Here's a summary of:
I also explain one reason I'm so furstrated with fiscal policymakers.
Here's a summary of:
I also explain one reason I'm so furstrated with fiscal policymakers.
Via email, Jim Bullard, President of the St. Louis Fed, responds to Tim Duy:
I read your "Fed watch" column this morning in our news clips. You do an excellent job of summarizing important issues facing the FOMC. I have three comments, all of which I have made publicly recently, and I think they are critical ones for the direction policy will take:
--on the "raising interest rates" question: I am not sure if you have looked at my paper, "Seven Faces of the Peril," but if not please take a look at Figure 1 there (web page below) and contemplate the left hand side of the picture. This convinces me that staying with the near-zero interest rate policy alone--and promising to stay near-zero for a long time without doing anything else--risks a deflationary trap. To avoid this, I am recommending additional QE as a supplement to the near-zero rate policy as our best option. You actually have one of the world's experts on the question of the dynamics behind Figure 1 at the U. of Oregon: George Evans. Rajiv Sethi's summary of this issue as linked in your blog is very good, but citing Howitt--a fine paper, to be sure--is missing the more sophisticated analysis of Evans and Honkapohja that I cite in my paper. I am not saying I necessarily agree with the Evans and Honkapohja policy conclusions, but they have good analytics for framing these issues.
--on the effectiveness of QE: I do not agree that asset purchases are somehow ineffective. I talk about this in my CNBC interview at Jackson Hole (also posted on my web page). The direct empirical evidence on the effectiveness of QE both in the U.S. and the U.K. is fairly strong. For example, see the paper by Chris Neely of our staff cited in the "Perils" paper.
--on the "disciplined" QE program: The quote from Vince Reinhart, who is a great guy, gives the "shock and awe" view of QE. I do not think this is remotely correct. We know how monetary policy works: through the expected future path of policy, not through the actual move on a particular day. When we make 25 basis point moves on the federal funds rate, those are small viewed in isolation, but they have important effects for macroeconomic stabilization because they imply an expected interest rate path over the coming years. The same is true for QE. A move on a particular day may seem small, but it implies a path for future policy, and a series of smaller moves may add up to a very large move if the incoming data are consistent with such an outcome. The "shock and awe" view, if applied to interest rate targeting, would suggest very large interest rate movements in response to relatively small changes in incoming data, a policy that most would view as destabilizing for the macroeconomy. The same is true for QE. So the point is that QE moves should be commensurate with the incoming data (a.k.a. "state contingent"). Of course we can argue about the incoming data--and I know you have strong views on that--but I think my position on a "disciplined" QE program is correct and that the dangerous policy is to make destabilizing moves out of line with the incoming data. Concerning the data itself, your colleague Jeremy Piger will update his recession probabilities shortly so I will be anxious to see how that comes out.
I hope these comments are not too confused, I enjoyed your blog and I think you do a fine job of tracking the issues in the Fed.
I am about to do a video with George Evans who will explain the issues involved with dynamics at the zero bound, how Howitt fits in, how learning changes things, etc., so please stay tuned...
Tim Duy is "anything but" reassured by Ben Bernanke's recent speech outlining the Fed's possible policy actions, and what it will take to put them into action:
Unless every able American pitches in, Congress and I cannot do the job. Winning our fight against inflation and waste involves total mobilization of America's greatest resources—the brains, the skills, and the willpower of the American people. --- President Gerald Rudolph Ford, "Whip Inflation Now" Speech (October 8, 1974)Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. --- Federal Reserve Chairman Ben Bernanke, "The Economic Outlook and Monetary Policy" Speech (August 27, 2010)
Rereading Federal Reserve Chairman Ben Bernanke's recent speech and measuring it against the incoming data leaves me with a pit in my stomach. I sense Bernanke reveals in this speech he is the proverbial emperor without clothes, short on policy options but long on hope. A last ditch attempt to persuade us that as long as we don't believe deflation will be a problem, it will not be a problem. But he faces the same challenge as did then President Gerald Ford. All hat and no cattle. You need to be ready to back up your talk with credible policy options. While Bernanke outlined possible policy options, reading between the lines makes clear he lacks conviction in the viability of any of those options. Simply put, Bernanke is not ready to embrace the paradigm shift bold action requires.
First, it is worth considering the economic context of the policy environment via the lens of July Personal Income and Outlays report. Real gains fells short of what I believe to be already diminished expectations, with a clearly suboptimal trend in place:
When Bernanke expresses concern for the near term pace of economic growth, he is concerned with failing to track the current path of economic activity, as illustrated by the path of consumption since July of last year. This already is a substantial lowering of the bar, and appears to be a resignation that previous trends are unattainable. That is a problem in many respects, the most important of which is that previous trends were consistent with full employment. The failure to acknowledge the importance of re-achieving the previous path is, in my opinion, an admission of the willingness to accept a protracted period of high unemployment. This, of course, has been essentially admitted by Bernanke:Although output growth should be stronger next year, resource slack and unemployment seem likely to decline only slowly. The prospect of high unemployment for a long period of time remains a central concern of policy. Not only does high unemployment, particularly long-term unemployment, impose heavy costs on the unemployed and their families and on society, but it also poses risks to the sustainability of the recovery itself through its effects on households' incomes and confidence.
As I have already commented, if unemployment is a concern, and there is no conflict between the Fed's dual mandate, then why is the Fed waiting for further evidence of disinflation before acting? Indeed, Scott Sumner saw a line in the sand in Bernanke's speech of a one percent inflation rate. The most recent PCE data suggests we are perilously close to testing that line already:
Let me explain, as simply as I can, the underlying reason for the strong reaction to Minnesota Fed president Narayana Kocherlakota's suggestion that raising interest rates would be helpful.
When a Federal Reserve president calls for an increase in interest rates while the economy is still struggling to recover, something that repeats the errors of 1937-38, all of his buddies in academia should expect a reaction. It comes with the job. The fact that he can point to a model that failed to provide much help with the situation we're in to justify the statement isn't of much comfort, and there are serious questions about the validity of the claim in any case.
This isn't just a theoretical exercise where finding novel, counter-intuitive results that may or may not have real world applicability draws the admiration of peers, people's livelihoods are at stake. Real people in the real world are depending on the Fed to get this right, and suggestions that the Fed raise interest rates to help with the recession go against every intuitive bone I have in my body. More importantly, for those who think those bones might be broken, it goes against the existing empirical evidence. This is not a game, actual policy is at stake that will affect people's lives, and we cannot be careless in how we approach it.
If I reacted strongly, it's because I don't want us to repeat the mistakes we made in the past, mistakes that would hurt people who have suffered enough already. Do the advocates of this policy really believe, way down deep, that raising interest rates is the right thing to do in this situation? Perhaps, but I sure don't, and I can't let it pass without comment.
It falls to the Fed to fuel recovery, by Clive Crook, Commentary, Financial Times: The US recovery is stalling. As a matter of economics the balance of risks strongly favors further fiscal and monetary stimulus. Politics appears to rule out the first, and a divided Federal Reserve is hesitating over the second. America’s leaders are letting the country down. ...
Unlike most other advanced economies, the US could undertake further fiscal stimulus at acceptably low risk. Global appetite for its debt is undiminished. The risk, such as it is, could be all but eliminated if Congress could commit itself to stimulus now, restraint later – an easy thing, you might suppose, but evidently beyond its grasp. The administration could and should be pushing for just such a package, but it is not.
The political problem is that US voters ... have wrongly decided that the first stimulus was an expensive failure. The administration is partly to blame. It oversold the ... first package...
One cannot know how many jobs the stimulus saved, but it is absurd to see high unemployment as proof that it was ineffective. More likely this shows how powerful the recession’s downward pull has been, and still is. Most economists think the stimulus helped a lot. Yet, as in other areas, President Barack Obama’s defense of his policy has been strangely diffident. ...
Meanwhile, there is monetary policy. At the end of last week,... Ben Bernanke, Fed chief, acknowledged the faltering recovery, and reminded his audience that the central bank has untapped capacity for stimulus. ... Mr Bernanke and his colleagues are understandably nervous about extending the radical measures they have already taken. ... But the balance of risks has moved. They need to go further. ...
This has annoyed me for several years now. Why won't the Kansas City Fed make the papers for the Jackson Hole conference available until after the conference is over? What's the purpose of this? None that I can think of, other than making themselves special, but that's no way for a public agency to behave.
This is the opposite of transparency. I can understand waiting until the final versions are submitted, but at that point, why not post the papers so we can read them prior to the conference and give more informed commentary on the event? As it stands, I have to rely upon reporters to accurately tell me what's in the papers and, while I do trust some of them to mostly get things right (but not all), I'd like to be able to check the papers for myself. Sometimes participants will give a report after the event is over, but that's a bit late and even then I'd like to be able to come to my own conclusions, or at least verify the reports from reading the papers themselves. What's the point in locking them up? (As far as I can tell, the authors aren't even allowed to post the papers on their own sites.)
The pdfs will also be copy protected when they are posted, another step that places unnecessary hurdles in the way of commenting on the papers. Under the KC Fed's policy, which extends to speeches by the president of the KC Fed but isn't followed by other district banks, reproducing a graph or a few paragraphs then becomes tedious. The copy protection doesn't stop anyone who really wants to post a paragraph or two as you are permitted to do, it's simply harder and hence discouraging (and the speeches themselves are supposed to be in the public domain and hence fully reproducible). But why discourage conversation about these papers? Why make it so that we can't actually read the papers and comment on them until the conference is over and people have lost interest in the event. Why make it as hard as possible to even take small excerpts? How is that helpful?
Creating an exclusive event like this does give the people involved power, it makes them special, it gives them the power to include and exclude people, and so on. But their duty is to serve the public interests, not create a special little club that only some can participate in, and then dribble out the important information in a way that maintains their exclusivity and power.
I can live with the copy-protection, but the attempts to discourage access to the conference papers is puzzling when viewed through the Fed's mission to serve the public interest.
[Maybe I've missed something obvious, it certainly wouldn't be the first time that's happened, and there's a good reason for this policy. If someone at the KC Fed wants to explain why they can't do what most conferences do and make the papers available prior to or at the beginning of the conference, or at the very least at the time of or right after a session is over, I will post the explanation. It would be nice if the explanation also included the reasons for trying to lock up other documents such as Fed speeches, something no other Fed tries to do.]
Did low interest rates cause the financial crisis as John Taylor and others contend? (I've argued that the low interest rate policy contributed to the crisis, but by itself was not the major factor. That is roughly consistent with their conclusion, though their numbers on the degree to which interest rates mattered are lower than I would have predicted):
Can interest rates explain the US housing boom and bust?, by Edward Glaeser, Joshua Gottlieb, and Joseph Gyourko: Between 2001 and the end of 2005, the Standard and Poor’s/Case-Shiller 20 City Composite House Price Index rose by 46% in real terms. By the first quarter of 2009 the index had dropped by about one-third before stabilizing. The volatility of the Federal Housing Finance Agency (FHFA) repeat-sales price index was less extreme but still severe. That index rose by 53% in real terms between 1996 and 2006 and then fell by 10% between 2006 and 2008. As many financial institutions had invested in or financed housing-related assets, the price decline helped precipitate enormous financial turmoil.
Much academic and policy work has focused on the role of interest rates and other credit market conditions in this great boom-bust cycle.
- One common explanation for the boom is that easily available credit, perhaps caused by a “global savings glut,” led to low real interest rates that boosted housing demand (Himmelberg et al. 2005, Mayer and Sinai 2009, Taylor 2009).
- Others have suggested that easy credit market terms, including low down payments and high mortgage approval rates, allowed many people to act at once and helped generate large, coordinated swings in housing markets (Khandani et al. 2009).
Those easy credit terms may have been a reflection of agency problems associated with mortgage securitization (Keys et al., 2009, 2010, Mian and Sufi, 2009 and 2010, Mian et al. 2008).
If correct, these theories would provide economists with comfort that we understood one of the great asset market gyrations of our time; they would also have potentially important implications for monetary and regulatory policy. But economists are far from reaching a consensus about the causes of the great housing market fluctuation. For example, Shiller (2003, 2006) long has argued that mass psychology is more important than any of the mechanisms suggested by the research cited above.
Re-evaluating the missing link
Motivated by this question, we re-evaluate the link between housing markets and credit market conditions, to determine if there are compelling conceptual or empirical reasons to believe that changes in credit conditions can explain the past decade’s housing market experience.
Holtz-Eakin is encouraging us to balance the budget even though the economy is still relatively weak, and in doing so, to make the same mistake we made during the Great Depression. A quick look at recent data, and all the talk about the chance of a double dip we've been hearing, shows that we are anything but certain we we will be back at full employment anytime soon. Recovery from a financial crisis is often a long, drawn out process, and that may be true this time as well, but that means the economy needs more help over a longer period, not a premature return to austerity that risks sending the economy back into recession.
Why would we want to risk sending the economy back into a recession by beginning to balance the budget before the economy is growing robustly on its own? Republicans believe some sort of confidence effect from the decline in the deficit -- one that cannot actually be observed in the data but is, nevertheless, asserted to be there anyway -- will somehow more than offset the certain decline in demand from the reduction in the government deficit. But the problem is that the decline in demand will have it's own confidence effect on businesses, one that is negative, more certain, and likely much larger than any positive effects from deficit reduction.
And is anyone else getting tired of the "Obama is creating business uncertainty" argument from the Party that is creating most of the uncertainty and uneasiness about what crazy things might happen should they be elected? It worked out so well for the economy the last time they were in power and emphasized growth above all else. We're still trying to get out of that sinkhole -- talk about creating uncertainty. In any case, as noted by Paul Krugman on the video, there's nothing at all to indicate that businesses are, in fact, holding back due to uncertainties created by the administration's policies. Businesses face lots of uncertainties due to lack of demand for their products, and perhaps over what might change if Republicans take power, something that can hardly be blamed on the administration. But balancing the budget as Holtz-Eakin would have us do would reduce demand and cause fewer paying customers to walk through their doors. That makes the uncertainty problem worse, not better.
Putting it more succinctly, the Party in power when we got into this mess wants to be given another chance so it can try policies that failed during the Great Depression. And some people think that's a good idea.
Tim Duy is puzzled by Ben Bernanke's reasons for keeping the Fed on hold:
Driving Me Crazy, by Tim Duy: No time for a long post this afternoon, just a short comment.
Today's speech by Federal Reserve Chairman Ben Bernanke contains one of those little inconsistencies that drives me nuts. In his assessment of economy:
The prospect of high unemployment for a long period of time remains a central concern of policy. Not only does high unemployment, particularly long-term unemployment, impose heavy costs on the unemployed and their families and on society, but it also poses risks to the sustainability of the recovery itself through its effects on households' incomes and confidence.
I was already beginning to view this as a throw away line, something that Bernanke feels he has to say but doesn't really intend to worry much about. That sense was reinforced later in his speech:
Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.
If in the current environment - note that traditionally "current" means "right now" - there is already disinflation and little or no conflict between the dual mandates, then why, why, WHY do we need to wait until conditions deteriorate and risk additional disinflation before monetary policymakers turn to the problem of high unemployment that Bernanke claims distresses him?
If there is no conflict, then there is room to maneuver. Not later, now. So either Bernanke actually believes there is a conflict, or his concern about unemployment is disingenuous. I still don't know which.
My reaction to Bernanke's speech:
What would you add?
Why aren't monetary and fiscal policymakers doing more to boost the economy?:
This Is Not a Recovery, by Paul Krugman, Commentary, NY Times: What will Ben Bernanke, the Fed chairman, say in his big speech Friday in Jackson Hole, Wyo.? Will he hint at new steps to boost the economy? Stay tuned. ...
Unfortunately,... this isn’t a recovery, in any sense that matters. ... The important question is whether growth is fast enough to bring down sky-high unemployment. We need about 2.5 percent growth just to keep unemployment from rising... Yet growth is currently running somewhere between 1 and 2 percent, with a good chance that it will slow even further in the months ahead. Will the economy actually enter a double dip, with G.D.P. shrinking? Who cares? If unemployment rises for the rest of this year, which seems likely, it won’t matter whether the G.D.P. numbers are slightly positive or slightly negative.
All of this is obvious. Yet policy makers are in denial.
After its last monetary policy meeting, the Fed released a statement declaring that it “anticipates a gradual return to higher levels of resource utilization” — Fedspeak for falling unemployment. Nothing in the data supports that kind of optimism. Meanwhile, Tim Geithner, the Treasury secretary, says that “we’re on the road to recovery.” No, we aren’t.
Why are people who know better sugar-coating economic reality? The answer, I’m sorry to say, is that it’s all about evading responsibility.
In the case of the Fed, admitting that the economy isn’t recovering would put the institution under pressure to do more. And so far, at least, the Fed seems more afraid of the possible loss of face if it tries to help the economy and fails than it is of the costs to the American people if it does nothing, and settles for a recovery that isn’t.
In the case of the Obama administration, officials seem loath to admit that the original stimulus was too small. True, it was enough to limit the depth of the slump..., but it wasn’t big enough to bring unemployment down significantly.
Now,... officials could, with considerable justification, place the onus for the non-recovery on Republican obstructionism. But they’ve chosen, instead, to draw smiley faces on a grim picture, convincing nobody. And the likely result in November — big gains for the obstructionists — will paralyze policy for years to come.
So what should officials be doing, aside from telling the truth about the economy?
The Fed has a number of options. ... Nobody can be sure how well these measures would work, but it’s better to try something that might not work than to make excuses while workers suffer.
The administration has less freedom of action, since it can’t get legislation past the Republican blockade. But it still has options. It can revamp its deeply unsuccessful attempt to aid troubled homeowners. It can use Fannie Mae and Freddie Mac ... to engineer mortgage refinancing that puts money in the hands of American families — yes, Republicans will howl, but they’re doing that anyway. It can finally get serious about confronting China over its currency manipulation...
Which of these options should policy makers pursue? If I had my way, all of them.
I know what some players both at the Fed and in the administration will say: they’ll warn about the risks of doing anything unconventional. But we’ve already seen the consequences of playing it safe, and waiting for recovery to happen all by itself: it’s landed us in what looks increasingly like a permanent state of stagnation and high unemployment. It’s time to admit that what we have now isn’t a recovery, and do whatever we can to change that situation.
I know how much some of you will disagree with this, but I have a hard time ascribing bad motives to people at the Fed and using it to explain policy decisions. I think people at the Fed believe in their heart of hearts that they are doing what's best for the economy as a whole as opposed to what's best for a particular party or some small group of people pulling the strings, but they are relying on bad assumptions, questionable models, convenient interpretations, etc. To me, some of the beliefs held by the other side are astoundingly unbelievable, but they would, of course, say the same thing about me. I don't deny that those beliefs can be convenient for the person holding them, but the idea that people at the Fed are consciously holding down the larger economy in order to benefit Republicans or some group of people is hard for me to buy into. There are certainly ideological divides that lead the other side to policies that I think are misdirected, or even counterproductive, but the bad motive explanation is hard to swallow. I'm more inclined to think this goes on in Congress where to some, winning the election is the only thing, but even then it's hard to assert this as a general proposition. But perhaps I have too much belief that people mostly try to do the right thing, and I am hopelessly trusting and naive (though see here). I expect to be told that I am.
Here's Andy Harless:
The Real Activity Suspension Program, by Andy Harless: (Think of this as a guest post by the Cynic in me. I’m not sure my Cynic is entirely right on either the facts or the economics, but he has a provocative point. And I apologize for the fact that he misuses the word “recession” to include the period since our inadequate recovery began.)
Americans got angry when the federal government tried to bail out banks by buying assets or taking capital positions. Whatever you may think of those bailout programs, they at least had the advantage that taxpayers were getting something in return for their money. There is another bank bailout program going on now – one that allows the federal government to recapitalize banks with public money, receive nothing at all in return, and somehow escape criticism for doing so. That bailout program is called the Recession.
How does the Recession allow the government to bail out banks? With the recession going on, people are afraid to do anything risky with their assets, so they keep them deposited in banks, earning no interest. Banks can then invest these deposits in Treasury notes and credit the interest on those Treasury notes to their bottom line, thus improving their balance sheets. So the government pays to recapitalize banks while receiving nothing in return.
Now this bailout program is not without its risks. The biggest risk is that the economy will recover, which would be a disaster for the program. Suddenly, not only would banks be holding losses on their Treasury notes, but their cost of funds would go up, as depositors realized that there were more attractive investments available than zero-interest bank deposits.
Another risk, with similar implications, is an increase in the expected inflation rate. That would also lead to capital losses on the banks’ Treasury note holdings and an increase in their cost of funds.
Finally, there is reinvestment risk. Treasury notes mature and need to be rolled over, the coupon payments need to be reinvested, and banks have new inflows of funds that need to be invested. A substantial decline in the yields on Treasury notes (perhaps a continuation of what we are seeing now) would benefit banks in the short run because of the capital gains involved, but ultimately it would effectively terminate the bailout program, since banks would no longer be able to earn a large spread on their safe investments.
So the success of this bailout program depends on avoiding recovery, avoiding increases in inflation expectations, and avoiding major declines in Treasury note yields. Now do you understand why the Federal Reserve Bank presidents – representatives of the banking sector – are the most hawkish voices at the FOMC’s policy meetings?
I'm getting some pushback on my post entitled "Jaws are Dropping," which is derived from a statement in one of the links I provided in the post. I think it must be either the title of the post or, when correcting a typo, the afterthought I added about the right answer to the question of whether a low federal funds rate eventually leads to a fall in inflation that has some people so worked up (good to see that Williamson has taking a break from his exhibitions of Krugman Derangement Syndrome, bashing Krugman seems to be the main point of his blog lately). It can't be anything else I said since my main point was that I didn't have time to say much about the whole controversy due to an impending deadline.
The main issue revolves around this statement from Minnesota Fed President Narayana Kocherlakota:
To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation
I think the assertion that it "must" lead to that outcome is unsupportable, there are models where that isn't true, but he means "must" in terms of a very specific model of how the economy works, including an assumption of the super neutrality of money (which is asserted as an uncontroversial assumption, but I'd quarrel with that). So, yes, it's possible to write down a very specific model that has this as an implication, but does that make it generally true? Not to me.
In any case, here's an email from a friend of Narayana defending his statements:
And, he sends along an update:
I rarely comment on posts on blogs, since most of the discussion seems to be most interested in scoring political points than in economic analysis. However today I will make an exception since Kocherlakota's words come directly from any standard treatment of monetary theory, and hence, they should have been anything except controversial.
In a large class of monetary models, the Euler equation of intertemporal maximization is:
FFR = (1/beta) *(u'(ct)/u'(ct+1))*inflation
where u'(.) is the marginal utility of consumption, FFR is the federal funds rate, and beta is the discount factor (see, for instance, equation 1.21 in page 71 of Mike Woodford's Interest and Prices for a derivation in a simple context).
Let us take first the case where money is neutral, probably an implausible case but a good starting point. In this situation, the ratio of marginal utilities is unaffected by the change in inflation or the FFR. Thus, a lower FFR means lower inflation. Otherwise, there are arbitrage opportunities left on the table. What is more, in such a world, the Fed can control inflation by controlling the FFR, so the relation is causal in a well-defined sense.
Now, let's move to the much more empirically relevant case of a New Keynesian model (here I am thinking about the standard NK model people use these days to analyze policy in the style of Mike Woodford, Larry Christiano or Martin Eichenbaum, with a lot of nominal and real rigidities, so I will not discuss the assumptions in detail).
Imagine that the Fed is targeting the FFR and decides to lower the long run target from, let's say 4% to 2%. What happens? Well, in the very short run, nominal rigidities imply that we will have a transition where inflation might (but not necessarily, it depends on details of the model) be temporarily higher but, after the necessary adjustments in the economy had occurred (adjustments that can be quite painful, generate large unemployment, and might reduce welfare by a considerable amount), we settle down in the lower inflation path. Again, the reason is that in most New Keynesian models, the ratio of marginal utilities is independent of the FFR (this will happen even in many models with long-run non-neutralities) and the Euler equation will reassert itself: the only way we can have a real interest rate of 3% when the target FFR is 2% is with a 1% deflation.
Hence, in the long run, as Kocherlakota's speech explicitly says:
"To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."
An alternative way to see this is to think about a Taylor rule of the form:
Rt/R = (πt/π)γ
where γ>1 (here I am eliminating extra terms in the rule for clarity) where Rt is the FFR, R is the long run target for the FFR, πt is inflation, and π is the long run target for inflation. In a general equilibrium model, the Fed can only pick either R or π but not both. If it decides to pick a lower R, the only way the rule can work is through a fall in π.
While one may disagree with many aspects of modern monetary theory (and I have my own troubles with it), one must at least acknowledge that Kocherlakota's treatment of this issue or the relation between the FFR and inflation in the long run is what would appear in any standard macro model.
One thing I forgot to mention: I guess that the intuition that most people have (and that reacts in a somewhat surprised way to Narayana's words) comes from a New Keynesian model, where lowering the FFR with respect to what the Taylor rule indicates (what we call a "monetary shock") increases inflation in the short run. But here we are not talking about the effects on inflation of a transitory monetary shock, but, as Narayana clearly says in his speech, about the long run effects of a change in the target of the FFR.
If you commit to a single class of models and the interpretation of the shocks within them, the kind of models and interpretations that Narayana Kocherlakota has questioned, at least in their standard forms, and if you buy all the embedded assumptions that are needed to obtain the result, not all of which are easy to defend (e.g. the assumption of long-run neutrality), then yes, "must" is correct. But "must" must be interpreted in a rather limited context, and in a more general setting it's not at all clear that this result will hold.
However, my real problem with this defense is that it doesn't deal with the assertion that if real rates normalize and the Fed doesn't raise its target rate in response, it will lead to deflation., i.e. it doesn't address Nick Rowe's point. If the target real rate is below the normal real rate, how does that cause deflation? That's the part that caused the objection in the first place, and the part that still leaves me puzzled. Here's Nick:
"To sum up, over the long run, a low fed funds rate must lead to consistent—but low—levels of deflation."
That could be interpreted two ways: a wrong way, and maybe, just maybe, a right way.
"When real returns are normalized, inflationary expectations could well be negative, and there may still be a considerable amount of structural unemployment. If the FOMC hews too closely to conventional thinking, it might be inclined to keep its target rate low. That kind of reaction would simply re-enforce the deflationary expectations and lead to many years of deflation."
Nope. He definitely meant it the wrong way. If the economy returns to normal, and the natural rate of interest rises, the Fed must raise its target rate of interest. (So far so good). If it doesn't, the result would be....deflation. ("Inflation" would be the right answer).
I also wonder if a permanent shock is the right way to think about this type of a policy, but I'll leave that as a question since I don't want to distract from Nick's point.
Update: Here's more from Nick:
What standard monetary theory says about the relation between nominal interest rates and inflation, by Nick Rowe: This is what I understand "standard" monetary theory to say about the relation between inflation and nominal interest rates.
I want to distinguish two cases.
In the first case the central bank pegs the time-path of the money supply. The money supply is exogenous. The nominal interest rate is endogenous. Standard monetary theory says that a permanent 1 percentage point increase in the growth rate of the money supply will (in the long run) cause both the nominal interest rate and the rate of inflation to rise by 1 percentage point. The Fisher relation holds as a long-run equilibrium relationship. The real interest rate is unaffected by monetary policy in the long run.
In the second case the central bank pegs the time-path of the nominal rate of interest. The nominal interest rate is exogenous. The money supply is endogenous. Start in equilibrium (never mind how we got there). Standard monetary theory says that if the central bank pegs the time-path of the nominal interest rate permanently 1 percentage point higher, this will cause the price level, and the rate of inflation, and the stock of money, to fall without limit. The Fisher relation will not hold, because there is no process that will bring us to a new long run equilibrium. The real interest rate will rise without limit.
These two cases are very different, because a different variable is assumed exogenous in each case.
I am assuming super-neutrality of money, in long-run equilibrium. The Fisher relation is a long run equilibrium relationship. We never get to the new long-run equilibrium in the second case, and so the Fisher relation does not hold.
Update: Brad DeLong comments.
Is Ben Bernanke about to "stake out a public position"?:
Fed to Outline Future Actions Friday, by Sewell Chan, NY Times: With fresh signs that the housing market is weakening,... Ben S. Bernanke, on Friday will offer his outlook on the economy, explain the Fed’s recent modest move to halt the slide and possibly outline other actions. ...
It is not known what Mr. Bernanke will say, but some insight may come from an episode in his past: his concern, soon after he became a Fed governor, that the economy was at risk of deflation as the nation gradually recovered from the dot-com bust a decade ago.
Mr. Bernanke’s worry then is similar to what troubles the Fed now, and his views will have no small bearing on the Fed’s course of action. ... Whether policy makers should take big steps to tackle the economic doldrums — by printing even more money and buying even more assets — [is] the dominant question...
Within the central bank, several officials are alarmed at the threat of the economy falling into a dangerous cycle of declining demand, wages and prices not experienced since the Depression. They say that a deflationary, double-dip recession is unlikely, but want to formulate concrete steps to ward it off.
Other officials contend the economic indicators, while dismaying, do not represent an immediate threat, and worry that additional monetary stimulus by the Fed could erode the already shaky confidence of the markets, or even backfire by eventually spurring uncontrolled inflation. ...
The risks are not symmetric. An extended period of stagnation is a highly undesirable outcome, and the Fed needs to take steps to try to prevent this from happening.
Minnesota Fed President Narayana Kocherlakota recently argued that low interest rates will eventually cause inflation deflation (sorry for the typo, it's hard to write the wrong answer). I'm trying to understand why people at the Fed are so reluctant to do more to help the economy, what the reasoning is, etc., but I have to meet a deadline and need to stop using the blog as a distraction. So let me just note that there is a lot of "jaw dropping" over Kocherlakota's claim. See, for example, Andy Harless, Nick Rowe, and Robert Waldmann. [Please see the update to this post.]
More bad news about the economy. New home sales were at a record low during July:
Sales of new single-family houses in July 2010 were at a seasonally adjusted annual rate of 276,000, according to estimates released jointly today by the U.S. Census Bureau and the Department of Housing and Urban Development. This is 12.4 percent (±10.8%) below the revised June rate of 315,000 and is 32.4 percent (±8.7%) below the July 2009 estimate of 408,000.
And durable goods orders also came in well below expectations:
New orders for manufactured durable goods in July increased $0.6 billion or 0.3 percent to $193.0 billion, the U.S. Census Bureau announced today. This increase followed two consecutive monthly decreases including a 0.1 percent June decrease. Excluding transportation, new orders decreased 3.8 percent.
I wonder if the people at the Fed who are standing in the way of more help for the economy will revise their belief that the recovery is underway and, although it is proceeding slower than they'd like to see, nothing needs to be done, nothing more can be done, to help? I doubt they will, instead they'll find a way to fit this into the narrative they want to believe in. I'd ask a similar question about Congress, fiscal policy is likely to be more effective than monetary policy in a severe recession, but I gave up on them long ago.
The meeting was a case study in Mr. Bernanke's management style, which reflects his days as chairman of Princeton University's economics department when he had to manage a collection of argumentative academics with strong personalities and often divergent views. Mr. Bernanke encourages debate and disagreement, and then weighs in at the end with his own decision, which has helped him win loyalty at the Fed, even among those who disagree with him, several officials say.
Tim Duy responds:
Uuhhg – I am too tired to address the WSJ Fed piece, and I don’t have time to tackle the piece, but you can add this if you wish:
I understand why his colleagues appreciate Bernanke’s management style, and why the media likes to ooze quiet praise on that style, but shouldn’t he be showing some leadership in the public as well? After all, the Federal Reserve, last time I checked, was not a University economics department. It is not the same. As we like to say in academics, the disputes are bitter because so little is at stake. Not so for the Fed. As an institution, it serves the public directly, and much, much is at stake. Perhaps it is time for Bernanke to stake out a public position. How exactly does he view the current economic situation in light of his work on Japan? For many of us, that work points to a much more aggressive policy stance. Is this the direction Bernanke wants to take? If so, why is he dragging his heels? If not, then what is different? This is the conversation I want to see him have with the public, on the record. And the sooner, the better.
What good is served by leaving so much uncertainty over what the Fed is likely to do next if various scenarios such as a stronger, weaker, or stagnant economy unfold? What could be the reason for Bernanke's reluctance to take his case to the public?
If Bernanke takes a particular position on future policy, that makes it very difficult for the Fed to do anything else without losing its credibility, and hence makes it difficult for other members of the FOMC to vote against such a proposal no matter how much they might disagree. If the Fed chair indicates one thing, and then the Fed lurches in another direction, that will hurt the Fed's credibility at a time when it doesn't have any credibility to waste. Even if Bernanke tries to make it clear that he is expressing his own views and not speaking on behalf of the FOMC, his views will still set the benchmark for thinking about where the Fed is headed next.
Unlike the Fed under Greenspan where the Fed chair used his influence to determine policy pretty much on his own, Bernanke has attempted to make the Fed a "a collection of argumentative academics" where everyone is allowed to have a say in the outcome. If he goes out in public and binds the Fed in advance, that undermines the more democratic committee process he has tried to create.
Should we worry about that?
I'm not sure I want to go back to the days of Greenspan, the other members of the committee should at least have some say in the policy decisions. It's true that the chair of the Fed should have the most influence over policy, that's intended in the design of the Fed as an institution, but the Chair should not run the entire show.
However, when there is considerable uncertainty due to disagreement on the FOMC, the Fed chair needs to use the influence bestowed upon him or her by the Fed's institutional arrangements, set a firm course for policy, and resolve the uncertainly. That might mean having lots of informal discussions with other members of the FOMC to make sure their views get a fair hearing, and some back and forth in the process, but at some point the Fed chair needs to step up and lead. Right now is one of those times.
This gives us a better idea of who to blame for standing in the way of more aggressive policy from the Fed:
Fed Split on Move to Bolster Sluggish Economy, by Jon Hilsenrath, WSJ: The Aug. 10 meeting of top Federal Reserve officials was among the most contentious in Ben Bernanke's four-and-a-half year tenure as central bank chairman.
With the economic outlook unexpectedly darkening, the issue was a seemingly technical one: whether to alter the way the Fed manages its huge portfolio of securities.
But it had big implications: Doing so would plunge the Fed back into the markets and might be a prelude to a future easing of monetary policy, moves that divided the men and women atop the central bank. ... At the end of an extended debate, Mr. Bernanke settled the issue by pushing successfully to proceed with the move. ...
Before the meeting, officials at the Federal Reserve Bank of New York, which manages the Fed's portfolio, had grown concerned ... the ... Fed's portfolio of mortgage-backed securities was about to begin shrinking much more rapidly than anticipated, as low mortgage rates led more Americans to refinance their mortgages. ... A shrinking portfolio in the face of slowing economic growth was unwelcome to many officials, including New York Fed President William Dudley. It amounted to prematurely applying the brakes. ...
The declining mortgage portfolio was the focal point of debate. ... Officials spent very little time discussing the idea of expanding the securities portfolio beyond its current size. ...
Officials were clustered in two camps. In one camp, Mr. Dudley, and the presidents of the Boston and San Francisco Fed banks, Eric Rosengren and Janet Yellen, were distressed that the Fed was far from its objectives of low unemployment and stable inflation. ... This camp was more inclined to act.
The other camp was skeptical. Fed governor Kevin Warsh, a former Wall Street investment banker..., Richard Fisher, president of the Dallas Fed,... Narayana Kocherlakota, president of the Minneapolis Fed,... president of the Philadelphia Fed, Charles Plosser,.., Thomas Hoenig of Kansas City, and Jeffrey Lacker of Richmond...
After listening intently, Mr. Bernanke summed up the debate, acknowledged the disagreements, and then said that the Fed shouldn't allow the passive tightening of financial conditions that was being caused by its shrinking balance sheet. In practice, that would mean taking proceeds from nearly $400 billion in maturing mortgage bonds and buying Treasury debt. The Fed also needed to acknowledge the slower growth outlook, he said. ...
The formal vote—9 to 1—disguised the disagreements. ... [Only] Mr. Hoenig, as he has at every opportunity this year, formally dissented. ...
Now the internal debate turns to the future, particularly whether to do more, and if so whether to make small or large steps. ...
My view is that it will take even more bad news about the economy before the Fed will consider additional moves, and if it does move, it will move gradually.
The Fed has been behind the curve since before the crisis started. It didn't see the crisis coming, when the crisis did come it was going to be contained rather than spread and cause bigger problems, and when the problems spread they were going to be short-lived -- Bernanke saw green shoots long, long ago. Now we have Fed officials hesitating once again based upon their relatively rosy expectations for the recovery.
One of the lessons the Fed thinks it learned about inflation is that when you see it, you need to move aggressively. Interest rates should rise by more than one to one with the rise in inflation expectations (this is called the Taylor principle). If you chase inflation upward with gradual steps instead of getting out in front of it and capping it off, you won't catch it until it reaches a very high level, and you may not catch it at all in extreme cases.
But when it comes to the other half of the Fed's mandate, unemployment, there is no sense of urgency, gradualism is fine. But just like inflation, a strategy of delaying and only gradually responding to signals that a problem exists is asking for trouble. Policymakers learned this lesson when inflation was the big problem in the economy, but they haven't figured out that the same lesson applies to situations like we're in (because it's not a feature of models with Calvo price stickiness, the standard model used to evaluate such questions, but that model doesn't do a very good job of capturing the essential elements of our present situation).
Hesitation and gradualism has already allowed unemployment to move far ahead of policy. We need an aggressive move from the Fed to try to catch up, trying to close the gap with small steps in not going to work. But even if the outlook deteriorates further, I doubt that's what we'll get.
Here is my first column for the Fiscal Times, and there will be more to follow:
Some of you will be unhappy with the outlet. But I can't change the minds of people I can't talk to, and when it comes to certain groups, they aren't coming to me. So into the belly of the beast to stop the beast from being starved. Or something like that. I should add that I expect to have complete freedom in what I can say. If that turns out to be a false expectation, then I will stop doing this and I will let people know why. Also, I chose to begin by talking about the Fed's relationship to Congress, but it occurs to me that given how much many of you disagree with my views on the Fed, I might have chosen a different topic to start this off.
The Economist asks:
My stock answer is here. I decided to stay on message with regard to fiscal policy. I don't think we should let Congress off the hook as we criticize the Fed for its inadequate response. There are also responses from Viral Acharya, Laurence Kotlikoff, Guillermo Calvo, Michael Bordo, and Tom Gallagher, with (perhaps) more to follow. (all responses)
There is another question:
I didn't answer this one, but there are responses from Ricardo Hausmann, Alberto Alesina, Lant Pritchett, Daron Acemoglu, and Arvind Subramanian. Again, additional responses may follow. (all responses)
A Bleak View, by Tim Duy: Deferring to the faltering economy, the Federal Reserve stepped up its policy efforts last week. Barely. Almost imperceptibly. Indeed, it is almost as if the Fed could muster nothing better than throwing a bone to its critics. Will they throw more bones in the coming months? In this environment, I suspect the Fed will continue to do more than I expect, but less than is necessary.
The few data releases since the FOMC meeting have not been particularly encouraging. The trade deficit expanded, implying a downward revision to the Q2 GDP numbers. Initial unemployment claims continue to hover at levels consistent with weak job growth. University of Michigan consumer sentiment ticked up, but signals that households remain under severe pressure. Retail sales edged up in July, reinforcing the long standing trend of this recovery - an inability to grow fast enough to reestablish the previous trend:
One can argue that the previous trend was unsustainable, driven on the back of a clearly faulted debt-fueled asset bubble dynamic. But even accepting that hypothesis, that spending was critical to ensuring full employment. If consumers fall back, some other sector needs to step up to the plate. Otherwise, the economy will continue to limp along a suboptimal growth path.
Will FOMC members continue to accept that path? Acceptance is dependent on the inflation outlook. And on that point, the July CPI release, which revealed a slight increase in core inflation, leaves me unsettled. Given downward nominal wage rigidities, it is not that difficult to imagine an economy stuck significantly below potential output, but with just enough price pressures to sustain a slightly positive inflation rate. Absent a substantial output decline, would the Fed be inclined to significantly expand quantitative easing in the face of low, but positive, inflation, combined with positive inflation expectations? Apparently no, as this is a description of the current situation. More of the same is likely to produce little drips of monetary easing here and there, but it is difficult to see, for example, a commitment to purchase $200 billion of Treasuries each quarter until unemployment stands at 7%.
Is dramatic action necessary? I believe so, which, ironically, brings me to last Friday's speech by arch-hawk Kansas City Federal Reserve President Thomas Hoenig. Hoenig is stepping up his public criticism of the FOMC, lambasting his colleagues for setting the stage for another financial crisis. In short, Hoenig sees parallels to the deflation scare of 2003, which prompted the Fed to lower rates to 1%. Shortly thereafter, economic activity accelerated on the back of the housing bubble. We all know how that story ended. In Hoenig's view, this was essentially a repeat of the experience of the late 90's equity bubble and subsequent collapse. Hoenig concludes that it is important to break the cycle; he suggests dropping the "extended period" language, moving the Federal Funds rate to 1%, pausing, and then make a final move to 2%. He does not view this as tight policy, but instead accommodative yet firmer policy. Tough love.
Hoenig's story of policy induced bubbles is certainly not new. Indeed, the fluctuations in household net worth appear to be intimately related to the business cycle since 1995:
We tend to view these asset bubbles as "bad," but I think this pattern also poses an interesting question. If you remove the asset bubbles, what is left? It sure looks like nothing more than an economy stuck in a subpar equilibrium. Perhaps rather than diverting capital from productive investments, capital flowed into asset bubbles due to a lack of investment opportunities. It is not so far fetched; we know that firms are sitting on nearly two trillion dollars of cash yielding low returns.
In other words, were the asset bubbles critical to maintaining full employment? And if so, how can we reflate the economy in their absence? Hoenig believes we will restructure the economy over time, but his story is woefully incomplete:
… then how might GDP and important components perform? Let me start with consumption, which for decades amounted to about 63 percent of GDP. During the boom it rose to 70 percent. It seems reasonable that the consumer will most likely return toward more historical levels relative to GDP and then grow in line with income. If so, the consumer will contribute to growth but is unlikely to intensify its contribution to previously unsustainable levels….
…While businesses need to rebalance as well, they are essential to the strength of the recovery. Fortunately, they are in the early stages of doing just that. Profits are improving and corporate balance sheets for the nonfinancial sector are strengthening and are increasingly able to support investment growth as confidence in the economy rebuilds. Also, although credit supply and demand may be an issue impeding the recovery to some extent, a shortage of monetary stimulus is not the issue. There is enormous liquidity in the market, and it can be accessed as conditions improve.
Finally, the federal government needs to rebalance its balance sheet as well. Federal and state budget pressures are enormous, and uncertain tax programs surely are a risk to the recovery. This adds harmful uncertainty upon both businesses and consumers. However, while these burdens are a drag on our outlook, they are not new to the U.S. and, by themselves, should not bring our economy down unless they go unaddressed.
It appears Hoenig believes both consumer and government spending are set to become less important to the growth mix. Yet, he also believes in such an environment, firms will continue to invest in new capital as confidence grows. But how are we to expect that firms will have any confidence in the absence of a strong consumer outlook or a government backstop? Indeed, the strains of such a dynamic emerge already. From Bloomberg:
Weaker-than-forecast sales at Cisco Systems Inc. and International Business Machines Corp. may signal a slowdown in the corporate spending that has led the U.S. recovery.
“It’s been business investment, particularly technology, that’s been in the driver’s seat,” said Stuart Hoffman, chief economist at PNC Financial Services in Pittsburgh. Should equipment spending slow significantly, “unless something else picks up the pace, it means the outlook for the economy is going to be that much dimmer.”
Note too that he conspicuously offers no mention of the external sector - perhaps no surprise given that an external impetus has been noticeably absent during this recovery. Simply put, if we take consumer, government, and external spending off the table, I don't see any path that leads to Hoenig's promised land.
Nor do I see a path to the promised land in the current stance of monetary policy. Nor do I see a path in what I suspect is the likely path - drips of easing here and there. Moreover, given the propensity of firms to offshore productive capacity, I am wary that even aggressive easing will stimulate investment activity. I think the latest trade release clearly show that stronger domestic demand is likely to get translated straight into imports. The same goes for consumer spending - the recession has ravaged credit ratings, leaving the pool of potential borrowers shriveled. And even if we can induce households to buy more flat screen TV's, such stimulus is more of a economic boost for the Port of Long Beach than anything else.
So, increasingly I worry the most effective policy paths are less than palatable for policymakers. And I can't say that I am particularly comfortable with said paths as well. But, at the risk of oversimplifying channels of monetary transmission, if future quantitative easing is to work, I suspect it needs to flow through one of two channels. The first is the via an explosion of net worth. In other words, a fresh asset bubble. I don't think this will happen spontaneously. Via financial reform, policymakers are in the process of injecting enough glue into the financial markets to keep asset bubbles at bay, at least for the time being. The other channel is via a sharp decline in the value of the Dollar. Undoubtedly, this would stimulate export and import-competing sectors (I tend to think the latter is actually the most important). The rest of the world, however, would be likely to lean against such a decline.
This is a depressing outlook, as it suggests that even aggressive monetary easing might not be enough unless such easing can be induced to work along one of two channels policymakers will resist. Indeed, I think it would be most effective if the Fed could eliminate the middleman of Treasury purchases. Accumulate equities to drive up net worth and thus sustain consumer spending, enough of which would be spent on nontradables (the beauty of the housing bubble, by the way) that the stimulative effect would remain in the US. This option, however, is not legally available to the Fed. But the Fed could accumulate foreign sovereign debt, thereby inducing a decline in the value of the Dollar. Alas, that option might as well be illegal as well, and it will never happen. It would be seen as a.) stepping on Treasury's turf, b.) risking retaliatory devaluations, and c.) setting the stage for an actual currency crisis.
Bottom Line: The Fed took a baby step forward last week. It is natural to interpret that step as a signal that more easing is coming. On the surface, however, such an interpretation is premature. If the economy continues to produce more of the same - steady growth with minimal inflation - policymakers are likely to keep additional policy responses to a minimum, more as an effort to placate critics than to affect meaningful changes to the economic path. Such meaningful policy might simply be a bridge too far for policymakers, especially if the asset bubbles during the past two business cycles were key to generating full employment. In such a framework, the Fed would either need to accept, and even support, a fresh asset bubble or a sharp decline in the value of the Dollar. Neither option looks acceptable at this time.
Update: Tim, who is on a camping trip, emails an update (he wrote the post before he left):
One could argue that government backed debt is the latest bubble supported by the Fed. But, in the context of the ongoing disruptions in lending channels, at least relative to what is necessary to hold the economy near potential, it is not a particularly effective bubble, absent a more committed fiscal complement.
Fiscal policymakers deserve their share of the blame for not responding adequately to the crisis, and I blame them first foremost, but monetary authorities have not responded adequately either. Disappointingly, and to the disadvantage of those hoping to find employment sooner rather than later, the Fed hasn't even taken the steps that Bernanke urged Japan to take when it faced similar circumstances:
Paralysis at the Fed, by Paul Krugman, Commentary, NY Times: Ten years ago, one of America’s leading economists delivered a stinging critique of the Bank of Japan, Japan’s equivalent of the Federal Reserve, titled “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” With only a few changes in wording, the critique applies to the Fed today.
At the time, the Bank of Japan faced a situation broadly similar to that facing the Fed now. The economy was deeply depressed and showed few signs of improvement, and one might have expected the bank to take forceful action. But short-term interest rates — the usual tool of monetary policy — were near zero and could go no lower. And the Bank of Japan used that fact as an excuse to do no more.
That was malfeasance, declared the eminent U.S. economist: “Far from being powerless, the Bank of Japan could achieve a great deal if it were willing to abandon its excessive caution and its defensive response to criticism.” He rebuked officials hiding “behind minor institutional or technical difficulties in order to avoid taking action.”
Who was that tough-talking economist? Ben Bernanke... So why is the Bernanke Fed being just as passive now as the Bank of Japan was a decade ago? ...
What could the Fed be doing? Back when, Mr. Bernanke suggested, among other things, that the Bank of Japan could get traction by buying large quantities of “nonstandard” assets... The Fed actually put that idea into practice during the most acute phase of the financial crisis, acquiring, in particular, large amounts of mortgage-backed securities. However, it stopped those purchases in March. ...
Back in 2000, Mr. Bernanke also suggested that the Bank of Japan could ... make private-sector borrowing more attractive by announcing that it would keep interest rates low until deflation had given way to 3 percent or 4 percent inflation — an idea originally suggested by yours truly. ... But as chairman of the Fed, Mr. Bernanke has explicitly rejected any such move.
What’s going on here? Has Mr. Bernanke been intellectually assimilated by the Fed Borg? I prefer to believe that he’s being political, unwilling to engage in open confrontation with other Fed officials — especially those regional Fed presidents who fear inflation, even with deflation the clear and present danger, and are evidently unmoved by the plight of the unemployed.
And in fairness to Mr. Bernanke, discord among senior officials also makes it difficult for policy to change expectations: it would be hard to credibly commit to higher inflation if this commitment were constantly being undercut by speeches out of the Richmond or Dallas Feds. In fact, I’d argue that loose talk by some Fed officials is already having a negative economic impact. But while Mr. Bernanke doesn’t have the authority to stop that loose talk, he could make it clear that it doesn’t represent overall Fed policy.
Last, but not least, policy is suffering from an act of neglect by President Obama, who waited until his 16th month in office before offering a full slate of nominees to fill vacancies on the Federal Reserve Board. If he had filled those slots quickly — his nominees still aren’t in place — the Fed might be less passive.
But whatever the reasons, the fact is that the Fed — which is required by statute to promote “maximum employment” — isn’t doing its job. Instead, like the rest of Washington, it’s inventing reasons to dither in the face of mass unemployment. And while the Fed sits there in its self-inflicted paralysis, millions of Americans are losing their jobs, their homes and their hopes for the future.
I posted a brief reaction to the FOMC Press Release:
Update: Paul Krugman reacts:
What the FOMC announced was a slight change in policy: rather than allowing its balance sheet to shrink as the mortgage-backed securities it owns mature, it will maintain the balance sheet’s size by reinvesting the proceeds in long-term government bonds. Roughly speaking, it has gone from a completely crazy policy of monetary tightening in the face of massive unemployment and incipient deflation, to a policy of standing pat in the face of same. Whoopee.
And it’s a very strange decision, if you think about it. Presumably there’s some optimal size of the Fed’s balance sheet, given the state and prospects of the economy. What are the odds that the optimal size of that balance sheet is precisely the size it’s currently at? ...
So why freeze the size of the balance sheet right where it is? The answer is that it was, literally, the least the Fed could do. If it had continued to let the balance sheet shrink, the reaction both from Fed critics and from the markets would have been terrible. In effect, reinvesting the funds from expiring securities became a focal point, an essentially arbitrary location in the space of policy responses that nonetheless had come to have “salience”, because it was what everyone was watching.
So why am I even slightly encouraged? Because the critics did, at least, succeed in moving the focal point. Not long ago gradual Fed tightening was the default strategy; but as I said, at this point the Fed realized that continuing on that path would have unleashed both a firestorm of criticism and a severe negative reaction in the markets.
What we need to do now is keep up the pressure, so that at the next FOMC meeting the members are once again confronted by the reality that not changing course would be seen as dereliction of duty. And so on, from meeting to meeting, until the Fed actually does what it should.
I know: it’s a heck of a way to make policy. In a better world, the Fed would look at the state of the economy and do what was right, not the minimum necessary. But wishing for that kind of world is like wishing that Ben Bernanke were running the place.
Part of what I said in the link above is that "It's something, and it indicates more awareness of the struggles the economy is having than some recent commentaries from FOMC members would suggest. But more aggressive action -- an actual expansion of the balance sheet -- is needed." So I certainly agree that more expansionary policy is needed, though it's probably hoping against hope for FOMC members to radically change course without external pressure. However, I have to hope anyway -- FOMC meetings are five to six weeks apart -- and pushing policy using a "meeting to Meeting" strategy of constant pressure will take forever, or so it will seem from the perspective of those waiting for an improvement in labor market conditions and hoping that their resources don't run out before they can find another job.
Here's part of the introduction and conclusion from the latest SF Fed Economic Letter by Travis J. Berge and Òscar Jordà. They find that "the macroeconomic outlook is likely to deteriorate progressively starting sometime next summer":
Future Recession Risks, by Travis J. Berge and Òscar Jordà, Economic Letter, SF Fed: By now, there is little disagreement that the Great Recession, as the last recession is often called, ended sometime in the summer of 2009 (see Jordà 2010), even though the National Bureau of Economic Research (NBER) has yet to formally announce the date of the trough in economic activity that marks the beginning of the current expansion phase. Intriguingly, just as we seemed to be leaving the recession behind, talk of a double dip became increasingly loud. ... A quick look at the number of Google searches and news items for the term "double-dip recession" reveals no activity prior to August 29, 2009, but a dramatic increase in search volume since then, especially in the past two months. Such concern is likely motivated by a string of poor economic news. ... It is understandable that the NBER has hesitated to call the end of the recession.
This spate of bad news has prompted a heated policy debate pitting those eager to mop up the gush of public debt generated by the recession and the fiscal stimulus package designed to counter it against those who would prefer to douse the glowing recession embers with another round of stimulus. ... In this Economic Letter, we calculate the likelihood that the economy will fall back into recession during the next two years. ...
Conclusion Any forecast 24 months into the future is very uncertain. ... Nevertheless, [Leading Economic Indicator] LEI forecast trends indicate that the macroeconomic outlook is likely to deteriorate progressively starting sometime next summer, even if the data suggest that a renewed recession is unlikely over the next several months. Of course, economic policy can strongly influence the outcome. The policies that are adopted today could play a decisive role in shaping the pace of growth.
We shall see what policies are adopted by the Fed today that "could play a decisive role in shaping the pace of growth," or at least we'll find out on Wednesday when the Fed announces the outcome if its latest FOMC meeting. But it sounds like, as Tim Duy said, opinion within the Fed is that the Fed needs to be more aggressive.
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.
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.
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.
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.
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.
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.
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.
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
easingtightening. 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?
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.
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.
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...
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:
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.
Policymakers should be more concerned about the possibility of rising long-term unemployment:
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.
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.
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:
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.
Robin Harding at the Financial Times blog Money-Supply says I'm being unfair:
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?
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.
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.
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]
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.
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.
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.
I have a new post a MoneyWatch:
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.
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.
One more from Tim Duy:
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.
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.
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?