Category Archive for: Monetary Policy [Return to Main]

Sunday, January 08, 2012

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

Tim Duy:

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

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

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

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

Forecast

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

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

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

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

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

3mpce

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

Saturday, January 07, 2012

Confused about Communication about Improving Communication

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

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

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

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

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

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

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

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

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

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

Friday, January 06, 2012

Fed Watch: A Few Quick Charts on Consumer Spending

Tim Duy:

A Few Quick Charts on Consumer Spending, by Tim Duy: In my last piece, I noted that excessive optimism or pessimism essentially cancelled each other out over the course of 2011 when tracking the overall economy. The same held true of consumption spending as well:
Pce1
Since the recession ended, consumer spending has been tracking a slightly slower growth trend than prior to the recession. Again, there looks to have been a long-lasting shock to the path of consumer spending. Interesting changes have occurred underneath the surface, however. The path of spending on services is markedly lower:

Pce2

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

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

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

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

Which brings us to the upturn in durable goods spending:

Pce3

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

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

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

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

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

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

Pce4

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

Pce6

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

Wednesday, January 04, 2012

Fed Watch: Still Cautious Heading Into 2012

Tim Duy:

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

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

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

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

Potential

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

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

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

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

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

Friday, December 30, 2011

Paul Krugman: Keynes Was Right

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

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

Tuesday, December 27, 2011

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

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

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

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

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

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

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

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

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

If confirmed by the Senate...

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

More on Stein from Noam Scheiber.

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

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

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

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

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

Thursday, December 22, 2011

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

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

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

Saturday, December 17, 2011

"A Financial Crisis Needn’t Be a Noose"

It doesn't have to be this way:

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

Tuesday, December 13, 2011

The Fed Leaves Policy Unchanged

A few comments on today's FOMC decision:

The Fed Leaves Policy Unchanged

Friday, December 09, 2011

"A Mixed Bag From Europe"

Tim Duy:

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

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

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

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

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

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

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

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

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

Europedebt

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

Tuesday, December 06, 2011

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

The Fed fires back:

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

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

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

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

Monday, December 05, 2011

Possible Fed Communication Strategy

Tim Duy:

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

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

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

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

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

Fed2yield interest rate guidance:

Fed1

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

Expect some push back from some Federal Reserve policymakers:

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

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

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

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

Friday, December 02, 2011

Unemployment Falls, But Is It Good News?

I just posted this at CBS News:

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

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

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

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

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

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

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

Wednesday, November 30, 2011

Did the Fed Go Far Enough?

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

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

Here are our responses:

[Additional comments here.]

Tuesday, November 29, 2011

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

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

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

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

Saturday, November 26, 2011

What Could Bernanke Do?

Brad DeLong explains how the "Federal Reserve might be able to spark a real economic recovery": What Could Bernanke Do?.

Wednesday, November 23, 2011

Fed Watch: And the Global Economic Saga Continues

Tim Duy:

And the Global Economic Saga Continues, by Tim Duy: The last week has been a non-stop flood of news. And, quite honestly, none of it is encouraging. I imagine the sole exception to that rule is the relatively sanguine nature of the US data. That said, I remain unconvinced that the US can for much longer resist the downward pull of the rest of the globe.

What more can we say about Europe that has not already been said? There has been no forward progress in the past week. To be sure, ECB bond buying has helped keep a lid on Italian bond yields. Yet, while ECB monetary policymakers focus on Italy, Spain and Belgium are slipping away. And France is clearly the next domino to fall. The "accidental" downgrade last week simply reveals that S&P has already prepared the report, clearly anticipating a deterioration in France's budget position as the Eurozone recession deepens. And to make matters worse, Zero Hedge points us to signs the Dexia bank rescue is faltering, and the Belgians realize they need to shift more of that burden of that rescue onto France. Meanwhile, the situation in Eastern Europe is rapidly deteriorating - Yves Smith directs us to the Telegraph for that story. And in Greece, the opposition party still insists they will not sign any pledge to commit to the October deal. Was any deal really reached last month?

Conventional wisdom is that the European Central Bank eventually acts as a lender of last resort to alleviate the sovereign debt crisis. This was clearly not on the mind of ECB President Mario Draghi in his recent speech. I certainly hope something was lost in translation, as the speech has some memorable moments. Notably:

Activity is expected to weaken in most of the advanced economies. This is the result of a weakening of various components of aggregate demand, both domestic and foreign.

Economic activity is weakening because the underlying components of economic demand are weakening. I am not sure this is particularly insightful. Is this the best analysis he can muster from the intellectual firepower of ECB economists? If so, we are in very big trouble. But it continues. The first two of Draghi's three pillars of monetary policy:

Continuity first and foremost refers to our primary objective of maintaining price stability over the medium term.

Consistency means to act in line with our primary objective and with our strategy both in time and over time.

I am having a hard time distinguishing between "continuity" and "consistency" here. The third (second?) pillar is predictable:

Credibility implies that our monetary policy is successful in anchoring inflation expectations over the medium and longer term. This is the major contribution we can make in support of sustainable growth, employment creation and financial stability. And we are making this contribution in full independence.

Gaining credibility is a long and laborious process. Maintaining it is a permanent challenge. But losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs.

Translation: "We can only save the Euro, but only at the cost of German hyperinflation of the 1920's." He then pulls a Ben Bernanke and tosses the ball back to fiscal policymakers"

National economic policies are equally responsible for restoring and maintaining financial stability. Solid public finances and structural reforms – which lay the basis for competitiveness, sustainable growth and job creation – are two of the essential elements.

But in the euro area there is a third essential element for financial stability and that must be rooted in a much more robust economic governance of the union going forward. In the first place now, it implies the urgent implementation of the European Council and Summit decisions. We are more than one and a half years after the summit that launched the EFSF as part of a financial support package amounting to 750 billion euros or one trillion dollars; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five and that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area. Where is the implementation of these long-standing decisions?

Here I think that Draghi is simply delusional. Does he not realize that plans to expand the ESFS are essentially dead at this point? That France and Germany are not willing or able to contribute more capital? That the plans to leverage the ESFS are floundering as the reality sets in that financial engineering will not work here? That the Chinese scoffed at efforts to get them to buy into such a plan? That the EU political system is capable at moving even a fraction of the speed of financial markets?

I understand the ECB does not want to take on the role of fiscal authority, but what other choice do they have? Little else than to oversee the collapse of the currency they are charged to protect.

Meanwhile, word is the Greek debt haircut deal is in jeopardy. Not a surprise, as not real was really reached at the summit, just a desperate attempt to buy time. Market participants should by now realize the outcome of any European summit is little more than smoke and mirrors.

Speaking of smoke and mirrors, the news from this side of the pond is not exactly encouraging. The Supercommitte hit a brick wall, to no one's surprise but Wall Street's. The stage is set for a nontrivial fiscal tightening in short order - 5 weeks or so. Greg Ip at the Economist puts some numbers on what is at stake, and comes up with contractionary policy on the order of 2.4% of GDP. Note that the Federal Reserve forecast for 2012 is 2.5% to 2.9%, and I bet not much fiscal contraction is built into those numbers. So, make no mistake, the failure of the Supercommittee to come up with a plan for "smart" austerity - austerity focused on the medium and long-runs, with stimulus in the short run, is very meaningful. The conventional wisdom is that Congress will not go home for the holidays without at a minimum extending the payroll tax credit. I will follow that lead, but remain worried that the weight of Washington gridlock argues for more disappointment in the weeks ahead.

Across the Pacific, another storm is brewing - the Chinese economy continues to slow. Via Bloomberg:

China’s manufacturing may contract this month by the most since March 2009 as home sales slide, adding to evidence the world’s second-biggest economy is slowing, a preliminary purchasing managers’ index shows.

The reading of 48 reported by HSBC Holdings Plc and Markit Economics today compares with a final number of 51 last month. A number below 50 indicates a contraction.

Conventional wisdom is that the downside is limited, as at its heart China is a command and control economy. That said, even a minor slowdown is disconcerting, as the US economy does not need another trade shock to add to the trade and, more importantly, financial shock about to flow from Europe.

Bottom Line: The world economy remains in a precarious place as we head into the final month of 2011.

Tuesday, November 22, 2011

Third Quarter GDP Growth Revised Downward

Our not so robust recovery is weaker than first reported:

Real gross domestic product ... increased at an annual rate of 2.0 percent in the third quarter of 2011 ... according to the "second" estimate released by the Bureau of Economic Analysis. ... The GDP estimates released today are based on more complete source data than were available for the "advance" estimate issued last month. In the advance estimate, the increase in real GDP was 2.5 percent...

So once again the advance estimate captured headlines and allowed policymakers to say hurray, things are improving, we don't have to act. I disagreed at the time -- even 2.5 percent is a sputtering recovery compared to what we need to reemploy the millions of jobless and policymakers have waited far too long already -- but the headline figure was enough to allow policymakers to "wait and see." Now, with growth even lower than we thought, will policymakers change course? Though I see no reason to let them off the hook, I gave up on fiscal policy authorities long ago. I just hope they won't make things worse. But monetary authorities ought to be acting now to bolster the economy further, especially given the substantial risks from Europe and elsewhere, and it's disappointing that they haven't done more already.

Update: More comments at CBS News.

Thursday, November 17, 2011

Why Hasn't the Fed Lowered the Rate It Pays on Reserves?

I've been wondering why the Fed hasn't lowered the interest it pays on bank reserves from its current value of .25 percent to zero. It probably wouldn't do much, but it would slightly lower the incentive for banks to hold cash rather than loaning it out, and more loans would help to spur the economy, so why not give it a try? In addition, unlike some other policies the Fed might pursue, this would be easily reversible, and it would help to convince critics that the Fed is trying everything it can think of.

Though it's buried deep within the post, the NY Fed explains the FOMC's reluctance to pursue this option. The argument is that it's possible for some interest rates to go slightly negative, and if they do it will cause various problems the Fed would rather avoid (see below). Since banks can borrow from anyone charging less than the rate they earn on reserves and arbitrage the difference away, paying interest on reserves puts a floor on interest rates.  Here's the full argument:

Why Is There a “Zero Lower Bound” on Interest Rates?, by Todd Keister, Liberty Street: Economists often talk about nominal interest rates having a “zero lower bound,” meaning they should not be expected to fall below zero. While there have been episodes—both historical and recent—in which some market interest rates became negative, these episodes have been fairly isolated. In this post, I explain why negative interest rates are possible in principle, but rare in practice. Financial markets are generally designed to operate under positive interest rates, and might experience significant disruptions if rates became negative. To avoid such disruptions, policymakers tend to keep short-term interest rates above zero even when trying to loosen monetary policy in other dimensions. These policy choices are the source of the zero lower bound.

The standard description of the zero lower bound begins with the observation that the nominal interest rate offered by currency is always zero: If I hold on to a dollar bill, I’ll still have one dollar tomorrow, next week, or next year. If I invest money at an interest rate of -2 percent, in contrast, one dollar of saving today would become only ninety-eight cents a year from now. Because everyone has the option to hold currency, the argument goes, no one would be willing to hold some other asset or investment that offers a negative interest rate.

This argument is only part of the story, however. Safeguarding and transacting with large quantities of currency is costly. One only needs to imagine the risk and hassle of making all transactions in cash—paying the rent or mortgage, utility bills, etc.—to appreciate the safety and convenience of a checking account. Many individuals would likely be willing to keep funds in deposit accounts even if these accounts pay a negative interest rate or charge maintenance fees that make their effective interest rate negative.

Large institutional investors are in a similar situation. They use a variety of short-term investments, such as lending funds in the “repo” (repurchase agreement) market and holding short-term Treasury bills, in much the same way individuals use checking accounts. These investments will remain attractive to large investors even at negative interest rates because of the security and convenience they offer relative to dealing in currency. Some repo rates did in fact become negative in 2003 (see this New York Fed study) and again more recently (see Bloomberg). Interest rates in the secondary market for Treasury bills have also been slightly negative recently (see Businessweek).

In other words, market interest rates can move somewhat below zero without triggering a massive switch into currency. Nevertheless, central banks typically maintain positive short-term interest rates even while using less conventional tools (such as large-scale asset purchases) to provide additional monetary stimulus.

The Federal Reserve, for example, currently pays an interest rate of 0.25 percent on the reserve balances that banks hold on deposit at the Fed. The ability to earn this interest gives banks an incentive to borrow funds in a range of markets (including the interbank market and the repo market) and thus has the effect of keeping market interest rates positive most of the time. The Federal Open Market Committee (FOMC) discussed the idea of reducing the interest on reserves (IOR) rate at its September meeting, but no action was taken. Reducing this rate would tend to lower short-term market interest rates and might push some rates below zero. The minutes from the meeting report that “many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict.”

Similarly, the Monetary Policy Committee (MPC) of the Bank of England discussed the possibility of lowering the official Bank Rate below 0.5 percent at its September meeting, but decided against doing so. The MPC had previously expressed concern that “a sustained period of very low interest rates would impair the functioning of money markets.” 

Some examples of areas where disruptions could potentially arise in U.S. financial markets are:

  • Money market mutual funds: Money market funds operate under rules that make it difficult for them to pay negative interest rates to their investors, either directly or by assessing fees. Many of these funds would likely close down if the interest rates they earn on their assets were to fall to zero or below, possibly disrupting the flow of credit to some borrowers.
  • Treasury auctions: The auction process for new U.S. Treasury securities does not currently permit participants to submit bids associated with negative interest rates. If market interest rates become negative, new Treasury securities would be issued with a zero interest rate—effectively a below-market price—and bids would be rationed if demand exceeds supply. Such rationing, which has occurred in recent auctions, would generate an incentive for auction participants to bid for more than their true demand, leading to even more rationing. This situation could generate market volatility, as unexpected changes in the amount of rationing in each auction could leave some investors holding either many more or many fewer securities than they desire.
  • Federal funds: A decrease in the IOR rate would also likely affect the federal funds market, where banks and certain other institutions lend funds to each other overnight. A lower IOR rate would give banks less incentive to borrow in this market, which would likely decrease the amount of activity. When less activity takes place, the market interest rate will be influenced more by idiosyncratic factors, making it a less reliable indicator of current conditions. This decoupling of the federal funds rate from financial conditions could complicate communications for the FOMC, which operates monetary policy in part by setting a target for this rate.

These examples demonstrate that many current institutional arrangements were not designed with near-zero or negative interest rates in mind. In principle, these arrangements—such as the rules governing mutual funds and Treasury auctions—could be changed. The implementation of a “fails charge” in 2009 for the settlement of Treasury securities (see this New York Fed study) is one example of an institutional adaptation that allows markets to function better at very low interest rates. (A similar charge is scheduled to take effect in some mortgage-related markets in February 2012.) In practice, however, such changes may take significant time to implement and could simply move disruptions to other markets.

Given the markets’ limited experience with very low interest rates, it is difficult to predict with any degree of certainty how they will react to them. If the types of disruptions described above turn out to be significant, taking steps to lower short-term interest rates could actually make financial conditions tighter rather than looser and thus hinder the economic recovery. To avoid this outcome, policymakers tend to choose policies that keep market interest rates positive. In other words, the potential for negative interest rates to disrupt financial markets limits the extent to which policymakers can stimulate economic activity by lowering interest rates. This limit is known as the zero lower bound.

Wednesday, November 16, 2011

"Rate of increase slows for Key Measures of Inflation"

Calculated Risk:

Rate of increase slows for Key Measures of Inflation

So, with inflation fears falling, the Fed is more likely to act, right? Don't set your hopes too high:

Fed’s Lacker: U.S. Inflation Still Too High - WSJ

But not all members of the FOMC share this sentiment. From the WSJ story:

John Williams, who leads the San Francisco Fed, Tuesday joined a rising chorus of central bank officials calling for continued action to bolster the economy.

But it also says:

Other officials remain staunchly opposed to taking further unconventional steps to spur growth, such as buying more mortgage bonds–and Lacker is among them.

And there's this from Boston:

Fed’s Rosengren: Fed Should Take Any Action It Can to Help Economy

While the Fed is taking it's time trying to figure out what to do, it should remember how many people are hoping that somebody does something to spur job creation, that most of the forces driving the recent spurt of headline inflation appear to be temporary (as today's data attests), and that the economic outlook is very risky -- we could use some insurance against future problems (especially with evidence that the potential cost of that insurance, i.e. the potential for inflation, is falling).

Thursday, November 10, 2011

"Could the ECB become the Central Fiscal Authority?"

Nick Rowe says the ECB needs to step in and save the Euro (I've called for fiscal federalism as a stabilization tool, but Nick is making a different point -- how the ECB can accomplish this on its own by using its powers to act as a central fiscal authority):

Could the ECB become the central fiscal authority?, by Nick Rowe: There is only one way to save the Euro now. The ECB acts as lender of last resort to the 17 Eurozone governments. But nobody would want to act as lender of last resort to a deadbeat, and the ECB wouldn't want to act as lender of last resort to a fiscal deadbeat. With the guarantee of unlimited loans from the ECB, the fiscal deadbeat would have every incentive to keep on borrowing and spending unlimited amounts. It's a mix of: the free-rider problem (because they are only one in 17, and even less than that for a small country); and the Samaritan's dilemma (if they know you are going to help them get out of trouble, they are not going to stay out of trouble).
The Eurozone lacks a central fiscal authority to match the central monetary authority. And it seems to lack the ability to create a central fiscal authority in the normal way. Nobody seems to have the power to exert that central fiscal authority, and force the 17 governments to do what they are told.
But the ECB does have that power. It can say to each of the 17 governments: "We will act as your lender of last resort if and only if you do what we say. If you don't do what we say, we will loudly announce that we will no longer act as your lender of last resort, and the bond markets will make mincemeat of your bonds, and there will be runs on all your banks."
In fact, the ECB is the only body that does have that power. I'm not talking about legal power. It's long past that stage of the game. Good central banks ignore all the rules in an emergency (as Brad DeLong tells us the Bank of England did for a century). The ECB has the de facto power to save any or all of the 17 countries. But it won't use that power unconditionally. It has to make the 17 governments do what it tells them to do. It has the power to do that. "Do what we say, or your country is toast".
The normal question in political macroeconomy is whether the monetary authority should have independence from the fiscal authority. It's time, in the Eurozone, to reverse that question. Should the 17 fiscal authorities have independence from the one monetary authority?
Is this democratic? Of course not. Might it happen? I don't know.

Thursday, November 03, 2011

"Negative Real Interest Rates"

David Andolfatto notes that the real interest rate is near zero, even negative in some cases, and says "Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow":

Negative real interest rates, Macromania: ...In macroeconomic theory, the nominal interest rate plays second-fiddle to the so-called real interest rate. The real rate of interest is ... a relative price. It is the price of output today measured in units of future output... So, if the risk-free annual interest rate on an inflation-indexed U.S. treasury is 2%, then one unit of output today is valued at 1.02 units of output in the future....
Economists typically focus on the real interest rate because people presumably care about output and not money (they care about money only to the extent that it may be used to purchase output). ... The higher the real interest rate, the more output is valued today vis-a-vis future output. A high real interest rate reflects the market's strong desire to have you part with your output today (in exchange for a promise of future output). Unlike the nominal interest rate, however, there is nothing that naturally prevents the real interest rate from becoming negative; see Nick Rowe. And indeed, this appears to have happened recently in the U.S. The following diagram plots the real interest rate as measured by the n-year treasury inflation-indexed security (constant maturity) for n = 5, 10, 20; see FRED.

Prior to the Great Recession, real interest rates are hovering around 2% p.a. and the yield curve is upward sloping (long rates higher than short rates), at least until early 2006 (when it flattens). Following the violent spike up in real interest rates (associated with the Lehman event), real interest rates have for the most part declined steadily since then. The 20 year rate is below 1%, the 10 year rate is basically zero, and the 5 year rate is significantly negative. What does this mean?
The decline in real rates that has taken place, especially since the beginning of 2011, is a troubling sign. ... This premium may be signaling an expected scarcity of future output. If so, then this is a bearish signal.

The decline in market real interest rates is consistent with a collapse (and anemic recovery) of investment spending (broadly defined to include investments in job recruiting). For whatever reason, the future does not look as bright as it normally does at the end of a recession. To some observers, this looks like a "deficient aggregate demand" phenomenon. To others, it is the outcome of a rational pessimism reflecting a flow of new regulatory burdens and a potentially punitive tax regime. Both  hypotheses are consistent with the observed "flight to safety" phenomenon and the consequent decline in real treasury yields.
Unfortunately, the two hypotheses yield very different policy implications. The former calls for increased government purchases to "stimulate demand," while the latter calls for removing whatever barriers are inhibiting private investment expenditure. There seems to be room for compromise though. Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow (assuming that borrowed funds are not squandered, of course).
In the event of an impasse, can the Fed save the day? It is hard to see how. The Fed's influence on real economic activity is usually thought to flow through the influence it has (or is supposed to have) on the real interest rate. One could make the case that real interest rates are presently low in part owing to the Fed's easing policies. But this would be ignoring the fact that the Fed's easing policies were/are largely driven by the collapse in investment spending. (I am suggesting that in a world without the Fed, these real interest rates would be behaving in more or less the same way.)
In any case, real interest rates are already unusually low. How much lower should they go? Is it really the case that our economic ills, even some of them, might be solved in any significant manner by driving these real rates any lower? My own view is probably not. If there is something the Fed can do, it is likely to operate through some other mechanism. ...

David also looks at inflation expectations and concludes:

there is no evidence to suggest that inflation expectations are whirling out of control, one way or the other. I'm not sure to what extent this constitutes success. At the very least it is not utter failure.

I am more confident that David is that the Fed can still help the economy, but it can't do it on its own and too much focus on the Fed takes the pressure off of Congress to do its part to help to overcome the unemployment crisis. Members of Congress need to be worried that their own jobs are at risk if they don't do something to help the unemployed (and they shouldn't be allowed to get away with claiming that cutting the deficit by cutting social insurance programs is a means to this end). That's one of the reasons I keep calling for fiscal policy as well -- both sets of policymakers need to feel as much pressure to act as possible.

Wednesday, November 02, 2011

The Fed Leaves Monetary Policy Unchanged

A few comments on the FOMC meeting:

The Fed Leaves Monetary Policy Unchanged

It's disappoinnting that the fed didn't do more to help th eeconomy, but not unexpected.

Update: Here is a response to Bernanke's Press Conference. "I don't think Bernanke explained adequately why the Fed is reluctant to do more to help the economy."

"Consumer Spending is Much More Fragile Than Commonly Believed"

One more from Tim Duy:

Meanwhile, Back on This Side of the Pond..., by Tim Duy: The break down in the relationship between consumer confidence and actual spending is something that has been nagging at me for awhile. This picture:

Fedcc
While confidence is at recession levels, real personal consumption expenditures continue to grow at a reasonable clip. Should confidence numbers be totally dismissed, or do they signal an underlying fragility among households that should not be ignored? Some hints at an answer may be found in the September income and spending report. Notably, real personal disposable income looks to have rolled over:

Feddpi

So where is the spending power coming from? A plunge in the saving rate:

Fedsav

It looks like households are struggling to hold onto the even meager spending gains achieved since the recession ended, and that struggle may be what is reflected in the consumer confidence numbers. Overall, this suggests to me that consumer spending is much more fragile than commonly believed.  

Manufacturing activity also looks shaky. To be sure, it is reasonable to expect some momentum from the surge in equipment spending in the third quarter. But it is also reasonable to believe that some of this demand was pulled forward as firms try to get ahead of the expiration of the accelerated depreciation benefit. And even with that surge, note the ISM report surprised on the downside Tuesday morning. On the positive side, the new orders measure climbed back above 50, while on the negative, both the export and import components fell. The latter point is a troubling indication of spillover from slowing manufacturing activity in China and Europe. A contraction in global activity isn't exactly what we need at this juncture, especially as it will first bleed through to what has been one of the bright spots in the US recovery.

Bottom Line: With all attention focused on the Greek drama, plus the well-received Q3 GDP report, it has been easy to overlook the underlying fragility in the US economy. This was especially the case when US equities looked to be on a nonstop trip to the moon. Perhaps the US economy can squeak through the next few quarters, and perhaps, in contrast to my expectations, Europe is able to bring an end to the crisis with limited collateral damage to the economy. But I can't shake the feeling that the US economy closer to running on fumes than is commonly believed, and will run out of gas in a very hostile global environment.

Tuesday, November 01, 2011

"A Walk Down Memory Lane with John Taylor"

David Glasner is displeased with John Taylor (for good reason, as he documents in the full post):

A Walk Down Memory Lane with John Taylor, Uneasy Money: John Taylor has had a long and distinguished career both as an academic economist and as a government official and policy-maker. He is justly admired for his contributions as an economist and well-liked by his colleagues and peers as a human being. So it gives me no pleasure to aim criticism in his direction. But it was pretty disturbing to read Professor Taylor’s op-ed piece (“A Slow-Growth America Can’t Lead the World”) in today’s Wall Street Journal, a piece devoid of even the slightest attempt to make a reasoned argument rather than assemble a hodge podge of superficial bromides about the magic of the market and the importance of fiscal discipline and sound monetary policies. It is almost surprising that Taylor failed to mention motherhood, apple pie, and American flag while he was at. Even more disturbing, Taylor proceeds, with no hint of embarrassment, to trash the half-hearted attempts by the Federal Reserve to use monetary policy to promote recovery even though the Fed’s policies are similar to, though much less aggressive than, the “quantitative easing” that he applauded the Japanese government and the Bank of Japan for adopting from 2002 to 2004 to extricate Japan from a decade-long period of deflation and slow growth starting in the early 1990s. ... Oh my what a difference four or five years make. Things do change, don’t they?

Monday, October 31, 2011

DeLong: The ECB’s Battle against Central Banking

Brad DeLong tells the ECB to start acting like a central bank:

The ECB’s Battle against Central Banking, by Brad DeLong, Commentary, Project Syndicate: ...The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” ...
Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. ...

Saturday, October 29, 2011

"Dear Ben: It’s Time for Your Volcker Moment"

Christina Romer tells Ben Bernanke that we need "aggressive actions," including adopting a nominal GDP target, to "help to heal the economy"

Dear Ben: It’s Time for Your Volcker Moment

No disagreement here about the need for more forceful monetary policy actions. We could use more help from fiscal policy too.

Thursday, October 27, 2011

GDP Grew by 2.5 Percent in the Third Quarter

I have some comments on the GDP report:

GDP Grew by 2.5 Percent in the Third Quarter

The main message is that even though the number improved over last quarter,  "policymakers should not conclude that they are off the hook."

"Hayek on Monetary Policy and Unemployment"

David Glasner:

... Sixty years ago Hayek was arguing against an extreme version of Keynesian doctrine that viewed increasing aggregate demand as a panacea for all economic ills. Hayek did not win the battle himself, but his position did eventually win out, if not completely at least in large measure. Today, however, an equally extreme version of Hayek’s position seems to have become ascendant. It denies that increasing aggregate demand can, under any circumstances, increase employment. I don’t know what Hayek would think about all this if he were alive today, but I suspect that he would be appalled.

Tuesday, October 25, 2011

Loose Monetary Policy and Excessive Risk-Taking by Banks

I guess this is former student day (Tim Duy, Steven Ongena -- now I learn from them):

Loose monetary policy and excessive credit and liquidity risk-taking by banks, by Steven Ongena and José-Luis Peydró, Vox EU: A question under intense academic and policy debate since the start of the ongoing severe financial crisis is whether a low monetary-policy rate spurs excessive risk-taking by banks. From the start of the crisis in the summer of 2007, market commentators were quick to argue that, during the long period of very low interest rates from 2002 to 2005, banks had softened their lending standards and taken on excessive risk.
Indeed, nominal rates were the lowest in almost four decades and below Taylor rates in many countries, while real rates were negative (Taylor 2007, Rajan 2010, Reinhart and Rogoff 2010, among others). Expansionary monetary policy and credit risk-taking followed by restrictive monetary policy possibly led to the financial crisis during the 1990s in Japan (Allen and Gale 2004), while lower real interest rates preceded banking crises in 47 countries (von Hagen and Ho 2007). This time the regulatory arbitrage for bank capital associated with the high degree of bank leverage, the widespread use of complex and opaque financial instruments including loan securitization, and the increased interconnectedness among financial intermediaries may have intensified the resultant risk-taking associated with expansive monetary policy (Calomiris 2009, Mian and Sufi 2009, Acharya and Richardson 2010).
During the crisis, commentators also continuously raised concerns that a zero policy interest rate combined with additional and far-reaching quantitative easing, while alleviating the immediate predicament of many financial market participants, were sowing the seeds for the next credit bubble (Giavazzi and Giovannini 2010).
Recent theoretical work has modeled how changes in short-term interest rates may affect credit and liquidity risk-taking by financial intermediaries. Banks may take more risk in their lending when monetary policy is expansive and, especially when afflicted by agency problems, banks’ risk-taking can turn excessive.
Indeed, lower short-term interest rates may reduce the threat of deposit withdrawals, and improve banks’ liquidity and net worth, allowing banks to relax their lending standards and to increase their credit and liquidity risk-taking. Acute agency problems in banks, when their capital is low for example, combined with a reliance on short-term funding, may therefore lead short-term interest rates – more than long-term rates – to spur risk-taking. Finally, low short-term interest rates make riskless assets less attractive and may lead to a search-for-yield by those financial institutions that have short time horizons.1
Concurrent with these theoretical developments, recent empirical work has begun to study the impact of monetary policy on credit risk-taking by banks. Recent papers that in essence study the impact of short-term interest rates on the risk composition of the supply of credit follow a longstanding and wide literature that has analyzed its impact on the aggregate volume of credit in the economy, and on the changes in the composition of credit in response to changes in the quality of the pool of borrowers.2
In Jiménez et al (2011), our co-authors and we use a uniquely comprehensive credit register from Spain that, matched with bank and firm relevant information, contains exhaustive loan (bank-firm) level data on all outstanding business loan contracts at a quarterly frequency since 1984:IV, and loan application information at the bank-firm level at a monthly frequency since 2002:02.
Our identification strategy consists out of three crucial components:
(1)   Interacting the overnight interest rate with bank capital (the main theory-based measure of bank agency problems) and a firm credit-risk measure
(2)   Accounting fully for both observed and unobserved time-varying bank and firm heterogeneity by saturating the specifications with time*bank and time*firm fixed effects (at a quarterly or monthly frequency), and when possible, also controlling for unobserved heterogeneity in bank-firm matching with bank*firm fixed effects and time-varying bank-firm characteristics (past bank-firm credit volume for example).
(3)   Including in all key specifications – and concurrent with the short-term rate – also the ten-year government-bond interest rate, in particular in a triple interaction with bank capital and a firm credit risk measure (as in (2)).
Spain offers an ideal setting to employ this identification strategy because it has an exhaustive credit register from the banking supervisor, an economic system dominated by banks and, for the last 22 years, a fairly exogenous monetary policy.
We find the following results for a decrease in the overnight interest rate (even when controlling for changes in the ten-year government-bond interest rate):
(1)   On the intensive margin, a rate cut induces lowly capitalized banks to expand credit to riskier firms more than highly capitalized banks, where firm credit risk is either measured as having an ex ante bad credit history (ie, past doubtful loans) or as facing future credit defaults.
(2)   On the extensive margin of ended lending, a rate cut has if anything a similar impact, ie, lowly capitalized banks end credit to riskier firms less often than highly capitalized banks.
(3)   On the extensive margin of new lending, a rate cut leads lower-capitalized banks to more likely grant loans to applicants with a worse credit history, and to grant them larger loans or loans with a longer maturity. A decrease in the long-term rate has a much smaller or no such effects on bank risk-taking (on all margins of lending).
Our results in Jiménez et al (2011) suggest that, fully accounting for the credit-demand, firm, and bank balance-sheet channels, monetary policy affects the composition of credit supply. A lower monetary-policy rate spurs bank risk-taking. Suggestive of excessive risk-taking are their findings that risk-taking occurs especially at banks with less capital at stake, ie, those afflicted by agency problems, and that credit risk-taking is combined with vigorous liquidity risk-taking (increase in long-term lending to high credit risk borrowers) even when controlling for a long-term interest rate.
In work with Vasso Ioannidou, we also investigate the impact of monetary policy on the risk-taking by banks (Ioannidou et al 2009). This study focuses on the pricing of the risk banks take in Bolivia (relying on a different and complementary identification strategy to Jiménez, et al 2011 and studying data from a developing country). Examining the credit register from Bolivia from 1999 to 2003, we find that, when the US federal-funds rate decreases, bank credit risk increases while loan spreads drop (the Bolivian economy is largely dollarized and most loans are dollar-denominated making the federal-funds rate the appropriate but exogenously determined monetary-policy rate). The latter result is again suggestive of excessive bank risk-taking following decreases in the monetary-policy rate. Hence, despite using very different methodologies, and credit registers covering different countries, time periods, and monetary policy regimes, both papers find strikingly consistent results.3
There are a number of natural extensions to these studies. Our focus on the impact of monetary policy on individual loan granting overlooks the correlations between borrower risk and the impact on each individual bank’s portfolio or the correlations between all the banks’ portfolios and the resulting systemic-risk impact of monetary policy. In addition, both studies focus on the effects of monetary policy on the composition of credit supply in only one dimension, ie, firm risk. Industry affiliation or portfolio distribution between mortgages, consumer loans and business loans for example may also change. Given the intensity of agency problems, social costs and externalities in banking, banks’ risk-taking – and other compositional changes of their credit supply for that matter – can be expected to directly impact future financial stability and economic growth. We plan to broach all such extensions in future work.
Disclaimer: Any views expressed are only those of the authors and should not be attributed to the Banco de España, the European Central Bank, or the Eurosystem.
References

Continue reading "Loose Monetary Policy and Excessive Risk-Taking by Banks" »

Fed Watch: Floating Rate Treasuries

Tim Duy:

Floating Rate Treasuries, by Tim Duy: Reports circulated today that the US Treasury is considering a new type of debt. From Bloomberg:

The U.S., seeking to attract investors who might otherwise avoid Treasuries amid a $1.3 trillion budget deficit, is considering the sale of floating- rate notes in what would be its first new security since it began offering inflation-linked debt 14 years ago.

The Treasury Department said this month it asked Wall Street’s biggest bond dealers for recommendations on structuring securities with coupons that rise or fall with benchmark rates. Officials are scheduled to gather with the 22 primary dealers, who include Goldman Sachs Group Inc. and JPMorgan Chase & Co., on Oct. 28 as it decides whether to go further during their regular meeting that precedes each quarterly refunding.

I find this idea intriguing. On the surface, with US 10-year debt hovering around 2 percent, there seems to be plenty of demand to dry up whatever Treasury issues. And it looks like a wise move to lock in as much debt as possible at those low rates. That said, at some point in the future (hopefully) rates will rise, and it is easy to see an inflection point where investors, wary that monetary policy may shift abruptly, would be wary to add to their Treasury holdings. Having a floating rate product on hand could be important in such circumstances, preventing any abrupt funding shortfalls and rates spikes by offering investors a form of insurance against rising rates.

Daniel Indiviglio at the Atlantic offers up some potential problems with such a product. First, he correctly notes the desire to lock in today's low rates. Second:

Tying U.S. debt costs to how interest rates rise and fall could also be dangerous. For every $1 billion in floating-rate debt that the Treasury issues, a 0.5% (50 basis point) increase in interest rates would result in its debt costs rising by $5 million. You can imagine how quickly U.S. debt costs could rise if the government had something like $1 trillion in floating rate debt and interest rates jumped a few percent in a year. Suddenly, the government would have to issue tens of billions of dollars in additional debt just to keep up with rising interest rates.

As I noted, I think this product would be particularly useful in the expected transition to higher rates and would not expect it to be a primary funding mechanism. I can also see a benefit in a mechanism that explicitly penalizes the fiscal authority for overspending should actual fiscal constraints emerge in the future. Consider it something of an automatic stabilizer - more spending power automatically emerges when the economy dips and debt costs fall, and vice-versa. Indiviglio offers another potential problem:

And if you think that the government puts too much pressure on the Federal Reserve to act now, just wait until it directly controls a portion of the nation's interest costs. Floating-rate note would likely include a benchmark rate controlled by the Fed. So if the U.S. is ever struggling to meet its debt obligations, the Fed may feel obligated to keep interest rates lower than it otherwise would. If it increases rates, a payment shock could affect U.S. financial stability. Due to this, floating-rate debt could lead to higher inflation, since the Fed may feel pressured to leave interest rates lower for longer.

I thought the Federal Reserve would be a natural buyer of such debt. Consider the current (what I think overplayed) worry that the Federal Reserve is threatened by huge captial losses on its existing portfolio when interest rates rise. There is some concern that the Fed will resist raising rates to avoid the erosion of it capital base, as it would lose some of its independence if monetary policymakers needed a capital injection from the US Treasury. In addition, there is a related concern that should the Fed need to raise interest on reserves abruptly to control inflation, then the Fed's expenses will surge well above the interest paid on its Treasury portfolio. Yet again another trip for a Treasury bailout.

While I was not concerned much about these scenarios, note that they would both be eliminated if the Fed held a significant portion of floating rate debt in its portfolio. It would automatically create a revenue stream to support higher interest on reserves. Obviously, the risk of capital loss would recede. Moreover, a large Federal Reserve holding of such debt would protect the taxpayer as well - higher debt servicing cost would just flow right back to the US Treasury (after Federal Reserve expenses). Finally, note then-Federal Reserve Governor Ben Bernanke made a similar proposal in his famous 2003 Japanese monetary policy speech. Essentially, a floating rate portfolio eliminates some imagined or real constraints on monetary policy, reducing the risk that additional quantitative easing will turn inflationary.

In short, I think the US Treasury has good reason to consider adding floating rate debt - and should find a ready buyer not only in Wall Street, but just across town.

Sunday, October 23, 2011

"Coordinated Fiscal and Monetary Policy"

I've been making these points in various ways since the crisis started, but with frustratingly little notice or effect. Maybe Brad DeLong will have more luck:

DeLong Smackdown Watch: Nominal GDP Targeting Through Unconventional Monetary Policy and Through Fiscal Policy Edition, by Brad DeLong: Duncan Black complains because he thinks I have not been critical enough of nominal GDP targeting via unconventional monetary policy alone:

Eschaton: Why Don't They Lend Me $30 Billion On The Security Of My Cats?: If we're going to actually move to more "unconventional" monetary policy, can we please recognize that the reason to do so is largely because conventional monetary policy - acting through the banking system - isn't working? We should understand that it isn't working because it almost destroyed the world a few years ago and is about to do so again because, you know, nothing changed and the overpaid assholes who almost destroyed the world then are still in charge. If we're going to give out dodgy loans, how about giving dodgy loans to people who might do something with the money other than visiting the Great Casino?

Point taken.

Touché.

I will report to the reeducation camp tomorrow...

I have been saying that coordinated fiscal and monetary policy--jen-U-ine helicopter drops or simple government-print-and-buy-useful-stuff--is the superior way to accomplish nominal GDP targeting, and that doing so via monetary policy alone runs risks.

But I have not been saying so loudly enough.

Look: targeting the nominal GDP path via monetary policy alone in a liquidity trap is a bet that private-sector financiers will:

  • be confident that the policy will not be reversed when the economy emerges from its liquidity trap,

  • be confident that the policy will succeed and that they should start spending now in anticipation of the faster nominal GDP growth that the policy will produce, plus

  • a little bit of taking risk onto the Federal Reserve's balance sheet and so freeing up private financier risk-bearing capacity to expand their loan portfolio.

Mostly, that is, the policy is a policy that succeeds if it is generally expected to succeed and fails if it is generally expected to fail. It thus has the confidence fairy nature.

To the extent that the policy does not have the confidence fairy nature, it is because it changes asset supplies here and now and thus private financiers' incentives to lend and businesses' incentives to produce. It does so because the policy involves swapping one asset for another asset that is not the same.

Right now because we are in a liquidity trap short-term Treasury bills and cash are effectively, for the moment, the same asset: they are both short-term zero-yield safe nominal government liabilities. Very few believe that the Federal Reserve's buying Treasury bills for cash and saying: "See! We are doing something! Nominal GDP growth will be faster! You should raise your expectations of real growth and inflation and act accordingly!" would actually do anything. By contrast, if the Federal Reserve buys long-term Treasury or agency or private debt the assets it is buying carry an expectational term premium, duration risk, and (perhaps) default risk: they are not identical to the assets that they are selling. Because the private sector's asset holdings change, private-sector financiers and businesses have incentives to change their behavior even if they don't buy the appearance of the confidence fairy at all--and the fact that they will change their behavior even if they don't believe is a reason for people to believe.

The superiority of unconventional monetary policy thus works off of the fact that the assets the government is buying are different than the assets it is selling--and thus the more different the assets it buys from the assets it sells, the greater the non-confidence-fairy bang from the policy.

What asset is most different from cash?

With a helicopter drop, the Federal Reserve sells cash and it buys… nothing at all. Cash and nothing are pretty different assets. Add cash to private-sector portfolios and take nothing away, and portfolios have shifted in meaningful ways and people will change what they do.

With print-money-and-buy-useful-things, the government sells cash and buys… roads, bridges, research into public health, flu shots, killer robots--all kinds of things that are very very different indeed from cash.

Thus--as Milton Friedman's teacher Jacob Viner knew well back in 1933--coordinated fiscal and monetary expansion via printing money and buying useful stuff (or handing it out via helicopter drops) is a policy that really does not have the confidence fairy nature. Because it does not require confidence to start working, it will (probably) work much more rapidly and certainly.

Friday, October 21, 2011

Signs that the Fed Will Provide More Stimulus for the Economy

I am starting to think the Fed might do more for the economy:

The Fed Is Laying the Groundwork for Further Easing

A Ticker-Tape Parade?

This caught my eye:

Simon Johnson ... said that a current member of the Fed told him he was “disappointed there hadn’t been a ticker-tape parade” for policymakers who, in the central banker’s mind, had saved the economy.

Suppose the fire department fails to do adequate inspections, and a big fire breaks out because of it. If that same fire department puts it out and saves the day, do we cheer them for cleaning up their own mess? I think not.

Wednesday, October 19, 2011

What's Needed to Successfully Target the Level of Nominal GDP?

Brad DeLong:

What Needs to Happen for the Fed to Successfully Target the Level of Nominal GDP?, by Brad DeLong: Paul Krugman writes:

Getting Nominal: “Market monetarists” like Scott Sumner and David Beckworth are crowing about the new respectability of nominal GDP targeting. And they have a right to be happy. My beef with market monetarism early on was that its proponents seemed to be saying that the Fed could always hit whatever nominal GDP level it wanted; this seemed to me to vastly underrate the problems caused by a liquidity trap. My view was always that the only way the Fed could be assured of getting traction was via expectations, especially expectations of higher inflation –a view that went all the way back to my early stuff on Japan. And I didn’t think the climate was ripe for that kind of inflation-creating exercise.

At this point, however, we seem to have a broad convergence. As I read them, the market monetarists have largely moved to an expectations view. And now that we’re almost four years into the Lesser Depression, I’m willing, out of a combination of a sense that support is building for a Fed regime shift and sheer desperation, to support the use of expectations-based monetary policy as our best hope.

And one thing the market monetarists may have been right about is the usefulness of focusing on nominal GDP. As far as I can see,the underlying economics is about expected inflation; but stating the goal in terms of nominal GDP may nonetheless be a good idea, largely as a selling point, since it (a) is easier to make the case that we’ve fallen far below where we should be and (b) doesn’t sound so scary and anti-social.

I still believe that the chances of success will be a lot larger if we have expansionary fiscal policy too; but by all means let’s try whatever we can…

Let's try to answer this question by using… the IS-LM model!

If you are--as we are right now--in a liquidity trap, with extremely interest-elastic money demand, then expansionary monetary policy that involved the Federal Reserve buying financial assets for cash:

  1. will have next to no effect on the short-term safe nominal interest rate--it's already zero.
  2. will decrease the long-term safe nominal interest rate to the extent that your open-market operations today change people's expectations of what your target for the short-term safe nominal interest rate in the future.
  3. will decrease the long-term safe real interest rate to the extent that it decreases the short-term nominal interest rate and changes expectations today of what inflation will be in the future.
  4. will decrease the long-term risky real interest rate to the extent that it decreases the long-term safe real interest rate and to the extent that the assets purchased for cash by the Federal Reserve free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads.
  5. will increase spending to the extent that it decreases the long-term risky real interest rate and to the extent that private spending responds positively to decreases in the long-term risky real interest rate.

Lots of steps here, some of which may well be weak.

By contrast, the alternative expansionary policy is for the government to print money and spend it buying useful things. Then:

  1. The buying of useful things raises spending.
  2. Financing it by printing money rather than issuing bonds means no increase in interest rates to crowd out private spending.
  3. Financing it by printing money rather than promising to levy future taxes means no increase in the present value of future tax liability to crowd out private spending.
  4. Financing it by printing money means no worries about any increase in fears of some future government default.

By contrast, if we tried to target nominal GDP through fiscal policy alone--through borrowing and spending buying useful things:

  1. The buying of useful things raises spending.
  2. Financing it by issuing bonds might mean an increase in interest rates that would crowd out private spending.
  3. Financing it by promising to levy future taxes means an increase in the present value of future tax liability that might crowd out private spending.
  4. Financing it by issuing bonds means a possible increase in fears of some future government default.

To try to target nominal GDP using either only monetary policy or only fiscal policy seems hazardous. To coordinate--monetary and fiscal expansion, money printing-financed purchase of useful things--seems to be the winner.

Yep, as I've been arguing since this started, we need attack the unemployment problem aggressively with both barrels of the policy gun.

Thursday, October 06, 2011

Fed Watch: Don't Let Monetary Policy Off The Hook

Tim Duy:

Don't Let Monetary Policy Off The Hook, by Tim Duy: Re-reading Federal Reserve Chairman Ben Bernanke’s latest testimony to Congress left me increasingly puzzled by his conclusion:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

This is a clear effort to shift the focus away from monetary policy onto the fiscal side of the equation. But I think there is a significant flaw in that position. Fiscal policymakers will be completely unable to address medium- or long-term budget issues as long as there exists a sizable output gap and high levels of unemployment. Persistently low levels of output will necessitate deficit spending, and low interest rates will justify that spending. That is the lesson of Japan. Nor will the economy naturally gravitate toward such any other outcome – we are stuck in a liquidity trap. That is also the lesson of Japan.

Assuming the proximate cause of the current US economic environment is indeed a liquidity trap, then a solution to that problem lays solely in the hands of monetary policymakers. In short, the primary economic challenge is to lift the US from the zero bound floor; until that happens fiscal policy will limp along like that of Japan, with ever-growing debt that does little than serve as a partial stopgap. The deficit spending becomes a long-run outcome rather than a short-run solution.

Simply put, the Federal Reserve needs to take responsibility for ending the liquidity trap. Instead, as Scott Sumner summarizes:

The Fed has plenty of credibility, that’s not the problem. The problem is that they are using the credibility to assure investors that low inflation is here to stay. With the right target, there would probably be no need for massive quantitative easing, or other extraordinary policies.

First and foremost, low inflation is the primary objective of Fed policy. They have repeatedly set expectations that the increase in the balance sheet is only temporary, and will be reversed as soon as possible. On not one but two occasions this cycle they prematurely shifted gears to setting expectations for tighter policy, which is effectively the same thing as engaging in tighter policy. They have offered a half-hearted attempt to remedy this situation by announcing a commitment to low rates, but have made it remarkably clear it is not a real commitment. From the Fed minutes:

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

Fear of inflation prevents the Federal Reserve from making an unconditional commitment. And therein lies the stumbling block to real policy change. It is virtually impossible to imagine reestablishing the pre-recession nominal GDP trend, and entirely impossible to regain the pre-recession price trend, without accepting a temporary acceleration of inflation along the way.

More succinctly, we will not lift the economy off the zero-bound without accepting higher than 2% inflation. Since the Federal Reserve has made it clear they will not accept inflation greater than 2%, the economy will not clear the zero-bound. And if the economy does not clear the zero-bound, we will be faced with perpetual and unavoidable deficit spending.

Deficit spending is not accommodated by the Federal Reserve via low interest rates; it is made necessary because the Federal Reserve sees no urgency ending the lower bound challenge. Which means it is ridiculous to believe that the Fed can dump off this problem on fiscal policymakers. How can the state of monetary policy have deteriorated so much that now even Bernanke claims “regulation” is holding back the economy? Yet here we are.

Where should the Fed go from here? First and foremost, they need to make a commitment to pull away from the zero-bound. As Sumner suggests, they need this commitment clearly defined by a target such as reestablishing nominal GDP or price level. The need to implement open-ended action to achieve this target. My suggestion is to announce they will make permanent additions to their balance sheet by purchasing on the secondary market $5 billion of US Treasury securities every week until the target is reached. I think they need to make permanent additions to be credible – they have clearly expressed that previous balance sheet expansions should be viewed only as temporary.

Won’t this amount to monetization of deficit spending? Yes, but if Sumner is correct, less than might be feared, as the commitment is more important than the size of the purchases. And I already arrived at the conclusion, aided by Bernanke’s 2003 speech, that the situation requires a greater coordination of monetary and fiscal policy. Moreover, even if sizable purchases are required, there is no reason this needs to be a problem. As Bernanke has already explained, the Fed simply needs to make clear its target and once that target has been reached, they will adjust policy appropriately to maintain the nominal GDP or price level trend. In other words, purchases will be suspended and policy will by that point revert to traditional interest rate management, with the possible reduction of the portion of the balance-sheet expansion that to-date has been viewed as temporary.

Once the Fed achieves normal monetary conditions, the ball will be back in the hands of fiscal policymakers, who may then soon understand that policy is a lot different when interest rates create real constraints on spending and taxes. But that is a battle for another day.

Bottom Line: It is ludicrous for the Fed to declare the primary economic responsibility is now on fiscal policy. As long as we are in a liquidity trap, fiscal policy is stuck in a never-ending cycle of deficit spending. Absent that spending, the economy will simply slip backwards into recession again and again. The exit from the liquidity trap can only come from the monetary side of the equation. Try as he might Federal Reserve Chairman Ben Bernanke cannot escape his policy responsibilities. And we shouldn’t let him.

Wednesday, October 05, 2011

Solow: Keynesian Economics Has Become Dramatically Relevant Again Today

Robert Solow:

... One reason why Keynes’s great book is so difficult to explain is that it is no masterpiece of clarity. ... I want to emphasize two of its themes, because they ... point directly to the reason why Keynesian economics, born in the 1930s, has become dramatically relevant again today. Back then, serious thinking about the general state of the economy was dominated by the notion that prices moved, market by market, to make supply equal to demand. Every act of production, anywhere, generates income and potential demand somewhere, and the price system would sort it all out so that supply and demand for every good would balance. Make no mistake: this is a very deep and valuable idea. ... Much of the time it gives a good account of economic life. But Keynes saw that there would be occasions, in a complicated industrial capitalist economy, when this account of how things work would break down.
The breakdown might come merely because prices in some important markets are too inflexible to do their job adequately; that thought had already occurred to others. It seemed a little implausible that the Great Depression ... should be explicable along those lines. Or the reason might be more fundamental, and apparently less fixable. To take the most important example: we all know that families (and other institutions) set aside part of their incomes as saving. They do not buy any currently produced goods or services with that part. Something, then, has to replace that missing demand. There is ... a natural counterpart: saving today presumably implies some intention to spend in the future, so the “missing” demand should come from real capital investment, the building of new productive capacity to satisfy that future spending. But Keynes pointed out that there is no market or other mechanism to express when that future spending will come or what form it will take. ... The prospect of uncertain demand at some unknown time may not be an adequately powerful incentive for businesses to make risky investments today. ...
So a modern economy can find itself in a situation in which it is held back from full employment ... not by its limited capacity to produce, but by a lack of willing buyers for what it could in fact produce. The result is unemployment and idle factories. ... There are some forces tending to push the economy back to full utilization, but they may sometimes be too weak to do the job in a tolerable interval of time. But if the shortfall of aggregate private demand persists, the government can replace it through direct public spending, or can try to stimulate additional private spending through tax reduction or lower interest rates. ... This was Keynes’s case for conscious corrective fiscal and monetary policy. Its relevance for today should be obvious. ...
A second characteristically Keynesian theme meshes very well with the first. In a complex economy, many business decisions have to be made in a fog of uncertainty. This is especially true of investment decisions... The standard practice is to focus on the uncertainty and think about it in terms of probabilities, which at least allow for an orderly analysis... Keynes preferred to focus on the fog. He thought that some of the important uncertainties were essentially incalculable. They would end up being dealt with in practice by a mixture of apprehensiveness, rules of thumb, herd behavior, and what he called “animal spirits.” The point of this distinction is not merely philosophical: it suggests that long-term investment behavior will sometimes be irregular, unstable, and given to doldrums and stampedes. ...

He also discusses Irving Fisher, Joseph Schumpeter, John Maynard Keynes, Friedrich Hayek, and John Stuart Mill.

Tuesday, October 04, 2011

Fed Watch: The Fed Drops the Ball

Tim Duy:

The Fed Drops the Ball, by Tim Duy: (Note: I am feeling bearish today, especially looking back to lost opportunities to get ahead of the current environment.)

By mid-summer it was evident the recovery was in jeopardy, that the slowdown in economic activity could not be entirely explained by temporary factors, that unemployment would remain unacceptably high, and that the slow motion train wreck that is the European experiment would be resolved only in the aftermath of financial chaos.

The Fed had the opportunity to get ahead of the curve. They chose not to. To be sure, they offered some half-hearted support to the existing policy stance. But this amounts to bring a knife to a gunfight.

At this point, we are faced with mounting recession forecasts. The Economic Cycle Research Institute publicly announced their recession call last week, confidently expecting to extend their 3-0 forecasting record. Nouriel Roubini already offered up his recession call. Today, Goldman Sachs placed 40% odds on recession in 2012.

And in the Goldman Sachs call lays the obstacle to an aggressive monetary response, as opposed to the simple rearranging of the deck chairs currently underway. There may be widespread belief that the seeds of the recession are planted and beginning to sprout, but the near-term data certainly will not confirm a recession is underway. From the Wall Street Journal:

So far, as many economists point out, the worst readings on the economy come from sentiment measures rather than hard numbers on economic activity.

The pessimism among consumers and businesses alike may be reactions to political uncertainty and the volatility in the stock market, while the nuts-and-bolts data on the U.S. economy look better.

In the latest round of data, August construction spending surprisingly rose 1.4% when a 0.4% drop was expected. September factory activity beat forecasts as well. The Institute for Supply Management said the sector’s expansion strengthened for the first time since June.

The data point to real gross domestic product growing at an annual rate above 2% in the third quarter, more than double the pace of the first half.

The economy was not in recession in the third quarter, which means the backward looking data flow through this month will not be particularly dire. We are really looking for whatever acceleration we see in third quarter GDP growth to ebb in the fourth quarter, a bad omen for the fiscal drag we will experience as the payroll tax credit expires. On top of that, you have to believe in unicorns and fairies if you think the European crisis is going to go anywhere other than from bad to worse in the next three months. The lesson of the past two years is the Europeans will arrive late and bring a club to the gunfight. Indeed, while today’s late rally was credited to the latest round of optimism on Europe, via Bloomberg:

Equities rebounded after the S&P 500 fell below 1,090.89, the closing level required to give the index a 20 percent slump from the three-year high reached on April 29. Stocks rose after the Financial Times quoted Olli Rehn, European commissioner for economic affairs, as saying there is an “increasingly shared view” that the region needs a coordinated approach to halt the sovereign debt crisis. After U.S. markets closed, Belgian Prime Minister Yves Leterme said a “bad bank” to hold Dexia SA (DEXB)’s troubled assets will be set up.

the reality is likely less optimistic:

“People are looking for optimism anywhere they can get it,” said Christopher Bury, co-head of fixed-income rates at Jefferies & Co., one of the 22 primary dealers that trade with the Federal Reserve. “You have these random stories and the market reacts, but how many times have we been down this road where these are just words?”

One additional note on the global environment – signs are emerging that the long running Chinese property boom is running into trouble. From Deustche Bank and via Business Insider:

In recent weeks, the number of phone calls received by an author of this report from China-based property agents has increased several fold, indicating a significant rise in the urgency for developers to raise cash from selling properties. A property consultant told us that he recently received requests to help raise RMB10bn for cash-strapped small and medium-sized property developers – this amount is a huge multiple of what he is used to dealing with. In the offshore market, where many Chinese developers seek foreign currency funding due to lack of access to domestic funds (the domestic stock, bond and trust loan markets are closed to them due to policy tightening, and banks are also very stringent), their USD bond yields have surged to 20-25% in past weeks from around 10% before August. This means that even the offshore markets are now largely closed to Chinese developers…

The Chinese government will act to cushion the downside for their property sector, but what will be the consequences of even a short-term slowdown for a global economy already on the downside?

Put aside the non-recessionary real economy data and instead turn to the financial markets for hints. There the signals are decidedly more pessimistic. Equities are heading into bear market territory, interest rates are collapsing, spreads between Treasuries and corporate debt are widening, commodity prices are in virtual free-fall, and the TED spread, while still well short of the highs reached during the financial crisis, have more than doubled from 15bp in the spring to 38bp now.

There is no way to read the ongoing financial turmoil as anything other than increasing fear that a recession is underway. Perhaps it is all simply a growth scare, and that in a few months we will wonder what all the fuss was about. But ECRI believes it is already too late for that story:

A new recession isn’t simply a statistical event. It’s a vicious cycle that, once started, must run its course. Under certain circumstances, a drop in sales, for instance, lowers production, which results in declining employment and income, which in turn weakens sales further, all the while spreading like wildfire from industry to industry, region to region, and indicator to indicator. That’s what a recession is all about.

About the only good news is that, as pointed out by Goldman Sachs, perhaps the downside will remain limited:

The downside risk is of course that these financial spillovers--or conceivably some other shock, perhaps greater fiscal tightening in 2012 than we now anticipate--prove sufficient to push the US economy into recession; both a quantitative model and our subjective assessment put recession risk in the neighborhood of 40% at this point. For now, we still think the base case is that the US economy avoids this outcome. The cyclical sectors of the economy are already quite depressed--in particular, homebuilding is barely above the depreciation rate of housing--so downside looks more limited.

Cold comfort, according to ECRI:

It’s important to understand that recession doesn’t mean a bad economy – we’ve had that for years now. It means an economy that keeps worsening, because it’s locked into a vicious cycle. It means that the jobless rate, already above 9%, will go much higher, and the federal budget deficit, already above a trillion dollars, will soar.

Here’s what ECRI’s recession call really says: if you think this is a bad economy, you haven’t seen anything yet. And that has profound implications for both Main Street and Wall Street.

With the US, we know that fiscal policy is off the table as gridlock rules the day in Washington. What more, it looks like the Federal Reserve resistance to additional action is at least partly based on a conviction this is no longer a problem for monetary policy – it is up to fiscal policy now. To be sure, financial markets today were at least initially buoyed by Federal Reserve Chairman Ben Bernanke’s comment:

The Committee will continue to closely monitor economic developments and is prepared to take further action as appropriate to promote a stronger economic recovery in a context of price stability.

But, after financial market participants sober up, they should recognize that this is nothing new. The Fed will offer more support. A hint from Bernanke as quoted by the Wall Street Journal:

Republicans also pressed the Fed chairman on the risk that the central bank could be stirring inflation with its efforts to pump money into the financial system to bring down interest rates. Mr. Bernanke dismissed such worries. He said a spurt in consumer prices earlier this year was already receding and that unemployment was a bigger threat.

"Right now, frankly, we're much further away from full employment than we are from price stability," he said. With that comment was a hint: The Fed might not be hurrying to do more to help the economy right now, but it is still leaning in that direction.

The only question is when and how much. Already, though, it is arguably too late. Recession or just slow growth, the policy delay will weigh heavily on the unemployed. Moreover, the Fed chair gives us little reason to believe he has much to offer:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

How different is this view from that of Dallas Federal Reserve President Richard Fisher in defending his last dissent?

One other factor gave me pause and that was, and remains, the moral hazard of being too accommodative. For years, I have been arguing that monetary policy cannot solve the problem of substandard economic performance unless it is complemented by fiscal policy and regulatory reform that encourages the private sector to put to work the affordable and abundant liquidity we are able to create as the nation’s monetary authority. These actions are not within the Fed’s purview; they are the business of Congress and the president.

I fail to see the wisdom in neglecting policy options simply because Congress is falling down on the job.

It seems that Bernanke is more center-right of Fed policymakers than center-left. Which suggests that he will need to be dragged kicking and screaming into another round of asset purchases. And, unfortunately, we will first need to see more citizens added to the ranks of the unemployed for that to happen.

Perhaps events will evolve in such away that the current round of pessimism will prove unfounded. But even if we avoid recession, the slow growth and constant threat of recession serve as a reminder that policymakers have fallen far short of doing what is needed to lift the economy from the zero bound. And, worse yet, neither monetary nor fiscal authorities appear particularly worried about achieving such a goal.

Bernanke: Fiscal Policy is of Critical Importance

A few remarks on Bernanke's testimony before Congress:

Bernanke: Fiscal Policy is of Critical Importance

Saturday, October 01, 2011

Fed Watch: Too Late for the Unemployed?

Tim Duy says that while Ben Bernanke suggested that the main unemployment problem was cyclical, not structural in his speech at Jackson Hole, Federal Reserve policymakers are increasingly adopting the structural view. Unfortunately, the belief that unemployment is mostly structural is a self-fulfilling proposition:

Too Late For The Unemployed?, by Tim Duy: The debate about whether unemployment is cyclical or structural unemployment arose last year. At this point, it looks like Federal Reserve policymakers increasingly favor the structural side of the debate.

Federal Reserve Chairman Ben Bernanke, speaking at Jackson Hole, suggested that cyclical unemployment remains the primary economic challenge:

Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view--the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow.

Note that he does not conclude the long-term unemployed are by definition structurally unemployed. Still, he continues to suggest that cyclical unemployment can turn structural:

In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.

But, as is well known, he throws the ball to the fiscal authorities:

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

But is it already too late? Has the cyclical unemployment turned structural? This week, serial-dissenter Philadelphia Federal Reserve President Charles Plosser embraced the structural view:

These numbers are troubling, especially when more than 40 percent of the unemployed, or some 6 million people, have been out of work for 27 weeks or longer. This underscores that we should not expect any easy solution. Millions of unemployed workers may take longer to find jobs because their skills have depreciated or they may need to seek employment in other sectors. These structural issues will take time to resolve. Jobs and workers will need to be reallocated across the economy, which is a long and slow process.

Plosser takes the rise in long-term unemployment as an indication of structural unemployment. He then extends the point to fight the last war:

We have provided a great deal of monetary accommodation to the economy, and given the stubbornness of the unemployment rate in responding to these efforts, we should be cautious and vigilant that our previous accommodative policies do not translate into a steady rise in inflation over the medium term even while the unemployment rate remains elevated. Creating an environment of stagflation, reminiscent of the 1970s, will not help businesses, the unemployed, or the consumer. It is an outcome we must carefully guard against.

Likewise, the centrist Atlanta Federal Reserve President Dennis Lockhart also speaks of structural factors with respect to the long-term unemployed, even invoking a comparison with Europe:

I was concerned by not only the persistence of high unemployment but also the complicated internal dynamics of the current labor market. To me, it is not clear to what degree structural factors are impeding the filling of job vacancies. And with some 43 percent of the unemployed out of work for more than six months, it is not clear to what extent the long-term unemployed are becoming a class of permanently unemployed, creating a problem resembling the so-called structural unemployment of some European countries. Further, it is not clear why participation in the labor force continues to fall. Finally, it is not clear what level of unemployment should be considered the natural or equilibrium rate under current circumstances.

Not to be outdone, the difficult-to-categorize St. Louis Federal Reserve Chairman James Bullard also looks to Europe for guidance. From his presentation this week:

  • Unfortunately, unemployment rates have a checkered history in advanced economies over the last several decades.
  • In particular, “hysteresis” has been a common problem, in which unemployment rises and simply stays high.
  • This occurred in Europe during the last 30 years.
  • If such an outcome happened in the U.S., and monetary policy was explicitly tied to unemployment outcomes, monetary policy could be pulled off course for a generation.

Now, it seems to me premature to be looking to Europe as an example. It seems reasonably obvious the unemployment problem is the result of a severe negative shock to spending. You might say no, it is structural in that we can no longer rely on housing to support incomes. But that just boils down to a spending problem - unemployment was at the natural rate as long as households and firms had the ability and willingness to spend. Moreover, I am a bit hard pressed to see how America was transformed into Europe in just three years. That said, I am not the policymaker. It appears Federal Reserve members increasingly embrace the structural unemployment story, and that suggests they will hesitate to bring out substantial additional stimulus until the see greater evidence of deflation. Of course, the longer we drag our heels on the unemployment crisis, the more easily it will be for policymakers to wash their hands of the issue, as the cyclical unemployment eventually will become structural.

Thursday, September 29, 2011

Plosser: Recent Stimulus Will Hurt the Fed's Credibility

Federal Reserve Bank of Philadelphia President Charles Plosser voted against Operation Twist -- the recent attempt for the Fed to help the economy -- because:

“The actions taken in August and September tend to undermine the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery. It is my assessment that they will not,” ... “We should not take certain actions simply because we can.”
“If we act as if the Fed has the ability to solve all our economic problems, the credibility of the institution is undermined,” Plosser said. “The loss of that credibility and confidence could be costly to the economy because it will make it much harder for the Fed to implement effective monetary policy in the future,” he said.

He certainly isn't acting like "the Fed has the ability to solve all our economic problems," (and two other Fed officials dissented along with him). In addition, the Fed officials who voted for this action have been careful to say this won't, in fact, solve all of our problems. They've said it can help modestly, and given the state of the economy even modest help is vary valuable, but they have not implied this will suddenly and magically fix our problems. So I really don't see how this action undermines credibility. Fed officials have been clear this is no magic bullet, but they think it could help some and things are so bad -- and the threat of inflation so low -- that they feel compelled to try.

But from Plosser's point of view, the Fed can't do much at all at this point, and the fear of inflation down the road trumps concerns about unemployment now. Plus, the Fed can't do anything about unemployment anyway:

“I am skeptical that this will do much to spur businesses to hire or consumers to spend, given the ongoing structural adjustments occurring in the economy and the uncertainties posed by the fiscal challenges both here and abroad,” Plosser said. Meanwhile, “we should be cautious and vigilant that our previous accommodative policies do not translate into a steady rise in inflation over the medium term even while the unemployment rate remains elevated.”

He is saying that unemployment is largely structural ("given the ongoing structural adjustments") even though it's clear that a large part of it is cyclical, and that uncertainty over fiscal policy is holding the economy back even though bond yields show no sign of this whatsoever. Thus, in his view the structural problems combined with uncertainty are holding back employment, and there's nothing the Fed can do about it.

Is he worried about inflation in the near term? No:

with many commodity prices now leveling off or falling, and inflation expectations relatively stable, inflation will moderate in the near-term

And why should we trust his forecasts in any case? He keeps seeing green shoots that aren't there:

“I was expecting GDP growth in 2011 to be 3% to 3.5%. Now, I expect GDP growth to be less than 2% in 2011, but to gradually accelerate to around 3% in 2012.” He added “I do not believe the current data signal that we are on the precipice of a so-called double-dip recession.”

So he keeps expecting growth that never comes, and uses those expectations along with the excuse that it's structural/uncertainty forestall policy action. What if his forecast for 3% growth in 2012 is as wrong as his previous forecast, and what if there is a double-dip? What if the unemployment problem is largely cyclical like most analysts say? What if, as many have concluded, uncertainty is not the problem? Is he really so certain about his forecasts and views about what's holding the economy back given his track record? With near term inflation falling, why not at least try to do more? Why should inflation risk trump the risk of continued sluggish growth (which in and of itself alleviates inflation concerns if it happens)? Is somewhat higher inflation down the road -- if it even happens -- really more worrisome than a period of elevated unemployment?

And why should this action produce inflation in any case? Operation Twist doesn't change the size of the Fed's balance sheet, it changes the average duration of the assets the Fed holds. If the balance sheet doesn't expand how, exactly, does that create inflation pressure to any significant degree? If there's no inflation pressure, what is the real concern? It appears to be the credibility argument and the fact that unemployment can't be helped -- it's structural/uncertainty -- but as noted above the structural/uncertainty claim is easy to rebut, and the concerns over credibility ring hollow. So he might at least consider the possibility that he has this wrong.

For me, one of the most frustrating thing about policy over the last several years is the continued insistence from some Fed officials that good times are just around the corner so any action they take will be inflationary. They have been wrong again and again, yet the optimism about future growth -- green shoots -- remains. Like Paul Krugman, I have been warning about a slow recovery since at least 2008, and warning about seeing green shoots that aren't there for almost as long, and it's disappointing to see policymakers continue to use the promise of good times just ahead -- especially policymakers who have been wrong again and again -- along with the easily refuted claim that the problem is all uncertainty and structural issues as an excuse to stand against doing more to try to help the unemployed (however modestly).

Wednesday, September 28, 2011

Ben Bernanke and the Washington Consensus

A few quick and somewhat scattered comments on Bernanke's speech today:

Ben Bernanke and the Washington Consensus

Fed Watch: Opinions and Rumors

Tim Duy:

Opinions and Rumors, by Tim Duy: Federal Reserve President Richard Fisher today attempted to defend his ongoing policy dissent. He gives plenty of material to work with, beginning with his version of research ahead of an FOMC meeting:

Before every FOMC meeting, I survey a select group of 30 or so private business and banking operators, imparting no information about monetary policy but listening carefully to their perspectives on developments in the economy as seen at the ground level. For weeks leading up to the meeting, there was speculation in the financial markets and in the press that an Operation Twist was being contemplated. I received an earful of opinions on these rumors.

A big red flag right away. He claims to listen to survey contacts on the state of the economy, but does he tell us what they said about the economy? No, of course not. Instead, he emphasizes that he heard a lot of opinions about rumors. Pay very close attention to what Fisher is saying. He is saying he does not attempt to make policy on the basis of economic fact. He believes policy should be made on the basis of random speculation. I guess it is too much work to look beyond that random speculation. He continues:

What I gleaned from those conversations was as follows:

Embarking on an Operation Twist would provide an even greater incentive for the average citizen with savings to further hoard those savings for fear that the FOMC would be signaling the economy is in worse shape than they thought.

The economy is in worst shape than the FOMC believed just months ago. Is it Fisher’s contention that the Fed’s best policy is to attempt to hide this fact? Apparently so – good luck establishing a credible monetary policy when the stated intent is to lie about the actual state of the economy.

They might view an Operation Twist as setting the stage for a new round of monetary accommodation―a QE3, if you will. Such a program was considered redundant by business operators given their surplus of undeployed cash holdings and bankers’ already plentiful excess reserves.

Actually, apparently market participants came to exactly the opposite conclusion and, realizing the path to QE3 was longer than initially believed, bid down long-term inflation expectations. More:

In addition, such a program might frighten consumers by further driving down the yields they earn on their savings and/or lead to long-term inflation that would erode the value of those savings;

I don’t know how you drive yields down any further, as the average savings account is paying nearly zero percent. And the second sentence doesn’t follow from the first – if rates are near zero, it is only because the environment is decidedly non-inflationary. See the point above. Again, the lack of significant action on the part of the Federal Reserve is dragging down inflation expectations and real interest rates. Only in Fisher’s fantasy land is the opposite happening. More objections:

The earning power of banks, both large and small, would come under additional pressure by suppressing the spread between what they can earn by lending at longer-term tenors and what they pay on the shorter-term deposits they take in;

I think this point gets overplayed. The prime-lending rate has been locked up at 3.25% since the beginning of 2009. The spread between the prime lending rate and short-term deposit rates:

Fisher1

Sure enough spread between the two has hovered around 300bp since 1990, holding true to the rule of thumb that the prime rate is 300bp plus the fed funds rate. Another example - the 24 month personal loan rate was 12.41% in 2006 when 1 month CD rates were 5%. Now the same loan rate is 11.47%, for a much wider spread. Same story with credit card rates, which have only come down a fraction of the amount of short rates. All of which makes me doubt this concern that Fed policy is deterring lending activity by crushing yields on Treasury debt (although I can see where it erodes the earnings on any Treasury debt held by the banking sector). Indeed, the opposite is occurring. Lending activity is on the rise for at least one segment of the market:

Fisher2

Apparently someone is lending money, although admittedly the consumer market is more challenging. If anything, the necessity of the banking community to earn a spread places a lower limit on lending rates, which explains the 3.25% prime rate which in turn would limit the uptake of loans (and justifies the use of higher inflation expectations to bring down real rates).

The ability to lend, however, is not only determined by the rate spread, but also by the demand from credit-worthy borrowers – and that demand has been sorely lacking as households deleverage. See also this note from the Wall Street Journal suggesting Operation Twist was a subsidy for banks. A final point is that looking through FDIC reports, the net interest margin has hovered within 25bp of 3.5% for the last decade. In 2Q11 it was 3.61% and in 2Q05 it was 3.49%. True enough, a few basis point lower spread is meaningful. But what is more important at this point is to see even higher loan growth to profit on that margin. And that is what the Fed is trying to induce. If the Fed allows the economy to slow and loan demand to falter, a slightly higher margin might not be sufficient to prop up earnings, not to mention the impact of additional loan-loss provisions that would come into play. In short, lots of dynamics on this issue. More from Fisher:

Pension funds would have to reassess their potential returns, with the consequence that public and private direct-benefit plans would have to set aside greater reserves that might otherwise have gone to investments stimulating job creation

Yes, low interest rates place an additional burden on pension funds, just as low rates squeeze the returns for savers. But is it the Fed driving rates lower, or is the Fed just following the economy. I think it is more the latter than the former. If the Fed was actually pursuing an aggressive monetary policy, the economy would firm and long rates rise. The problem is that, contrary to the belief at Constitution Ave., the Fed's commitment to supporting economic activity is only half-hearted. And does Fisher really believe everything would be better if the Fed hiked rates by 200bp? Would pension funds really be better off if we knocked 25% off of equity valuations? More:

Expanding the holdings of the Fed’s book of longer-term debt would likely compound the complexity of future policy decisions. Perversely, the stronger the economy, the greater the losses the Fed would incur as interest rates rise in response and the prices of those longer-term holdings depreciate. The political incentive to hold rates down might then become stronger precisely when we want to initiate tighter monetary policy. This concern, of course, would be a good news/bad news issue: The good news is that it would stem from a stronger economy; the bad is that might hurt our maneuverability and, in doing so, might undermine confidence in the Fed to conduct policy independently.

This concern over the Fed’s balance sheet is way overblown. First, San Francisco Federal Reserve economist Glenn Rudebusch addressed this issue earlier this year, concluding that:

Such interest rate risk appears modest, especially relative to the Fed's policy objectives of full employment and price stability

Second, then Governor Ben Bernanke already dismissed this concern in 2003, and noted very clearly it would be a mistake to allow such concerns to prevent the central bank from acting. The Fed should simply reach an agreement with Treasury to take this concern off the table entirely, otherwise Fisher and his ilk will just continue to use it as an excuse to justify inaction. And, quite frankly, rather than basing policy on "opinions on these rumors," wouldn't a real policymaker attempt to explain why such opinions are unfounded? He continues:

One other factor gave me pause and that was, and remains, the moral hazard of being too accommodative. For years, I have been arguing that monetary policy cannot solve the problem of substandard economic performance unless it is complemented by fiscal policy and regulatory reform that encourages the private sector to put to work the affordable and abundant liquidity we are able to create as the nation’s monetary authority.

The argument here is that the Fed is enabling a dysfunctional fiscal process by attempting to aid the economy. In other words, according to Fisher, the Fed needs to let the economy collapse to prove a point about fiscal policy. That sounds great around the coffee table, but in reality, such wanton disregard for economic welfare only promises to leave behind a mountain of collateral damage.

Finally, Fisher channels former Federal Reserve Chairman Paul Volker:

Paul Volcker, who has the scars on his back from his Herculean effort to rein in inflation in the 1980s, wrote of this in the New York Times on Sept. 18. He reminded us that once unleashed, inflation combines with stagnation to make stagflation, the most painful of all combinations for the poor, for workers, for job seekers, for bond and stock holders and for businesses trying to navigate the economy.

I addressed this last week. Ultimately, for all his antics, this is what Fisher is about - hard money. He might claim that:

…while I remain on constant watch for signs of inflationary impulses, I believe the most urgent issue is job creation and the reduction of the scourge of unemployment.

but in reality he sees nothing but economic apocalypse in 3% inflation. He cannot wrap his mind around one simple fact – the 1970’s began with 2.5% unemployment. We are currently facing unemployment above 9%. Apples and oranges. But Fisher is simply too intellectually lazy to attempt to differentiate between apples and oranges. For him, policy begins and ends with a single idea: Hard money is just morally good. And he will base policy on any "opinions on these rumors" that sound like they support his ideological conviction.

Tuesday, September 27, 2011

How the GOP Assault on the Fed Could Backfire

I have a new column on the need for Federal Reserve independence:

How the GOP Assault on the Fed Could Backfire

I expect disagreement on this one. The emphasis is on the long-run, but I wish I would have had the space to talk more about the short-run, i.e. that the Fed could be more aggressive in the short-run and allow inflation to rise temporarily without abandoning its commitment to long-run price stability. That's implied by the statement that "I don’t think the voice of the unemployed is adequately represented in monetary policy decisions," but it may not be clear. I also wish I would have had the space to talk about why a return to the gold standard -- which is behind some of the attacks on the Fed -- is a bad idea.

Friday, September 23, 2011

Mankiw: I am Not Very Worried about Inflation Just Now

Greg Mankiw:

Why I am not very worried about inflation just now, by Greg Mankiw:

Click on graphic to enlarge.
Several people have asked me in recent days if the Fed's aggressive attempts to get the economy going will lead to galloping inflation to go along with our weak economic growth. It is possible that this might occur down the road, of course, but I don't see it happening just now. The slack labor market has kept growth in nominal wages low, and labor represents a large fraction of a typical firm's costs.  A persistent inflation problem is unlikely to develop until labor costs start rising significantly. Notice in the graph above that the period of stagflation during the 1970s is well apparent in the nominal wage data. The same thing is not happening now. This is one reason I think the Fed is on the right track worrying more about the weak economy than about inflationary threats.

Thursday, September 22, 2011

Fed Watch: Working on the Wrong Margins

Tim Duy:

Working on the Wrong Margins, by Tim Duy: Brad DeLongs offers some tepid support of yesterday's FOMC outcome.

At the moment ten-year Treasury bonds are selling at a present-value discount of20 14%, and thirty-year Treasury bonds are selling at a present-value discount of 45%. Guess that half of these discounts are expectations of interest rate changes and half are rewards for risk bearing. Then if the Fed buys half 10-year and half 30-year bonds it takes risk currently valued at $60 billion off of the private sector's balance sheet. A ten-year corporate investment project of about $150 billion carries $60 billion worth of risk with it, so if this works and if the risk-bearing capacity freed-up by this version of quantitative easing is then deployed elsewhere, we will have an extra $150 billion of business investment over the year or so it takes to roll out this program and for it to have its effect.

Still, the outcome is too little:

$150 billion is, as Christina Romer likes to say "not chopped liver"--not even in a $15 trillion economy. But it is about 1/10 of our current problem--maybe less when you reflect that our current-problem is a multi-year problem.

I am skeptical that taking on longer-term US debt really draws off much if any risk-bearing capacity off the public's balance sheet, thereby freeing up capacity for additional business investment. I am even more skeptical that even if such risk were reduced, firms would take advantage. There is plenty of cash already on corporate balance sheets, but little incentive to put it to work in an economic environment characterized by slow and uncertain patterns of growth.

I think market participants are also skeptical that this is even a marginally effective policy - note that as of last week, the ten-year TIPS breakeven was just a notch under 2%. As of right now, the breakeven has plunged to 1.72%. Not exactly a ringing endorsement of the Fed's actions. Indeed, quite the opposite - the Fed's relative inaction is intensifying disinflationary expectations.

Simply put, it sure looks like the Fed is playing around at the wrong margins. Barry Ritholtz summarizes:

There is no calvary coming to the rescue.

Will the calvary eventually come? It will not be long before we are right back where we were last fall - a 1.5% ten-year breakeven, pushing the Fed toward another round of quantitative easing. But will the Fed have the stomach to bring it out in meaningful quantities to compensate for operating on the weak margins of monetary policy? They need to stop thinking on the order of hundreds of billions and start thinking on the order of trillions. And they need to be willing to allow inflation to rise above 2% to be most effective. It seems, however, that this is too big a package to expect from the Fed.

Bottom Line: We need policy that decisively lifts the economy off the zero bound. Policies that work through traditional avenues, primarily the credit channel, have been ineffective. Surely effective would be a cooperation between fiscal and monetary authorities - print the money and spend it. We are faced with increasing expectations if disinflation coupled with fears to spend more because of the size of the deficit. There should be more than ample room for policy coordination, and that policymakers are not more aggressive at this point is bewildering. Inaction on the part of the Administration and the Federal Reserve is endangering both of them politically. The former is risking the White House, the latter is only adding fuel to the fire of right-wing criticism by engaging in half-measures with minimal, difficult to quantify results. Caught in the middle is the American people, staring at the possibilty of another lost decade.

"The Fed's Latest Moves May Fall Flat"

I have some comments at NPR:

The Fed's Latest Moves May Fall Flat, Experts Say, by Scott Horsley

[Story, Listen]

Fed Watch: FOMC Reaction – The Extended Version

Tim Duy:

FOMC Reaction – The Extended Version, by Tim Duy: Earlier I posted my quick reaction to the FOMC statement. Now it is time for some extended comments. First off, the Fed sees increasing risks of disappointing news in the months ahead. The August sentence:

Moreover, downside risks to the economic outlook have increased.

was changed to:

Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.

The downside risks are now “significant,” and we can thank the Europeans for that. I already commented on the twist operation – I tend to think it is too little to have much impact, largely just changing the composition of already safe assets. There was a reaction at the long end of the curve, with the 30 year yield down nearly 20bp. I am sure the Fed is pleased with that; the stock market, however, did not view it as much of a silver bullet, and sold off 2.5%.

What I didn’t have a chance to digest earlier was this:

To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.

That the debt overhang in mortgage markets is weighing on the recovery is not much of a secret. The Fed views that overhang as hampering the effectiveness of monetary policy, and rightfully so. By keeping assets in the mortgage markets, the Fed is hoping to encourage even lower rates and, by extension, a greater pace of refinancing. Worth a try, to be sure. I don’t know that this addresses the critical impediments to refinancing – underwater mortgages and tighter underwriting conditions. Yes, if we allow the loan to value ratio of federally insured mortgages to increase, then we can get some traction. And the Fed’s move may be in anticipation of such action – I am hoping this is so.

Increased opportunities to refinance, however, may not have as much of an immediate impact as would normally be the case. It depends on the ratio of households that refinance into another 30-year mortgage, reducing their payments by extending the payoff date at a lower interest rates versus those that refinance into a 15-year mortgage and reduce their current consumption to save more.

For what it is worth, here is what I am doing. With my children now in kindergarten and first grade, we finally experienced a drop in child-care expenses. The drop just happens to be almost exactly what I need to refinance into a 15-year mortgage. Better to pay down debt than allow my standard of living to ratchet up. And, quite frankly, paying down debt at a more rapid pace is pretty much the best safe investment right now. Holding cash in the bank yields nothing, paying down the mortgage debt at least earns around 4-5% depending on your mortgage, tax-free. That said, in the long-run, by holding rates low, the Fed is contributing to balance sheet restructuring. I just tend to think the process would be quicker and more effective via wage inflation.

The Fed reiterated their expectation that rates will hold near zero through 2013, and once again committed to additional action should it be necessary. Of course, arguably it is already necessary. Still, it is the marker that keeps hopes of another round of quantitative easing alive.

Ezra Klein argues the Fed struck a blow for independence today, coming in slightly above expectations and effectively ignoring the thinly-veiled Republican threat. Yes, kudos to Federal Reserve Chairman Ben Bernanke on that point. Stan Collender nails this one – the Republicans have effectively put an end to fiscal stimulus, and now hope to derail monetary stimulus as well. I think the Republican leadership is doing themselves a disservice with this line of attack. Quite frankly, the remaining monetary tools are very weak, and the willingness of the Federal Reserve to ramp them up to levels that might be effective is very low. In effect, the Republicans are needlessly taking a hard line position on this one. The Fed isn’t going to come to the rescue. The numbers are simply too big – remember Goldman Sach’s $10 trillion figure for the Fed’s portfolio if they wanted to deliver the correct level of policy accommodation in 2009? Something like that is not even on the outer edges of the radar screen.

Bottom Line: I think Fed official believe they are being bold; I see them as continuing to ease policy in 25bp increments. Expect that to continue. Assuming the economy fails to regain momentum, the Fed will follow up with additional action – QE3 will be the next stop. Ignore the dissents; they are background noise. Don’t expect miracles; expect small moves, the equivalent of 15bp here, 25bp there. The real leverage could potentially come from fiscal policy leveraging the easy monetary policy. Print the money and spend it. Open up the refinancing channel. Overall, make the objective of national economic policy simply be to decisively move us off the zero bound. Not deficits, not the dual mandate, just commit to pulling us off the bottom.

Wednesday, September 21, 2011

FOMC Decides to Implement Operation Twist

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

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

On the run, so very quick reaction:

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

2. It's not big enough.

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

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

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

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

Update: Tim Duy reacts to the decision.

Update: Via Daniel Indiviglio:

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

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