Category Archive for: Monetary Policy [Return to Main]

Monday, August 09, 2010

Fed Watch: Waiting for Nothing?

What is the Fed likely to do at its meeting this week?:

Waiting for Nothing?, by Tim Duy: Incoming data give the Fed a green light to ease further. There is frequent chatter from unnamed sources that the Fed can do more and will consider more at this Tuesday's FOMC meeting. The public stance of Fed officials in recent weeks has tended to downplay the necessity for action at this juncture. This combination leaves the outcome of this week's FOMC meeting in doubt. My baseline expectation is that the FOMC statement acknowledges the weakness in recent data, but leaves the current policy stance intact. There is a nontrivial possibility that the Fed either implicitly or explicitly ends the policy of passive balance sheet contraction. I believe it very unlikely that the Fed sets in motion an expansion of the balance sheet.

Much has already been written on the disappointing employment report. Excluding Census workers, the economy added a decidedly pathetic 12k employees. Private sector job growth came in at just 71k, while state and local governments shed 48k employees. While some commentators have highlighted the 630k private sector gain since the beginning of the year, the bulk of that gain - 399k - came in March and April. Since then, the private sector has added a scant 51k jobs a month. Enough jobs to be sustainable. Maybe, although this is even questionable given the decline in temporary help hiring, which may signal even softer numbers in the months ahead. But even if sustainable, certainly extremely vulnerable to negative shocks. And even if sustainable, the current rate is sure to decrease unemployment only if job seekers continue to exit the labor force.

Indeed, the labor force numbers turned south, sending the participation rate down as well. Although the technical recovery - at least as measured by GDP growth - has been in place for four quarters, participation rates still fall short of year ago levels. The gains of earlier this year appear to be as ephemeral as Census hiring. Indeed, it is likely that hiring, not any broader improvement in labor markets, drew people back into the labor force. Who says the government can't create jobs?

Not that below trend job growth should be any surprise given the trend in output growth. The math is easy on this one - the pace of growth has decelerated sharply since the end of 2009. Job growth is simply following this trend. Nor is their much hope for a substantial reacceleration. Factors that supported Q2 growth, especially inventory correction, residential investment, and government spending, are all expected to wane as the year progresses, while consumer spending growth is expected to remain lackluster. In that environment, it is even doubtful that the solid run of equipment and software gains can be sustained.

In reality, the story is effectively unchanged from four quarters ago. It has always been the case that meaningful labor market recovery required growth of real final sales of at least three times the numbers we have seen. That just is not going to happen without substantially more stimulus efforts.

Are such efforts forthcoming? I think that everyone has pretty much written off any possibility of fiscal stimulus coming to the rescue anytime soon. To be sure, there may be a few billion here, a few billion there that show up, but no one expects any serious effort to, for example, attempt to close the output gap. Administration efforts have shifted to trying to spin the data as a solid recovery. Along those lines, we saw US Treasury Secretary Timothy Giethner lift the "Mission Accomplished" move right out of the Bush II Administration's playbook with his NYT editorial, which can be summarized as "growth is positive, we did that, quit whining because you don't have a job." Simply put, if the Administration is content with the numbers we see, they are effectively content with a sustained, substantial output gap and the associated unemployment. They must be, as there is no urgency to do more. The pendulum has shifted. The Administration must feel it necessary to believe the recovery is sufficient and intact, otherwise they will be accepting the Republican claim that the stimulus package failed. Moreover, I think they genuinely believe that the deficit needs to be brought under control sooner than later. This, I think, is the problem of an Administration that is a reload of the Clinton Administration. They believe Rubinomics will work its magic again, rather than recognize that the today's economic challenges are very different than those of the mid-1990's.

With fiscal policy off the table, our last hope is monetary policy. It seems clear that persistent unemployment tilts the odds towards deflation, but the Fed appears to be like a deer stuck in the headlights. Like Geithner, Federal Reserve Chairman Ben Bernanke showed no urgency in his speech last week to accelerate the path to achieving the Fed's dual mandate. Moreover, leadership at the Fed may be as out of touch as that in the Administration. As Mark Thoma and Dean Baker note, Bernanke expects higher wages to support spending in the months ahead, despite the weak incoming wage data. Remember - Bernanke gave that speech after having the weekend to dissect the GDP report.

Presumably Bernanke is referring to data such as the following:


While Washington appears content with the numbers as long as they are trending in the right direction, I believe the focus should be the gap between where personal income less transfer payments would have been in absence of the recession, and the likely trajectory now. That trajectory, in my opinion, is clearly subpar. Enough so that it fills me with an increasing sense of urgency. This is lost income for Americans. Income that pays for food and shelter. Medical care and vacations. Retirement and college savings. The costs of failure are immense.

Did the July employment report shift the odds toward more easing? It should, but I believe the most likely scenario is that it merely confirms the Fed's priors - that the pace of labor market improvement will be glacially slow. They have never expected anything else. Indeed, to what extent is the data really that different from those expectations. It seems to me that what is most different is that the upside risk is essentially off the table - the V is not meant to be. Does the magnitude of the downside risk warrant additional action? Yes, with the V-shaped recovery off the table, so too are the "risks" of additional easing, notably the risk of higher inflation. Fed leadership, however, appears to view the downside risks as relatively limited giving the amount of stimulus (expansion of the balance sheet and low interest rates) already in place. Any more is a venture into the unknown, a trip that is still unwarranted in the absence of economic freefall.

That said, despite Fedspeak that appears resistant to further easing, the press has been fueling speculation that more easing - albeit largely symbolic - is imminent. From where does this chatter emanate, other that unnamed sources? Perhaps from high ranking staff. Word on the street is that Fed staff are increasingly frustrated with the lack of action from leadership. Why exactly is Bernanke showing such deference to the more hawkish elements such as Kansas City Federal Reserve President Thomas Hoenig, Dallas Federal Reserve President Richard Fischer, and Philadelphia Fed President Charles Plosser? If you seek more easing, you are not alone. Board staff are increasingly your allies.

Why the lack of additional action? A set of possible impediments:

  • As described above, incoming data is not sufficiently different from the Fed's forecast to justify additional action. This is my primary reason to expect little action from the Fed tomorrow.
  • Similarly, additional action requires nonconventional monetary policy, of which the impacts are unknown. I think one of the potential impacts of concern is possibility that additional easing fuels a new asset bubble, in addition to the specter of inflation.
  • Concern that additional easing will be interpreted as deficit monetization, and thereby unhinge inflation expectations.
  • Fears that additional easing will trigger a disorderly devaluation of the Dollar. Of course, this may be what exactly what we need.
  • Possibly that more action will be a repudiation of the Administration's claim that the economy in on the mend.

That said, the internal and external pressure suggests the possibility for a small change at tomorrow's meeting. From the Wall Street Journal:

At their policy meeting Tuesday, Fed officials plan to discuss whether to take the small but symbolically important step of reinvesting proceeds from its portfolio of mortgage-backed securities to maintain support for the economy. The weak jobs numbers add to the case for taking action, though officials must assess whether taking even a tiny step could create expectations for larger actions in coming months.

Note the final sentence - the concern that more now is essentially a guarantee for more later. If the Fed eases more now, with the data largely in line with there already weak forecast, how could officials argue against additional easing later when the data continues to support their forecast?

Bottom Line: The incoming data appears largely consistent with the Fed's priors - especially expectations of glacially slow improvement in the labor market. Yet the probability of any upside risk to the forecast have diminished markedly. The V-shaped recovery has not emerged. The elimination of that upside risk argues for additional easing, but the Fed appears hesitant to do more. Uncertainty about the effectiveness of additional easing argues against more action, especially given relatively quiescent financial markets and positive, albeit lackluster, growth. Moreover, any additional action now is essentially a promise to do more later, even if growth remains along its current trajectory. All of these points argue against additional easing tomorrow, and that remains my baseline scenario. The case becomes muddied by internal, staff level pressure to do more now, combined with rising expectations of imminent easing given the steady flow of leaks to the press. This opens the possibility of a small policy adjustment that eliminates that passive reduction of the balance sheet. Any more is off the table.

Saturday, August 07, 2010

A Little Panic Would be Good

Kenneth Rogoff:

In the short term, it is important that monetary policy in the US and Europe vigilantly fight Japanese-style deflation, which would only exacerbate debt problems by lowering incomes relative to debts. In fact,... it would be far better to have two or three years of mildly elevated inflation, deflating debts across the board, especially if the political, legal, and regulatory systems remain somewhat paralyzed in achieving the necessary write-downs.
With credit markets impaired, further quantitative easing may still be needed. As for fiscal policy, it is already in high gear and needs gradual tightening over several years, lest already troubling government-debt levels deteriorate even faster. Those who believe – often with quasi-religious conviction – that we need even more Keynesian fiscal stimulus, and should ignore government debt, seem to me to be panicking.

Since we're giving opinions -- let's call them "seems to me-isms" -- rather analysis, let me give mine:

Those who believe – often with quasi-religious neoclassical conviction – that no further  Keynesian fiscal stimulus is needed, and that government debt cannot be ignored, seem to me to be insensitive to the needs of the millions of unemployed, and at odds with the available evidence.
As for the snide remark about "panicking," for those who are truly panicking due to the struggles they face finding a job, paying the bills, and so on, some urgency from policymakers would be much appreciated.

Friday, August 06, 2010

The Employment Report

The employment report came out today. Calculated Risk shares my assessment of the overall picture that emerges from the numbers in the report:

This is a very weak report, especially considering the downward revision to June. The participation rate declined again, and that is why the unemployment rate was steady - and that is bad news.

Many observers are looking for "glimmers of hope" in the report and pointing to private sector job growth of 71,000, which is higher than in previous months and thus evidence of acceleration in job growth, to an increase in hours worked, an increase in wages, and a fall in workers involuntarily working part-time.

However, as noted in the "glimmers of hope" link, and as I have noted many, many times, we need 100,000-150,000 jobs per month just to keep up with population growth, and even more than that if we want to make up for past losses. That is, we need faster growth than 100,000-150,000 per month if we want the economy to do more than just keep up with population growth and reemploy the millions and millions of people who are now out of work. So job growth of 71,000 still represents a declining labor market, and does nothing to offset past losses.

Dean Baker reviews the numbers, and adds cautionary notes as to why the glimmers of hope aren't quite the positive signs they might appear to be at first glance:

Job Loss Sends Employment Ratio Downward, by Dean Baker: For the second consecutive month, the economy created virtually no jobs, net of temporary Census jobs. The Labor Department reported that the economy lost 131,000 jobs in July, 12,000 less than the 143,000 drop in the number of temporary Census workers. ...
The job loss corresponds to a decline in labor force participation. While the unemployment rate has edged down by 0.2 percentage points to 9.5 percent since May, this is attributable to people who gave up looking for work and left the labor force. The employment to population ratio fell by 0.3 percentage points to 54.4 percent, only slightly above the 54.2 percent low in December. ...
There were substantial declines in all the measures of duration of unemployment. This likely reflects many long-term unemployed dropping out of the workforce after losing benefits. The percent of multiple jobholders dropped by 0.3 percentage points to the lowest on record. This presumably reflects difficulty in getting jobs.
There are very few obvious sources of job growth on the establishment side. Manufacturing added 36,000 jobs, but most of this increase was attributable to a 20,500 rise in jobs in the auto industry and a 9,100 increase in jobs in fabricated metals. Most of these rises are attributable to the fact that Detroit auto makers did not shut down in July to change models. The underlying rate of job growth in manufacturing is very weak, even if at all positive.
Retail trade added 6,700 jobs, but with a 13,000 downward revision to last month’s job loss number, employment is still 14,000 below the May level. Financial services lost 17,000 jobs, with real estate counting for more than half of the loss. Professional and business services are now shedding jobs, with the sector losing 13,000 jobs last month. Employment services lost 23,300 jobs, a bad harbinger for future job growth. Even the restaurant sector is losing jobs, shedding 10,600 workers in July, the 3rd consecutive decline.
State and local governments shed 48,000 jobs in July, a result of budget cutting coinciding with the new fiscal year. The only sectors that added substantial numbers of jobs were health care (27,800) and, strangely, ground transit which added 10,600 jobs in July, 2.5 percent of employment in the sector.
There was a small uptick in average hours (all in the goods-producing sector), but this just returned hours to the May level. ... Nominal wages rose at just a 1.4 percent annual rate, also not a good sign.
With the end of the inventory cycle, a huge wave of state and local cutbacks and further declines in house prices on the way, the situation looks bleak for the second half of 2010.

Robert Reich emphasizes many of the same points:

The economy is still in a deep hole, and we’re not climbing out.
Remember, we need 125,000 new jobs per month simply to keep up with the growth of the American population seeking jobs. But according to this morning’s job’s report, private-sector employers added just 71,000 jobs in July. ... In other words, the hole keeps getting deeper. ...
The only slightly bright news is that manufacturing payrolls increased by 36,000 in July, but those gains are almost surely going to evaporate in August. Manufacturing expanded in July at the slowest pace of the year as orders and production decelerated.
All this blur of numbers means two things: An extraordinary number of Americans are still hurting. And it’s more important than ever for the US government to step in with a larger stimulus that puts more people to work (a WPA, for example), and tax cuts for people who will spend them (a two-year payroll tax holiday on the first $20K of income). We cannot get out of this hole without major federal action.

Many of us who worried this was coming have been calling for more action for well over a year now, but to no effect. As the WSJ notes, this will set off a debate within the Fed about whether to try to give the economy more help at it's monetary policy meeting this week. My own view is they will continue to rationalize -- perhaps with those so-called glimmers of hope discussed above -- why there's nothing more they can and should do, and they will continue to sit on their hands. There's more than enough evidence to justify more action, and that was true before this report added to it, but the Fed refuses to see it.

I should add one more thing. My first choice in trying to help the economy would be fiscal policy, I think that has a much better chance of working, creating jobs in particular, than monetary policy. Take a look at what happened to state and local hiring, one place where fiscal policy could clearly help. Thus, I don't want criticism of the Fed to be used to deflect criticism from Congress for their (lack of) response. Fiscal policy authorities have not responded adequately to this crisis, and we see the results in today's report. So we shouldn't let fiscal authorities off the hook as we also criticize the Fed's failure to do more.

For more on the report, see: WSJ, FT, Bloomberg, Washington Post, NY Times, RTE, and Angry Bear. [Also posted at MoneyWatch.]

Update: Let me add this note on the numbers. Above, Dean Baker says the private sector job loss was 12,000 and Calculated Risk says the same thing. However, most reports are citing a figure of 71,000. Why the difference?:

Employment Report: Why the different payroll numbers?, by Calculated Risk: Once again there is some confusion about which payroll number to report.
Basically the media is confusing people. I explained this last month: ...The headline payroll number for July was minus 131,000. The number of temporary decennial Census jobs lost was 143,000.
To be consistent with previous employment reports (and remove the decennial Census), the headline number should be reported as 12,000 ex-Census. ... Instead most media reports have been using the private hiring number of 71,000 apparently because of the complicated math (subtracting -143,000 from -131,000). Private hiring is important too, but leaves out changes in government payroll and is not consistent.
I've posted all the numbers, but I've led with the headline number ex-Census - and that is especially important now since state and local governments are under pressure.

I probably should have noted this earlier and explained why the 12,000 figure should be used, hence the second thoughts and this update only minutes after this was posted. But I thought it would simply confuse the issue and deflect attention from the important point which is that job growth is very weak no matter how it is measured.

Wednesday, August 04, 2010

Are Inflation Expectations Stable?

David Beckworth:

Inflation Expectations Are Not Stable!, by David Beckworth: Many observers, including myself, have been puzzled by the Fed's lack of urgency in recent months over the apparent slowing down of aggregate demand. The one thing monetary policy is capable of doing is stabilizing total current dollar spending, but it isn't and this inaction effectively amounts to a tightening of monetary policy. There have been many reasons given for this seeming complacency by the Fed: internal divisions over policy, fear of political backlash, opportunistic disinflation, fear of awakening bond vigilettentes, and sheer exhaustion. Another potential reason is that the Fed simply doesn't see this aggregate demand slowdown in the data. I actually considered this possibility some time ago but never put too much weight on it since this is the Federal Reserve after all. It has far more resources than I do and surely sees what I see in the data. However, after Fed Chairman Ben Bernanke's speech yesterday I am beginning to wonder if the Fed is actually missing something in the data. In particular, I was stunned to read this sentence in the speech:

Meanwhile, measures of expected inflation generally have remained stable.

Uhm, unless I have been living in parallel universe and just got phased into a different one this statement is completely wrong. Inflation expectations, as I show below, have been persistently declining since the start of 2010. Not only that, but Bernanke's claim that inflation expectations are stable has huge policy implications. It is widely understood that expectations of future inflation are a key determinant of current aggregate demand. If expectations of inflation are stable as Bernanke claims then aggregate demand growth should also be relatively stable. On the other hand, if inflation expectations are falling and have been doing so for some time as I claim then it is likely that current aggregate demand growth also has been falling.*

If Bernanke really believes inflation expectations are stable then one must give him credit for implementing monetary policy in a manner consistent with that understanding. However, I simply cannot understand how he or anyone else at the Fed could hold such a view. The best indicators of inflation expectations have been screaming red alert for some time now. How the Fed could have missed this red alert is unfathomable to me, but on the off chance that they have and are reading this post I ask that they please take note of the following set of figures.

The first figure shows the term structure of expected inflation over the first half of 2010. The plotted curves in the figure show the average expected inflation rate at various yearly horizons for the first six months of 2010. The data comes from the Cleveland Fed. This figure makes clear that inflation expectations have been trending down across all horizons since the start of the year. Note that the 1-year horizon has seen inflation expectations drop by about 100 basis points. (Click on figure to enlarge)

Now to put this figure into perspective let's look at the term structure of inflation expectations the last time expected inflation fell rapidly and caused aggregate demand to tank. Yes, that would be the late 2008, early 2009 period. Here is the figure for this time. Notice any similarities? (Click on figure to enlarge.)

Here too we see a decline across all horizons with the 1-year having the sharpest decline. Now current inflation expectations have not fallen as much as these above but they are persistently falling. And we know from the late 2008, early 2009 experience what happens to aggregate demand when inflation expectations are allowed to continue to fall: you get the greatest decline in nominal spending since the Great Depression.

Now the dire picture painted by the Cleveland Fed data is wholly corroborated by the inflation expectations implied by the the difference between the nominal interest rates on regular treasury securities and the real interest rates on treasury inflation protected securities (TIPS). This measure of inflation expectations is graphed below using daily data on 5-year treasuries for the period January 4, 2010 - July 29, 2010: (Click on figure to enlarge.)

Here again there is a clear downward trend. Inflation expectations are falling and there is currently no end in sight. Given all of this evidence, how can Ben Bernanke assert that inflationary expectations are stable? I am truly bewildered by that claim. I hope Fed officials who have read this far are also bewildered and are now reconsidering their views. Let me be very clear what all of this implies: by failing to stabilize inflation expectations the Fed is effectively tightening monetary policy at a most inopportune time. I hope this is not how the Fed wants to be remembered.

Tuesday, August 03, 2010

"Bernanke Says Rising Wages Will Lift Spending"

When I saw this:

Federal Reserve Chairman Ben S. Bernanke said rising wages would probably spur household spending in the next few quarters, even as weak job gains dragged down consumer confidence.

I wondered what Bernanke was talking about. Dean Baker had the same reaction:

The NYT headline told readers that, "Bernanke Says Rising Wages Will Lift Spending." Real wages have been virtually unchanged over the last year. Let's hope that the NYT got the story wrong and that Bernanke knows this.

What do the latest data show?:

Personal incomes were ... flat in June as private wages and salaries fell.

There have been several instances lately where things Bernanke has said make me wonder how familiar he is with what recent data are telling us about the economy. Lately the Fed seems more interested justifying why it doesn't need to do anything more to boost the economy rather than grappling with actual data showing that the economy needs more help from the Fed. Maybe Bernanke is right and the next few quarters will show rising wages leading to higher spending and that will lead to a more robust recovery, but there's nothing in the current data to give me confidence that is going to happen and I don't think policy should be based upon this expectation.

Fed Watch: Handicapping the Next FOMC Meeting

Tim Duy:

Handicapping the Next FOMC Meeting, by Tim Duy: The game is on. The relatively weak data flow in recent weeks, culminating with the clearly subpar GDP report, has combined with rumblings from the Federal Reserve that yes, we can do more. The net result is growing expectations that additional easing will occur sooner than later. As early as next week, in fact. Logically, the story hangs together reasonably well except for one key ingredient - the top dog, Federal Reserve Chairman Ben Bernanke, does not appear overly concerned with the economic outlook. But the chatter is becoming almost undeniable. Someone is sourcing the press to believe that a policy change is imminent. And Fedspeak aside, that source cannot be ignored.

Hat tip to Calculated Risk, for seeing this CNBC report today:

Japan's Nomura has become the first investment bank to predict the Federal Reserve will begin to ease monetary policy following the recent slowdown in growth in the world's biggest economy.

The deterioration in expectations for growth and inflation argues for an easing of monetary policy, Paul Sheard, the global chief economist at Nomura, wrote in his latest report.

"We expect the Fed to at least stop the passive contraction of its balance sheet," he added.

More than one analyst recognizes the Fed's policy to allowing mortgage assets to mature from the balance sheet (or as they are prepaid) as contractionary. A small step forward would be to acquire an offsetting amount of Treasuries as mortgages mature, thus at least holding policy steady. The report continues:

"Perceptions about sustainability are not binary, but lie along an unobservable continuum. A concerned and forward-looking policymaker would presumably take action some time before the economy had irreversibly slipped from sustainability," Sheard wrote.

"We now believe that current conditions have moved policymakers into action and that the FOMC will adopt a more accommodative stance at its 10 August meeting," he added.

The Fed is likely to stop shrinking its huge balance sheet for the moment, a subtler form of easing than just buying assets again, according to the research...

..."To the extent that the size of the Fed's balance sheet matters, this, in effect, amounts to a gradual tightening of monetary policy. Further shrinkage of its asset holdings now seems inappropriate in light of downside risks to growth," he explained.

"We therefore think the committee will return to the explicit language of early 2009, in which it articulated a commitment to 'keep the size of the Federal Reserve's balance sheet at a high level,'" he added.

The idea is pushed even further in today's Wall Street Journal:

Federal Reserve officials will consider a modest but symbolically important change in the management of their massive securities portfolio when they meet next week to ponder an economy that seems to be losing momentum.

The issue: Whether to use cash the Fed receives when its mortgage-bond holdings mature to buy new mortgage or Treasury bonds, instead of allowing its portfolio to shrink gradually, as it is expected to do in the months ahead. Any change—only four months after the Fed ended its massive bond-buying program—would signal deepening concern about the economic outlook. If the Fed's forecast deteriorates significantly, it could also be a precursor to bigger efforts to pump money into the economy.

This is relatively strong language - strong enough, in fact, to imply that it is already a done deal. Why source a piece to raise expectations when you know you are going to dissappoint?

The basic - and reasonable - argument is that risks are now sufficiently weighted to the downside to justify, in the minds of monetary policymakers, an easier policy stance. And holding the balance sheet steady could be a middle ground for opposing camps in the FOMC. Still, while policymakers have shaded down their growth forecasts, they appear relatively at ease with the current level of downside risk. Bernanke's basic outlook today:

After a precipitous decline in late 2008 and early 2009, the U.S. economy stabilized in the middle of last year and is now expanding at a moderate pace. While the support to economic activity from stimulative fiscal policies and firms' restocking of their inventories will diminish over time, rising demand from households and businesses should help sustain growth. In particular, in the household sector, growth in real consumer spending seems likely to pick up in coming quarters from its recent modest pace, supported by gains in income and improving credit conditions. In the business sector, investment in equipment and software has been increasing rapidly, in part as a result of the deferral of capital outlays during the downturn and the need of many businesses to replace aging equipment. At the same time, rising U.S. exports, reflecting the expansion of the global economy and the recovery of world trade, have helped foster growth in the U.S. manufacturing sector.

Notably, he again highlights his expectation for stronger household spending despite the consumer slowdown evident in the latest GDP report. In other words, he still anticipates that the private sector will pick up where the public sector leaves off. He also reiterates the dismal labor market picture:

Importantly, the slow recovery in the labor market and the attendant uncertainty about job prospects are weighing on household confidence and spending. After two years of job losses, private payrolls expanded at an average of about 100,000 per month during the first half of this year, an improvement but still a pace insufficient to reduce the unemployment rate materially. In all likelihood, significant time will be required to restore the nearly 8-1/2 million jobs that were lost over 2008 and 2009. Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers' employment and earnings prospects.

Notice that he offers no reason to believe that he has the power to change the state of the labor market. He simply takes it as given a depressingly long wait until unemployment rates decline meaningfully. And as far as long-term unemployment, interesting and worrisome, but not much we can do about it. As far as disinflation:

Inflation has been low, with consumer prices rising at an average annual rate of about 1 percent in the first half of this year, and we anticipate it will remain subdued over the next couple of years. Slack in labor and product markets has damped wage and price pressures, and rapid productivity increases have helped firms control their production costs. Meanwhile, measures of expected inflation generally have remained stable.

No mention of further disinflation, just subdued inflation. And, critically, no concern that inflation expectations have taken a turn to the downside. I think that such a turn would prompt further action, but in their mind it hasn't happened.

In my opinion, Bernanke offers a reasonable optimistic assessment of US growth, optimistic at least compared to those of us worried about a protracted period of weakness. He just doesn't sound like someone concerned enough to push on the economic gas.

And, of course, we also have the ever colorful Dallas Fed President Richard Fischer. Paul Krugman has the analysis. In short, Fischer a.) is comfortable with current inflation forecasts, b.) views Administration-induced uncertainty as the chief impediment to economic growth, and c.) is very worried that additional asset purchases would be akin to deficit monetization. A relatively right-winged approach to policy. One wonders to what extend Bernanke shares his views. It is often easy to forget that the Fed chief is a Republican.

At the other end of the scale is the door opened by St. Louis Federal Reserve President James Bullard. Similar to Fischer, Bullard likes to talk, but at least retains intellectual coherency. From Bloomberg:

“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard said, warning in a research paper released yesterday about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

Is this, however, a call for an imminent policy shift? Bullard continues:

“The most likely possibility from where we sit today is that the recovery will continue through the fall, inflation will start to move up and this issue will all go away,” Bullard said to reporters on a conference call yesterday. “Suppose we get another negative shock, another surprise. We have to be prepared in that event to have a plan in place to do something."

Again, his basic outlook is relatively sanguine. He is looking for another negative shock. But how big does that shock need to be? I don't think we have seen it yet.

Note to that Bullard is laying the groundwork to avoid a discussion on extending or terminating the "extended period" language from the FOMC statement:

“The academics will tell you what you have to do is sort of dump interest-rate targeting and switch to something else,” he said. “In the policy debate, that is not really happening. So we need a sharper departure from interest-rate targeting if we are going to get out of this problem.”

I think this is a good interpretation:

Bullard’s stance aims to bridge the gap between two camps at the Fed, said Vincent Reinhart, a former Fed monetary-affairs director. Bernanke is in one group believing that the path of short-term rates is important, while Kansas City Fed President Thomas Hoenig is among officials uncomfortable with the “extended period pledge,” Reinhart said.

I am not particularly confident, however, that Hoenig will embrace a fresh round of asset purchases, extended period pledge or not. One point of worry:

Bullard, who has voiced concerns with the extended-period language since early March, said during the call he wanted to spark debate and his preference has been not to dissent.

Is he seeking to spark debate or generate publicity for himself? If the latter, is he leading us to a premature policy conclusion by so vocally identifying his preferred policy choice? I admit to being concerned that Bullard is leading market participants to expect more sooner than Bernanke is willing to deliver. In any event, Bullard is setting the stage for an expansion of quantitative easing. The most we will get next week is holding steady on the balance sheet.

Bottom Line: The weak GDP report should, on the margin, push the Fed toward further easing. But Bernanke's speech today, like his testimony on two weeks ago, did not indicate much of a push at all. And a credibly sized contingent of policymakers appear to be dead set against additional easing. On the other side, you see chatter, largely anonymously sourced, about additional easing policies the Fed could pursue. Is this contingent trying to manipulate expectations to push the Fed into additional action? Regardless, a straightforward interpretation is this: The FOMC has downgraded its growth expectations slightly, and need to lean against that with a small - possibly more symbolic than anything else - shift to hold the balance sheet steady and prevent premature easing tightening. It is not clear that we are getting this from publicly available Fedspeak, especially from Bernanke, but the press seems increasingly certain. Still, any handicapping might simply be premature as we look forward to the Friday's employment report. A game changer, or just another indication that the economy has settled into a subpar growth path, pretty much what the Fed already expects and is not acting on?

Update: 11:37pm

I see Bloomberg is running a "hold steady" story:

Federal Reserve policy makers signaled they will probably pass on providing more stimulus at their Aug. 10 meeting and wait to see if signs of weaker economic growth persist.

Chairman Ben S. Bernanke told lawmakers in South Carolina yesterday that consumer spending is “likely to pick up” amid a “moderate” expansion. St. Louis Fed President James Bullard said on July 29 that he expects the “recovery will continue through the fall.” Three days earlier, Philadelphia Fed President Charles Plosser said in a Bloomberg News interview that calls for more Fed stimulus “are premature.”

This, I believe, is the correct analysis of the Fedspeak and data flow. The willingness of someone to source a different story to the Wall Street Journal, however, calls this analysis into question.

Monday, August 02, 2010

Paul Krugman: Defining Prosperity Down

Before the crisis hit, the dynamic nature of the US economy was cited as one of its strong points by free marketeers, especially in comparison with European economies. Economic shocks, we were told, would be bring about a quick adjustment in a relatively free economy like the US. There was no need for government intervention. The price system would send the necessary signals and in no time at all the economy would be back at full employment running just as well, if not better, than before. That is, so long as things like oversized government, social insurance, and unions don't get in the way (like they supposedly do in Europe).

So it will be interesting to see if the same people who promoted the economy's ability to quickly respond to shocks and reabsorb unemployed labor and other resources now blame structural factors for the slow recovery, particularly the slow reabsorbtion rate for labor. As noted below by Paul Krugman, blaming structural factors serves as an excuse for the Fed and Congress to say there's nothing more they can do to help, the economy will just have to heal on its own. Some people will also try to blame government for the slow recovery in order to resolve the inconsistency between their prior claim that the US economy could handle anything thrown at it (citing things like 911 and Hurricane Katrina as examples), and the slow recovery that we are actually experiencing. They'll say it's unemployment compensation stopping people from working, fear of deficits, uncertainty surrounding regulation, etc., etc.

Thus, we'll hear that it's structural factors, it's government, it's whatever it takes for policymakers to rationalize why they shouldn't do any more (and hence avoid any associated risks, real or perceived). And it's whatever it takes, real or imagined, evidence based or not, for those who oppose government intervention generally, and government spending most particularly, to stop any further action to help the economy and to discredit what has already been done:

Defining Prosperity Down, by Paul Krugman, Commentary, NY Times: I’m starting to have a sick feeling about prospects for American workers — but not, or not entirely, for the reasons you might think.
Yes, growth is slowing, and the odds are that unemployment will rise, not fall, in the months ahead. That’s bad. But what’s worse is the growing evidence that our governing elite just doesn’t care — that a once-unthinkable level of economic distress is in the process of becoming the new normal. ...
First, we see Congress sitting on its hands, with Republicans and conservative Democrats refusing to spend anything to create jobs, and unwilling even to mitigate the suffering of the jobless.
We’re told that we can’t afford to help the unemployed — that we must get budget deficits down immediately or the “bond vigilantes” will send U.S. borrowing costs sky-high. Some of us have tried to point out that those bond vigilantes are ... figments of the deficit hawks’ imagination... But the fearmongers are unmoved: fighting deficits, they insist, must take priority over everything else — everything else, that is, except tax cuts for the rich, which must be extended, no matter how much red ink they create.
The point is that a large part of Congress — large enough to block any action on jobs — cares a lot about taxes on the richest 1 percent of the population, but very little about the plight of Americans who can’t find work.
Well, if Congress won’t act, what about the Federal Reserve? The Fed, after all, is supposed to pursue two goals: full employment and price stability, usually defined in practice as an inflation rate of about 2 percent. Since unemployment is very high and inflation well below target, you might expect the Fed to be taking aggressive action to boost the economy. But it isn’t.
It’s true that the Fed has already pushed ... short-term interest rates, its usual policy tool,... near zero. Still, Ben Bernanke ... has assured us that he has other options... But the Fed hasn’t done any of these things. Instead, some officials are defining success down.
For example, last week Richard Fisher, president of the Federal Reserve Bank of Dallas, argued that the Fed bears no responsibility for the economy’s weakness, which he attributed to business uncertainty about future regulations — a view that’s popular in conservative circles, but completely at odds with all the actual evidence. In effect, he responded to the Fed’s failure to achieve one of its two main goals by taking down the goalpost.
He then moved the other goalpost, defining the Fed’s aim not as roughly 2 percent inflation, but rather as that of “keeping inflation extremely low and stable.”
In short, it’s all good. And I predict — having seen this movie before, in Japan — that if and when ... below-target inflation becomes deflation, some Fed officials will explain that that’s O.K., too. ...
Here’s what I consider all too likely: Two years from now unemployment will still be extremely high, quite possibly higher than it is now. But instead of taking responsibility for fixing the situation, politicians and Fed officials alike will declare that high unemployment is structural, beyond their control. And ... over time these excuses may turn into a self-fulfilling prophecy, as the long-term unemployed lose their skills and their connections with the work force, and become unemployable.
I’d like to imagine that public outrage will prevent this outcome. But while Americans are indeed angry, their anger is unfocused. And so I worry that our governing elite, which just isn’t all that into the unemployed, will allow the jobs slump to go on and on and on.

Sunday, August 01, 2010

Fed Watch: More on Disinflation

Tim Duy:

More on Disinflation, by Tim Duy: Paul Krugman pulls together three charts to illustrate the link between high unemployment and disinflation in two major disinflationary episodes, 1974-1977 (Series 1 in chart below) and 1980-1986 (Series 2). He then tracks the pattern of the current cycle (Series 3), which suggests that the combination of high unemployment and past disinflationary responses to such unemployment is very likely deflationary. Krugman asks:

How can you look at this record and not conclude that deflation is a very real risk? I have no idea where the complacency of many at the Fed comes from.

An explanation for the Fed's complacency can be found by plotting all three episodes on the same chart:

I believe when monetary policymakers look at this chart, they ask a different question: Why has the disinflationary response been so muted in this cycle? It would have been reasonable to conclude that unemployment rates at this magnitude should have long ago pushed the US economy into deflationary territory. What is the Fed's explanation for the relatively tame disinflation? Krugman already has the answer:

All of this was to be understood in terms of a Phillips curve in which actual inflation at any point in time depends both on the unemployment rate and on expected inflation….

Fed officials will say that inflation expectations are currently well anchored. Indeed, the early 1980's experienced a period of rapid disinflationary expectations:

Note that expectations by this measure are stable. What about financial market expectations? The difference between 5 year Treasuries and 5 year TIPS fell slightly in recent months, but nothing like the clear taste of deflationary expectations at the end of 2008:

But are stable inflation expectations written in stone? Krugman concludes the above sentence with:

...and expected inflation gradually adjusts in the light of experience.

The implication is that the Fed should not get too complacent as persistently high unemployment will eventually erode those expectations.

Now - just thinking out loud - suppose downward rigidity of nominal wages, with workers unwilling to accept nominal wages declines. Does this support positive - albeit low - inflation expectations? Which thus prevents deflationary expectations from forming…which is good, but prevents the Fed from further action despite high unemployment rates? And the lack of action that increases structural unemployment, ensuring NAIRU increases? Something else to chew on...

Saturday, July 31, 2010

"Some Observations Regarding Interest on Reserves"

Does paying interest on reserves discourage lending? Are there good reasons to pay interest on reserves?:

Some Observations Regarding Interest on Reserves, by David Altig: One of the livelier discussions following Federal Reserve Chairman Ben Bernanke's testimony to Congress on monetary policy has revolved around the issue of the payment of interest on bank reserves. Here, for what it's worth, are a few reactions to questions raised by that discussion: ...

What is the opportunity cost of not lending?

...[C]ertainly the real issue about the IOR policy concerns the presumed incentive for banks to sit on excess reserves rather than putting those reserves into use by creating loans. This, from Bruce Bartlett, is fairly representative of the view that IOR is, at least in part, to blame for the slow pace of credit expansion in the United States:

"… As I pointed out in my column last week, banks have more than $1 trillion of excess reserves—money that the Fed has created that banks could lend immediately but are just sitting on. It's the economic equivalent of stuffing cash under one's mattress.

"Economists are divided on why banks are not lending, but increasingly are focusing on a Fed policy of paying interest on reserves—a policy that began, interestingly enough, on October 9, 2008, at almost exactly the moment when the financial crisis became acute."

OK, but the spread that really matters in the bank lending decision is surely the difference between the return on depositing excess reserves with the Fed versus the return on making loans. In fairness, it does appear that this spread dropped when the IOR was raised from its implicit prior setting of zero…


… but it's also pretty clear that this development largely reflects a general fall in market yields post-October 2008 as much is it does the increase in IOR rate...

And here's another thought: As of now, the IOR policy applies to all reserves, required or excess. Consider the textbook example of a bank that creates a loan. In the simple example, a bank creates a loan asset on its book by creating a checking account for a customer, which is the corresponding liability. It needs reserves to absorb this new liability, of course, so the process of creating a loan converts excess reserves into required reserves. But if the Fed pays the same rate on both required and excess reserves, the bank will have lost nothing in terms of what it collects from the Fed for its reserve deposits. In this simple case, the IOR plays no role in determining the opportunity cost of extending credit.

Of course, the funds created in making a loan may leave the originating bank. Though reserves don't leave the banking system as a whole, they may certainly flow away from an individual institution. So things may not be as nice and neat as my simple example.  But at worst, that just brings the question back to the original point: Is the 25 basis point return paid by the central bank creating a significant incentive for banks to sit on reserves rather than lend them out to consumers or businesses? At least some observers are skeptical:

"Barclays Capital's Joseph Abate…noted much of the money that constitutes this giant pile of reserves is 'precautionary liquidity.' If banks didn't get interest from the Fed they would shift those funds into short-term, low-risk markets such as the repo, Treasury bill and agency discount note markets, where the funds are readily accessible in case of need. Put another way, Abate doesn't see this money getting tied up in bank loans or the other activities that would help increase credit, in turn boosting overall economic momentum."


Are there good reasons for paying interest on reserves?

Even if we concede that there is some gain from eliminating or cutting the IOR rate, what of the costs? Tim Duy, quoting the Wall Street Journal, makes note (as does Steve Williamson) of the following comment from the Chairman:

Continue reading ""Some Observations Regarding Interest on Reserves"" »

Greenspan and Empathy

From an interview of Alan Greenspan:

Lunch with the FT: Alan Greenspan, by Alan Beattie, FT: ...He has admitted to having been “30 per cent wrong” in his time as Fed chairman, particularly in assuming that banks and financial institutions would closely monitor the creditworthiness of the people with whom they were doing business. But his present plan for preventing a recurrence of the global financial crisis still shows a predilection for the light touch: make banks hold more capital to back their lending, demand higher collateral that can be seized if financial transactions go wrong, and keep more cash on hand in case of emergencies.

In extremis, he says, banks might have to be broken up by law if they become too big to fail without bringing down the whole financial system. But he makes clear that he regards such an intervention as a last resort. He retains faith in markets and doesn’t even think that US-style finance capitalism will lose ground to the softer, more regulated model of European social democracy... It is a question of making precise technocratic adjustments. ...

His approach to everything is the same. Look at the data; calculate the probabilities; make a dispassionate calibrated decision. Just before we leave, he bemoans the calls on “poor Obama” to be seen to be caring more about the oil spill in the Gulf of Mexico. “I complained when people were saying he’s not showing enough empathy,” he says. “I said, ‘That’s not what I want to see.’ I want to see cold, cool, deliberative action. Empathy is not going to solve this problem.” ...

I don't think I want to hear Obama say "I feel your pain," but there may be a reason to combine "cold, cool, deliberative action" to solve a problem with empathy for those affected by it. Empathy shows that you understand the significance and urgency of the problem, and that you are willing to devote the resources needed to find a solution. Perhaps a Fed chair, unlike a president, can get away with cold dispassionate calculation, but a little more empathy might have served Greenspan well.

Tuesday, July 27, 2010

Fed Watch: Rising NAIRU?

Policymakers should be more concerned about the possibility of rising long-term unemployment:

Rising NAIRU?, by Tim Duy: Brad DeLong reads Greg Mankiw and reaches the conclusion that:

Mankiw's broader point is that since we have seen nothing like this before except for the Great Depression, we should be humble and risk averse--and hence have the government stand back and wash its hands of the situation.

Paul Krugman concurs, adding a sense of urgency to the current situation:

Quite. I really don’t think people appreciate the huge dangers posed by a weak response to 9 1/2 percent unemployment, and the highest rate of long-term unemployment ever recorded…

...Right now, I’m reading Larry Ball on hysteresis in unemployment (pdf) — the tendency of high unemployment to become permanent. Ball provides compelling evidence that weak policy responses to high unemployment tend to raise the level of structural unemployment, so that inflation tends to rise at much higher unemployment rates than before. And the kind of unemployment we’re experiencing now, with many workers jobless for very long periods, is precisely the kind of unemployment likely to leave workers permanently unemployable.

And there are already indications that this is happening. Bill Dickens, one of the people has who worked on downward nominal rigidity, tells me that the Beveridge curve — the relationship between job vacancies and the unemployment rate — already seems to have shifted out dramatically. This has, in the past, been a sign of a major worsening in the NAIRU, the non-accelerating-inflation rate of unemployment.

Mankiw said something eerily familiar recently:

This recession looks very different, and much more troubling, than those in the recent past. I wonder how this dramatic change in the nature of unemployment will alter traditional macroeconomic relationships, such as Okun's Law and the Phillips curve.

Some research suggests that the long-term unemployed put less downward pressure on inflation. If that is indeed the case, then the increase in long-term unemployment may mean that we will see less deflationary pressure than we might have expected from the high rate of unemployment. In other words, the NAIRU may have risen, perhaps quite substantially. This is mostly conjecture, however. It seems likely we will see more work on this topic in the coming years.

So Mankiw recognizes the problems posed by protracted periods of economic weakness, yet in his criticism appears to push for more caution while overlooking an obvious reason why the impact of fiscal policy was insufficient to significantly alleviate the recession. It was simply too small - as economists predicted at the time. Indeed, if he is so worried about the risk of rising NAIRU, he should be pushing for policymakers to pull out all the stops.

Mankiw is not alone in seeing the challenges posed by protracted unemployment. From Federal Reserve Ben Bernanke's Congressional testimony:

Moreover, nearly half of the unemployed have been out of work for longer than six months. Long-term unemployment not only imposes exceptional near-term hardships on workers and their families, it also erodes skills and may have long-lasting effects on workers' employment and earnings prospects.

The difference between Mankiw and Bernanke is that the latter not only recognizes the problem, but could also do something about it. Not that he is inclined to. Of course, he is not alone. Philadelphia Fed President Charles Plosser was quoted today:

“Lowering the interest rates closer to zero could have very disruptive effects on the financial markets,” Plosser said. “If we bought Treasury bills we could un-anchor expectations of inflation because the public might begin to think we are going to buy up the public debt.”

Plosser repeats the credibility story, arguing that additional action as suggested by Joe Gagnon will trigger an inflationary spiral. Likewise, San Francisco Fed President Janet Yellen expressed an unwillingness to adopt a new inflation target:

Janet Yellen, President Barack Obama’s pick to be the Federal Reserve’s next vice chairman, said it would be “risky” to adopt a long-run inflation goal of 4 percent, and that supervision and regulation are “the first line of defense” against risks to the financial system.

She made the comments in written responses to questions posed by U.S. Senator Richard Shelby, a Republican from Alabama, following her July 15 hearing before the Senate Banking Committee. Yellen, president of the San Francisco Fed, is awaiting confirmation, along with Obama’s other nominees, Sarah Bloom Raskin and Peter Diamond…

...She said that while a higher long-run inflation goal would “give the Fed more maneuvering room in the future,” she agrees with Bernanke that such a move “would be a risky policy strategy.” Most policy makers regard 2 percent as a level consistent with price stability.

I would think that, despite having to endure a higher inflation target, Yellen would be eager to have more maneuvering room. After all, there is not a lot of working room for conventional policy in a liquidity trap. Yet Fed officials seem to prefer the idea that unemployment becomes a long term challenge rather than a short run cyclical issue over the risk of inflation. Like fiscal policy, monetary policy is now limited by imaginary obstacles.

It is worth noting that the long term challenge may already be upon us. David Altig puzzles over the implications of a shifting Beveridge curve, suggesting that extended unemployment benefits may have a role. He then hones in on the possibility of a skills mismatch:

Now I realize that a few anecdotes don't make facts, but I have been in more than a few conversations with businesspeople who have claimed that the productivity gains realized in the United States throughout the recession and early recovery reflect upgrades in business processes—bundled with a necessary upgrade in the skill set of the workers who will implement those processes. This dynamic suggests that the shift in required skills has been concentrated within individual industries and businesses, not across sectors or geographic areas that would be captured by our most straightforward measures of structural change.

To be honest, I hear this complaint too, but have trouble swallowing it. I believed it in the mid and late 1990's, but now? The eight million people dropped into unemployment are all unemployable? Firms are willing to lose profits than do the unthinkable, on the job training, actually invest in their employees? I also have heard the opposite story, of overeducated temporary Census workers desperate for employment, completing assignments in a fraction of the expected time, not realizing that their productivity would only be rewarded with a shorter stint of employment. And if we are experiencing all these magical productivity gains and a shortfall of workers, then wages should be rising quite smartly. But from one of the articles cited by Altig:

Here in this suburb of Cleveland, supervisors at Ben Venue Laboratories, a contract drug maker for pharmaceutical companies, have reviewed 3,600 job applications this year and found only 47 people to hire at $13 to $15 an hour, or about $31,000 a year.

You get what you pay for. To put this into perspective, the average national wage for Wal-Mart was $11.24/hour in 2009. I would hope, however, that Ben Venue Laboratories pays better benefits.

I would really appreciate a good story that explained why we should be happy about high productivity growth if real wage growth is not surging. The lack of the latter makes me question the reality of the former.

Putting my skepticism aside, if a skills mismatch is really a problem, then the solution is to ramp up activity until labor shortages raise wages and force employers to reach deeper into the barrel and in turn bring more people into the labor force to gain those missing skills. Better to do it sooner than later. If the productivity gains are real, the wage gains should not be inflationary. This was the story of the 1990s. Otherwise, policymakers sit and wait as the potential structural rigidities deepen, thereby ensuring a higher NAIRU in the future. And, driven by fear of inflation, this appears to be exactly what policymakers intend to do.

Saturday, July 24, 2010

"A Toxic Toolkit"

Why is the Fed unwilling to do more to help the economy?:

A toxic toolkit, by Greg Ip, Free Exchange: Asked Wednesday what he’d do if the economy needed more stimulus, Ben Bernanke was noncommittal: “We are going to continue to monitor the economy closely and continue to evaluate the alternatives that we have.”
Mark Thoma (here and here) is dismayed that Mr Bernanke, given the time the Fed has had to study this, doesn’t seem to know what he’ll do. Robin Harding says Mark is unfair: what Mr Bernanke does will depend on what happens, and then on developing a consensus with his colleagues.
Mr Harding is right that what the Fed would do differs depending on whether it faces a liquidity crisis or a shortfall in aggregate demand and rising threat of deflation. Yet Mr Thoma is also right that this does not exonerate Mr Bernanke. That he knows what to do in a liquidity crisis ... is of small comfort since such a crisis is not in anyone’s forecast. To echo Mr Thoma, the question is, how will you deal with the plausible forecast of inadequate demand, disturbingly high unemployment and low inflation bordering on deflation? That the Fed has a plan for when another fire breaks out on its drilling rig is fine, but where's the plan for capping the well that's already spewing oil into the ocean?
I think the reasons for Mr Bernanke’s reticence are twofold. First, he’s genuinely optimistic the economy will be okay, in part because he’s sanguine about the expiration of fiscal stimulus.
If it becomes clear ... that that optimism is misplaced, I think the Fed will swing into action quite quickly. ... Only a minority of FOMC members are opposed to more quantitative easing (QE), but because they’re so vocal, it gives the impression of more opposition than really exists. ...
The Fed is not helpless; it has two powerful tools left—but both are politically toxic. One is unsterilized foreign exchange intervention: buying foreign currencies with newly printed dollars... This would both stimulate net exports by pushing down the nominal value of the dollar, and alleviate deflation pressure by pushing up the price of tradable goods. ... But the Fed won't do this without the Treasury’s approval, which for its part doesn't want the rest of the world accusing it of exporting its deflation.
The other tool is a money-financed fiscal expansion..., buying newly issued bonds specifically to enable the federal government to spend more money would be a powerful boost to demand. But this needs the federal government to agree to a lot more fiscal stimulus and the Fed to set aside concerns about being the Treasury’s hand maiden. Neither looks likely.
Mr Bernanke described both those options as hypothetical in his famous 2002 speech on deflation. Eight years later, it’s apparent they are just that: hypothetical.

Friday, July 23, 2010

Fed Watch: Bernanke Post Mortem

Tim Duy looks at the Fed's likely course of action:

Bernanke Post Mortem, by Tim Duy: Federal Reserve Chairman Ben Bernanke's Congressional testimony should leave little doubt about the stance of monetary policymakers. Swift reaction came from Mark Thoma, Paul Krugman, Scott Sumner, and Joe Gagnon. Simply put, an incipient second half slowdown and fears of an outright double dip are insufficient to prod additional action on the part of the Federal Reserve. Policymakers are comfortable with the idea that neither objective of the dual mandate will be met in the foreseeable future. And even should the economy deteriorate such that they are forced into additional action, the likely policy candidates are woefully insufficient to meaningfully change the path of economic activity.

For all intents and purposes, the Fed is done. To be sure, the Fed would roll out its new set of lending facilities in response to another financial crisis. But setting the possibility of crisis aside, it is not clear what data flow short of a significant drop in activity would prompt a change of heart at the Fed.

Market participants set themselves up for disappointment. The set up began back with the Washington Post article suggesting that policymakers were actively considering the next set of policy options in light of recent data. I suggested the threshold for such actions was actually quite high, but the story fed upon itself until it became rumored that Bernanke would signal an end to providing interest on reserves. As Neil Irwin and Ryan Avent pointed out, the Fed Chair was simply not going to make a major policy announcement of that sort in Congressional testimony.

Worse, Bernanke did not appear overly concerned with the incipient second half slowdown. To be sure, he acknowledged the relatively weak data flow, but incoming information has only made the outlook "somewhat weaker," implying very little real shift in the fundamental view that the recovery is self-sustaining and sufficient to consume excess capacity over time and thus provides little reason to consider new policy options. Indeed, a substantive portion of the prepared remarks were devoted to tightening mechanisms, with the notion of additional easing left to the throwaway lines:

Of course, even as the Federal Reserve continues prudent planning for the ultimate withdrawal of extraordinary monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain. We will continue to carefully assess ongoing financial and economic developments, and we remain prepared to take further policy actions as needed to foster a return to full utilization of our nation's productive potential in a context of price stability.

Participants may also have been rattled by Bernanke's seemingly nonchalant attitude regarding additional easing options. From the Q&A:

Continue reading "Fed Watch: Bernanke Post Mortem" »

Thursday, July 22, 2010

"Time for a Monetary Boost"

More on the Fed's wait and see approach to doing more to try to help the economy recover:

Time for a Monetary Boost, by Joseph E. Gagnon: In his testimony to the Congress this week, Fed Chairman Ben Bernanke left the door open to further monetary stimulus but made it clear that such action is not imminent. ...
The Federal Reserve's own forecast shows that it will take at least three or four years for employment to return to its long-run sustainable level. This extended period of high unemployment represents a massive waste of productive labor and untold personal suffering of unemployed workers. The Fed should be aiming to get us back on track within two years. And the urgency of Fed action is all the more important because Congress has refused to provide more stimulus.
In addition, it is now apparent that deflation is a more serious risk for the US economy than inflation. The latest data show overall declines in consumer and producer prices..., core inflation has trended well below the 2-percent level that ... the Fed has adopted as its goal.
Clearly, the case for monetary stimulus is strong. But what form should it take? ... Three actions, in particular, would be helpful at this time.
First, the Fed should lower the interest rate it pays on bank reserves to zero. This is a small step, as the current rate is only 0.25 percent, but there is no reason to pay banks more than the rate paid by the closest substitute, short-term Treasury bills. Three-month Treasury bills currently yield 0.15 percent, and that rate, too, should be brought down to zero.
Second, the Fed should bring down the rates on longer-term Treasury securities by targeting the interest rate on 3-year Treasury notes at 0.25 percent and aggressively purchasing such securities whenever their yield exceeds the target. That is a 65-basis point reduction from the current rate of 0.90 percent. This step would ... reduce a wide range of private borrowing rates, encouraging business investment, supporting the housing market, and boosting exports through a weaker dollar. Moreover, pushing down yields on short- to medium-term Treasury securities is precisely the strategy for fighting deflation recommended by Ben Bernanke in 2002.
Finally, the Fed could bolster the stimulative effects of these actions by establishing a full-allotment lending facility to enable banks to borrow (with high-quality collateral) at terms of up to 24 months at a fixed interest rate of 0.25 percent.
These measures are all within the Federal Reserve's established powers. They pose essentially no risk to the Fed's balance sheet. They would reduce unemployment roughly as much as a 2-year $600 billion fiscal package and yet they would actually reduce the federal budget deficit. And they can be reversed quickly should the balance of risks shift from deflation to inflation.
Given the unsatisfactory outlook for unemployment and inflation and the lack of action by Congress, that is the right medicine for the US economy now.

As I've said before, there are reasons to worry that this won't provide enough of a boost, these policies provide incentives that may or may not be acted upon and that's why I've emphasized fiscal policy. But additional fiscal policy isn't going to happen unless there is a significant downturn in economic conditions, so this is our best hope.

Am I Being Unfair to the Fed, or is the Fed Being Unfair to Those Who Need Its Help?

Robin Harding at the Financial Times blog Money-Supply says I'm being unfair:

Why the Fed’s options are still under review, by Robin Harding: In his testimony today Ben Bernanke said that the Fed has not yet decided on its leading option in the event that it has to ease policy further. Mark Thoma asks, why?

After all this time, and after all the calls for the Fed to do more, they don’t even know what the leading options are? Bernanke says they are prepared to do more if conditions warrant it, but if there was a sudden disruption in financial markets tomorrow, they wouldn’t even know which policy option to prefer. I expected better than this from Bernanke and the rest of the Fed.

I don’t think that’s fair. I think the Fed knows exactly what it would do if there was a sudden disruption in financial markets tomorrow: liquidity programs like those we saw during the crisis and then probably asset purchases if they didn’t work.

I think the Fed is still pondering for a few reasons. First, the best response would depend on the conditions at the time, e.g. asset purchases will deliver better results if markets are stressed and the effect of communications will depend on the yield curve.

Second, the FOMC is quite split about the effectiveness of asset purchases, how much they distort markets, and the risks to the Fed’s credibility. Those debates are reasonable enough. It’s hard to expect a consensus to form unless it has to, because the Fed has decided to act (whether it should already be acting is a separate debate).

Third, I think the Fed is keen to keep revisiting all possible options, including those it has decided against in the past. That seems healthy enough to me.

I'll accept that the Fed may know what it would do if financial markets have a sudden breakdown tomorrow, but I'm not sure they know "exactly" what to do. That requires that they've worked out the uncertainties that plagued them the first time they faced a sudden financial crisis, and I don't think we know for sure that they have. But the point is that what the Fed needs to do in the case of a sudden financial disruption is different from what it needs to do to give a boost to an economy struggling to recover, and that they can know one without knowing the other. That's fair. But isn't it also fair to expect the Fed to be prepared for both?

So I don't accept that the Fed should not know what its best option is for dealing with the situation as it exists today. The first rationale for this given above, that the best response is state dependent (i.e. that it will depend upon the conditions at the time), is not an excuse for waiting to figure out what to do. If the Fed faces different possible future outcomes, then it should develop state contingent policy responses, i.e. it should know what it will do under all of the future scenarios it can imagine. It's a mistake to wait until you know what the conditions are before starting to figure out what to do. Instead, there should be a plan that says what the best response is to a variety of potential future states of the economy. A black swan could always appear and that would require policy to be developed on the fly, but the response to most potential future economic conditions should already be known.

The second objection, that the Fed is split, is not a very compelling excuse either. Policy splits are common, nothing new there. Take a vote or institute a process for resolving this. Better to get the disputes resolved now than trying to resolve them in the middle of a crisis when quick action is needed. The third excuse is that the Fed may discover a better policy as it revisits its options. The Fed should revisit its options, no disagreement there, and if a better option presents itself later, the Fed should certainly adopt it. But how does that stop the Fed from making the best choice given what it knows right now? There's always the possibility of finding a better solution in the future, and the Fed shouldn't stop trying to improve, but it should also know what the best options are given present conditions. Being able to say what they'd do if they had to act today doesn't seem to be too much to ask.

So the answer I expected from Bernanke was something like, "while we continue to try to fine-tune and improve policy, as always, we are fully prepared to react to a wide variety of future conditions, and could act today if we thought we needed to do so."

What this really says, to me anyway, is that the Fed does not believe conditions are bad enough right now, or can possibly get bad enough in the near future, to make the Fed feel the need to be ready to act. It also says that six months ago, or however long it takes to figure this out, they were convinced that the economy would not need more help today, so there was no need to be ready. But how did they know then that they wouldn't want to act today? Members of the Fed think they have plenty of time yet to weigh their options carefully, and in the unlikely event things really do get worse, measurably worse than they are now, then they'll figure out what to do. But, apparently there's no rush.

That they haven't even felt the need to be ready to react to conditions like we are seeing today -- unemployment staying persistently high, deflation month after month, and so on, conditions worse than the Fed expected six months ago -- is the disappointing part. The main problem I have with the Fed's position is that they haven't told us what they are so worried about if they do act now. Is it inflation? Even after recent data showing deflation? Is it credibility? The Fed has an obligation to address both inflation and unemployment, and it's a mistake to base their credibility on just one component of its dual mandate. The Fed is losing credibility with the public daily, and its not because of worries over inflation. They've tossed out a variety of possibilities regarding the things they are worried about, but the specifics have been lacking.

What, exactly is the cost if they do act now? Until the Fed has a good answer to that question, and so far I haven't heard it, I will continue to wonder not only why they aren't ready to act now, which is bad enough, but why they haven't tried to do more to help an economy that is clearly struggling. We're in danger of a lost decade or worse, and the Fed is not responding adequately to that threat.

Wednesday, July 21, 2010

Why are the Fed's Options Still under Review?

I'm in a bit of a rush, but I want to note this from Ben Bernanke:

Bernanke’s comments to Congress are largely as expected, but some may be a bit taken aback by his comments on shrinking the balance sheet, which doesn’t suggest much central bank appetite to provide additional stimulus to a troubled economy. ...
In the testimony, Sen. Shelby asks Bernanke what everyone wants to know: what more can the Fed do for the economy, if needed. Bernanke replies that the Fed has options from lowering the interest on reserves rate, to language changes in the FOMC outlook, to balance sheet tweaks.
He notes current policy is “already quite stimulative” and adds “we do still have options, but they are not going to be conventional options.”
Bernanke says any additional action is still under review, saying “we have not come to the point where we can tell you precisely what the leading options are.”

After all this time, and after all the calls for the Fed to do more, they don't even know what the leading options are? Bernanke says they are prepared to do more if conditions warrant it, but if there was a sudden disruption in financial markets tomorrow, they wouldn't even know which policy option to prefer. I expected better than this from Bernanke and the rest of the Fed.

The we could do more but aren't ready to do so just yet line from Bernanke is also puzzling. With unemployment as high as it is and with the projections for a very slow recovery -- if we can avoid a double dip -- why doesn't the Fed do more now? Why hasn't it done more already? That question has never been answered to my satisfaction.   [dual posted]

Sunday, July 18, 2010

Don't Expect Miracles from Monetary Policy

A recent post of mine at MoneyWatch:

Don't Expect Miracles from Monetary Policy, Maximum Utility: ...As I've said many times, I think the economy needs more help, particularly labor markets. But where will that help come from? Additional fiscal policy seems to be off the table due to worries about the deficit, worries I think are baseless, but I don't control the fiscal policy levers. That's the best thing to do right now, but it's not going to happen.

That leaves monetary policy, and the Fed is making noises about giving the economy more help. Though the Fed isn't willing to go this far yet, one thing they could do is to purchase long-term securities in an attempt to lower long-term interest rates. Or they could set a higher inflation target to try to lower long-term rates. The idea is that this will spur investment spending by businesses and new spending on durables by households.

Paul Krugman, in a relatively wonkish post, discusses the options the Fed has, and notes that when it comes to the purchase of long-term securities (also known as quantitative easing), we shouldn't expect too much:

But how strong would this effect be? Even if the Fed bought a couple of trillion dollars’ worth, probably not all that large. I’m not saying don’t do it, but don’t expect miracles.

He doesn't explain in detail why we shouldn't expect much, but here's the worry I would have. Lowering interest rates either through purchases of long-term securities or through a higher inflation target (another policy Krugman discusses) is just the first step in this policy, and some of the additional steps that are needed are problematic. With respect to the first step, there's no guarantee that the purchase of long-term securities will lower long-term rates, but most analysts think it could if it is carried out on a large enough scale (the necessary scale -- trillions -- is is one of the things causing resistance to this policy). So let's assume the Fed can lower rates by a point of two if it so desires, either through quantitative easing or through a higher inflation target.

For the policy to be effective, there is a second step that must occur. Firms and households must respond to this incentive by investing more in new plants and equipment and purchasing more durable consumer goods. But as this discussion at The Economist I took part in notes, firms are saving rather than investing right now, and the reason seems to be due to a poor outlook for the economy along with considerable existing excess capacity. Under those conditions, a poor outlook and lots of excess capacity, a point tor two fall in the interest rate is unlikely to spur much new activity (and households, who are still struggling with high unemployment rates, are unlikely to increase their purchase of durables enough to make up the difference). So I fully agree with Krugman. We should try this, the state of the economy demands that we try something even if it may not work, but we shouldn't expect miracles.

Thursday, July 15, 2010

Fed Watch: The Dance Continues

This is the second of three consecutive posts from Tim Duy. He said he had a lot of coffee today:

The Dance Continues. by Tim Duy: The Fed dance continued today with the release of the minutes. In most ways, the content of the minutes was largely expected, as reported by Free Exchange. Forecasts for growth and inflation were knocked down, while the forecast for unemployment was edged up. Overall, the Fed concluded that:

The economic outlook had softened somewhat and a number of members saw the risks to the outlook as having shifted to the downside. Nonetheless, all saw the economic expansion as likely to be strong enough to continue raising resource utilization, albeit more slowly than they had previously anticipated. In addition, they saw inflation as likely to stabilize near recent low readings in coming quarters and then gradually rise toward more desirable levels. In sum, the changes to the outlook were viewed as relatively modest and as not warranting policy accommodation beyond that already in place.

They did inject some uncertainty over the path of policy:

However, members noted that in addition to continuing to develop and test instruments to exit from the period of unusually accommodative monetary policy, the Committee would need to consider whether further policy stimulus might become appropriate if the outlook were to worsen appreciably

Still, the minutes read as if additional policy stimulus is a remote chance. As has been reported, recent Fedspeak has been decidedly more mixed.

Paul Krugman bemoans the fact that the Fed understands and is largely comfortable with meeting neither of its dual objectives. The minutes are quite clear on this point:

A number of participants expressed the view that, over the next several years, both employment and inflation would likely be below levels they consider to be consistent with their dual mandate, but they anticipated that, with appropriate monetary policy, both would rise over time to levels consistent with the Federal Reserve's objectives.

I guess you are not all that worried about high unemployment for "several years" when you have a 13 year appointment. Two additional gems in the minutes:

Participants also noted that several uncertainties, including those related to legislative changes and to developments in global financial markets, were generating a heightened level of caution that could lead some firms to delay hiring and planned investment outlays.


Reportedly, employers were still cautious about adding to payrolls, given uncertainties about the outlook for the economy and government policies.

These two lines imply that some Fed members are buying the story that the lack of business confidence is due to all the uncertainty created by the Obama Administration. Convenient excuse to avoid additional stimulus. Nothing we can do, this is a problem caused by those silly fiscal policymakers.

And another point I find odd:

Participants also noted a risk that continued rapid growth in productivity, though clearly beneficial in the longer term, could in the near term act to moderate growth in the demand for labor and thus slow the pace at which the unemployment rate normalizes.

Rapid productivity growth should never be a problem. It is only a problem if policymakers hold demand unnecessarily low such that the additional potential output cannot be absorbed. Answer: Do more to stimulate demand.

Bottom Line: The minutes paint a picture of monetary policymakers slightly more concerned about an already questionable outlook, but not concerned enough to do anything about it. This stance appears a bit more vulnerable in light of flow of data since the last FOMC meeting, and that flow of data may be exactly what recently pushed some Fed officials to emphasize the "we can do more" story. In effect, a preemptive effort to alleviate the seemingly hawkish stance of the minutes. Hopefully, Federal Reserve Chairman Ben Bernanke will provide additional clarity of the Fed's stance with regard to additional easing at next week's semi-annual testimony.

Helicopter Money

I sent an email to Brad DeLong. He gives me more credit than I deserve:

DeLong Smackdown Watch: Mark Thoma: Mark Thoma writes to inquire why I am endorsing a helicopter drop--a money printing-financed mass mailing of tax rebate checks--when a money printing-financed increase in government purchases dominates it from an economic point of view. Aren't I surrendering to the dysfunctionality of our political system rather than fighting it?

Mark Thoma snarks:

I am very simplistic.

When you trade money for bonds, it simply changes the composition of what people have in savings. Before it was bonds, now its cash. No effect on real activity. You need actual demand, or the prospect of it, to create expected inflation.

When you drop money from helicopters, the people who need it most scramble for it, and then rush to spend it before everyone else spends their money and drives up prices (expected inflation) or causes stock-outs. It has real effects. And I don’t think the people willing to fight for $100 bucks when the helicopter comes each day give a damn about future taxes.

But instead of simply dropping it, why not buy something on the first step? Print money, buy labor (the labor then spends the “found”, i.e. earned, money). Print money, buy goods and services. Because this is too slow. Deciding what labor should do, hiring, etc. takes way too much time and political effort, as does figuring out what to buy.

So save this time by just letting the money rain down on people and letting them figure out what to do with it. I’d guess that money falling in a city would begin to see effects on aggregate demand, oh, a matter of minutes, if that long.

But I know this is too simple.

Tuesday, July 13, 2010

Should You be Worried about Inflation? What about Deflation?

I have a new post a MoneyWatch:

Should You be Worried about Inflation? What about Deflation?

The post explains the tools at the Fed has at its disposal to offset inflationary and deflationary pressures, and why I am more worried about the response to short-run deflationary pressures than I am about the response to the possibility of inflation in the long-run.

"Sagging Global Growth Requires Us to Act"

Nouriel Roubini and Ian Bremmer are worried about the prospects for world economic growth:

Sagging global growth requires us to act, by Nouriel Roubini and Ian Bremmer, Commentary, Financial Times: It looks as if the global economy is heading for a serious slowdown this year. ... The most realistic scenario for global growth is painful, even if we avoid a double dip. ...

Politically, this second global slowdown could not have come at a more difficult time. In the US, Democrats and Republicans will soon retreat to their corners to prepare for November’s mid-term elections. Meanwhile, President Barack Obama must again persuade America’s taxpayers that a new surge in government spending is needed to protect a fragile recovery – and at a moment when voters are telling pollsters that America’s debt is as great a threat as terrorism.

So the president must also tell voters that the longer-term solution to America’s economic insecurity involves both austerity and sacrifice. But abroad he faces an even larger problem. Mr Obama has limited leverage ... to persuade European governments to shrug off fiscal worries. These countries seem unlikely to shift from their view that events of the past year in Greece, Spain and elsewhere – and fears of further crises to come – demand that the continent must learn to live within its means. Nor should we expect much from the next G20 meeting in Seoul in November. ...

Yet ... words matter. Plans to boost government spending in the near term, and to embrace austerity in the longer term, will only become more difficult if the president fails to explain the need for them. For their part, America’s Republicans need to accept that the path to a global recovery begins at home, with extended unemployment insurance and help for state and local governments.
Countries that save too much must also do their part for global demand. In particular, the Chinese leadership should recognize that failure to allow a more substantive revaluation of its currency will have serious consequences at home. ...
The eurozone needs fiscal austerity, but it also needs a level of growth best provided by an easing of monetary policy from the European Central Bank. Early debt-restructuring of insolvent members should also be on the agenda. Germany should postpone its fiscal consolidation for a couple of years to boost disposable income and consumption. Outside Europe, Japan must accelerate economic reforms.
These steps will take time. Even if all are undertaken properly, global growth will recover only slowly. But if they are not undertaken at all, the risk of a global double dip, and a new financial crisis, will grow sharply. Policymakers cannot keep kicking the can down the road for much longer.

Monday, July 12, 2010

Fed Watch: A Deepening Divide?

One more from Tim Duy:

A Deepening Divide?, by Tim Duy: Last week the Washington Post raised expectations that the Fed was seriously considering additional policy action:

Federal Reserve officials, increasingly concerned over signs the economic recovery is faltering, are considering new steps to bolster growth.

Today nonvoter Richmond Fed President Jeffrey Lacker pushed back hard on those expectations:

Federal Reserve Bank of Richmond President Jeffrey Lacker said any consideration of further monetary easing by U.S. central bankers “is very far away.”

“It would take a very substantial, unanticipated adverse shock” for further steps at stimulus to be appropriate, Lacker told reporters today in Richmond. “Consideration of further easing steps is very far away.”

And note this morning I concluded with:

My concern is that policymakers will view a retrenchment in growth as a natural "pause," simply a delay on the path the strong rebounds that have traditionally followed deep recessions.

This is not dissimilar to Lacker's interpretation of the data:

“I’m comfortable with rates where they are now,” Lacker, who doesn’t vote on rate decisions this year, said today at the opening of an exhibit at the Richmond Fed on the history of the central bank. “You have some surges, some slower periods. It’s just going to be a choppy recovery.”

Interestingly, he appeared to be joined by Governor Elizabeth Duke:

Separately, Fed Governor Elizabeth Duke said in an interview with CNBC that the central bank is “in the right place” on its monetary policy and that she sees a “moderate recovery” taking place.

It sounds as if a battle is brewing within the Fed, with the Washington Post's unnamed sources trying to keep monetary policy options open while another contingent is happy shutting down those options. Separately, Felix Salmon opines that the debate has already been decided:

Bernanke is a consensus builder, as Krugman knows, having been part of the Princeton economics department during Bernanke’s tenure as its head. And it may or may not make sense for the Fed to ease much more aggressively. But so long as that remains outside the general consensus, Bernanke’s not going to do it.

Salmon believes that Federal Reserve Chairman Ben Bernanke - a Republican - will not break from that party's consensus that too much has been done already. Some of Bernanke's defenders may find that paints a too narrow view of his motivations. But Salmon also notes that even Democrats are not eager for additional policy action. If the White House is not willing to push for more, why should Bernanke do so, especially when it will apparently require him to expend political capital internally?

If Salmon's thesis is correct, it is a particularly sad outcome given Bernanke's own words from 2002:

In short, Japan's deflation problem is real and serious; but, in my view, political constraints, rather than a lack of policy instruments, explain why its deflation has persisted for as long as it has. Thus, I do not view the Japanese experience as evidence against the general conclusion that U.S. policymakers have the tools they need to prevent, and, if necessary, to cure a deflationary recession in the United States.

Politics could be every bit a problem in the United States as it has been in Japan. More to the point, it already is.

Paul Krugman: The Feckless Fed

Frustration with the Fed:

The Feckless Fed, by Paul Krugman, Commentary, NY Times: Back in 2002, a professor turned Federal Reserve official by the name of Ben Bernanke gave a widely quoted speech titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Like other economists, myself included, Mr. Bernanke was deeply disturbed by Japan’s stubborn, seemingly incurable deflation, which in turn was “associated with years of painfully slow growth, rising joblessness, and apparently intractable financial problems.” This sort of thing wasn’t supposed to happen to an advanced nation with sophisticated policy makers. Could something similar happen to the United States?
Not to worry, said Mr. Bernanke: the Fed had the tools required to head off an American version of the Japan syndrome, and it would use them if necessary.
Today, Mr. Bernanke is the Fed’s chairman — and his 2002 speech reads like famous last words. We aren’t literally suffering deflation (yet). But inflation is ... trending steadily lower; it’s a good bet that by some measures we’ll be seeing deflation by sometime next year. Meanwhile, we already have painfully slow growth, very high joblessness, and intractable financial problems. And what is the Fed’s response? It’s debating — with ponderous slowness — whether maybe, possibly, it should consider trying to do something..., one of these days.
The Fed’s fecklessness is, to be sure, not unique. It has been astonishing and infuriating, as the economic crisis has unfolded, to watch America’s political class... Washington seems to feel absolutely no sense of urgency. Are hopes being destroyed, small businesses being driven into bankruptcy, lives being blighted? Never mind, let’s talk about the evils of budget deficits.
Still, one might have hoped that the Fed would be different. For one thing, the Fed, unlike the Obama administration, ... doesn’t need 60 votes in the Senate; the outer limits of its policies aren’t determined by ... senators from Nebraska and Maine. Beyond that, the Fed was supposed to be intellectually prepared for this situation. Mr. Bernanke has thought long and hard about how to avoid a Japanese-style economic trap, and the Fed’s researchers have been obsessed for years with the same question.
But here we are, visibly sliding toward deflation — and the Fed is standing pat.
What should it be doing? Conventional monetary policy, in which the Fed drives down short-term interest rates..., has reached its limit:... short-term rates are already near zero... But the message of Mr. Bernanke’s 2002 speech was that there are other things the Fed can do. It can buy longer-term government debt. It can buy private-sector debt. It can try to move expectations by announcing that it will keep short-term rates low for a long time. It can raise its long-run inflation target, to help convince the private sector that borrowing is a good idea and hoarding cash a mistake.
Nobody knows how well any one of these actions would work. The point, however, is that there are things the Fed could and should be doing, but isn’t. Why not? ...
The closest thing I’ve seen to an explanation is a recent speech by Kevin Warsh of the Fed’s Board of Governors, in which he declared that doing what Mr. Bernanke recommended back in 2002 risked undermining the Fed’s “institutional credibility.” But how, exactly, does it serve the Fed’s credibility when it fails to confront high unemployment, while consistently missing its own inflation targets? How credible is the Bank of Japan after presiding over 15 years of deflation?
Whatever is going on, the Fed needs to rethink its priorities, fast. Mr. Bernanke’s “it” isn’t a hypothetical possibility, it’s on the verge of happening. And the Fed should be doing all it can to stop it.

Friday, July 09, 2010

How Close to Deflation are We?

Mike Bryan of the Atlanta Fed:

How close to deflation are we? Perhaps just a little closer than you thought, macroblog: Since last October, the consumer price index (CPI) has gone up an annualized 0.7 percent. On an ex-food and energy basis, the number is a little lower, at 0.5 percent. And the Cleveland Fed's trimmed-mean and median CPIs, at 0.7 percent and 0.2 percent, respectively, also put the recent trend in consumer prices in pretty low territory.
And this is before we take into account any potential mismeasurement, or "bias," in the construction of the CPI.
How big is the CPI's bias? Well, in 1996, the Social Security Administration commissioned a study on the accuracy of the CPI as a measure of the cost of living. This so-called "Boskin Commission Report" said the CPI was overstated by about 1.1 percentage points per year. The commission identified several sources of potential bias, but about half of the 1.1 percentage points resulted from new products and quality changes that were slow or otherwise imperfectly introduced into the price statistic.
Since that time, the Bureau of Labor Statistics has initiated a number of methodological changes that have reduced the CPI's mismeasurement bias. In a 2001 paper, Federal Reserve Board economists David Lebow and Jeremy Rudd put the CPI bias at only about 0.6 percentage points. And again, of this amount, the big share of the bias (about 0.4 percentage points) resulted from the imperfect accounting of new and improved goods.
Now, in an article (available to all in its working paper version) appearing in the latest issue of the American Economic Review, Christian Broda and David Weinstein say the earlier estimates of the new goods/quality bias may be a bit understated. The authors examine prices from the AC Nielsen Homescan database and conclude that between 1996 and 2003, new and improved goods biased the CPI, on average, by about 0.8 percentage points per year. If this estimate is accurate, consumer price increases since last October would actually be around zero, or even slightly negative, once we account for the mismeasurement of the CPI caused by new and improved goods.

But (oh, you just knew there was going to be a "but" in here, right?) the authors also point out that, because new goods are introduced procyclically, this bias tends to be larger during expansions and smaller during recessions. In other words, given the severity of the recession and the modest pace of the recovery, there may not be a whole lot of innovation going on right now in consumer goods. This is a bad thing for consumers, of course, but it would be a good thing for the accuracy of the CPI.

Given this and other indications of the economy's weakness, should monetary and fiscal policymakers do more? I think they should, but key policymakers don't share that view. In fact some say that despite recent data indicating trouble may be ahead, the recovery is proceeding normally and doesn't need any further help. Here's Richmond Fed President Jeffrey Lacker:

The recent spate of weaker economic data doesn’t mean the U.S. recovery is faltering, and the Federal Reserve continues to get closer to the time when it will need to raise interest rates... Lacker believes, like many other Fed officials, that the economy doesn’t yet need fresh support from the Fed. He put very low odds the Fed will come back into the market to buy mortgages, saying “I don’t think this is the time to shift gears again” and “we are a long way a ways from needing to think about starting up asset purchases again.”

What's he afraid of? Inflation?

Fed Watch: What is the Threshold For More Fed Action?

Tim Duy says the Fed talks a lot, but the threshold for action is pretty high:

What is the Threshold For More Fed Action?, by Tim Duy: Yesterday's Washington Post article suggesting the Fed was moving closer to additional policy action left me somewhat puzzled. It left out a critical piece. What is the threshold for additional action? Particularly any action of significance? Recent Fedspeak suggests the threshold is pretty high - financial crisis high. Otherwise, any action is likely to be more window dressing than anything else.

Neil Irwin at the Post claims:

Top Fed officials still say that the economic recovery is likely to continue into next year and that the policy moves being discussed are not imminent. But weak economic reports, the debt crisis in Europe and faltering financial markets have led them to conclude that the risks of the recovery losing steam have increased. After months of focusing on how to exit from extreme efforts to support the economy, they are looking at tools that might strengthen growth.

Note the rhetorical claim suggesting this article is sourced by "top Fed officials." But the only officials cited are St. Louis Fed President James Bullard and Boston Fed President Eric Rosengren. No one from the Board, interestingly. To be sure, Bullard is an intellectual heavy hitter. But Bullard can be difficult to read. He talks. A lot. But with Bullard, the Post reduces his quotes to pretty pedestrian stuff:

"If the economic situation changes, policy should react," James Bullard, president of the Federal Reserve Bank of St. Louis, said in an interview Wednesday. "You shouldn't sit on your hands. . . . I think there's plenty more we could do if we had to."

Surprising. I have to imagine that Bullard provided a lot of good quotes. And Irwin doesn't appear to challenge Bullard to explain how much the economic situation needs to change to prompt a policy change. But, luckily, Bullard gave an interview to Reuters at the end of June, and reporter Mark Felsenthal gave us a little more to work with. Yes, this is not new news. Just new for the Post.

For me, the Reuters piece had three main takeaways. First, Bullard and his colleagues underestimated the likelihood of a jobless recovery:

"We just started getting our job growth going three months ago, and then all of sudden we get a kind of a weaker number," said Bullard, who is a voter this year on the Fed's policy-setting panel. Nonfarm payrolls added a disappointing 41,000 private sector jobs in May, denting hopes for a speedy recovery.

Second, and related, the Fed actually believes we are experiencing a typical post-war recession in which output rapidly returns to trend:

Setting aside worries raised by softer economic indicators and Europe, the Fed continues to envision a moderate recovery, Bullard said.

"We would expect ... at some point start to gradually withdraw the accommodation and then things would continue to recover, and then eventually we would get back to normal," he said.

Does the Fed really fail to realize that the only reason the US economy returned to "normal" after the last recession was attributable to a housing bubble that was unsustainable? A topic for another time. Finally, the threshold for meaningful additional action is very, very high:

However, if the economy takes a decisive turn for the worse, the Fed would have to consider further stimulus, probably buying more Treasury securities to ease financial conditions, Bullard said.

"If things got really bad in some dimension and we were back in crisis mode, I think the FOMC wouldn't hesitate to do more if we had to, but I don't really think that that's the situation we're in right now," he said.

Note: "back in crisis mode." Note: "ease financial conditions." Nothing like "to ease the pain of unemployment." Did Bullard say the same thing to Irwin? We don’t know, because Irwin falls back on plain vanilla quotes.

Putting the pieces together, it appears the Fed is beginning to realize that economic activity will not bounce back rapidly, but there is little meaningful they are willing to do unless they are in crisis mode. And that analysis is based largely on interviews with a single Fed official. Other Fed officials appear even less likely to act. From Bloomberg over the weekend:

Two Federal Reserve policy makers differed on the strength of the U.S. consumer in Nikkei newspaper interviews, amid evidence that the recovery in the world’s largest economy is slowing.

Jeffrey Lacker, president of the Federal Reserve Bank of Richmond, said consumer spending is “moderately strong” and along with business investment will help sustain the recovery, the Japanese newspaper quoted him as saying. Richard Fisher, president of the Dallas Fed, cited “cautious” households as a reason for a growth to cool in the second half.

The remarks reflect debate on the durability of the economy after reports last week showed private-sector payrolls rose less than forecast in June, consumer confidence slumped and manufacturing growth slowed. Fed officials last month retained a pledge to keep record-low interest rates for an “extended period” and signaled Europe’s debt crisis may harm growth.

Lacker said he was comfortable with the current level of interest rates, according to Nikkei. Later this year it will be a “legitimate question” whether to drop the ‘extended period’ language and “think about raising rates,” the newspaper reported him as saying.

Fisher said any tightening of monetary policy “depends on the course of the economy,” according to the report. He said on June 4 that while it’s not time for central bankers to tighten policy, they may be “getting closer” as the economy further expands this year.

Goodness, over the weekend, both Richmond Fed President Jeffrey Lacker and Dallas Fed President Richard Fisher were still looking forward to tightening policy. Of course, Fisher, similar to Bullard, likes to talk. Indeed, Fisher looks closer to Kansas City Fed President Thomas Hoenig:

Hoenig, 63, has been the sole policy maker to dissent this year from decisions of the Federal Open Market Committee, objecting four times to its pledge to keep interest rates at a record low for an “extended period.”

He also said the central bank should dispose of assets accumulated while fighting the crisis “as reasonably as we can, as quickly as we can.” While he has proposed raising the target for overnight loans among banks to 1 percent by September, Hoenig said in the interview that the timing “can be debated.”

Fisher indicated there’s little more the Fed can do after cutting interest rates to a record low in December 2008 and pumping more than $1 trillion into the financial system through asset purchases.

“We ought to be very careful about not going too far,” he said. “Interest rates are zero. It’s not the cost of money that’s the issue.”

One can only imagine what kind of crisis would prompt Hoenig for additional action. Something that would rapidly deteriorate to the guns and gold portfolio. Still waiting for someone from the Board to speak. Wait, yes they did. Fed Governor Kevin Warsh gave a rousing speech:

The Federal Reserve should be wary of the short-term allure of further asset purchases, said Fed governor Kevin Warsh on Monday. In a speech in Atlanta, Warsh set a high bar for his support of further asset purchases, saying he would need to be convinced the benefits of the purchases would outweigh the costs of "erosion of market functioning, perceptions of monetizing indebtedness, crowding-out of private buyers, or loss of central bank credibility."

Which gets to the crux of the issue. Realistically, to generate significant impacts at the zero bound, the Fed is going to have to commit to policies that look a lot like debt monetization. We are nowhere near that stage. Indeed, after two decades, the Bank of Japan is not there. Sure, maybe the Fed commits to a long term ZIRP (pretty much there already), buys mortgage backed assets to offset maturing securities, or, as a temporary response to a fresh crisis, expands the balance sheet a bit. But commit to a higher inflation target? Target long bond rates? Those actions likely require sustained, massive purchases of US Treasuries - a bridge too far to cross for policymakers who view central bank credibility as a one sided game. The only real policy error is inflation. Anything else is interesting, but not important.

A Response to Arnold Kling

Arnold Kling:

An Assignment for Mark Thoma: I would like for Mark or for Paul Krugman to write an essay on the topic of what would happen if tomorrow the Fed stopped paying interest on reserves. ... I would like for Mark or for Paul Krugman to write an essay on the topic of what would happen if tomorrow the Fed stopped paying interest on reserves.

I don't know if I can get a whole essay out of this. This is something the Fed is considering, but I don't think it would have a very large impact on economic activity. The reason is that I don't think the lack of investment activity, or loan activity more generally (a new report says consumer credit fell again), is due to a problem on the supply side. Banks have tightened up a bit as the economic outlook has deteriorated, but I believe the main problem is lack of loan demand. Here's one reason I hold this view:

How "discouraged" are small businesses? Insights from an Atlanta Fed small business lending survey, macroblog: ..[T]here is congressional debate going on about how to best aid small businesses and promote job growth. Many people have noted the decline in small business lending during the recession, and some have suggested proposals to give incentives to banks to increase their small business portfolios. But is a lack of willingness to lend to small businesses really what's behind the decline in small business lending? ...
We at the Federal Reserve Bank of Atlanta have ... noted the paucity of data in this area and have begun a series of small business credit surveys. ... [T]he results of our April 2010 survey suggest that demand-side factors may be the driving force behind lower levels of small business credit. ...

Based upon this and other indications that this is primarily a demand side problem, I am not convinced that lowering the interest rate on reserves from one quarter of a percent to zero will have much of an effect on investment activity. What we need is a reason for firms to want to invest, and that will require a much improved outlook for the economy, something that could be aided by the government providing additional stimulus to aggregate demand.

Thursday, July 08, 2010

Don’t Expect Miracles from Monetary Policy

I have a new post at MoneyWatch:

Don’t Expect Miracles from Monetary Policy

It responds, briefly, to today's report on new claims for unemployment insurance, but the main discussion follows up on a post from Paul Krugman and looks at how effective further monetary policy initiatives might be.

Wednesday, July 07, 2010

"The Rising Threat of Deflation"

As I hope you already know, conservatives (update: and some misdirected liberals) aren't standing on very firm ground with their worries about inflation and their calls for austerity. In fact, merely saying the ground they are standing on is shaky is far too generous. But if you need further evidence that they are promoting bad ideas, note that they can't even get the American Enterprise Institute to agree with them:

The Rising Threat of Deflation, by John H. Makin, AEI, July 2010: As we enter the second half of 2010--the ... United States and Europe are heading toward--and Japan already suffers from--deflation, a classic prolonger of crises that boosts the real burden of debt and crushes profit margins.
U.S. year-over-year core inflation has dropped to 0.9 percent--its lowest level in forty-four years. ... Europe's year-over-year core inflation rate has fallen to 0.8 percent... Ireland's deflation rate is 2.7 percent. As commodity prices slip, inflation will become deflation globally in short order. Meanwhile in Japan,... the ... gross domestic product (GDP) deflator had fallen 2.8 percent, reflecting an accelerating pace of deflation in a country where the price level has been falling every year since 2004. ...
The financial crisis of 2008 prompted aggressive monetary and fiscal easing by most governments. ... Many market participants and policymakers have warned that such aggressive easing will lead to inflation. Contrary to those expectations, as noted above, core inflation has steadily moved lower... By later this year, persistent excess capacity will probably create actual deflation in the United States and Europe. Moreover, the recent appreciation of the dollar, especially against the euro, exacerbates the U.S. deflation threat. ...
Perhaps it is time for central banks, the ECB especially, to take note. Financial crises are usually deflationary. Pretending otherwise ... constitutes a necessary, although not sufficient, condition for a global depression. ... A persistent failure to respond to the dangers of further deflation, such as the premature removal of accommodative monetary policy apparently favored at the ECB or a sharp fiscal contraction favored by the European Monetary Union, would sharply elevate the risk of global deflation and depression.
At this point in the postbubble transition to deflation, fiscal rectitude and monetary stringency are a dangerous policy combination, as appealing as they may be to the virtuous instincts of policymakers faced with a surfeit of sovereign debt. ... The G20's shift toward rapid, global fiscal consolidation--a halving of deficits by 2013--threatens a public sector, Keynesian "paradox of thrift" whereby because all governments are simultaneously tightening fiscal policy, growth is cut so much that revenues collapse and budget deficits actually rise. ...
The link between volatile financial conditions and the real economy has been powerfully underscored by the events since mid-2007. Growth has suffered and subsequently recovered given powerful monetary and fiscal stimulus. And yet, the damaged financial sector, unable to supply credit; a jump in the precautionary demand for cash; and a persistent overhang of global production capacity have combined to leave deflation pressure intact. The G20's newfound embrace of fiscal stringency only adds to the extant deflation pressure. ...

Monday, June 28, 2010

Paul Krugman: The Third Depression

A failure of policy, in particular a "stunning resurgence of hard-money and balanced-budget orthodoxy," increases the likelihood that we are headed for a third depression:

The Third Depression, by Paul Krugman, Commentary, NY Times: Recessions are common; depressions are rare. As far as I can tell, there were only two eras in economic history that were widely described as “depressions” at the time: the years of deflation and instability that followed the Panic of 1873 and the years of mass unemployment that followed the financial crisis of 1929-31.
Neither the Long Depression of the 19th century nor the Great Depression of the 20th was an era of nonstop decline — on the contrary, both included periods when the economy grew. But these episodes of improvement were never enough to undo the damage from the initial slump, and were followed by relapses.
We are now, I fear, in the early stages of a third depression. It will probably look more like the Long Depression than the much more severe Great Depression. But the cost — to the world economy and, above all, to the millions of lives blighted by the absence of jobs — will nonetheless be immense.
And this third depression will be primarily a failure of policy. Around the world ... governments are obsessing about inflation when the real threat is deflation, preaching the need for belt-tightening when the real problem is inadequate spending. ... After all, unemployment — especially long-term unemployment — remains at levels that would have been considered catastrophic not long ago, and shows no sign of coming down rapidly. And both the United States and Europe are well on their way toward Japan-style deflationary traps.
In the face of this grim picture, you might have expected policy makers to realize that they haven’t yet done enough to promote recovery. But no: over the last few months there has been a stunning resurgence of hard-money and balanced-budget orthodoxy.
As far as rhetoric is concerned, the revival of the old-time religion is most evident in Europe, where officials seem to be getting their talking points from the collected speeches of Herbert Hoover, up to and including the claim that raising taxes and cutting spending will actually expand the economy, by improving business confidence. As a practical matter, however, America isn’t doing much better. The Fed seems aware of the deflationary risks — but what it proposes to do about these risks is, well, nothing. The Obama administration understands the dangers of premature fiscal austerity — but because Republicans and conservative Democrats in Congress won’t authorize additional aid to state governments, that austerity is coming anyway, in the form of budget cuts at the state and local levels.
Why the wrong turn in policy? The hard-liners often invoke the troubles facing Greece and other nations around ... Europe to justify their actions. And it’s true that bond investors have turned on governments with intractable deficits. But there is no evidence that short-run fiscal austerity in the face of a depressed economy reassures investors. ...
It’s almost as if the financial markets understand what policy makers seemingly don’t: that while long-term fiscal responsibility is important, slashing spending in the midst of a depression, which deepens that depression and paves the way for deflation, is actually self-defeating.
So I don’t think this is really about Greece, or indeed about any realistic appreciation of the tradeoffs between deficits and jobs. It is, instead, the victory of an orthodoxy that has little to do with rational analysis, whose main tenet is that imposing suffering on other people is how you show leadership in tough times.
And who will pay the price for this triumph of orthodoxy? The answer is, tens of millions of unemployed workers, many of whom will go jobless for years, and some of whom will never work again.

Sunday, June 27, 2010

Should Monetary Policy be More Expansionary?

Martin Wolf:

Is monetary policy too expansionary or not expansionary enough?, by Martin Wolf: People with a free-market orientation believe that the economy has a strong tendency towards equilibrium. Over the long term money is “neutral”: a rise in the money supply merely raises the price level. In the short term, however, monetary policy may have a big impact on the economy. A big question, however, is over how to measure the impact of monetary policy in an environment such as the present one, when short-term interest rates are close to zero and the credit system is damaged.
The difficulty arises because of the huge divergence between what is happening to the monetary base (the monetary liabilities of the government, including the central bank) and what is happening to broader measures of money (principally the liabilities of the banking system). The former has exploded. But the growth rate of the latter is extremely low. ...
The ... inflationary impact of “money printing” can ... only happen if the overall money supply starts to grow rapidly. This is not now happening. Only the monetary base is expanding rapidly. Should such a broader expansionary impact emerge, monetary policy will have been successful, the central bank can then raise rates, thereby preventing a rapid growth in credit and so constraining the growth of broad money.
My conclusion is that what is happening to the balance sheet of the central bank is unimportant, except to the extent that it has prevented a collapse of credit and money. What matters is the overall supply of credit and money in economies. This continues to be stagnant in the developed world. Concern about an imminent outbreak of inflation is consequently a grave mistake. To the extent that there is a danger of “monetization” of debt, it will emerge only if we fail to return to growth, because that is the situation in which it is most likely that public sector deficits will fail to close. It follows that strong monetary tightening now may increase the long-term threat of inflation, rather than reduce it.
What do you think?

There is no evidence of worry over the threat of inflation in financial markets. To repeat a point that's been made here many, many times, increasing interest rates too soon would be a mistake since it will make it more difficult for the economy to recover. If anything, given the weakness that still exists in the economy, more ease is called for.

Wednesday, June 23, 2010

No Changes from the FOMC

As expected, the FOMC tells us how weak the economy is, and that it may be getting weaker. But it expresses confidence that the economy will somehow take care of itself, and decides to stay on hold rather than moving toward a more aggressive monetary policy stance. Here's the Press Release on the decision:

Continue reading "No Changes from the FOMC" »

Is the Fed's Caution Justified?

Why doesn't the Fed take more aggressive action to help the economy?:

When Caution Carries Risk, by David Leonhardt, NY Times: Ben Bernanke believes that he and his Federal Reserve colleagues have... “...considerable power to expand aggregate demand and economic activity, even when its accustomed policy rate is at zero,” as it is today. Mr. Bernanke also believes that the economy is growing “not fast enough”... He has predicted that unemployment will remain high for years and that “a lot of people are going to be under financial stress.”
Yet he has been unwilling to use his power to lift growth and reduce joblessness from near a 27-year high... How can this be? How can Mr. Bernanke simultaneously think that growth is too slow and that it shouldn’t be sped up? There is an answer — whether or not you find it persuasive. ...
Fed officials are ... not so much worried about inflation, the traditional source of Fed angst, as they are about upsetting the markets’ confidence in Washington. Yes, investors remain happy to lend the United States money at rock-bottom interest rates, despite our budget deficit and all of the emergency Fed programs that will eventually need to be unwound. But no one knows how long that confidence will last.
In effect, Mr. Bernanke and his colleagues have decided to accept ... high unemployment ... for years to come — rather than risk an even worse situation — a market panic, a spike in long-term interest rates and yet higher unemployment. As the last few years have shown, market sentiment can change unexpectedly and sharply.
Still, you have to wonder if the Fed is paying enough attention to the risks of its own approach. ... The main historical lesson of financial crises is that governments are usually too passive. They respond in dribs and drabs, as Japan did in the 1990s and Europe did in 2008. Or they remove support too quickly, as Franklin Roosevelt did in 1937, and then the economy struggles to escape its funk.
Look around at the American economy today. Unemployment is 9.7 percent. Inflation ... has been zero. States are cutting their budgets. Congress is balking at spending the money to prevent state layoffs. The Fed is standing pat, too. Bond investors, fickle as they may be, show no signs of panicking.
Which seems to be the greater risk: too much action or too little? ... In the end, Mr. Bernanke’s ... decision comes down to weighing the probabilities and the possible outcomes. Let’s just be clear about the risks and costs that the Fed has chosen. It is ... willing to accept a jobless rate of almost 10 percent, with all of the attendant human costs.
“About half of the unemployed have been unemployed for six months or more, which means that they are losing skills, they’re losing contact with the job market,” a prominent economist said at a public dinner in Washington this month. “If things go on and they simply sit at home or work very irregularly, when the economy gets back to a more normal state, they’re not going to be able to find good work.”
That economist happened to be Ben Bernanke, one of the few people with the power to do something about the situation.

I wish I had a better sense why the Fed is so worried about a market panic when there is no evidence indicating that financial markets are near the tipping point. Is there actual evidence that has them worried -- if there is, how about sharing it? -- or is it just some general sense that we must be getting near the threshold?

I think the economy needs more help, and that fiscal policy is the best choice right now. But given the present inclination toward policy timidity, I'll take what I can get, and I wish that the Fed would be more aggressive. However it doesn't look at all likely that monetary or fiscal policy policymakers are going to make any significant moves toward further stimulus, we'll be lucky if they don't do the opposite before the economy is ready, so it appears that Bernanke's forecast that unemployment will remain high for years may come true. But unworried financial markets -- and those who benefit the most from them -- won't have to worry about worrying.

Tuesday, June 22, 2010

Keynes and Social Democracy

Was Keynes in favor of big government? Do Keynesian policies necessarily lead to big government?:

Keynes and Social Democracy Today, by Robert Skidelsky, Commentary, Project Syndicate: For decades, Keynesianism was associated with social democratic big-government policies. But John Maynard Keynes’s relationship with social democracy is complex. Although he was an architect of core components of social democratic policy – particularly its emphasis on maintaining full employment – he did not subscribe to other key social democratic objectives, such as public ownership or massive expansion of the welfare state. ...
Until The General Theory was published in 1936, social democrats did not know how to go about achieving full employment. Their policies were directed at depriving capitalists of the ownership of the means of production. How this was to produce full employment was never worked out. ...
Keynes demonstrated that the main cause of bouts of heavy and prolonged unemployment was ... fluctuating prospects of private investment in an uncertain world. Nearly all unemployment in a cyclical downturn was the result of the failure of investment demand.
Thus, the important thing was not to nationalize the capital stock, but to socialize investment. Industry could be safely left in private hands, provided the state guaranteed enough spending power in the economy to maintain a full-employment level of investment. This could be achieved by monetary and fiscal policy: low interest rates and large state investment programs.
In short, Keynes aimed to achieve a key social democratic objective without changing the ownership of industry. Nevertheless, he did think that redistribution would help secure full employment. A greater tendency to consume would “serve to increase at the same time the inducement to invest.” ...
Moderate re-distribution was the more politically radical implication of Keynes’s economic theory, but the measures outlined above were also the limits of state intervention for him. As long as “the state is able to determine the aggregate amount of resources devoted to augmenting the instruments [i.e., the capital base] and the basic reward to those who own them,” there is no “obvious case” for further involvement. ...
Today, ideas about full employment and equality remain at the heart of social democracy. But the political struggle needs to be conducted along new battle lines. Whereas the front used to run between government and the owners of the means of production – the industrialists, the rentiers – now, it runs between governments and finance. ...
Being too big to fail simply means being too big. Keynes saw that “it is the financial markets’ precariousness which creates no small part of our contemporary problem of securing sufficient investment.” That rings truer today – more than 70 years later – than in his own day. ...
This, once again, calls for an activist government policy. ... Keynes’s main contribution to social democracy, however, does not lie in the specifics of policy, but in his insistence that the state as ultimate protector of the public good has a duty to supplement and regulate market forces. If we need markets to stop the state from behaving badly, we need the state to stop markets from behaving badly. Nowadays, that means stopping financial markets from behaving badly. That means limiting their power, and their profits.

On Keynesian policy and big government, as I've explained many times (e.g.), there is no necessary connection between the size of government and Keynesian stabilization policy. Want the government to grow? Then cure recessions by increasing spending, and pay for it by raising taxes during the good times. After a few business cycles under this policy, government will be larger. This is the strategy that Democrats are accused of playing.

Want the opposite result? No problem, just use tax cuts to stimulate the economy during a recession, then pay for the cuts by reducing government spending during the subsequent boom. A few cycles later, and government is much smaller. This is the Republican starve the beast strategy that they fully admit to playing (I am abstracting, of course, from the political difficulties with either strategy).

Want to keep government the same size? Then simply use the same policy tool on both sides of the business cycle. Increase government spending in a recession, then reverse it in the good times, or, alternatively, cut taxes during the bad times, then raise them when things improve.

Summarizing: Using a different policy tools on each side of as recession changes the size of government, while using the same policy tool does not. But the main point is that, contrary to what you may have been led to believe, there is nothing inherent in Keynesian economics that connects stabilization policy to the size of government. There are, I think, political considerations that make it easier to cut taxes or raise spending when times are bad than to do the opposite when things improve (e.g. the argument that it will kill job growth!). But there is nothing in the underlying economics that says Keynesian policy necessarily leads to a change in the size of government.

Sunday, June 20, 2010

Reducing the Influence Banks Have over Monetary Policy

I don't have anything to post, so until I do, here's something I posted at MoneyWatch a few days ago. The post addresses the latest proposal for financial reform, in particular the proposal to change the way the District Bank presidents are chosen in an attempt to reduce the power banks have over monetary policy. One part of the proposal was to have the NY Fed president chosen by the president rather than the NY Fed's Board of Directors because of the NY Fed's special role in the implementation of national monetary policy. One question I ask at the end of this post is whether the NY Fed needs to have a special role in monetary policy and be elevated above all other District Banks. Why can't the execution of monetary policy be housed in a separate agency under the control of the FOMC (or, alternatively, the Board of Governors)? There was a time when proximity to Wall Street was essential, but that has changed in the last 70 years, and, in any case, the agency could be located as close to Wall Street as needed. Communication with Washington, to the extent it's needed, could us digital technology. This would put the NY Fed on a more equal footing with the other Fed's, and solve the problem of how to represent both regional and national interests in the selection of the NY Fed president:

Reducing the Influence Banks Have over Monetary Policy: There's some news on the Dodd proposal for financial reform, something I wrote about when the details of the proposal initially came out.

Continue reading "Reducing the Influence Banks Have over Monetary Policy" »

Friday, June 18, 2010

"Name That Stimulus Proponent"


Name That Stimulus Proponent, by Motoko Rich, Economix: The raging debate over what to do about the deficit is now getting its own lingo.

Mark Thoma, who blogs at Economist’s View, has coined the catchy term “Austerians” for those deficit hawks who are exhorting governments to reduce their debt levels.

So what about the stimulus boosters on the other side? What shall we call them?

A few suggestions:

  • Stimulants
  • Stimubuffs
  • Stimu-plussers

What would you suggest?

Thursday, June 17, 2010

"Reducing the Influence Banks Have over Monetary Policy"

Here are some comments on the latest proposal to restructure the Fed:

Reducing the Influence Banks Have over Monetary Policy

At the end of the post, I suggest an alternative policy.

Wednesday, June 16, 2010

"Government to the Economic Rescue"

Alan Blinder says (correctly) that the "government—including two administrations, Congress, and the Fed" saved "us from falling into the abyss":

Government to the Economic Rescue, by Alan S. Blinder, Commentary, WSJ: ... It seems that more Americans believe that "Barack Obama's economic policies" (the pollsters' exact words) have made economic conditions worse (29%) than better (23%), and another 35% of Americans think his policies have "not had an effect so far." So only 23% of the public thinks the president's policies have helped while 64% thinks they have failed. ...
The 64% are wrong. You can certainly argue that the administration has not done enough, or that other policy choices would have been better. ... But to say that the president's policies either had no effect or were harmful flies in the face of both logic and fact. ...
While it's certainly too early for historical perspective on the stunning events of 2007-2009, I venture to guess that, when the history of the period is written, it will read something like this: For a host of reasons the U.S. economy was struck by a calamitous financial crisis followed by a vicious recession. The government—including two administrations, Congress, and the Fed—marshaled enormous resources to save the financial system and to fight the recession. It worked.
Specifically, I would point to three policy landmarks, two of which were and remain terribly unpopular—and which probably account for the negative polling results. The first was the much-maligned Troubled Asset Relief Program (TARP)... The second ... was the fiscal stimulus package that President Obama signed into law..., the third ... the "stress tests" of 19 big financial institutions...
So the next time you see Chairman Bernanke, congratulate him... And the next time you see members of the House and Senate who voted for TARP and the stimulus package, give them a hug and say thank you for taking two monumentally tough votes that helped keep us from falling into the abyss.

Monday, June 14, 2010

Rudebusch: The Fed's Exit Strategy for Monetary Policy

Glenn Rudebusch looks at the Fed's exit strategy for its special liquidity facilities, the lowering of short-term interest rates, and the increase in the Fed’s securities holdings. Along the way he tries to dispel worries about the "inflation monster"(see figure 4). The bottom line for interest rates is that "it seems likely that the Fed’s exit from the current accommodative stance of monetary policy will take a significant period of time." This is in contrast to Raghu Rajan who continues to argue that rates should go up, partly on the basis of the effects of low interest rates on countries like Brazil. This serves as a counterpoint to the argument that low interest rates will cause "dangerous financial imbalances, such as asset price misalignments, bubbles, or excessive leverage and speculation", e.g. see the discussion just before figure 2, as well as a more general counterpoint to the "we need to raise rates" argument:

The Fed's Exit Strategy for Monetary Policy, by Glenn D. Rudebusch, Economic Letter, FRBSF: As the financial crisis has receded, the Federal Reserve has scaled back its extraordinary provision of liquidity. Eventually, the Fed will remove all remaining monetary stimulus by raising the federal funds rate and shrinking its balance sheet. The timing of such renormalizations depends crucially on evolving economic conditions.

To many observers, the Federal Reserve’s extraordinary policy actions during the recent crisis averted a financial Armageddon and curtailed the depth and duration of the recession (Rudebusch 2009). To combat panic and dislocation in financial markets, the Fed provided an enormous amount of liquidity. To mitigate declines in spending and employment, it reduced the federal funds interest rate—its usual policy instrument—essentially to its lower bound of zero. To provide additional monetary stimulus, the Fed turned to an unconventional policy tool—purchases of longer-term securities—which led to an enormous expansion of its balance sheet.

As financial market strains eased and economic recovery began, discussion turned to how the Fed would unwind its actions (Bernanke 2010). Of course, after every recession, the Fed has to decide how quickly to return monetary conditions to normal to forestall inflationary pressures. This time, however, policy renormalization is especially challenging because of the unprecedented economic conditions and Fed actions. This Economic Letter describes various considerations in formulating an appropriate policy exit strategy. Such a strategy must unwind each of the Fed’s three key actions: the establishment of special liquidity facilities, the lowering of short-term interest rates, and the increase in the Fed’s securities holdings.

Continue reading "Rudebusch: The Fed's Exit Strategy for Monetary Policy" »

Sunday, June 13, 2010

"It's Not Fears About Inflation"

What should fiscal and monetary policymakers be worried about, inflation or economic growth? Jim Hamilton:

There's a common thread to all the above figures, and it's not fears about inflation. Instead it's worries about the level of real economic activity, showing up in a flight to safety.

The market is worried about growth. There are both monetary and fiscal policies measures that could help. So where are all the people who think policymakers should address market worries? Why aren't they calling for policymakers to do something to spur growth (and employment)? Do the market worries only count when they point to austerity?

Saturday, June 12, 2010

"Strange Arguments For Higher Rates"

Paul Krugman responds to Raghuram Rajan's latest defense of his view that the Fed should raise the target interest rate:

Strange Arguments For Higher Rates, by Paul Krugman: So Raghuram Rajan has posted a further explanation of his case for raising interest rates in the face of very high unemployment, presumably a response to Mark Thoma. It’s good to see Rajan put his cards on the table — but what he says only further confirms my sense that we’re talking about some kind of psychological desire to be tough...
Rajan’s argument boils down to two assertions:
1. Raising rates a bit wouldn’t significantly deter investment.
2. “Unnaturally low” interest rates are distorting asset prices.
The first thing to say about these two assertions is that they are essentially contradictory. If the difference between current rates and the rates Rajan wants is trivial — just a wafer thin mint — how can that same difference be leading to a major distortion in financial markets? Are we to believe that an interest rate change that matters not at all to firms making real investments somehow has huge effects on speculators? And actually, don’t asset prices themselves matter for real investment?
It might be worth noting, in this context, that just because the interest rate on safe bonds is near zero, that doesn’t mean that people making risky investments can borrow at near-zero rates.
Beyond all that, what does Rajan mean by “unnaturally low” rates? What makes them unnatural?
My take on the current economic situation is quite simple... Right now, we clearly don’t have enough demand to make full use of the economy’s productive capacity. This means that the real interest rate is too high. And so the “natural” thing is for the real rate to fall. Yes, that would mean a negative real rate. So?
The trouble is that getting that negative real rate isn’t easy, because the nominal rate can’t go below zero, and there’s no easy way to create expected inflation. If you ask what would happen if prices were completely flexible, the answer, as I figured out long ago, is that prices would fall so far now that people would expect them to rise in the future, creating expected inflation. Bur prices aren’t that flexible, which is why we turn to quantitative easing, fiscal policy, and more.
Surely, though, we want to get rates as close to their appropriate level as possible — which means a zero nominal rate. There’s nothing “unnatural” about it. On the contrary, the “natural rate of interest”, as Wicksell defined it, is clearly negative right now.
So why does Rajan feel that there must be something wrong with low rates (and he’s not alone)? I think his language, with its odd moral tone, is the giveaway: it’s the sense that economic policy is supposed to involve being tough on people, not giving money away cheap.
I actually understand the seductiveness of that posture; I can sort of understand how economists succumb to it. But right now, with the world desperately in need of clear thinking, is no time to give in to the subtle allure of inflicting economic pain.

I had the same response. If raising rates doesn't change investment, how does raising rates choke off risky (and distorted) financial investment which ultimately depends upon real investment activity?

(There is also an argument that high rates, not low rates, cause an increase in the proportion of investors taking high risks. When rates are high, only the riskiest, highest expected return projects will have a chance of being profitable, so these are the only projects that are pursued. In this case higher rates, not lower rates, lead to an increase in the fraction of risky investment. This is where Krugman's point that the interest rates people making risky investments actually face are not zero, and increasing these rates by another 2 to 2.5 percent, as recommended, will raise them even higher and potentially induce more risk-taking behavior. This doesn't directly overturn the argument the arguments Rajan is making, but it is a potential countervailing force.)

Let me also address this part of Raghu Rajan's response, which I assume is directed at the title and content of this post ("The Fed Should Raise Rates Because Brazil has Low Unemployment?"):

If the Federal Reserve were to accept the responsibilities of its role as central banker to much of the world, it would have to admit that its policy rates are too accommodative for the world as a whole. Does the Fed have responsibility to help the world while hurting its own economy (or as one commentator put it, am I advocating that the U.S. raise rates because Brazil is overheating)? Of course not! But when the benefits to its own economy are dubious, it should also give some thought to the global effects of its policies. For eventually, the consequences of its policies will come back to haunt it if they precipitate crises elsewhere.

That the benefits of low rates are dubious is an assertion, not a demonstrated fact. Rajan's post attempts to make the case that low rates have costs that exceed the benefits, i.e. that the net benefits are "dubious," but here he is assuming he has already proven his case. So, yes, if you assume that there is no cost to raising rates (which is what the debate is all about, so clearly I disagree with this assumption), assume that low rates will cause a crisis in Brazil or somewhere else (the argument is that these countries need to raise rates, but low rates in the US prevent them from doing so), and assume that a crisis in one of these countries will cause a crisis in the US (or at least significant troubles), then yes, I suppose we should take this into account. But it takes quite a few "dubious" assumptions to come to this conclusion, the contradictory "it won't change investment" among them, so I am not at all convinced by this argument.

Wednesday, June 09, 2010

Rodrik: Who Lost Europe?

Germany says it took the time and effort to build a solid house, just like the bric-house countries, and the pigs will have to fight the big bad financial wolves on their own. If Germany opens the its bric-house doors and lets the pigs in where they are safe, they'll never learn their lesson. They'll keep relying upon structures that collapse when the slightest financial wind blows against them.

What the bric house residents are forgetting, however, is the mutual dependence that exists. If the pigs perish, so will the source of income that pays for the bric house they live in. The other countries do need to build houses that are safe from the wolves, but that's a lesson that seems likely to be learned even if the bric-house residents open their doors and foot the bill required to provide safe shelter. Allowing the pigs to be completely destroyed is not in the bric-house country's best interest. (Or something like that, not sure if it's fair to characterize all of the pigs in this way -- some thought they had built strong houses -- the point is that it may not be in Germany's best long-run interest to refuse to help at all):

Who Lost Europe?, by Dani Rodrik, Commentary, Project Syndicate: ...Having suffered a deeper economic collapse in 2009 than the United States did, Europe’s economy is poised for a much more sluggish recovery... European leaders have so far offered no solution to the growth conundrum other than belt tightening. The reasoning seems to be that growth requires market confidence, which in turn requires fiscal retrenchment. As Angela Merkel puts it, “growth can’t come at the price of high state budget deficits.” 
But trying to redress budget deficits in the midst of a collapse in domestic demand makes problems worse, not better. ... In fact, it sets in motion a vicious cycle. The poorer an economy’s growth prospects, the larger the fiscal correction and deleveraging needed to convince markets of underlying solvency. But the greater the fiscal correction and private-sector deleveraging, the worse growth prospects become. The best way to get rid of debt (short of default) is to grow out of it.
So Europe needs a short-term growth strategy... The greatest obstacle to implementing such a strategy is the EU’s largest economy and its putative leader: Germany. ... What makes this perverse is that Germany runs a huge current-account surplus..., 5.5% of GDP in 2010,... not far behind China’s 6.2%. So Germany has to thank deficit countries like the US, or Spain and Greece in Europe, for propping up its industries and preventing its unemployment rate from rising further. ...Germany is not only failing to do its fair share, but is free-riding on other countries’...
Germany’s refusal to boost domestic demand and reduce its external surplus, along with its insistence on conservative inflation targets for the ECB, severely undercuts prospects for European prosperity and unity. It virtually guarantees that Greece, Spain, and others with large private and public debts will be condemned to years of economic decline and high unemployment. At some point, these countries may well choose to default on their external obligations rather than endure the pain.
Germany’s leaders may take comfort in lecturing other governments about their profligacy. And it is true that some, like the Greek government, ran too-high deficits during the good times and endangered their future. But what about Spain or Ireland, where the borrowers were not the government but the private sector? If others borrowed too much, doesn’t it follow that Germans lent excessively?
If Germany wants the rest of Europe to swallow the bitter pill of fiscal retrenchment, it will eventually have to recognize the implicit quid pro quo. It must pledge to boost domestic expenditures, reduce its external surplus, and accept an increase in the ECB’s inflation target. The sooner Germany fulfills its side of the bargain, the better it will be for everyone. 

[Kevin O'Rourke has also argued recently that a collapse in domestic demand makes problems worse, not better.]

Tuesday, June 08, 2010

The Fed Should Raise Rates Because Brazil has Low Unemployment?

Wow. Raghuram Rajan says the Fed should raise rates because hiring in Brazil is robust:

Moreover, even if corporations in the US are not hiring, corporations elsewhere are. Brazil’s unemployment rate, for example, is at lows not seen for decades. If the Fed were to accept the responsibilities of its de facto role as the world’s central banker, it would have to admit that its policy rates are not conducive to stable world growth.

The Fed has made it very clear that it worries about conditions in other countries only to the extent that they feed back upon conditions within the US. That is, while I think US should consider the welfare of other countries when implementing policy (though in this case, the effects of low interest rates on Brazil would not be much, if any, of a concern), the Fed has made it clear that's not how it operates. It's charter has different instructions and it must abide by them. Legislators would not stand for the Fed raising rates based upon conditions in Brazil and other countries in any case, that would be a sure way to lose independence.

Some parts of the essay are OK, e.g. the parts about the need to modernize the social safety net, but for the most part it is a complaint about the Fed holding rates too low:

Equally deleterious to economic health is the recent vogue of cutting interest rates to near zero and holding them there for a sustained period. It is far from clear that near-zero short-term interest rates (as compared to just low interest rates) have much additional effect in encouraging firms to create jobs when powerful economic forces make them reluctant to hire. But prolonged near-zero rates can foster the wrong kinds of activities.

His main arguments against low rates are that they distort investment toward high risk assets:

For example, households and investment managers, reluctant to keep money in safe money-market funds, instead seek to invest in securities with longer maturities and higher credit risk, so long as they offer extra yield. Likewise, money fleeing low US interest rates (and, more generally, industrial countries) has pushed up emerging-market equity and real-estate prices, setting them up for a fall (as we witnessed recently with the flight to safety following Europe’s financial turmoil).

The problems in Greece and other countries were caused by low interest rate policies? I'll have to think about that, but with respect to the flight into long duration, risky assets he discusses, I thought the current problem was an excess demand for safe assets, not an excess demand for risk.

He is also not much of a fan of fiscal policy:

Much of what is enacted as stimulus has little immediate effect on job creation, but does have an adverse long-term effect on government finances. For example, the 2009 stimulus package enacted by the Obama administration had many billions of dollars devoted to cancer research, though such research employs few people directly and is spent over a long time horizon – far beyond that of even a prolonged recovery.

I think it's a bit disingenuous -- and perhaps telling that he doesn't have much of an argument -- that he points to such a small portion of the stimulus package as his big example (the spending for cancer research was $1.26 billion of the $787 billion package). He is also making an assertion about "little effect on job creation" that is contrary to the evidence. The CBO says (and these numbers are consistent with a wide range of other estimates) the stimulus package generated 2 million jobs (1.2 million to 2.8 million is the range they report). It could have been better with a larger, better constructed package, but 2 million is far from "little immediate effect."

We need more fiscal policy not less, and more aggressive monetary policy to combat unemployment, not an increase in rates. Monetary policy should stay on hold if more aggressive policy is not possible for political reasons or because of objections within the FOMC, but we should not give in to the immediate increase in rates that Raghuram Rajan and others are calling for. That's not the best possible path to recovery.

Monday, June 07, 2010

Fed Watch: A Good Crisis, Wasted

Tim Duy is discouraged that policymakers have failed to use the crisis as an opportunity "to bring some sanity to the global financial architecture":

A Good Crisis, Wasted, by Tim Duy: It is official. The rest of the world assumes the economy can pick up were we left off in 2006, with the US as the driver of global demand. And it is apparent there is little US policymakers can or will do to counter the trend. Once again, crisis - and along with it the opportunity to rebalance global growth - is wasted.

The Greek debt crisis gave Europe's deficit hawks just the excuse they have needed to pull back on fiscal stimulus. From Bloomberg:

Chancellor Angela Merkel said Germany is poised for a “decisive” round of budget cuts that will shape government policy for years to come, fueling disagreement with U.S. officials who favor measures to step up growth.

Speaking at the start of two days of Cabinet talks in Berlin called to identify potential savings of 10 billion euros ($12 billion) a year, Merkel said Europe’s debt crisis underscores the need for budget tightening to ensure the euro’s stability.

German Chancellor Angela Merkel has a cheerleader at the ECB:

European Central Bank President Jean- Claude Trichet and Treasury Secretary Timothy F. Geithner diverged on prescriptions to sustain growth, with Europe set to tighten budgets and the U.S. seeking stronger domestic demand.

The impact of narrower budget gaps “on growth could not be considered negative because it would improve confidence,” Trichet told reporters yesterday after meeting with Group of 20 finance chiefs in Busan, South Korea. The need for such action is clear in “old industrialized economies,” he said.

In the eyes of Trichet, the tragedy of the Greek crisis was that the ECB was pulled into the fray, forced to buy sovereign debt in a move that threatened the independence of Europe's central bank. Obviously, one way to prevent a repeat of this supposed travesty is simply to ensure that all EMU parties bring spending under control. Whether they really need to or not - no reason to go through that messy business of trying to differentiate between nations.

Elsewhere in the Euro zone, some are quite pleased to let the Euro sink:

“I see good news from the current euro-dollar rate,” French Prime Minister Francois Fillon told reporters in Paris June 4. President Nicolas Sarkozy “and I have been saying for years that the euro-dollar rate didn’t reflect reality and was penalizing our exports,” he said.

And the Chinese remain hesitant to change policy, so perhaps Europeans are wise to just throw in the towel:

“Something has to be done on the currency,” Strauss-Kahn told reporters in Busan. “The IMF still believes that the renminbi is substantially undervalued,” he said, using another term for China’s currency.

Perhaps it is naïve to believe Chinese policymakers would let the renminbi rise given their inability to manage their domestic economy. From the Wall Street Journal:

Government policy changes have thrown China's booming property market into a period of paralysis that some industry executives say will last for several months, weighing on global growth prospects already battered by the turmoil in Europe.

A rebound in China's property market has been central to the nation's rapid recovery from the financial crisis, but surging housing prices had led to increasingly open discontent from middle-class families in major cities. After months of indecision, Beijing in mid-April announced a package of policies intended to blow the froth out of the market by restricting speculative purchases.

Officials may have gotten more than they bargained for. Though still too recent for their effect to show up in official economic statistics, early indications are that the new measures have sharply cooled the property market. Arriving around the same time as the debt crisis in Greece, China's new restrictions caused many investors and businesses to question the strength of the global recovery. Domestic steel prices are down 7.4% since the April measures, and as of Thursday China's main stock market index is down 19.4%.

Chinese policymakers are not willing to upset the export cart at the same time they are dealing with start-stop internal issues. Where this all ends for the US is painfully obvious. US Treasury Secretary Timothy Geithner wrote in an open letter to the G20 finance ministers:

...achieving a strong and sustainable global recovery requires that we make further progress on rebalancing global demand. Given the broader shifts underway in the U.S. economy toward higher domestic savings, without further progress on rebalancing global demand, global growth rates will fall short of potential. In this context, we are concerned by the projected weakness in domestic demand in Europe and Japan. In keeping with the Pittsburgh Framework on Strong, Sustainable, and Balanced Growth, the necessary shift toward higher savings in the United States needs to be complemented by stronger domestic demand growth in Japan and in the European surplus countries, and sustained growth in private demand, together with a more flexible exchange rate policy, in China.

Don Geithner, tilting at windmills. His battles are futile. Financial markets know it, sensing that the global growth cannot be sustained on the back of the US alone. Of course, this was always the case; demand in the US alone was never sufficient to recreate the fabled "V" recovery of the 1980s. Market participants also know that US policymakers have their finger in the dam of a tidal wave of competitive devaluations. The Dollar, for all its warts, remains the big dog of reserve currencies, and Geithner fears the global pandemonium that would result from an actual US response to the currency manipulation of others. Thus the postponed report on currency manipulators becomes another case of "extend and pretend."

In the end, why continue to hold the Euro on what is increasingly the myth of global rebalancing? It is clear European policymakers want a weaker Euro, and US policymakers are powerless to prevent a stronger dollar. At least we are getting cheaper oil as a result.

When it all shakes out, the US will actually be asked to do more, not less. Lower interest rates will discourage saving and diffuse a political barrier to enhance fiscal stimulus in the US. Goodness, as I write this, the yield on the 10 year is again below 3.20%. Clearly, the world is looking for more, not less AAA debt, and the US will eventually be the last nation willing to issue it. Moreover, eventually the persistent unemployment problem will weigh on politicians such that while they might bluster on about deficit spending, they will forced to do just that. Meanwhile, the Federal Reserve claims to be prodding banks to lend more aggressively. From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke said he’s concerned about the costs U.S. joblessness is imposing on the economy and that the central bank is telling field examiners to encourage lending to creditworthy businesses.

“One particularly difficult issue is the continued high rate of unemployment,” Bernanke said today at a forum at the Chicago Fed’s Detroit office, calling joblessness among the “important concerns” for the recovery. “High unemployment imposes heavy costs on workers and their families, as well as on our society as a whole.”

Again, the jobs problem. A problem that will magically receive more attention as Wall Street flails. After all, an unemployed high school dropout won't be writing checks for $10,000 a plate campaign fundraisers, not like that nice man from the hedge fund.

Where does this all leave us? The rest of the world is intent on pursuing a begger thy neighbor strategy, with the US being the neighbor. I suspect US policymakers will eventually relent; it will be the only choice left. All we can do now is sit back and wait for the inevitable explosion in the US trade deficit, waiting idly by for the next crisis and the "chance" to bring some sanity to the global financial architecture.

Saturday, June 05, 2010

Things are Different at the Zero Bound

Here's a summary of a recent exchange with Tyler Cowen and Scott Sumner:

1. Tyler Cowen says that (New) Keynesians such as DeLong, Krugman, and Thoma advocate fiscal policy, but he thinks monetary policy is a better choice.

2. I respond by saying that monetary policy suffers from time-consistency problems that fiscal policy does not have, and that's one of the reasons I prefer fiscal policy. There are ways to revive monetary policy, but they are uncertain. I then note that fiscal policy has uncertainties too, and therefore my choice is not to rely exclusively on either policy tool, instead we should pursue both types of policies.

3. Scott Sumner responds by saying fiscal policy has problems too.

4. I respond by noting that the problems he is talking about are not problems in the model I am using. They may be problems in other models, and other people are free to use those models if they think they are better, but that does not change the fact that within the class of models I am using the problems are not present.

5. Scott Sumner responds by saying he was using a different model, one he made up on the spot yesterday when writing the original post. Unfortunately, the model in the original post is buried in a large amount of text, and the point being made is not as clear as it might have been (in response to one of his complaints, it's not always the reading that's the problem).

Using a different model is fine. I've already noted that the models I have been using have their problems, and that there can be a legitimate debate over what type of model is best. But at some point you have to commit to a specific model and use it to answer your questions, one that has hopefully been carefully specified and thoroughly investigated, and that does not change daily. Full awareness of the model's weak spots and limitations should be used to qualify the answers you give, but you cannot avoid committing to a model of some sort. The policy advice I have been advocating is based upon these models and is fully consistent with them. That doesn't mean that other models won't give different answers, but those aren't the models I am using.

Now, assuming I've unearthed it correctly, let me turn to Scott's specific objection. One way to impose Scott's objection on the models I am using is to assume the Fed is a strict inflation targeter, i.e. that it never let's the price level deviate from target if there is any way at all to avoid doing so (so inflation is always zero in the model unless the zero bound for the nominal interest rate gets in the way). I base this interpretation on the following statement Scott made in a follow-up to his original post:

if people begin to believe the Fed intends to keep core inflation at 1% per year for the next 10 years, there really isn’t much fiscal policy can do. 

Here's Woodford's description of what happens in this case during normal times, i.e. when the Fed pursues a strict inflation target and the interest rate is above zero:

As an example of another simple hypothesis about monetary policy, suppose that the central bank maintains a strict inflation target, regardless of the path of government purchases. (For conformity with the assumption made above about the long-run steady state, suppose that the inflation target is zero.) In the case of the Calvo model of price adjustment,... maintaining a zero inflation rate each period requires that pt = Pt each period... [U]nder this policy, aggregate output Yt will be the same function of Gt as in the case of flexible prices, and the multiplier will be given by (1.7). Again, this result does not depend on the precise details of the Calvo model of price adjustment. ...

Equation 1.7 is the multiplier in the classical model with full price adjustment, and it is necessarily less than one. So if the Fed is a strict inflation targeter and prices are sticky, the result is the same as if prices are fully flexible. Thus, under strict inflation targeting fiscal policy will not be very effective in times when the interest rate is above zero. When government spending goes up during normal times, inflation increases, and sharp increases in the real interest rate are needed to return inflation to its target value. The sharp increase in the real interest rate offsets the increase in output brought about by the increase in government spending, and this is what makes the multiplier small in this case. Under reasonable parametrizations, there "really isn’t much fiscal policy can do."

[More particularly, with strict inflation targeting, the multiplier is less than one. When the Fed follows a Taylor rule instead of strict inflation targeting, the multiplier is larger, but still less than one (though not always, it could even be less than the multiplier for strict inflation targeting under some conditions). If monetary policy maintains a constant real rate instead of following a Taylor rule, the multiplier is equal to one.

This means that during normal times, sticky price models predict fiscal policy multipliers of a magnitude less than or equal to one, with the exact magnitude depending upon the rule the Fed follows, i.e. how the real interest rate responds to fiscal policy changes. These values are much like those we see from actual estimates using data from time periods when the interest rate is above the zero bound. Thus, contrary to what many people believe, estimates of multipliers less than one obtained using data from time periods where the nominal interest rate is above zero (e.g. war periods) actually support New Keynesian models.]

The results above are only applicable when the interest rate is unconstrained by the zero bound. But things change when the zero bound is a constraint (as Scott seems to acknowledge in a subsequent post). It's no longer true that fiscal policy multipliers are relatively small. In general, at the zero bound fiscal policy multipliers are greater than one, and this remains true under strict inflation targeting. Woodford explains:

Note that if, as in Eggertsson and Woodford (2003), it is assumed that the central bank pursues a strict zero inflation target as long as this is consistent with the zero lower bound, then the ... values computed here for the multipliers dYL/drL and dYL/dGL are the same under that simpler hypothesis.

The larger multiplier occurs because the increase in government spending increases inflation (more precisely it reduces the rate of deflation). If the crisis is expected to last another period with some probability, as it will in the model, then government spending is expected to persist as well and expected inflation will rise. The increase in expected inflation lowers the real interest rate when the zero bound is a constraint (even with strict inflation targeting), and the lower real interest rate generates additional economic activity.

Note that the source of the increase in expected inflation is the expected increase in government spending in the next time period. All that's required for expected inflation to rise is that fiscal policy is expected to persist another period. However, the Fed won't do anything in response to the rise in inflation expectations because under the assumptions of the model the target interest rate remains negative (and to go back to an earlier point in the discussion, the expected inflation is credible due to observable changes in fiscal policy in the present time period).

The bottom line is that despite recent claims to the contrary, when the economy is at the zero bound fiscal policy is still effective, i.e. it has a multiplier greater than one, even under strict inflation targeting.

If I've mischaracterized anyone, I'm sure I'll hear about it.

Friday, June 04, 2010

"The Case for More Monetary Stimulus Remains"

Joseph Gagnon says further monetary ease is needed and, furthermore, it does not rely on expected future policy rates or other purely expectational effects (I've argued recently that generating such effects might be difficult to do):

Still No Exit: The Case for More Monetary Stimulus Remains Strong, by Joseph E. Gagnon: Six months ago I wrote a policy brief [pdf] in which I argued for large additional purchases of long-term bonds by the central banks of the four largest advanced economies—the United States, the euro area, Japan, and the United Kingdom—to reduce long-term interest rates. That advice remains relevant today for three of these economies. In the United Kingdom, however, policy should remain on hold pending further developments in inflation.
The European sovereign debt crisis is causing euro area and UK politicians to tighten fiscal policy faster than expected, which will weigh on economic growth, and the spillover effects also will be negative for growth in Japan and the United States. This fiscal retrenchment makes it all the more important for monetary policy to support economic recovery.
Over the past six months, forecasts of economic activity have improved noticeably in Japan, supported by exports to developing Asia. However, the improved outlook is still far below Japan’s long-run sustainable economic path. Prices continue to fall in Japan so that, on balance, Japan needs monetary ease more urgently than any other economy.
Economic prospects in the euro area have been marked down from a level that was already far below potential. At the same time, core inflation fell to 0.7 percent in April,1 pointing to a dramatic undershooting of the European Central Bank’s 2 percent inflation target over the next few months now that energy prices have stabilized. The need for monetary ease has greatly increased in the euro area.
Forecasts of US growth have been marked up a bit over the past six months, but this improvement is threatened by the strengthening dollar. Moreover, the Federal Reserve’s latest forecast (compiled before the recent wave of bad news from Europe) continues to show unemployment far above its long-run level through the end of 2012. In addition, the news on inflation has been strikingly weak. The core consumer price index (CPI) rose only 0.9 percent in the 12 months to April and only 0.3 percent (annual rate) in the last six months. These rates are far below the Fed’s desired inflation rate of around 2 percent. With both employment and inflation below desired levels over the foreseeable future, the case for more monetary ease is strong.
The United Kingdom is the exception. At 3.2 percent, the UK core inflation rate in April was higher than expected and above the Bank of England’s target for headline inflation of 2 percent.2 With output still far below potential, inflation is likely to fall in coming months. Thus, the current low policy interest rate is appropriate, but the risk of a further unwelcome rise in inflation suggests that it may be prudent to wait for inflation to fall before easing policy further.
With short-term interest rates close to zero, the way to ease monetary policy now is by lowering longer-term interest rates. In a recent paper, my coauthors and I showed that Fed purchases of safe long-term bonds in 2009 lowered 10-year bond yields around 50 to 75 basis points. The latest inflation report of the Bank of England shows that similar purchases in the United Kingdom last year lowered long-term rates there, also. There is no reason to believe that such policies cannot work in the euro area and Japan. The Fed’s actions last year spurred record issuance of corporate bonds in the United States, supporting business investment and employment. We need even more this year.
1. Core inflation is the 12-month change in the harmonized index of consumer prices (HICP) excluding energy and unprocessed food. Excluding volatile food and energy prices provides a better measure of where inflation is trending.

2. Core inflation is the 12-month change in the CPI excluding energy and unprocessed food. This rate includes the effect of a value-added tax increase in January that appears to have temporarily boosted inflation by at least 1 percentage point.

Let me add that even with the lags in monetary policy, today's employment report reinforces that it could be a long, long time before labor markets recover fully, so there's plenty of time for policy to have a positive effect in boosting the recovery.

Thursday, June 03, 2010

"The Mankiw Rule Today"

Andy Harless says the Mankiw rule for monetary policy indicates is will be quite awhile before the Fed starts increasing the target interest rate:

US Monetary Policy in the 2010’s: The Mankiw Rule Today, by Andrew Harless: To make a short story even shorter, the Mankiw Rule suggests that the Zero Interest Rate Policy will continue for quite some time, barring dramatic changes in the inflation and/or unemployment rates.

“The Mankiw Rule” is what I call Greg Mankiw’s version of the Taylor Rule. “Taylor Rule” is now the general term for a rule that sets a monetary policy interest rate (usually the federal funds rate in the US case) as a linear function of an inflation rate and a measure of economic slack. ... Unfortunately, there are now many different versions of the Taylor Rule, which all lead to different conclusions. Not only are there many different measures of both slack and inflation; there are also an infinite number of possible coefficients that could be used to relate them to the policy interest rate. ...

Parsimony suggests that a good Taylor rule should have 3 characteristics: it should be as simple as possible; it should use robust, easily defined, and well-known measures of slack and inflation; and it should fit reasonably well to past monetary policy. Also, to have credibility, such a rule should have “stood the test of time” to some extent: it should fit reasonably well to some subsequent monetary policy experience after it was first proposed. The Mankiw Rule has all these characteristics. It uses the unemployment rate and the core CPI inflation rate as its measures, and it applies the same coefficient to both. This setup leaves it with only two free parameters, which Greg set in a 2001 paper (pdf) so as to fit the results to actual 1990’s monetary policy. As you can see from the chart below, the rule fits subsequent monetary policy rather well, although policy has tended to be slightly more easy (until 2008) than the rule would imply.

You will notice a substantial divergence, however, after 2008, between the Mankiw Rule and the actual federal funds rate. If the reason for this divergence isn’t immediately clear, you need to take a closer look at the vertical axis. ...

If we wanted to make a guess as to when the Fed will (or should) raise its target for the federal funds rate, a reasonable guess would be “when the Mankiw Rule rate rises above zero.” When will that happen? (Will it ever happen?) Nobody knows, of course, but the algebra is straightforward as to what will need to happen to inflation and unemployment. If the core inflation rate remains near 1%, the unemployment rate will have to fall to 7%. If the core inflation rate rises to 2%, the unemployment rate will still have to fall to 8%. Do you expect either of these things to happen soon? I don’t.

I don't either, but that doesn't mean the Fed can't deviate from its past pattern. Let's hope that the members of the FOMC are smart enough not to begin raising interest rates too soon. However, the hawkish statements coming from the Fed recently, particularly from presidents of the regional Federal Reserve banks, do make me wonder if the Fed will begin raising rates while unemployment remains substantially elevated. For example (and this relatively dovish overall compared to, say, this):

The implication is that the policy rate may have to begin to rise even while unemployment is considerably higher than before the recession. I'm very concerned about unemployment, and certainly employment trends should be a critical consideration in setting policy. But I accept that good policy, even in circumstances of unacceptable levels of unemployment, may incorporate higher interest rates.

Wednesday, June 02, 2010

"Does Washington Care About Unemployment"

Continuing the political economy discussion from yesterday, why is there so little urgency in Washington about the unemployment problem?:

Does Washington Care About Unemployment?, by Brad DeLong: We are live at The Week: ... The last time we had an oversupply of workers of this magnitude was 1983, during the Reagan-Volcker disinflation. ... The unemployment rate hit 10.5 percent. ... Washington, D.C. was in a panic. With high unemployment perceived as a genuine national emergency, the Federal Reserve embarked on a policy of massive monetary ease. The Reagan administration promised that the deficits created by its 1981 tax cuts and increased defense spending were the recipe for putting America back to work. Everybody had a plan to reduce unemployment. And every lobbyist or speculator with a scheme unrelated to jobs recast his pet project as a magic unemployment-reducing bullet.
Today, the unemployment rate is kissing 10 percent. ... Yet, unlike 1983, there is no sense of urgency in Washington. ...
The Federal Reserve has had its monetary throttle fully open for more than two years now. But it is no longer talking about further turbo-charging the engines of growth. Instead, deliberations within the Federal Open Market Committee appear preoccupied with how best to apply the brakes. A degree of panic would be more appropriate — along with a commitment to use that panic to drive job-creation. ...
The Obama administration and the Democratic majority in Congress passed a fiscal stimulus plan half the size recommended by Democratic economists fifteen months ago. Since then, they have been unable to assemble a political majority to finish the second half of the job. There seems to be no appetite for addressing ten percent unemployment.
Instead, we have the Obama administration calling for a three-year spending freeze on programs unrelated to national security. We have Democratic Congressional Campaign Committee chairman Chris van Hollen calling for deeper short-term spending cuts. We have an administration experiencing difficulty finding $23 billion to prevent additional teacher layoffs, even though maintaining — no, expanding — investment in education in a recession is the no-brainiest of no-brainers.
Why the enormous disconnect? ... I can’t help but think that ... a deep and wide gulf has grown between the economic hardships of Americans and the seeming incomprehension, or indifference, of courtiers in the imperial city.
Have decades of widening wealth inequality created a chattering class of reporters, pundits and lobbyists who’ve lost their connection to mainstream America? Has the collapse of the union movement removed not only labor’s political muscle but its beating heart from the consciousness of the powerful? Has this recession ... left the kind of people who converse with the powerful in Washington secure in their jobs and thus communicating calm while the unemployed are engulfed in panic? Are we passively watching an unrepresented underclass of the long-term unemployed created before our eyes?
I don’t know. But this unseemly calm does astonish me.

Tuesday, June 01, 2010

Tyler Cowen: Is There a General Glut?

Tyler Cowen argues that:

Is there a general glut?, by Tyler Cowen: ... Reading the Keynesian bloggers, one gets the feeling that it is only an inexplicable weakness, cowardice, stupidity, whatever, that stops policies to drive a more robust recovery.  The Keynesians have no good theory of why their advice isn't being followed, except perhaps that the Democrats are struck with some kind of "Republican stupidity" virus.  (This is also an awkward point for Sumner, who seems to suggest that Bernanke has forgotten his earlier writings on monetary economics.)  The thing is, that same virus seems to be sweeping the world, including a lot of parties on the Left.
Romer, Geithner, Summers, know all the same economics that Krugman and DeLong and Thoma do.  If a bigger AD stimulus would set so many things right, they'd gladly lay tons of political capital on the line to see it through and proclaim triumph at the end of the road.

Except they expect it would bring only a marginal improvement. ...

I still think they should try to do it -- through more aggressive monetary policy -- but it's a judgment call and that's why they are more or less staying put. ...

I don't get the claim that since the administration's economists are not pushing for a large, new stimulus package, it means they don't think it would work. In fact, I don't even agree with the basic premise that they have been silent on this issue. For example, I recently noted an op-ed by Christina Romer that appeared in the Washington Post where she argues for more fiscal stimulus, particularly measures that prevent teacher layoffs (but she also calls for more help generally when she says "Further targeted actions to speed the recovery and reduce unemployment... are good for the economy and good for families...") This was written at a time when Congress was considering a meager amount of additional stimulus. The politics were clear, Congress was not about to increase the amount of additional stimulus, instead they were considering reducing it. Romer was trying to stop them from doing this by pointing our how harmful such reductions would be, and if she is successful, it will be far from a "marginal improvement." So, contrary to the claim Tyler makes, the administration is pushing for more stimulus -- but, understandably, only when they think there is some chance it might do some good.

The mere fact that the administration can read the writing on Congressional walls, that the administration has decided that using political capital to push forcefully for more stimulus is tossing valuable political capital down a sinkhole, does not imply that the administration's economic advisors see no large benefit from further stimulus. Beating dead horses does not get you anywhere, it simply wastes valuable time and resources. It's not that they are unwilling to "Put their reputations behind policies which might backfire or irritate Congress" as Tyler suggests as one reason they are reluctant to push for more fiscal stimulus, it's that they don't think there's any real chance of getting the votes needed to pass the legislation. Call it ignorance among members of Congress, "weakness, cowardice, stupidity, whatever," but the votes simply aren't there.

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

Fiscal policy does not have these problems. Maybe monetary policy would work in spite of the time consistency problems, I'm willing to try and there are creative ways around this problem that might work (see here for how to credibly commit to irresponsibility). But I'm not willing to put all my faith in this one policy basket, particularly since I think fiscal policy is the superior tool in deep recessions (but not in normal times). Fiscal policy must be part of the mix as well, and since the economy is not expected to return to full employment for several years, there's more than enough time for further fiscal stimulus directed specifically at job creation to work.

In a subsequent post, Tyler Cowen posts an excerpt from Kevin Drum:

Kevin Drum on fiscal stimulus, by Tyler Cowen:

But despite all this, there's one pretty good reason to think that Tyler is basically right: tax cuts. Lefty economists might generally believe that increasing spending is a more efficient way of stimulating consumption than reducing taxes, but they'd almost certainly accept a big tax cut as an almost-as-good substitute. And tax cuts have two big advantages over spending. On the substantive side, they work faster. Spending takes time to work its way through the economy, but a tax cut (for example, a payroll tax holiday) boosts the economy almost immediately. And on the political side it's quite doable. Republicans would be persuadable because they love tax cuts and Democrats would be persuadable because it would help the economy. For Obama, then, it would be the best of all worlds: a fast stimulus that gets bipartisan support, something that boosts the economy while dampening the inevitable criticism he'd get for blowing up the deficit.

But he's not pushing for this. Not even quietly. And this suggests that Tyler is right: Obama's advisors might be in favor of further fiscal stimulus, but not by much. And the best explanation for this is that lefty or not, they're genuinely afraid, as Tyler says, that it would bring only marginal improvements at the cost of significant problems down the road.

The full link is here.

First, a payroll tax cut is a supply-side policy that has demand side effects (as do all supply-side tax cuts). Increasing AS when AD is too low is a bad idea, it cause deflation which raises the real interest rate and slows the recovery. So the AS effects of these policies can be troublesome -- better to use AD side policies like government spending.

Second, what evidence is leading them to conclude that temporary tax cuts have a strong impact on demand? I argued that tax cuts can be helpful here, but not because they have large AD effects, the evidence suggests they are mostly saved (see the two graphs in the post). Better targeting could improve that, and I'm not opposed to well-targeted tax cuts being part of the mix (consistent with Drum's claim), but Congress has very poor aim and it's unlikely that tax cuts will be well-targeted. Again, we have several years before employment recovers -- even if tax cuts can produce an immediate impact, there's plenty of time for fiscal policy to be used as part of the mix.

Finally, again I don't understand how making a political calculation that there is no chance Congress will sign on to a package providing significantly more help implies that "they're genuinely afraid ... that it would bring only marginal improvements," and I certainly don't see why it implies that it would come at "the cost of significant problems down the road." Where's the evidence for that? And why aren't costs balanced against benefits? Is the worry that interest rates will go up? Then solve the medical cost escalation problem driving the long-run debt, further stimulus is a drop in the bucket compared to that. A credible plan for the deficit over the long-run is the key here, but that plan has little to do with whether or not more fiscal stimulus is put into place now and everything to do with how we rein in health care costs in the future.

There are probably all sorts of policies that the administration's economic advisors believe would be beneficial to the nation, but they know there's no chance that Congress will approve them so they don't even bother to bring them up. The mere fact that the administration's economists aren't out using up Obama's political capital says very little about what they think it the correct policy at this point. They are constrained by political advisors who determine what will and won't be pursued. The economists make their impassioned pleas behind closed doors, we do not get to witness this, and then decisions are made independently of them as to what they administration will and will not push for. It is not up to the economists to determine how political capital will be spent, and more than economics goes into this decision. Maybe Tyler's right and they don't think the policies will help much, or maybe they made an impassioned plea that more is necessary that, in the end, did not persuade the political advisors. Christina Romer's recent op-ed suggests that the administration's economists do see large benefits from further stimulus, but in any case, the fact that they are not out pushing for this forcefully does not tell us much about their beliefs concerning the benefits of further stimulus.

What the administration's economists truly believe I can only speculate about. But I know what I think. The economy, the labor market in particular, needs more help and fiscal policy -- and here I mean government spending targeted at job preservation and creation first and foremost -- has an important role to play in giving the economy the boost it needs.

[See also, Brad DeLong, Nick Rowe, and Scott Sumner.]

Monday, May 31, 2010

Paul Krugman: The Pain Caucus

The budget and inflation hawks are winning the battle to define the "conventional wisdom" over how policymakers should respond now that the economy is just setting out on the long road to recovery. The wisdom may be conventional, but it is not very wise:

The Pain Caucus, by Paul Krugman, Commentary, NY Times: What’s the greatest threat to our still-fragile economic recovery? Dangers abound... But what I currently find most ominous is the spread of a destructive idea: the view that now, less than a year into a weak recovery from the worst slump since World War II, is the time for policy makers to stop helping the jobless and start inflicting pain.
When the financial crisis first struck, most of the world’s policy makers responded appropriately, cutting interest rates and allowing deficits to rise. And by doing the right thing, by applying the lessons learned from the 1930s, they managed to limit the damage: It was terrible, but it wasn’t a second Great Depression.
Now, however, demands that governments switch from supporting their economies to punishing them have been proliferating in op-eds, speeches and reports from international organizations. Indeed, the idea that what depressed economies really need is even more suffering seems to be the new conventional wisdom...
The extent to which inflicting economic pain has become the accepted thing was driven home to me by the ... Organization for Economic Cooperation and Development... The O.E.C.D. is a deeply cautious organization; what it says at any given time virtually defines that moment’s conventional wisdom. And what the O.E.C.D. is saying right now is that policy makers should stop promoting economic recovery and instead begin raising interest rates and slashing spending.
What’s particularly remarkable ... is that ... the O.E.C.D.’s own forecasts show no hint of an inflationary threat. So why raise rates? The answer, as best I can make it out, is that the organization believes that we must worry ... that markets might start expecting inflation, even though they shouldn’t and currently don’t...
A similar argument is used to justify fiscal austerity. Both textbook economics and experience say that slashing spending when you’re still suffering from high unemployment is a really bad idea — not only does it deepen the slump, but it does little to improve the budget outlook, because much of what governments save by spending less they lose as a weaker economy depresses tax receipts. And the O.E.C.D. predicts that high unemployment will persist for years. Nonetheless, the organization demands both that governments cancel any further plans for economic stimulus and that they begin “fiscal consolidation” next year.
Why do this? Again, to give markets something they shouldn’t want and currently don’t. Right now, investors don’t seem at all worried about the solvency of the U.S. government; the interest rates on federal bonds are near historic lows. ...
The best summary I’ve seen of all this comes from Martin Wolf..., who describes the new conventional wisdom as being that “giving the markets what we think they may want in future — even though they show little sign of insisting on it now — should be the ruling idea in policy.”
Put that way, it sounds crazy. And it is. Yet it’s a view that’s spreading. And it’s already having ugly consequences. Last week conservative members of the House, invoking the new deficit fears, scaled back a bill extending aid to the long-term unemployed — and the Senate left town without acting on even the inadequate measures that remained. As a result, many American families are about to lose unemployment benefits, health insurance, or both — and as these families are forced to slash spending, they will endanger the jobs of many more.
And that’s just the beginning. More and more, conventional wisdom says that the responsible thing is to make the unemployed suffer. And while the benefits from inflicting pain are an illusion, the pain itself will be all too real.

Sunday, May 30, 2010

Growth Policy versus Stabilization Policy

I posted this at Maximum Utility a few days ago:

Growth Policy versus Stabilization Policy, by Mark Thoma (with a few minor edits): In macroeconomics, there are two important policy questions, and our attention to one or the other changes with the economic events of each era. One question concerns stabilization policy -- keeping the economy as close as possible to the long-run growth path -- and the other is growth policy, i.e. policy that attempts to maximize the long-run growth rate. (There is also work on whether stability and growth are related. More stable economies could grow faster due to reduced uncertainty, but government intervention to stabilize the economy could also stifle growth according to some models, so the relationship is not clear a priori. In modern models, these are not strictly separable, but it is still a useful way to think about policy conceptually)

We could go back further than this, but let me pick the story up in the 1970s. A few economists were worried about growth at this time, but the main concern during the tumultuous 1970s and early 1980s was with how to do a better job of stabilizing the economy. The traditional Keynesian policies, which had not taken account of inflation or expectations in a satisfactory way, had failed to produce the desired stabilization. This led to the search for a new economic model that could provide better guidance. The result was the development of the New Classical model, replaced soon after by the New Keynesian model when the New Classical could not explain both the duration and magnitude of actual cycles, and it's implication that only unanticipated money matters appeared to be contradicted by actual data.

The New Keynesian model, and its new advice for stabilization policy concerning the use of interest rate rules, seemed to work and we entered into a period known as "The Great Moderation"  (stated compactly, the new policy involved targeting an interest rate with a Taylor rule that responds to output and inflation, where the response to inflation was more than one to one). This period, which began in the early 1980s, saw low and stable inflation rates, and a fall in the variation in GDP of around 50 percent. The result was the emergence of the view that the stabilization problem had been solved. By using the correct monetary policy, policymakers had produced the Great Moderation, and that left other policy tools such as fiscal policy free to pursue the maximum growth objective (and the result was supply-side fiscal policies such as cutting capital gains and dividend taxes justified by arguments about their contribution to growth).

Because of this, the profession moved on to growth theory and policy. Stabilization had been solved with monetary policy, and growth was now the major question to be solved. If the economy was still as jittery as it had been in the past, then stabilization policy would have also been of concern to academic economists, but developing optimal monetary policy rules from the New Keynesian structure seemed to have solved that problem.

Of course, recent events show us in no uncertain terms that the stabilization problem has not been solved, and questions about how to stabilize the economy ought to be coming to the forefront again. And they are, to some extent, but I'd argue that our ability to stabilize the economy has been limited by those who still think growth is the only important consideration for evaluating policy. For example, because of this, the stimulus package that was put into place had to be justified by its ability to stimulate long-run growth when its main concern should have been with how to stabilize the economy. That led us to concentrate on tax cuts (because conservatives believe tax cuts increase economic growth) and infrastructure spending. However, tax cuts of the type that were implemented are mostly saved, and infrastructure spending takes much too long to put into place (and may not generate as much employment per dollar as other types of spending). These are not optimal stabilization policies. Other types of spending, the types that get money into people's hands and puts people to work right away, might have worked faster and had a greater benefit in terms of moving the economy closer to trend, but since these policies were harder to justify in terms of their contribution to long-run growth. Therefore, they could not find the support they needed.

I believe that stability is important to people (i.e. that utility is lower when there is more economic uncertainty), and because of this stabilization policy can be justified on its own terms, there's no reason to insist that stabilization policy maximize growth. The policies that maximize growth are different in some cases from the polices that stabilize the economy, and insistence that all policies can be justified by their contribution to long-run growth causes us to sacrifice economic stability. The policies we put into place should pay attention to both goals, but I believe we have paid far too much attention to growth in formulating recent policy, and not nearly enough to stability.

Hopefully, recent events will begin to shift our thinking away from the "growth above all else" policies we've pursued since the early 1980s, and that we will devote more attention to stabilization policy. We can put people back to work faster than we did this time around, and we can do a better job of increasing aggregate demand early in the recession (thereby reducing the fall in GDP and employment). But to do so we have to realize that stabilization is an important policy goal, and that it does not always lead to the same policies that are needed to maximize growth. People's lives, or at least their livelihoods, depend on it.