that political independence of central banks is "impossible to defend in a democratic society":

Shell game: Zero-interest policies as hidden subsidies to banks, by Axel Leijonhufvud, Vox EU: The two pioneers of modern monetary economics – Irving Fisher and Knut Wicksell – were passionately concerned to find monetary arrangements that would insure against arbitrary redistributions of income and wealth. They saw such distributive effects as offenses against social justice and consequently as a threat to social and political stability. 

Fisher and Wicksell thought that price level stability was a sufficient condition for avoiding distributive effects. In this they were in error. A hundred years later, the motivating concern for their work has long since disappeared from monetary economics.

But the error survives. For example:

  • The Fed is supplying the banks with reserves at a near-zero rate. Not much results in bank lending to business, but banks can buy Treasuries that pay 3% to 4%.
  • This hefty subsidy to the banking system is ultimately borne by taxpayers. Neither the subsidy, nor the tax liability has been voted for by Congress.

The Fed policy drives down the interest rates paid to savers to some small fraction of 1%. At the same time, banks leverage their capital by a factor of 15 or so, thus earning a truly outstanding return from buying Treasuries with costless Fed money or very nearly costless deposits.

Wall Street bankers are then able once again to claim the bonuses they became used to in the good old days and to which they feel entitled because of the genius required to perform this operation. These bonuses are in effect transfers from tax-payers as well as from the mostly aged savers who cannot find alternative safe placements for their funds in retirement.

The shell game: “Now you see it, now you don’t.”

The Fed’s low-interest-rate policy has turned into a shell game for the general public who are unable to follow how the money flows from losers to gainers.

  • The bailouts of the banks during the crisis were clear for all to see and caused widespread outrage; now the public is being told that they are being repaid at no cost to the taxpayer.
  • What the public is not told is that the repayments come to a substantial extent out of revenues paid by taxpayers for the banks to hold Treasuries.
  • Both parties supported the bailouts so neither party seems ready to protest the claim that they are being repaid at no cost to taxpayers.

The goals of monetary policy

Present monetary policy achieves two aims.

  • One is to recapitalize the banks and to do so without the government taking an equity stake.

The authorities do not want to be charged with “nationalization” or “socialism.” So the banks have to be given the funds outright. Economists have agonized a lot lately about the zero lower bound to the interest rate as an obstacle to effective policy in the present circumstances. The agony seems misplaced. As long as the big banks are to be subsidized, why not just pay them to accept reserves from the friendly central bank?

  • The second aim, of course, is to prevent the housing bubble from deflating all the way.

In this respect, the policy has had some effect. Homeowners whose houses are not “under water” can often refinance at long-term rates around 5% and sometimes even lower. 

Miscalculation of economic values: Who pays?

Any financial crash reveals a large, collective miscalculation of economic values. The incidence of the losses resulting from such miscalculations has to be worked out before the economy can begin to function normally again. Because the process of a crash is unstable, it cannot be left for the markets and bankruptcy courts to work out the eventual incidence. In the present case, doing so would simply have led into another Great Depression.

This means political choices have to be made to determine who bears the losses from this collective miscalculation. Obviously such choices are terribly difficult. Yet, temporizing can prolong the period of subnormal economic performance indefinitely – as the history of Japan over the last 20 years illustrates. The shell game, as presently played, is in effect an attempt to settle a large part of the incidence problem “under the radar” of public opinion.

The risks of this quiet bank subsidy

Quite apart from its distributional effects, the policy is not without risk.

  • To the extent that it succeeds in inducing the banks to load up on long-term, low-yield assets, a return to more normal rates will spell another round of banking troubles.

If the US were to suffer years of slow deflation, a return to higher rates will be long postponed. At present, strong deflationary pressures are kept at bay by equally strong inflationary policies. If the US escapes the Japanese syndrome, the Fed will sooner or later have to raise rates to stem inflation or to defend the dollar.

Central Bank independence?

For the last 20 or 30 years, political independence of central banks has been a popular idea among academic economists and, of course, heartily endorsed by central bankers. Such independence has not been much in evidence in the recent crisis. But central banks would very much like to restore their independence.

The independence doctrine, however, is predicated on the distributional neutrality of their policies. Once it is realized that monetary policy can have all sorts of distributional effects, the independence doctrine becomes impossible to defend in a democratic society.

Monday, January 24, 2011

Fed Watch: Inevitable Inflation Fears

Tim Duy notes rising concern about inflation from hawkish central bankers in Europe and elsewhere, and the tension that is building "as emerging markets fight the Fed":

Inevitable Inflation Fears, by Tim Duy: The Wall Street Journal is reporting that ECB head Jean-Claude Trichet is turning increasingly hawkish:

Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent's debt crisis.

In an interview with The Wall Street Journal ahead of this week's annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don't gain a foothold in the global economy…

An interesting development in light of the ongoing (or is it never ending?) European Debt Crisis. Rate hikes will just be adding insult to injury for the peripheral nations already struggling with a debt-deflation spiral. The price for being part of the Euro just keeps getting higher.

Inflation fears have yet to grip the Federal Reserve, for good reason. Back to the Wall Street Journal:

While high unemployment and spare capacity are restraining underlying inflation pressures in the U.S. and elsewhere in the developed world, annual inflation in China is almost 5%—and a sizzling 9.8% economic growth rate in the fourth quarter triggered fears of more price pressures ahead. Inflation in Brazil is even higher.

The next inflation crisis is not occurring in the US, as opponents of QE2 thought likely, but in the developing markets instead. To be sure, my sympathy for developing nations wore thin long ago. They will identify the Federal Reserve as the proximate cause of their problems, whereas they have only themselves to blame. Higher inflation abroad was the only outcome if the protocols of Bretton Woods II did not submit to the onslaught of QE2. And the Federal Reserve has very good reason to keep the pedal to the medal. A review of recent inflation behavior:

If inflation abroad is a problem, it is not because the Federal Reserve has set rates too low, but because emerging markets been unwilling to allow their currencies to appreciate sufficiently against the Dollar. See, for example, recent Dollar buying on the part of Brazil. See also Paul Krugman, who illustrates the clear difference in emerging and developed nation industrial production trends. Again, if inflation abroad is a problem, it is one that emerging markets need to tackle themselves.

Expect global tensions to continue building as emerging markets fight the Fed. While the Fed may identify higher commodity prices as a potential concern, policymakers are not likely to reverse course and tighten policy unless higher commodity prices push through to core inflation. Such an outcome appears unlikely given persistently high unemployment. Consider too that the likely outcome of rising commodity prices is to slow US growth, thereby decreasing the odds of pass-through to core.

I have said this before – I do not see how this ends well. Given that the Fed is not likely to back down from this fight, emerging markets need to put the brakes on their internal inflation issues, the sooner the better. Otherwise they will be facing pain of a real inflation crisis, one that requires stepping on the brakes even harder. How this story unfolds this year will determine of the global economy can transition to a sustainable, balanced growth trajectory, or plunges into yet another of the seemingly all-too-frequent crises.

Sunday, January 16, 2011

Fed Watch: Housing and the Fed in 2005

Tim Duy:

Housing and the Fed in 2005, by Tim Duy: The Federal Reserve released the 2005 FOMC transcripts this week. Attention quickly turned to the Fed's view of the growing housing bubble. Calculated Risk finds some very prescient warnings from then Atlanta Fed President Jack Guynn, who describes housing as an "accident waiting to happen." Bloomberg continues with the obvious path of criticism:

Federal Reserve staff and policy makers identified a housing bubble in 2005 and failed to alter a predictable path of interest-rate increases to slow down the expansion of mortgage credit, transcripts from Open Market Committee meetings that year show.

Led by then-Chairman Alan Greenspan, the FOMC raised the benchmark lending rate in quarter-point increments to 4.25 percent from 2.25 percent at the end of December 2004. The committee also removed uncertainty about the pace of rate increases by telegraphing that future moves would be “measured” in every statement.

The “measured” pace language helped fuel the housing boom by keeping longer-term interest rates low and was inappropriate at the time given the uncertainties about both inflation and asset prices, said Marvin Goodfriend, a professor at Carnegie Mellon University in Pittsburgh.

“It was a major mistake of the Fed,” said Goodfriend, who attended some of the 2005 meetings as a policy adviser to the Richmond Fed. “It gave markets a sense that the Fed was on top of everything to a degree that wasn’t the case. It gave the impression that this was a mechanical adjustment to normality. The market was overconfident.”

David Beckworth follows up:

With the release of the 2005 FOMC transcripts we learn that the Fed was aware of the housing boom but failed to alter monetary policy. Among other damning evidence, we find this gem in the December 2005 FOMC meeting. It shows the real federal funds rate compared to the Fed's estimate of the equilrium or neutral real federal funds. There is a striking gap that emerges during the early-to-mid 2000s. This indicates the Fed was highly accommodative and aware of it.

The problem with this criticism is that it fails to capture the implications of the low interest rate environment for the economy at large. Andy Harless, in a response to Beckworth, beats me to the punch:

I just don't get how this Fed-too-easy story is consistent with the data on NGDP growth. From 2001 to 2006, NGDP grew at an annual rate of 5.3%. That's actually slightly slower than the prior 5 year period (5.4%) or the 5 years before that (also 5.4%). If the Fed was too easy in 2002-2003, then that period should have been followed by a huge boom in NGDP. It wasn't. All that happened was that NGDP grew (almost) fast enough (about 6% annually) to make up for the slow growth during the recession and the year of weak recovery that followed. As far as I can tell, the data vindicate the judgment of Fed officials who ignored the model-based estimates.

Looking back at the path of nominal GDP over the last decade:


Considering the path of employment, output, and prices, I have difficulty arguing that the level of rates was significantly wrong. I tend to think that regulatory failure was the primary Fed error - if the Fed realized the housing market was evolving into a bubble, shouldn't they have been more focused on the kind of mortgage lending that was taking place? Shouldn't, in their jobs as banking regulators, made more aggressively us of stress tests before housing prices began to melt? More directly, from a regulatory perspective, the Fed simply lost view of its societal function. Via Rajiv Sethi:

But even in our very imperfect world, might we not have been able to stabilize output and employment by returning quickly and forcefully to the original mandate of the Federal Reserve, to channel credit preferentially to productive uses?

The Fed was probably too captured by a free markets ideology to seriously question the wisdom of channeling so much capital into housing, which was really less about capital investment and more about consumption. And, in their defense, attempting to direct capital flows is indeed tricky business fraught with peril. But allowing everybody and their cousin to get a half million dollar mortgage with no income documentation? Addressing that issue seems like it should have been doable.

Still, rather than lay all the blame at the feet of monetary policymakers, I think the real question we still need to resolve is more fundamental. Turning the question around, why did the US economy struggle so dramatically this decade that the Fed was pushed into a very low interest rate environment? The jobs record is simply unprecedented - a decade with no job growth. To what extent are domestic policymakers to blame? And was it domestic policy at all? I don't recall the 1970's as a policy paradise, but at least jobs were created over that decade. Answers will vary; mine is that US policymakers across the ideological spectrum allowed and even supported the pursuit of foreign nations' mercantilist policies on a unprecedented scale, thereby distorting global patterns of production and consumption in a way that fundamentally hobbled the US economy. If this is true, how can we chart a path back?

In short, I think we need to understand why the last decade was jobless - it is tempting to blame the Fed, but the story is likely deeper. Until we do, I don't think I can definitively say the next decade will be any different.

Friday, January 14, 2011

Fed Watch: A Mixed Bag of Data

Tim Duy:

A Mixed Bag of Data, by Tim Duy: Today's data flow suggests ongoing expansion, but should also send a note of caution. Industrial activity continues to respond to firming demand, but capacity has yet to show solid gains. Firms are still not sufficiently confident, or lack sufficient demand, to justify widespread investment. Similarly, consumer spending continues along its upward trend, although the increase in energy costs are likely constraining the pace of that growth and keeping a lid on consumer confidence. Something of a mixed bag largely consistent with the general consensus view.

Start with the better than expected industrial production report, via Bloomberg:

Industrial production in the U.S. rose in December more than forecast, boosted by gains in business equipment and home electronics that indicate factories remain at the forefront of the recovery as the new year begins.

Output at factories, mines and utilities climbed 0.8 percent, the most in five months, after a revised 0.3 percent increase in November, figures from the Federal Reserve showed today in Washington. Economists forecast a 0.5 percent gain, according to the median of 82 projections in a Bloomberg News survey. Manufacturing climbed 0.4 percent, and utility output increased 4.3 percent as snowstorms swept parts of the nation.

I have taken to looking at the capacity data for signs of a solid, self-sustaining recovery. Here we see the most tentative signs of improvement, or at least stabilization:


Looking back at the decade, capacity gains really took hold in late-2004 as the economy finally shook off the post tech-bubble doldrums on the back of the building housing bubble:


Before one gets too excited at the possibility, we can take a look back at the pace of progress during the 1990s.


We should be hoping for a recovery more like the 1990s than the 2000s, but it is challenging to find a story that allows for that kind of growth. I am not even sure how we get the recovery of the 2000s without an asset price bubble.

Moving on to retail sales, the numbers fell short of the outsized expectations that developed in the run up to the Christmas season. Still, the overall trend looks intact:


That said, I think you get a cleaner picture of underlying consumer trends by stripping out auto related sales:


Here the rebound looks less impressive, but the trend remains in the right direction. That said, there was a noticeable decline in the rate of monthly growth during the final quarter, 0.77%, 0.59%, and 0.36% for October, November, and December, respectively. I think it is safe to say that the consumer has some momentum, especially with rising nonfarm payrolls, but higher energy prices are likely to constrain the pace of growth going forward.

Similarly, rising energy costs were a culprit behind the decline in consumer confidence. And those higher costs clearly showed up in the consumer price index. Bloomberg has a curious introduction:

The cost of living in the U.S. climbed more than forecast in December, led by higher fuel and food prices, while other goods and services showed the smallest annual increase on record.

Looking at the the CPI release, one gets something of a different story:

The energy index increased in December. The gasoline index rose sharply and accounted for about 80 percent of the all items seasonally adjusted increase. The household energy index, which declined in November, increased as well. The food index increased slightly in December, with the fruits and vegetables index rising notably.

The headline increase was driven by energy, not food as Bloomberg reports. Core prices increased just 0.1% for the month and 0.8% compared to last year. So far, higher energy/commodity prices have yet to work their way through to final prices, not surprising given persistently weak labor markets and consistent with the Beige Book story.

Finally, Richmond Fed President Jeffrey Lacker offered up the possibility of reviewing the large scale asset purchases:

“While the outlook may not have improved enough yet to warrant adjusting our purchase plans in the near-term, I anticipate earnest re-evaluation as economic developments unfold in the months ahead,” Lacker said today in prepared remarks of a speech in Richmond, Virginia.

I am not surprised that some policymakers would point to better data as a reason to reevaluate the program. But I would think about the timeline on this. Lacker says describes the process in the months ahead. But how many months do we have left? The current program is expected to end by the second quarter of this year, just about 5 months. Unless growth explodes, by the time FOMC members would feel comfortable disrupting the plan, it will be almost complete anyway. Even other traditionally hawkish policymakers expect the plan to concluded as planned.

Bottom Line: Data generally in line with a sustainable growth, but expectations that the economy is about to take off remain premature. Inflation fears still appear overblown given that inability to pass higher commodity prices through to consumers. Energy prices, however, do appear to be constraining consumer spending. Overall better data will continue to be reflected in Fedspeak, but time is running short to change the current asset purchase program.

Fed Watch: Shifting to Autopilot

Tim Duy:

Shifting to Autopilot, by Tim Duy: Incoming data this week suggest the US economy continues to meander on its upward path, albeit at a rate that is decisively lackluster, at least relative to the magnitude of the output gap. That path of growth guarantees the Fed completes the current large scale asset purchase program. But soon we will have to turn our attention to what comes next. The baseline scenario is that the Fed holds pat - holding the balance sheet steady for the remainder of 2011, a scenario endorsed by at least two policymakers this week. Still, we should continue to challenge this assumption. Considering the expected slow improvement in labor markets and tame inflation, will the Fed consider extending asset purchases beyond the most recent $600 billion? Probably not.

Thursday we saw some reminders that the path to recovery is not a straight line. First, initial unemployment claims retraced some of the recent declines. Mark Thoma has the story here. To be sure, given the noise in this series, one week of data contains limited information. In general, the downward trend remains intact. Still, it argues against expectations the job market is set to rocket forward.

Housing news continues to tell the same old story. The record level of foreclosures in 2010 is not expected to be a record for long, while more evidence collects that housing prices are still falling. That said, housing is an old story. Nothing to see here folks, please move along.

More importantly, the trade data also was not as supportive as one could hope. While the nominal deficit improved in November, the real deficit deteriorated slightly in contrast to October's significant improvement. Still, barring a surprise deterioration in December, the external accounts should contribute positively to 4Q10 growth. To be sure, this adds to the positive momentum heading into 2011, but one quarter is not enough to break the general downward trend of 2010. The combination of high unemployment and a lack of clear direction on rebalancing of global activity promises to keep the threat of global trade wars alive. US Treasury Secretary Timothy Geithner rattled the sabers this week to keep pressure on his Chinese counterparts. From the Wall Street Journal:

"We are willing to make progress" on issues of interest to China, Mr. Geithner said at Johns Hopkins University's School for Advanced International Studies, "but our ability to move on these issues will depend on how much progress we see from China," including a faster appreciation of the Chinese currency.

To be sure, I question whether Geithner is truly committed to global rebalancing. A reminder from Bloomberg:

U.S. Treasury Secretary Timothy F. Geithner said he has continued to support the strong dollar policy he helped craft in the Clinton administration when he worked for his predecessor Robert Rubin.

“That particular phrase and commitment of policy was first written in my office at the Treasury Department in 1995,” Geithner said today, when asked about the currency during a Senate Finance Committee hearing.

Sorry, don't mean to be skeptical, but I am sensing mixed messages. The resolution, of course, is that the appropriate policy direction is one of managed exchange rate depreciation - no sudden stops of capital, please. On this point, Geithner talks a good game:

Geithner said he agreed that the U.S. needs to show commitment to lowering its deficits over time, to avoid losing the confidence of investors around the world. That could hurt the economy, raise interest rates and reduce investment, the Treasury chief said.

“If we do not make people believe that we are going to fix those deficits, bring them down over time, then we will risk losing confidence in our financial future,” Geithner said.

Something of a Catch-22, I fear. Sustaining confidence in US markets means resolving long term US fiscal issues, but there is no pressing reason to address those issues in the absence of a loss of confidence.

Ultimately, I fear that should the Dollar fall enough to provide a significant boost to the US economy, it will also be enough to rattle Wall Street. I hate to say it, but I suspect should that point be reached, Washington will choose Wall Street over Main Street. Pessimist or realist? Of course, the ongoing European crisis suggests this is not a problem anything soon, as the uncertainty helps prop up the Dollar. I imagine US policymakers are in an uncomfortable place (or at least should be) on that topic. They probably want to see the Euro remain intact, rather than risk the impact of a rapidly appreciating Dollar. Of course, that means forcing a debt-deflation spiral on the periphery nations. Doesn't seem quite right.

Warts aside, forecasters continue to upgrade their expectations for US growth. From the Wall Street Journal:

Economists have steadily grown more upbeat about growth in recent months and boosted their estimates for the fourth quarter of 2010 in this survey. On average, respondents now estimate the U.S. grew 3.3% at a seasonally adjusted annual rate in the fourth quarter—up from an estimate last month of 2.6% growth. The economy grew 2.6% in the third quarter.

Amid the stronger growth forecasts, economists now expect the U.S. to generate nearly 180,000 jobs a month on average this year, significantly more than last year's average of 94,000. But with continued population growth, that isn't nearly enough to quickly bring down the unemployment rate, now at 9.4%. By the end of 2011, the economists, on average, expect the jobless rate to be 8.8%.

Federal Reserve Chairman Ben Bernanke shares a similar view:

“We see the economy strengthening,” Bernanke said as part of a panel discussion on boosting lending to small businesses. “It looks better in the last few months. We think that a 3 to 4 percent-type of growth number for 2011 seems reasonable.”

“Now you’re not going to reduce unemployment at the pace that we’d like it to,” Bernanke said. “But certainly it would be good to see the economy growing. That means more sales, more business for companies of all sizes.”

So, let's establish 3 to 4% as the Bernanke Baseline, which would be above trend growth, but, as Bernanke reiterates, still imply painfully slow improvements in the unemployment rate. Still, above trend it is, and that suggests to me that extending the current asset purchase program would meet a great deal of internal resistance. True to form, Dallas Federal Reserve President Richard Fischer, now a voting member of the FOMC, appears opposed to additional action:

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we have reached our limit. I would be wary of further expanding our balance sheet. But here is the essential fact I want to emphasize today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place...

...the key to correcting the underperformance of the American economy and American job creation does not rest with the Federal Reserve. It is in the hands of those who make fiscal and regulatory policy.

The Fed has reduced the cost of business borrowing to the lowest levels in decades. It has seen to it that liquidity is widely available to banks and businesses. It has kept the economy from deflating and it has kept inflation under control. This has helped raise the economic tide. Recent data make clear that the risks of a double-dip recession and deflation have ebbed and that economic growth and job creation are beginning to flow…

I don’t believe this has much to do with the Fed. None of my business contacts, large or small, publicly held or private, are complaining about the cost of borrowing, the lack of liquidity or the availability of capital. All express concern about taxes, regulatory burdens and the lack of understanding in Washington of what incentivizes private-sector job creation. All are stymied by a Congress and an executive branch that have appeared to them to be unaware of, if not outright opposed to, what fires the entrepreneurial spirit. Many have begun to feel that opportunities for earning a better and more secure return on investment are larger elsewhere than here at home.

Colorful, as always. I have to admit enjoying Fischer's speeches, at least for their entertainment value. Still, he is not immediately worried about inflation:

The policy maker said he saw some evidence that firms are trying to push through price increases, and added commodity prices are on the rise mostly on strong global demand factors. But he also allowed that the Fed’s easy money policy may be contributing to some of the gains. That said, Fisher is not worried about inflation, saying “I don’t see inflation presently” or in the “immediately foreseeable future.” Instead, policy makers’ problem “is getting the economy moving again.”

No time to halt current policy. This repeats the story of the Beige Book:

Most District reports mentioned increasing prevalence of cost pressures but only modest pass-through into final prices because of competitive pressures.

Pushing through hirer prices remains a challenge. Another FOMC member who spoke up on the asset purchase program was now voting member Philadelphia Fed President Charles Plosser:

Charles Plosser, president of the Federal Reserve Bank of Philadelphia, was the latest to signal a desire for continuity from the Fed, even though he is highly skeptical of the program's effectiveness. "I wish we hadn't done it, but that doesn't mean I want to stop it right now," Mr. Plosser said in an interview with The Wall Street Journal...

...In a separate interview with The Wall Street Journal, Mr. Fisher said, "I would not have voted for QE2 had I been a voting member" last year.

Neither Fischer nor Plosser would be willing to call an end to the current program, but with growth above trend, both would likely dig in their heals against additional action. I don't think they would be alone. Remember, the Fed was hesitant to act further last summer, clinging to forecasts of solid growth. It was only the mid-year slowdown and its threat of a double-dip that pushed them into action. If Bernanke's current forecast is realized, it is difficult to see where the support would come from to prompt another round of easing.

Bottom Line: The data still is not perfectly clean. That said, forecasts for 2011 are firming, both within and outside the Fed, and pointing toward above trend growth. Nothing spectacular, to be sure, which will keep up the pressure on the Administration to address high unemployment. That promises continued verbal support of external rebalancing from Treasury. On the monetary front, Bernanke will have plenty of support to continue the current policy, but the FOMC will be wary about further easing. At the same time, the current constellation of growth, inflation, and unemployment rates argues against any tightening in the near term. Policy is thus likely to shift to autopilot.

Monday, January 10, 2011

Arizona Shooter's Obsession with Returning to the Gold Standard

The editors at CBS MoneyWatch asked my to discuss Jared Lee Lougher's views on the gold standard, and whether his call to return to the gold standard is entirely crazy. They thought that there might be "value in giving some context on his views and noting that he's not alone in holding them":

Arizona Shooter's Obsession with Returning to the Gold Standard

Fed Watch: Are Oil Prices About to Undermine the Recovery?

Tim Duy:

Calculated Risk directs us to an LA Times story identifying the possibility that rising gasoline prices will undermine the recovery. He also reminds us that James Hamilton recently wrote on the subject as well, concluding:

I could certainly imagine that an abrupt move up in gasoline prices from here could hurt the struggling recovery of the domestic auto sector and dampen overall consumer spending. I do not think it would be enough to give us a second economic downturn, but it could easily be a factor reducing the growth rate.

I would add that the current price appears inline with the general upward trend since the beginning of last decade. Here I extrapolated on the 2000-2006 trend:

New Picture
The sudden rise in oil in 2007, a clear deviation from the trend in the first half of the decade, led to substantial demand destruction, a severe blow to the US economy which at the time was struggling under the weight of the housing meltdown and the financial crisis (and arguably still is). The recent rise in oil appears different, more a reestablishment of the previous trend.

From this point on, I tend to think the issue is less of will oil continue to rise, but at what speed will it rise. The trend over the last decade appears to make a lie of recent claims that we have entered into a period of plentiful energy (see also James Hamilton), and while higher oil prices will tend to crimp growth, a gradual price increase should allow for non-disruptive adaptation on the part of economic agents.

What I more concerned with is the possibility of another sharp spike in prices, such as occurred in 2007-08. A repeat of that incident would once again cripple households, who, after 18 months of recovery, are just barely starting to see the light. The most obvious channel to trigger such a spike is monetary, that the Federal Reserve's large scale asset purchases trigger a disruptive decline in the Dollar. Federal Reserve Chairman Ben Bernanke was not buying that story last week. From the Wall Street Journal:

Mr. Bernanke says his quantitative easing policy is not to blame for the sharp increase in the price of oil. Instead, oil’s rise is the result of strong demand from emerging markets. The dollar, he notes, has been “quite stable” in the past few months. One worry in the run up to the Fed’s $600 billion bond-buying announcement in November was that it was going to cause the dollar to fall sharply, which would in turn put upward pressure on commodities like oil priced in dollars. The stable dollar, which has risen since the program’s announcement, implies the Fed isn’t the problem in commodities markets, Mr. Bernanke notes.

Movements in commodity prices have not been sufficiently disruptive to suggest a Fed-induced cause is at hand, and have tended to be more consistent with indications of general economic improvement.

In short: Energy prices are yet another thing to keep an eye on. Still, recognize the increase to date appears to be more of a return to the recent trends than a disruptive price spike. Not that rising prices won't have consequences, but the trend of the past decade may simply be something we need to learn to live with. Rather than watching the trend itself, be watching for upward spikes from that trend - those would almost certainly translate into something nasty for the still struggling US economy.

Saturday, January 08, 2011

"What is the Treasury Up To?"

Stephen Williamson:

What is the Treasury Up To?, New Monetarist Economics: As I pointed out here, the QE2 Treasury security purchases by the Fed have actually had little effect on the stock of outside money, principally because there have been large inflows into the Treasury's General Account at the Fed. That continues to be the case. The ... Fed's stock of securities has increased about $122 billion since the QE2 program began in November 2010. However,... we see modest increases in currency and reserves.  Since early November, the increase in currency is about $18 billion, and in reserves only about $10 billion. The ... Treasury accumulated $81 billion in its General Account over the same period.

In its General Account and Supplementary Financing Account with the Fed, the Treasury now holds a total of about $315 billion. ...[I]f you thought that some of the effects of QE2 might come through effects on the stock of outside money (e.g. increases in the currency stock as banks dump the extra reserves), there is not that much of that happening.

"Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?"

An interesting new paper from Hess Chung, Jean-Philippe Laforte, and David Reifschneider of the Board of Governors, and John Williams of the SF Fed:

Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?, by Hess Chung, Jean-Philippe Laforte, David Reifschneider, and John C. Williams, January 7, 2011: Abstract Before the recent recession, the consensus among researchers was that the zero lower bound (ZLB) probably would not pose a significant problem for monetary policy as long as a central bank aimed for an inflation rate of about 2 percent; some have even argued that an appreciably lower target inflation rate would pose no problems. This paper reexamines this consensus in the wake of the financial crisis, which has seen policy rates at their effective lower bound for more than two years in the United States and Japan and near zero in many other countries. We conduct our analysis using a set of structural and time series statistical models. We find that the decline in economic activity and interest rates in the United States has generally been well outside forecast confidence bands of many empirical macroeconomic models. In contrast, the decline in inflation has been less surprising. We identify a number of factors that help to account for the degree to which models were surprised by recent events. First, uncertainty about model parameters and latent variables, which were typically ignored in past research, significantly increases the probability of hitting the ZLB. Second, models that are based primarily on the Great Moderation period severely understate the incidence and severity of ZLB events. Third, the propagation mechanisms and shocks embedded in standard DSGE models appear to be insufficient to generate sustained periods of policy being stuck at the ZLB, such as we now observe. We conclude that past estimates of the incidence and effects of the ZLB were too low and suggest a need for a general reexamination of the empirical adequacy of standard models. In addition to this statistical analysis, we show that the ZLB probably had a first-order impact on macroeconomic outcomes in the United States. Finally, we analyze the use of asset purchases as an alternative monetary policy tool when short-term interest rates are constrained by the ZLB, and find that the Federal Reserve’s asset purchases have been effective at mitigating the economic costs of the ZLB. In particular, model simulations indicate that the past and projected expansion of the Federal Reserve's securities holdings since late 2008 will lower the unemployment rate, relative to what it would have been absent the purchases, by 1½ percentage points by 2012. In addition, we find that the asset purchases have probably prevented the U.S. economy from falling into deflation.

And, from the conclusions:

Continue reading ""Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?"" »

Friday, January 07, 2011

Fed Watch: More of the Same

Tim Duy:

More of the Same, by Tim Duy: The jobs report was a clear disappointment relative to both expectations at the beginning of the week and certainly after the blowout ADP report.  After adjusting expectations to the upside, ADP once again scores a major miss (how we came to care about this data series still remains a mystery to me).  That said, the overall tenor of fourth quarter employment reports suggest an economy growing around trend growth.  Better, but not good enough to prompt a policy response from the Fed.

The headline NFP gain was 103k overall, 113k private.  Consensus had been looking for something around 140k at the beginning of the week.  On the upside, the BLS revised up the October and November numbers, so that the average monthly NFP gain during the fourth quarter was 128k, pretty much right in the middle of the 100k to 150k estimates of growth required to keep a lid on unemployment.  And the unemployment rate did more than hold steady - it retreated, falling from 9.8% to 9.4%.  The improvement, however, is less positive than at first blush.  Persistently high unemployment continues to drive workers out of the labor force, illustrated by a fresh decline in the labor force participation rate:

New Picture 
The report internals were not particularly reassuring if one is still looking for the fabled V-shaped recovery.  Gains in wholesale and retail trade as well as transportation and warehousing   were consistent with the generally solid consumer spending news during the quarter.  But the biggest gainer was the ever consistent health care sector, which added 37.1k.  Something of a disappointment was the deteriorating trend in the rate of temporary help gains - the sector added just 15.9k jobs, down from 31.1k in November and  28.6 in October.  Weekly hours, both average and aggregate were unchanged, while hourly wage gains were a minimal 3 cents.

In short, nothing to change the direction of monetary policy, a point reinforced by Federal Reserve Chairman Ben Bernanke's Senate testimony today.  Although Bernanke begins with a nod to the recent data:

More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. In particular, real consumer spending rose at an annual rate of 2-1/2 percent in the third quarter of 2010, and the available indicators suggest that it likely expanded at a somewhat faster pace in the fourth quarter. Business investment in new equipment and software has grown robustly in recent quarters, albeit from a fairly low level, as firms replaced aging equipment and made investments that had been delayed during the downturn.

his ultimate conclusion remains unchanged:

Although it is likely that economic growth will pick up this year and that the unemployment rate will decline somewhat, progress toward the Federal Reserve's statutory objectives of maximum employment and stable prices is expected to remain slow. The projections submitted by Federal Open Market Committee (FOMC) participants in November showed that, notwithstanding forecasts of increased growth in 2011 and 2012, most participants expected the unemployment rate to be close to 8 percent two years from now. At this rate of improvement, it could take four to five more years for the job market to normalize fully.

Bernanke continued his defense of large scale asset purchases, explaining the importance of ongoing monetary easing given the persistent deviation of unemployment and inflation from the Fed's mandate.  He also emphasizes that this policy is ultimately temporary and not equivalent to unbounded government spending:

As I am appearing before the Budget Committee, it is worth emphasizing that the Fed's purchases of longer-term securities are not comparable to ordinary government spending. In executing these transactions, the Federal Reserve acquires financial assets, not goods and services. Ultimately, at the appropriate time, the Federal Reserve will normalize its balance sheet by selling these assets back into the market or by allowing them to mature.

Bernanke then places himself, again, in the middle of the fiscal policy debate.  Should this be the purview of the Fed Chair?  Does it invite Congress to meddle with monetary policy?  Is this a reflection of Bernanke's political affiliation, his desire to take sides with fellow deficit hawk Republican's?  Interesting that Bernanke continues the tradition of blaming retirees for the nation's fiscal challenges:

In subsequent years, the budget outlook is projected to deteriorate even more rapidly, as the aging of the population and continued growth in health spending boost federal outlays on entitlement programs. Under this scenario, federal debt held by the public is projected to reach 185 percent of the GDP by 2035, up from about 60 percent at the end of fiscal year 2010. 

By linking the aging population and health care costs in the same sentence, he sends the message that the old are sick and consequently the cause of the impending crisis.  I would have preferred that he explicitly separated rising health care prices we all face from the issue of the aging population. 

Bottom Line:   The employment report was lackluster, consistent with expectations the US economy is operating - sustainably - around trend growth.  The report was also consistent with the view that this just isn't good enough to rapidly alleviate the hardships imposed by the recession.  The lack of more dramatic improvement in labor markets keeps the idea of policy tightening off the FOMC's table, and while I can envision the Fed bringing a halt to large scale asset purchases when the current program is complete, given the employment and inflation data, I can't wrap my mind around a rate increase this year.

Wednesday, January 05, 2011

Fed Watch: Generally Positive

Tim Duy is "generally positive" about the economy, but still sees reasons to worry:

Generally Positive, by Tim Duy: Today's ISM nonmanufaturing headline figure provided further evidence the US economy left 2010 on firmer footing. Generally solid internals as well, with both production and new orders posting solid gains. Like its manufacturing cousin, the weak spot was employment, a critical determinant for the evolution of Fed policy this year.

In contrast, the ADP numbers were released with great fanfare, suggesting a 297k gain in private nonfarm payrolls. A potential blowout in the making given that expectations for Friday's employment report was 140k overall. However, a word of caution regarding the ADP figure via the Wall Street Journal:

But there is a seasonal quirk in the ADP number that may have inflated the December number. ADP and Macroeconomic Advisers do a seasonal adjustment that takes into account a typical December purge, where employers who have fired workers over the course of the year but don’t remove them from officials payrolls right away clear the rolls.
Ben Herzon of Macroeconomic Advisers explains: "If companies were laying off fewer employees throughout 2010 than had been the case in recent years, the amount by which the seasonal adjustment process subtracted from [ADP National Employment Report] growth last year through November was too great. Following the same logic, fewer layoffs through November implies fewer December purges than in recent years, so the boost to December employment growth to offset the normal December purge may have been too large."

On the inflation outlook, today's ISM release revealed a higher percentage of firms reporting higher prices. Firming demand may allow firms to pass on some of these cost increases to consumers, but as the Wall Street Journal notes, this isn't a bad outcome:

If higher commodities prices do trigger a small but manageable pickup in U.S. inflation, it will count as a success for the Fed’s extraordinary efforts to avoid the ravages of deflation that have beset Japan these past two decades.

Three additional factors likely to weigh on the Fed: Housing, state and local budgets, and Europe. From the FOMC minutes:

Others pointed to downside risks to growth. One common concern was that the housing sector could weaken further in light of the considerable supply of houses either on the market or likely to come to market. Another concern was the ongoing deterioration in the fiscal position of U.S. states and localities, which could lead to sharp cuts in spending and increases in taxes. In addition, participants expressed concerns about a possible worsening of the banking and financial strains in Europe, which could spill over to U.S. financial markets and institutions, and so to the broader U.S. economy.

Despite an improving revenue picture, state and local budgets are expected to fall short of what is necessary to maintain current service levels, especially given escalating wage and benefit costs. This is likely to remain a drag on growth - and jobs - until the governments realign spending and revenue growth trends. Nothing really new here, just an ongoing concern.

And, finally, Europe. Via CR, Europe looks to be heading to renewed crisis. It would appear that despite all the EU interventions, investors believe a day of reckoning is still at hand, that at most sovereign defaults have simply been pushed out three years. I find it difficult to see how the situation is resolved without an enhanced fiscal authority in Europe with the power to make transfers, not loans, from solvent to insolvent regions, the exit of some nations from the Euro, or some combination of these two. I wish that European leaders would see the light sooner than later rather than dragging us through two or three more crises.

Bottom Line: Data continues to be supportive, with at least one more hint of solid job growth to add to the improving trend evidence in initial claims. Still, the hole we are in is deep, not every piece of data has fallen into line, the positive trends are relatively recent, and at least three swords are still holding over the heads of FOMC members. The combination should keep policymakers clinging to the current stance of monetary policy, although even the more dovish will need to publicly recognize the more solid pattern of data sooner than later.