Category Archive for: Monetary Policy [Return to Main]

Tuesday, April 03, 2012

Fed Watch: Fed Minutes Confirm Policy on Hold

Tim Duy:

Fed Minutes Confirm Policy on Hold, by Tim Duy: The minutes of the most recent Federal Reserve meeting were not exactly what one would call a page turner. Much of the contents had already been covered in recent speeches to varying degrees, culminating with an unexpectedly sanguine view of the economy:

With respect to the economic outlook, participants generally saw the intermeeting news as suggesting that economic growth over coming quarters would continue to be moderate and that the unemployment rate would decline gradually toward levels that the Committee judges to be consistent with its dual mandate. While a few participants indicated that their expectations for real GDP growth for 2012 had risen somewhat, most participants did not interpret the recent economic and financial information as pointing to a material revision to the outlook for 2013 and 2014.

The recent flow of data has done little to alter the Fed's basic outlook that the recovery will continue to grind along at a pace slower than hoped for but fast enough such that no additional easing is required. And on the prices side of the equation, inflation expectations remain anchored, and any pass-through from higher oil and gas prices will be temporary. As expected, some participants were concerned about inflation prospects:

One participant pointed to inflation readings and a high rate of long-duration unemployment as signs that the current level of output may be much closer to potential than had been thought, and a few others cited a weaker path of potential output as a characteristic of the present expansion.

These concerns, however, were largely dismissed by the rest of the committee:

However, a number of participants judged that the labor market currently featured substantial slack. In support of that view, various indicators were cited, including aggregate hours, which during the recession had exhibited a decline that was particularly severe by historical standards and remained well below the series' pre-recession peak; the high number of persons working part time for economic reasons; and low ratios of job openings to unemployment and of employment to population.

Not to be deterred so easily, the hawks come back later with:

A couple of participants noted that recent readings on unit labor costs had shown a larger increase than earlier...

That picture looks like this:


Heaven forbid we allow any catch-up in unit labor costs. In any event, I would be cautious about reading too much into the most recent data given weak wage growth:


Which is the same conclusion other the participates in the meeting:

...but other participants pointed to other measures of labor compensation that continued to show modest increases.

The hawks do make one last effort:

Other participants, however, were worried that inflation pressures could increase as the expansion continued; these participants argued that, particularly in light of the recent rise in oil and gasoline prices, maintaining the current highly accommodative stance of monetary policy over the medium run could erode the stability of inflation expectations and risk higher inflation.

This despite the experience of last year where the same arguments were made and ultimately proved wrong.

Finally, if you were looking for signs that another round of QE, your hopes were dashed:

A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

A half-hearted call for additional easing at best. The Fed is simply not inclined to overshoot. As Mark Thoma points outs, the best we get is a signal that the Fed is not ready to pull the trigger on tighter policy.

Bottom Line: The Fed remains in a holding pattern; more QE is dependent upon a meaningful deterioration in the outlook and/or a flattening out of the unemployment rate. Otherwise, it remains a debate about when the first tightening will occur, and for the moment that event is still far in the future.

Fed Meeting Minutes Blunt Hopes for QE3

Here's a quick reaction to today's release of the Fed's minutes from its March 13 rate setting meeting:

Fed Meeting Minutes Squash Hopes for QE3

As I told the editor, beyond the headline that there was little to suggest that the Fed will provide more stimulus, there wasn't much to say but I said it anyway. There was also a discussion of potential output that I failed to note, i.e. whether the unemployment problem is cyclical or structural, but the fact that "a number of participants judged that the labor market currently featured substantial slack" indicates that the many Fed members believe that cyclical fluctuation, i.e. lack of demand, is an important component of the unemployment problem (which points to more aggressive policy, or at the very least a continuation of present policy). 

"U.S. Economy Needs Stimulus, Not Soothsayers"

I have argued many, many times that policy mistakes are asymmetric, mostly to no avail, so it's nice to see Justin Wolfers and Betsey Stevenson emphasizing the point that the costs of doing too little are larger than the costs of doing too much, and what this implies for policy:

U.S. Economy Needs Stimulus, Not Soothsayers, By Betsey Stevenson and Justin Wolfers: Here’s something you don’t often hear an economist admit: We have very little idea where the economy will be next year. ...Why? Data are imperfect. Theories are coarse. Models oversimplify. The economy is constantly evolving and can’t be subjected to controlled experiments. Economic cycles are infrequent, so our understanding of them necessarily proceeds very slowly. 
None of these drawbacks, though, is fatal to the enterprise. ... Consider the current economic-policy debate. Most forecasters suggest that as the recovery slowly grinds on, unemployment will fall to about 7.5 percent by the end of 2013, from the current 8.3 percent. While this isn’t great progress, it is fast enough that some have argued against further stimulus.
We know, though, that the consensus forecast is highly likely to be wrong. Unemployment could fall to 6.5 percent, or rise to 8.5 percent. Each of these possibilities needs to be considered, and weighed according to its potential benefit or harm.
If unemployment falls to 6.5 percent, there’s no overwhelming reason for concern. ... By contrast, the longer-run consequences could be dreadful, if we find ourselves with 8.5 percent unemployment fully six years after the recession began. ...
In other words, the cost of too little growth far outweighs the cost of too much. If we readily bear the burden of carrying an umbrella when there’s a reasonable chance of getting wet, we should certainly be willing to stimulate the economy when there’s a reasonable risk that doing nothing could yield a jobless generation.

Monday, April 02, 2012

No Sign of an Inflation Problem

Via the Dallas Fed, once the volatile prices have been stripped out there's no evidence of inflation. If anything, inflation has been falling in recent months (before objecting that these measures do not capture actual changes in the cost of living for households, please see here):

Trimmed Mean PCE Inflation Rate, FRB Dallas: February 2012 The trimmed mean PCE inflation rate is an alternative measure of core inflation in the price index for personal consumption expenditures (PCE). It is calculated by staff at the Dallas Fed, using data from the Bureau of Economic Analysis (BEA). ...
The trimmed mean PCE inflation rate for February was an annualized 1.4 percent. According to the BEA, the overall PCE inflation rate for February was 3.8 percent, annualized, while the inflation rate for PCE excluding food and energy was 1.6 percent.
The tables below present data on the trimmed mean PCE inflation rate and, for comparison, the overall PCE inflation and the inflation rate for PCE excluding food and energy. The tables give annualized one-month, six-month and 12-month inflation rates.
One-month PCE inflation, annual rate

PCE excluding food & energy
Trimmed mean PCE


Six-month PCE inflation, annual rate

PCE excluding food & energy
Trimmed mean PCE


12-month PCE inflation

PCE excluding food & energy
Trimmed mean PCE
NOTE: These data are subject to revision ...

James Bullard is trying to make the case that domestic inflation depends upon the global output gap, and that gap looks inflationary, but I just don't see evidence for an emerging inflation problem in the tables. For the last four months or so, inflation has been stable or falling depending on the measure you choose, and that's not what you'd expect if there was increasing price pressure due to either global or domestic forces.

Sunday, April 01, 2012

Real-Time Economic Analysis

When Narayana Kocherlakota gave this speech based on this paper, a paper that uses a very simply model that is essentially an IS curve analysis, the economists who believe strongly in the science of monetary policy were appalled. How could Narayana have crossed over to the dark side?

I defended him, and it leads me into a broader discussion of the problems of doing what I've called "real-time economic analysis." Let me start with something I wrote about this awhile back:

Economic research is largely backward looking. After the fact – when all of the data has been collected and the revisions to the data are complete – economists examine data on, say, a financial crisis, and then figure out what caused the economy to become so sick. Once the cause has been determined, which may involve the construction of new theoretical frameworks, they tell us how to avoid it happening again, i.e. the particular set of policies that would have prevented or attenuated the damage.
But the internet and blogs are changing what we do, and to some extent we now act like emergency room physicians rather than pathologists who have the time to carefully examine data from tests, etc., determine what went wrong, and then recommend how to avoid problems in the future. When the financial crisis hit so unexpectedly, it was like a patient showed up at the emergency room very sick and in need of immediate diagnosis and care. We had to reach into our bag of macroeconomic models, choose the one that was correct for this question, and then use it to both diagnose the problems and prescribe policies to fix them. There was no time for a careful retrospective analysis that patiently determined the cause and then went to work on the potential policy responses.
That turned out to be much harder than expected. Our models and cures are not designed for that type of use. What data should we look at to make an immediate diagnosis? What tests should we conduct to give us data on what is wrong with the economy? If we aren’t sure what the cause is but immediate action is needed to save the economy from getting very sick, what is the equivalent of using broad spectrum antibiotics and other drugs to attack unknown problems? The development of blogs puts economists in real-time contact with the public, press, and policymakers, and when a crisis hits, traffic spikes as people come looking for answers.
Blogs are a start to solving the problem of real-time analysis, but we need to do a much better job than we are doing now at providing immediate answers when they are needed. If Lehman is failing and the financial sector is going down with it, or if Europe is in trouble, we need to know what to do right now. It won’t help to figure that out months from now and then publish the findings in a journal article. That means the discipline has to adjust from being backward looking pathologists with plenty of time to determine causes and cures to an emergency room mode where we can offer immediate advice. Blogs are an integral part of that process.

Policymakers at the Federal Reserve face this problem continuously. They must confront changes in the data that aren't always well understood in near real time, and make policy decisions every few weeks. If pre-existing models apply to the problem at hand, great, it can be used to guide policy decisions. But what should policymakers do when they are faced with an important decision about how to react to a large shock, and they reach into their black bag of models and none of them seem to fit?

One approach is what Paul Krugman does so well, something Narayana Kocherlakota seems to also be doing. Reach for simple models that get to the heart of the problem and hence offer guidance about what to do next. These models are not intended to explain the world generally, they are not "science" in that respect, they are intended to shine a light and provide guidance on a very narrow issue. It takes considerable skill to do this since, as I argued yesterday, it requires the practitioner to thoroughly understand the pitfalls of the simple approach, the ways in which it could go wrong.

So I think Narayana and others are correct to reach for simple models for guidance when they are faced with a decision that existing models do not address very well and there's not time to build a full-blown model of the problem.

My call to those who object that this approach is not "science," those who look down their noses at people like Krugman and Kocherlakota when they adopt this approach, is this. What is the scientific way to diagnose the economy is real-time, and confront unknown or uncertain pathologies? As I noted in another essay that discusses this problem, doctors have tests that can be done very quickly to provide a diagnosis, and they can they use broad-spectrum drugs and other approaches to try to heal the patient when the tests point to unknown causes.

What tests should we do that are quick and informative? There are lots of data, but what should we be examining to try to diagnose problems effectively before they get really bad? If we detect a problem, and don't fully understand it, what's the most robust way to attack it? What policies tend to work on a broad variety of underlying causes? Are there tests that can guide us to the correct robust policy?

My reaction when the crisis hit, and ever since, was to recommend a "portfolio of policies."  People who say only monetary policy will work, or only fiscal policy will work, blah, blah, blah are talking with more confidence than was justified by the models they are using. I decided early on that I really didn't know for sure which macroeconomic model was best. I had my preferences, strong preferences, but I couldn't say for sure that the model I preferred was correct. And it didn't really apply very well to the financial crisis in any case.

So, I thought, why not do what a doctor would do and give a broad spectrum drug that tends to work no matter the cause. There is the danger of side effects. If we aren't sure about which policy will work and we give full doses of both monetary and fiscal policy only to have them both work, the side effect of inflation could occur as the economy heals. But to me the side effect was far less worrisome than the disease itself, and in any case the side effect could be controlled by backing off the dosage once the patient was up and about once again. But what are the optimal weights for monetary and fiscal policy in such a situation? What else ought to be in the portfolio of policies (e.g. policies that can help even if the problem is structural rather than cyclical). What guidance can we give policymakers?

Those who believe in the science of monetary policy can sneer at the Krugman/Kocherlakota approach all they want, but there's a real (time) problem to be solved here and we could use their help. As I said above this is an area where the Fed has considerable experience, real-time analysis is a large part of what they do, and my push for Federal Reserve banks to interact more through blogs is partly for this reason. Hearing how Federal Reserve policymakers approach these problems would be useful.

But it would also be useful if the profession more generally would get aboard and help us understand how to better solve the difficult questions that arise when decisions must be made based upon only a partial understanding of the problem that is affecting the economy. In the long-run it's still important to build new, full blown models that can explain the problem and provide guidance. Macroeconomists are certainly doing that presently as they try to provide better models of how a breakdown in financial intermediation can impact the real economy than we had before, and so on. But work on how to better conduct real-time analysis is not getting as much attention, and that's something that needs to change.

Friday, March 30, 2012

"Are Unemployed Construction Workers Really Doing Better?"

I've been trying to get the Federal Reserve banks to engage more with the public through blogs, with economics bloggers in particular. We'll see how that goes, but it's encouraging to see that they are starting to converse and debate among themselves:

Are unemployed construction workers really doing better?, Pedro Silos and Lei Feng, macroblog: Two New York Fed economists, Richard Crump and Ayşegül Şahin, writing in Liberty Street Economics, have shared some interesting findings regarding developments in the labor market during the ongoing recovery. Their conclusion is that unemployed construction workers, according to several indicators, seem to be doing better than workers who lost jobs in other sectors. ...
These facts, according to the authors, provide support to the hypothesis that problems in the labor market cannot be blamed on the degree of mismatch between displaced construction workers and job vacancies in other sectors.
In this post, we present an alternative view of the fate of unemployed construction workers...

Hope to see more of this.

Fed Watch: Inflation: Still Nothing to See Here

Tim Duy:

Inflation: Still Nothing to See Here, By Tim Duy: The Februrary Personal Income and Outlays report came out this morning, and with it a fresh read on the Federal Reserve's preferred inflation measure, the PCE price index. On a year-over-year basis, headline inflation is trending down to the 2% target, while core is settling in just below that target.  


As a reminder, the Fed targets headline over the longer run, but watches core as a signal to where headline is headed.  Headline is trending down to core, as expected. The Fed was right to dismiss last year's energy-induced headline increase as a temporary phenomenon. Is there any near term trends to be concerned about? The three-month core trend edged down a notch to just above 2%:


Still less than the rise experienced in the first part of 2011.  What about the path of prices? Still tracking along a trend below that of prior to the recession:


Opportunistic disinflation at work.
Bottom Line:  Inflation remains contained - by itself, price trends provide no reason for the Fed to turn hawkish. Moreover, there is nothing here to stop Federal Reserve Chairman Ben Bernanke from easing policy should the US recovery falter.

Thursday, March 29, 2012

DeLong: The Shadow of Depression

Flight delay, so one more -- Brad DeLong:

The Shadow of Depression, by Brad DeLong, Commentary, Project Syndicate: Four times in the past century, a large chunk of the industrial world has fallen into deep and long depressions characterized by persistent high unemployment: the United States in the 1930’s, industrialized Western Europe in the 1930’s, Western Europe again in the 1980’s, and Japan in the 1990’s. Two of these downturns – Western Europe in the 1980’s and Japan in the 1990’s – cast a long and dark shadow on future economic performance.
In both cases, if either Europe or Japan returned – or, indeed, ever returns – to something like the pre-downturn trend of economic growth, it took (or will take) decades. In a third case, Europe at the end of the 1930’s, we do not know what would have happened had Europe not become a battlefield following Nazi Germany’s invasion of Poland.
In only one instance was the long-run growth trend left undisturbed: US production and employment after World War II were not significantly affected by the macroeconomic impact of the Great Depression. Of course, in the absence of mobilization for WWII, it is possible and even likely that the Great Depression would have cast a shadow on post-1940 US economic growth. That is certainly how things looked, with high levels of structural unemployment and a below-trend capital stock, at the end of the 1930’s, before mobilization and the European and Pacific wars began in earnest. ...[continue reading]...

Wednesday, March 28, 2012

"The Close Connection Between Nominal-GDP Targeting and the Taylor Rule"

From the Dallas Fed:

All in the Family: The Close Connection Between Nominal-GDP Targeting and the Taylor Rule, by Evan F. Koenig: Abstract: The classic Taylor rule for adjusting the stance of monetary policy is formally a special case of nominal- gross-domestic-product (GDP) targeting. Suitably implemented, moreover, nominal-GDP targeting satisfies the definition of a "flexible inflation targeting" policy rule. However, nominal-GDP targeting would require more discipline from policymakers than some analysts think is realistic.

I've been asking this for some time now, but I viewed nominal GDP targeting as a special case of the Taylor rule (when the coefficients are set just right), but it's the other way around -- the Taylor rule is the special case:

Note that the Taylor rule is a special case of nominal-GDP targeting... The chief difference between the two policy approaches is that under nominal-GDP targeting, policymakers look at a longer history of price changes than they do under the Taylor rule when deciding on the appropriate policy setting. Secondarily, the estimate of potential output that enters the nominal-GDP-targeting rule is less sensitive to short-term supply shocks than is the estimate that enters the Taylor rule.

The last point about temporary supply shocks is important as I tried to emphasize here (the post talks about why policymakers should not respond to temporary supply shocks under a Taylor rule, I didn't mention nominal GDP targeting as a solution).


One might think that nominal-GDP targeting's ability to work around the zero-bound constraint would appeal to monetary policy doves and that its tighter control of inflation expectations would appeal to monetary policy hawks. Why hasn't nominal-GDP targeting received more widespread support? The main issue is credibility.[14] Some analysts are concerned that future FOMCs may fail to follow through on promises of accommodation, while others fear that future FOMCs may back away from nominal-GDP targeting should it call for tighter policy than the current approach. To the extent that the public shares the former concern, an announced shift to nominal-GDP targeting would do little to accelerate the economy's recovery. To the extent that the public shares the latter concern, an announced shift to nominal-GDP targeting might be seen as a relaxation of the Federal Reserve's commitment to price stability rather than an enhancement to that commitment.


Tuesday, March 27, 2012

The Economy’s Great Fall: Are the Losses Permanent?

DeLong and Summers, the debate over potential output, and whether Bernanke has the courage, foresight, and persuasiveness to follow Greenspan's lead:

The Economy’s Great Fall: Are the Losses Permanent?

I wrote this before Bernanke's speech on the labor market on Monday. He says, echoing the topic of the column:

Is the current high level of long-term unemployment primarily the result of cyclical factors, such as insufficient aggregate demand, or of structural changes, such as a worsening mismatch between workers' skills and employers' requirements? ... I will argue today that ... the continued weakness in aggregate demand is likely the predominant factor.

So maybe the structural impediment, inflation hawk types at the Fed will be vanquished after all. We shall see. [See Tim Duy's comments on as well.]

Fed Watch: Bernanke, Bullard, and QE3

Tim Duy:

Bernanke, Bullard, and QE3, by Tim Duy: This morning Federal Reserve Chairman Ben Bernanke gave a speech that apparently was identified as proof that QE3 is still in the cards. He argues that while labor markets have shown improvement in recent months, conditions are far from normal. Moreover, he sees the problem of long-term unemployment as largely structural, and delivers what many believed to be the money quote:

I will argue today that, while both cyclical and structural forces have doubtless contributed to the increase in long-term unemployment, the continued weakness in aggregate demand is likely the predominant factor. Consequently, the Federal Reserve's accommodative monetary policies, by providing support for demand and for the recovery, should help, over time, to reduce long-term unemployment as well.

In my opinion, to interpret this as a call for additional quantitative easing is a bit of a stretch. It sounds like simply a confirmation that Bernanke believes the current policy stance is appropriate and that the existence of long-term unemployment should not be viewed as a reason to believe that we are closing in on a resource constraint that would necessitate a tightening of the policy stance. I was drawn to a much more nuanced section:

However, to the extent that the decline in the unemployment rate since last summer has brought unemployment back more into line with the level of aggregate demand, then further significant improvements in unemployment will likely require faster economic growth than we experienced during the past year. It will be especially important to evaluate incoming information to assess whether the recovery is picking up as improvements in the labor market feed through to consumer and business confidence; or, conversely, whether the headwinds that have impeded the recovery to date continue to restrain the pace at which the labor market and economic activity normalize.

In essence, Bernanke suggests that the recent rapid improvements in unemployment reflect largely a reversal of out-sized deterioration experienced during the recession. As such, we should not expect a slower pace of improvement given current growth forecasts. Under such conditions, I believe, Bernanke would push for another round of QE - although it stills begs the question of why he doesn't push for more now given the existing forecasts. But he hasn't, so we can only infer that he thinks the costs of additional easing outweigh the benefits.

He leaves open the possibility, however, that labor markets will continue to improve at the recent pace, in which I think QE3 is off the table. And that is where Federal Reserve President James Bullard steps in to the picture. He said pretty much the same thing in a CNBC interview:

"I think QE3 would require the economy to deteriorate somewhat from where it is right now," Bullard said. "The basic story on the U.S. economy is that we've had good news over the last six months or so, especially compared to the recession scenario that was being painted in the August-September time period of last year."

That said, this is somewhat softer language than he used in a speech last week:

But now, with the Committee on pause, it may be a good time to take stock of whether we may be at a turning point. Many of the further policy actions the Committee might consider at this juncture would have effects extending out for several years. As the U.S. economy continues to rebound and repair, those policy actions may create an overcommitment to ultra-easy monetary policy. The ultra-easy policy has been appropriate until now, but it will not always be appropriate.

The FOMC has often been criticized historically for overstaying policy stances that might have made sense at one juncture but are no longer appropriate as macroeconomic conditions change. This occurs in part because of the lags in the effects of policy, the difficulty in interpreting real-time data, much of which is subsequently revised, and the sheer uncertainty of macroeconomic developments. With numerous monetary policy actions still on the table, and others still affecting the economy with a lag, it may be especially difficult to remove policy accommodation at the appropriate pace and at the appropriate time. One may want to approach such a situation with caution.

This seems to suggest he is in fact entertaining the possibility that the turning point for policy will occur sooner than expected. My view is that the crux of any disagreement between Bullard and Bernanke is the timing of any tightening. Both would push for additional easing should conditions deteriorate. But Bernanke is willing to leave existing policy in place for well into the future, whereas Bullard is looking forward to pulling the trigger on tighter policy sooner than later.

This, by the way, is a debate Bernanke would win in the absence of clear indications that tightening is necessary.

Incredibly, in his CNBC interview, Bullard strays into the world of Japanese monetary policy:

"I think one of the biggest mistakes is continue to throw us much more in the way of monetary injections into the economy and with that, you get a much higher increase in commodity prices and potentially produce less global consumption across the world, which slows economic activity down," Bullard said. "I'm afraid that's the real danger just now - that we've maintained too loose of a policy right across the global economy and what results is inflation and reduction in real spending power."

I get this, I really do. But I have come to the conclusion that the Federal Reserve should not consider the reaction functions of other central banks when setting policy. Simply put, this is not the Fed's problem. To the extent that other nations import the Fed's monetary policy, they do so by choice. Bullard continues:

Bullard says he would like to see the Federal Reserve resume a "more normal monetary policy as soon as possible" because it has detrimental effects on the economy.

"It (the policy) punishes savers, for instance, in the economy, it does send a pessimistic signal about the economy and I think that can hurt investment prospects in the U.S.," Bullard said. "But we need to provide the right amount of support for the recovery as we do that, and we need to keep an eye on inflation."

Concerns that like the commodity price issue seem to mimic those of Bank of Japan Governor Masaaki Shirakawa. And we all know what about the wisdom of BoJ monetary policy.

Bottom Line: I do not think Bernanke's speech is a signal that QE3 is guaranteed. But it is a signal that QE3 is definitely not off the table. It is entirely data dependent. The current flow of data does not support additional action. I don't think it would take much of a deterioration to prompt additional action, so if you have a bearish view of the US economy, expect QE3. But if you have a bullish view, don't expect a rapid policy reversal. Bernanke isn't ready to go there.

Monday, March 26, 2012

Fed Watch: Lessons From Japan?

Tim Duy:

Lessons From Japan?, by Tim Duy: Via Mark Thoma, Robin Harding at the FT Money Supply blog reports on a speech given by Bank of Japan Governor Masaaki Shirakawa. The speech reportedly details the problems that emerge from aggressive monetary policy. I cannot find a link to the speech itself, but luckily the FT quotes key sections.

The first concern is two-fold:

Mr Shirakawa’s first point is that loose monetary policy mitigates the pain as households repair their balance sheets, but reduces their incentive to do so quickly, not just for the private sector but for governments as well. However, he also suggests that the effectiveness of loose policy may fall over time as households that weren’t damaged by the crisis bring forward such spending as they want to.

The first sentence sounds like a rehashing of the "liquidationist" approach. We should let the economy collapse rather than provide support during balance sheet adjustment. The second part suggests that there is only so much spending that can be brought forward via low interest rates. But I think this is not really a novel idea, as we pretty much know that the effectiveness of monetary policy fades at the zero bound:


In this case, I drew the LM curve as a (dotted) horizontal line at a positive zero interest rate, suggesting an economy at the zero nominal bound with deflation. Yes, the effectiveness of low interest rates waned as the zero bound was a approached. At this point, if the BoJ wanted to induce additional spending, they would need to make a credible commitment to a higher inflation target. In other words, the effectiveness of monetary policy did not fade unexpectedly - it is exactly what you would expect given the zero bound problem.

The second concern is that a low interest rate environment is hurting potential growth. This time, Shirakawa:

“If low interest rates induce investment projects that are only profitable at such interest rate levels, this could have an adverse impact on productivity and growth potential of the economy by making resource allocation inefficient. While central banks have typically conducted monetary policy by treating a potential growth rate as exogenously given, when the economy is under prolonged shocks arising from balance-sheet repair, we may have to take into account the risk that a continuation of low interest rates will affect the productivity of the overall economy and lower the potential growth rate endogenously.”

I don't think this makes any sense at all (neither does Harding). I could see a problem if low productivity projects are funded instead of high productivity projects, but presumably the latter would still be funded first in any event. In other words, I don't see that the low interest rate environment by itself would alter the composition of investment. And if we cut off funding for the less productive investments, the capital stock would grow more slowly, and that would certainly reduce potential growth. And note that this is separate from the worry that government investment is displacing private investment. Government investment is compensating for the lack of private investment. If anything, Japan needs lower real interest rates to support higher levels of private investment to lessen its dependence on fiscal deficits. And that too is another result of the zero bound problem.

The third concern is aptly handled by Harding:

Point three is the more standard argument that flattening the yield curve too far for too long will undermine the profitability of the financial sector.

Again, while I am sympathetic to the financial market consequences of low interest rate environments, the central bank is really just following the economy down. In the absence of sufficient economic activity to pull longer term rates up, if the Bank of Japan raised rates they would simply be inverting the yield curve - and I don't see that as positive for the financial sector.

The final concern is almost laughable:

“Even though such a rise in commodity prices is affected by globally accommodative monetary conditions, individual central banks recognise that the fluctuation in commodity prices is an exogenous supply shock and focus on core inflation rates which exclude the prices of energy-related items and food. The resulting reluctance of individual central banks to counter rising commodity prices, when aggregated globally, could further boost these prices. From a global perspective, such a situation represents nothing more than a case where a hypothetical “World Central Bank” fails to satisfy the Taylor principle, which ensures the stability of global headline inflation. While it is understandable that the central banks would pursue the stability of their own economies in the conduct of monetary policy, it is increasingly important to take into account the international spillovers and feedback effects on their own economies.”

First, Shirakawa is making the error of thinking the Federal Reserve targets core inflation. They do not, and they have made that clear. They target headline inflation, but use core-inflation as a guide as to the direction of headline inflation. Shirakawa implies that while core-inflation is tame, headline is running wild - and that simply is not true:


The path of headline inflation is actually on a lower trend compared to before the recession. Moreover, please explain how headline inflation is causing such a problem for the Bank of Japan:


Finally, as Harding notes, if you don't like US monetary policy, don't import it.
Bottom Line: I would be cautious about taking lessons from Shirakawa. The concerns about the low interest rate environment beg the still unanswered question: What is the alternative for monetary policy? To hike short term interest rates? It sounds like Shirakawas "concerns" are more excuses for an ongoing monetary policy failure on the part of the Bank of Japan.

Thursday, March 22, 2012

"The Macroeconomic Effects of FOMC Forward Guidance"

I've been trying to figure out whether the Fed's declaration that it would maintain exceptionally low rates through late 2014 represents a conditional or unconditional statement. That is, if the economy improves faster than expected, will the Fed raise rates prior to that time? Or will it honor this as a firm commitment that is independent of the actual evolution of the economy?

The statement clearly leaves wiggle room -- if the Fed wants out of the commitment the language is there. But I have the impression that the public views it as a firm, unconditional commitment and if the Fed backs away it will be seem as breaking a promise (i.e. lose credibility).

Apparently, I'm not the only one who is unsure about this. This is from Jeffrey R. Campbell, Charles L. Evans, Jonas D.M. Fisher, and Alejandro Justiniano (Charles Evans is the president of the Chicago Fed). They look at the effectiveness and viability of the two types of forward guidance, and conclude that a firm commitment with an escape clause specified as a specific rule (e.g. won't raise rates until until unemployment falls below 7% or inflation expectation rise above 3%) can work well:

Macroeconomic Effects of FOMC Forward Guidance, by Jeffrey R. Campbell, Charles L. Evans, Jonas D.M. Fisher, and Alejandro Justiniano, March 14, 2012, Conference Draft: 1 Introduction Since the onset of the financial crisis, Great Recession and modest recovery, the Federal Reserve has employed new language and tools to communicate the likely nature of future monetary policy accommodation. The most prominent developments have manifested themselves in the formal statement that follows each meeting of the Federal Open Market Committee (FOMC). In December 2008 it said "the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time." In March 2009, when the first round of large scale purchases of Treasury securities was announced, "extended period" replaced "some time." In the face of a modest recovery, the August 2011 FOMC statement gave specificity to "extended period" by anticipating exceptionally low rates "at least as long as mid-2013." The January 2012 FOMC statement lengthened the anticipated period of exceptionally low rates even further to "late 2014." These communications are referred to as forward guidance.
The nature of this most recent forward guidance is the subject of substantial debate. Is "late 2014" an unconditional promise to keep the funds rate at the zero lower bound (ZLB) beyond the time policy would normally involve raising the federal funds rate? ... Alternatively, is "late 2014" simply conditional guidance based upon the sluggish economic activity and low inflation expected through this period? ...
Our paper sheds light on these issues and the potential role of forward guidance in the current policy environment. Motivated by the competing interpretations of "late 2014," we distinguish between two kinds of forward guidance. Odyssean forward guidance changes private expectations by publicly committing the FOMC to future deviations from its underlying policy rule. Circumstances will tempt the FOMC to renege on these promises precisely because the policy rule describes its preferred behavior. Hence this kind of forward guidance resembles Odysseus commanding his sailors to tie him to the ship's mast so that he can enjoy the Sirens' music.
All other forward guidance is Delphic in the sense that it merely forecasts the future. Delphic forward guidance encompasses statements that describe only the economic outlook and typical monetary policy stance. Such forward guidance about the economic outlook influences expectations of future policy rates only by changing market participants views about likely outcomes of variables that enter the FOMC's policy rule. ...
The monetary policies elucidated by Krugman (1999), Eggertsson and Woodford (2003) and Werning (2012) rely on Odyssean forward guidance, and these have inspired several policy proposals for providing more accommodation at the ZLB. The more aggressive policy alternatives proposed include Evans's (2012) state-contingent price-level targeting, nominal income-targeting as advocated by Romer (2011), and conditional economic thresholds for exiting the ZLB proposed by Evans (2011). These proposals' benefits depend on the effectiveness of FOMC communications in influencing expectations. Fortunately, there exists historical precedent with which we can assess whether FOMC forward guidance has actually had an impact. The FOMC has been using forward guidance implicitly through speeches or explicitly through formal FOMC statements since at least the mid-1990s. Language of one form or another describing the expected future stance of policy has been a fixture of FOMC statement language since May 1999. The first part of this paper uses data from this period as well as from the crisis period to answer two key questions. Do markets listen? When they do listen, do they hear the oracle of Delphi forecasting the future or Odysseus binding himself to the mast?
Our examination of whether markets are listening to forward guidance builds on prior work... We find results that are similar to, if not even stronger than, those of Gurkaynak et al. (2005). That is, we confirm that during and after the crisis, FOMC statements have had significant affects on long term Treasuries and also corporate bonds and that these effects appear to be driven by forward guidance.
Studying federal funds futures rates during the day FOMC statements are released identifies forward guidance, but does not disentangle its Odyssean and Delphic components. ... To answer our second key question, we develop a framework for measuring forward guidance based on a traditional interest rate rule that identifies only Odyssean forward guidance. ... We highlight here two results. First, the FOMC telegraphs most of its deviations from the interest rate rule at least one quarter in advance. Second, the Odyssean forward guidance successfully signaled that monetary accommodation would be provided much more quickly than usual and taken back more quickly during the 2001 recession and its aftermath. Overall, our empirical work provides evidence that the public has at least some experience with Odyssean forward guidance, so the monetary policies that rely upon it should not appear entirely novel.
The second part of the present paper investigates the consequences the Odyssean forward put in place with the "late 2014" statement language. On the one hand this language resembles the policy recommendations of Eggertsson and Woodford (2003) and could be the right policy for an economy struggling to emerge from a liquidity trap. On the other hand there are legitimate concerns that this forward guidance places the FOMC's mandated price stability goal at risk. We consider the plausibility of these clashing views by forecasting the path of the economy with the present forward guidance and subjecting that forecast to two upside risks: higher inflation expectations and faster deleveraging. ...
Evans (2011) has proposed conditioning the FOMC's forward guidance on outcomes of unemployment and inflation expectations. His proposal involves the FOMC announcing specific conditions under which it will begin lifting its policy rate above zero: either unemployment falling below 7 percent or expected inflation over the medium term rising above 3 percent. We refer to this as the 7/3 threshold rule. It is designed to maintain low rates even as the economy begins expanding on its own (as prescribed by Eggertsson and Woodford (2003)), while providing safeguards against unexpected developments that may put the FOMCs price stability mandate in jeopardy. Our policy analysis suggests that such conditioning, if credible, could be helpful in limiting the inflationary consequences of a surge in aggregate demand arising from an early end to the post-crisis deleveraging.

Wednesday, March 21, 2012

Fed Watch: On Straw Men

Tim Duy:

On Straw Men, by Tim Duy: Arnold Kling claims I am using a straw man:

Recently, bloggers have been talking about potential output or potential GDP. I find the discussion to be frequently misleading. For example, Mark Thoma quotes Tim Duy:

If we claim the economic potential of the nation has declined - that in aggregate, we can not make as much stuff as we did a few years ago...

But nobody claims that. The pessimists on potential output only claim that it is growing below some previous trend. They never claim that it has declined in absolute terms.

I refer Kling to St. Louis Federal Reserve President James Bullard:

The wealth shock view puts a different expectation in play. The negative wealth shock lowers consumption and output. But after the recession ends, the economy simply grows from that point at an ordinary rate, neither faster nor slower than in ordinary times. It is more like an earthquake which has left one part of the land higher than another part. There is no expectation of a “bounce back” to a higher level of output after the recession ends. This is closer to what has actually happened since mid-2009. Output has grown at a moderate rate, but not a rapid rate, since the recession ended.

Read carefully: " an earthquake which has left one part of the land higher than another part." (Side note: I kind of like that simile). He is clearly saying that the 5% drop in output during the recession was a permanent shift. Unless you really believe that potential GDP was overestimated by 5% - in which case we would expect inflation to have been much higher than actually experienced - the only reasonable conclusion is that at least one person believes that in fact potential GDP declined in absolute terms during the recession.

Also refer to Grep Ip:

You don’t need to be a supply sider to believe that potential has fallen; you could equally worry that actual output has been depressed for so long, that hysteresis has set in and dragged potential down with it.

He proceeds with charts of GDP for Sweden and Korea, both of which reveal what are interpreted as downward shocks to the absolute level of potential output. And note, I don't ignore the possibility that Ip is in fact correct - the failure to respond with significant force to the recession may very well have allowed cyclical issues to fester into structural ones. And this is even more likely if Bullard's position is widely adopted by policymakers such that they actively manage the economy along the new trend. In such a case the hysteresis can be the result of a self-fulfilling prophesy. If we deliberately keep people unemployed, they will eventually become structurally unemployed or exit the workforce.

I don't in any way disagree that the rate of potential output growth may be slower than prior to the recession, thus estimates of the output gap might be lower than those currently available. But there is indeed another concern that there has been a negative shock to (long run) potential output in absolute terms.

Tuesday, March 20, 2012

Fed Watch: Fed Still Lowering Potential Output Growth Estimates?

Tim Duy:

Fed Still Lowering Potential Output Growth Estimates?, by Tim Duy: While financial market participants continued to sell Treasury bonds thinking that the Fed is out of the game, New York Federal Reserve President WIlliam Dudley gave no indication to suggest that either QE3 was off the table or just around the corner. Still, he was clearly concerned that the recovery is more fragile than the data would have us believe, suggesting that he would leap relatively quickly into additional easing if the economy faltered.

While Dudley certainly did not ignore the improved tenor of economic data in recent months,

The incoming data on the U.S. economy has been a bit more upbeat of late, suggesting that the recovery may be finally establishing a somewhat firmer footing.

he also suggested caution:

While these developments are certainly encouraging, it is far too soon to conclude that we are out of the woods. To begin with, the economic data looked brighter at this point in 2010 and again in 2011, only to fade as we got into the second and third quarters of those years.

In particular, he pointed to the moderate weather as a factor in the recent numbers:

Moreover, the United States has experienced unusually mild weather over the past few months, with the number of heating degree days in January and February about 17 percent below the average of the preceding five years. While this reduces the amount that households and businesses must spend for heating, I suspect that it temporarily boosts economic activity overall.

In the question and answer period (via the WSJ), Dudley commits to nothing but a data dependent policy:

Dudley was asked by an audience member what he expects will be the future path of interest rates. “We will continue to assess what’s appropriate” for monetary policy, he answered, saying “if the economy were to change in a meaningful way, obviously we’d change” the current plans for interest rates and other stimulus efforts.

Specifically on QE3, via Reuters:

"Nothing has been decided," he said of QE3, in which the Fed would make large-scale asset purchases in an attempt to lower rates and give the economy another controversial shot of adrenaline.

"It all depends on how the economy evolves," Dudley added. "It's about costs and benefits, and if we get to a point where we think the benefits of another program of QE outweigh the costs, then we'll certainly do so."

More interesting, in my view, were his comments on potential growth:

To put the recent pace of growth into perspective, we believe that the economy's long-run sustainable growth rate (what economists call the potential growth rate) is around a 2 1/4 percent annual rate. We need sustained growth above that rate to absorb the substantial amount of unused productive capacity. Thus, our recent growth rates are barely keeping up with our potential.

The 2.25% rate caught my eye, as it was slightly below the 2.3-2.6% range for longer term growth in the most recent Fed projections. And that itself was a downgrade from the 2.4-2.7% November projection.

At this point, it becomes a little tricky:

Although the sharp decline in the unemployment from 9 percent last September to 8.3 percent in February suggests we are doing better than that, it is important to recognize that about half of that decline was due to a declining labor force participation rate. In fact, had the labor force participation rate not declined from around 66 percent in mid-2008 to under 64 percent in February, the unemployment rate would still be over 10 percent.

So half the decline in the unemployment rate since last September was due to falling labor force participation, while the other half was the result of growth slightly above potential. GDP growth in the second half of last year averaged 2.4%, slightly above Dudley's estimate of potential GDP, and enough to bring down unemployment somewhat.

Looking back to what Dudley said last November:

After a very weak first half, when GDP growth was less than 1 percent, economic activity has strengthened somewhat and inflation pressures are starting to ease. Growth in the third quarter is currently estimated to be 2.5 percent, and recent indicators suggest growth in the fourth quarter could be somewhat higher...However, as we look toward 2012, the U.S. economy continues to face several obstacles to a robust recovery. Accordingly I expect growth of about 2.75 percent for 2012...One summary statistic says it all—the unemployment rate is unacceptably high at 9 percent. Given my outlook, the decline of unemployment over the next year is likely to be modest...To sum up, growth has picked up modestly in the second half of 2011, but not enough to bring unemployment down.

Last fall, Dudley thought that growth somewhat above 2.5% would not bring unemployment down, while 2.75% would only have modest impacts. That suggests an estimate of potential growth around 2.6-2.7%. Now we only need to cross the 2.25% mark to bring unemployment down. That is a fairly rapid adjustment, and not just due to slower labor force growth:

Also, it appears that productivity growth has slumped recently. Although that means that a given amount of growth translates into bigger employment gains, it certainly is not an unmitigated good development.

This isn't sounding so good - growth is weak, but the hurdle is lower. Does this mean that Dudley is less dovish than widely suspected? I don't think so. Another excerpt from Dudley's speech today:

More importantly, real economic activity has yet to be strong enough on a sustained basis to make a big dent in the overall amount of slack in the U.S. economy. While it is true that growth was stronger in the fourth quarter, most of that growth was due to inventory accumulation. Growth of final sales was actually quite weak. Historically, a quarter in which inventory investment makes a significant growth contribution is typically followed by a quarter in which that growth contribution is modest or even negative. That appears to be what is shaping up for the first quarter of this year.

This I find just plain irritating, as it sure sounds like he is saying that even though potential output growth has slowed, the existing gap remains unacceptably wide. If so, why is a policy change dependent on incoming data as he says in the Q and A? This is somewhat more amazing given his lack of faith in the quality of the recovery:

Based on available data, current expectations are that real GDP will expand at around a 2 percent annual rate during the first quarter of 2012. Despite the increase of light vehicle sales, overall consumer spending has been sluggish. While growth of retail sales in February was reasonably strong in nominal terms, it was considerably less impressive when the large increase of gasoline prices that occurred that month is taken into account. Based on data for the first half of March, gasoline prices are continuing to move higher which will further sap consumers' real purchasing power. And growth of business investment spending, which was quite strong in the second and third quarters of 2011, entered the new year with little forward momentum.

Not exactly a resounding endorsement of the economy. Sounds like he views the downside risks as the greater concern. But apparently not enough that the costs of additional easing (which I think amounts to the perception that QE is an inflationary nightmare waiting to happen) outweigh the benefits.

Bottom Line: Dudley presents a rather sober view of the US economy - signs of life are hopeful, but he isn't counting on their sustainability in any way, shape, or form. His estimate of potential output growth is falling, but the existing gap remains wide. The gap coupled with his obvious lack of enthusiasm for the quality of the recovery should point him in the direction of QE3 sooner than later. But there is nothing to suggest that such a move is imminent barring a deterioration of the data - he seems to make this clear in the Q&A. He seems ready to stick with the wait and see approach to policy, possibly because the declining potential growth rate makes him somewhat concerned the output gap could close faster than he would expect. But it sure doesn't sound like it would take too much disappointment in the days ahead to push him to support going back to the monetary well for another round of easing.

Monday, March 19, 2012

Fed Watch: The Output Gap Debate Continues

Tim Duy:

The Output Gap Debate Continues, by Tim Duy: The blogoshpere witnessed some additional contributions to the output gap debate this weekend. Greg Ip offers up the possibility that potential output, both level and trend, are much lower than previously imagined. Karl Smith responds with what I believe is an important point:

I’d, however, encourage everyone, as well, to think of the disaggregated story that we are telling here. If trend GDP is overstated, then we are arguing that one or more sectors of the US economy will is less capable of producing output over the next decade or so, than we would have otherwise thought.

Smith suggests we focus on the construction of housing, hospitals and medical facilities, public infrastructure, and transportation equipment. He concludes:

So, if we think these things will repair themselves then we have an obvious path back to trend.

and then extends:

I don’t want to get too invested in this but a cursory look at the data suggests that GDP is likely to grow above trend in the coming years because two very high productivity export sectors are expanding – computers and gasoline and distillates.

What I like in Smith is the more careful consideration of the structural change story. If we claim the economic potential of the nation has declined - that in aggregate, we can not make as much stuff as we did a few years ago - we need to identify what stuff isn't being made, why it isn't being made, why we don't think it should be made, and why no other sectors are growing to compensate for those in decline.

Mark Thoma makes an important contribution to the debate by identifying a short-run path for potential output:

Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, idle equipment, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.

Mark notes, however, that policy makers should not focus too intensely on short-run potential output because capacity will grow as the economy recovers. In other, don't confuse a temporary decline in potential with a permanent decline. Mark extends this to an explanation for relatively stable inflation during the recession.

That said, Ip does note that a permanent - or at least very persistent - drop in labor force participation rates could cause at least some downward shift in potential output, with a story that in aggregate we cannot make as much as before because we lack sufficient labor, although here too there should be sector specific impacts similar to Smith's critique (unless all sectors lost access to a more or less proportionate share of labor). And Ip also raises the somewhat different issue of the path of potential output going forward - a decline in both productivity and labor force growth implies a lower path forward, although would not explain a sharp drop in the past.

Finally, I find Felix Salmon's explanation for fall in potential GDP less compelling:

In other words, in order to keep up a steady rate of GDP growth, we had to saddle ourselves with ever more cheap and dangerous debt.

Then, suddenly, the growth of the credit markets screeched to a halt, and we had a major recession. And since then, the size of the credit market has been roughly flat.

It makes sense that if we needed ever-increasing amounts of debt to keep up that long-term GDP growth rate, then when the growth of the debt market stops, our potential growth rate might fall significantly.

Salmon is telling a story about this chart (although he actually uses what I believe is a more difficult chart):


Smith responds by noting this is really a story about mortgage debt, with the first run-up being a natural consequence of the Volker Disinflation and the second being the housing bubble, which Smith views as largely an internal transfer of wealth.

My additional criticisms of Salmon approach is that is seems primarily a demand side story to a supply-side question. Presumably, all of the productive resources (or nearly all of them, allowing for some hysteresis effects) still exist. The debt is just plumbing in the background that helps support the demand for those resources. So Salmon's story just collapses down to an aggregate demand shortfall that really has nothing to do with potential output.

Moreover, Salmon ignores the assets on the other side of the debt. We really need to look at some story about net worth:


Here again I think you are fundamentally telling a demand side story to explain the past two business cycles - both were dependent on asset price bubbles to hold output at potential (or even slightly above at the peaks). Why did the US become dependent on these bubbles? Here I tend to find the global saving glut story compelling. A combination of aging developed economies combined with the high savings propensities of primarily Asian central banks has pushed the equilibrium real rate into negative territory, below that attainable given the zero bound and low inflation expectations. Absent an asset bubble to compensate by adding wealth-effect induced aggregate demand, we are left with a savings-investment imbalance that becomes evident as a subpar equilibrium level of output.

I still believe that primarily we are looking at an aggregate demand shortfall rather than a collapse of potential output, but would agree that only one thing is for sure: That we haven't seen the end of this debate.

Sunday, March 18, 2012

The Gap In Monetary and Fiscal Policy

One of the big questions for policymakers is how much of the current downturn represents of temporary cyclical fluctuation and how much of it is a permanent reduction in out productive capacity. If the downturn is mostly temporary, then we will eventually bounce back to the old output trend line. Something like this:


But if it's mostly permanent, i.e. if the trend has fallen to a lower value and will stay there, then the picture is different:


In the first case, highly stimulative policy is appropriate to help the economy get back to the long-run trend as soon as possible. There's still a lot of ground to cover, and policy can help. But in the second case the economy is already back to it's long-run trend at most points in time, or nearly so, and there is no need for policymakers to do much of anything at all. At least that's what we're told.

However, I think this misses part of the story. What it misses is that AS shocks themselves can be both permanent and temporary, and some people may be confusing one for the other. For example, when there as a large AD shock in the form of a change in preferences, say that people no longer like good A as it has gone out of fashion and have now decided B is the must have good, then there will be high unemployment in industry A and excess demand for labor and other resources in industry B. As workers and resources leave industry A, our productive capacity falls and it stays lower until the workers and other resources eventually find their way into industry B. When this process is complete, productive capacity returns to where it was before, or perhaps goes even higher. Thus, there is a short-run cycle in productive capacity that mirrors the business cycle.

Even a standard business cycle type AD shock will temporarily depress capacity and produce similar effects. Suppose that interest rates go up, taxes go up, government spending goes down, investment falls --pick your story -- causing aggregate demand to fall. When, as a result, businesses lay people off, idle equipment, etc., productive capacity will fall. It can be cranked up again, and will be when the economy recovers, but rehiring labor and taking equipment out of mothballs takes time. In the interim the natural rate of output falls and, just as with a change in the preference for good A versus good B, a negative aggregate demand shock can cause "frictions" on the supply side that temporarily increase the natural rate of unemployment. And there are many other ways this can happen as well.

The point is that there can be short-run cyclical AS effects, and failing to account for these can lead to policy errors. Consider the following diagram:


Up until the point where the line splits into three pieces, assume the economy is in long-run equilibrium with output at the natural rate (we can discuss whether the natural rate actually exists another time, I want to work in the standard model for the moment since that is where the policy discussion is centered). Then, for some reason, aggregate demand falls leading the economy into a recession. As AD falls, people are laid off, equipment is stored, factories are shuttered, and so on and the economy's capacity to produce falls in the short-run as shown by the blue line on the diagram.

But this is a temporary, not a permanent situation. Eventually people will be put back to work, trucks in parking lots will be back on the road, factories will reopen -- you get the picture -- and productive capacity will grow as the economy recovers. I believe many people are treating what is ultimately a temporary fall in capacity as a permanent change, and they are making the wrong policy recommendations as a result.

In fact, there's no reason to think productive capacity can't return to its long-run trend just as fast or faster than output can recover. If so, then it would be a mistake to do as many are doing presently and treat the blue short-run y* line as a constraint for policy, conclude that the gap is small and hence there's nothing for policy to do. Capacity will recover, and policymakers must take this into account when looking at whether additional policy can help the economy. If capacity can grow fast as the economy recovers, then it poses little constraint and policymakers should try to return us to the long-run trend as soon as possible. That is, aggressive policy is still called for even if productive capacity is presently relatively low.

And even if the economy can recover faster than productive capacity can return to its long-run trend, i.e. actual output can "catch" the blue line before it reaches the dotted long-run y* line, it would still be wrong for policymakers to treat the value of productive capacity today is a constraint. Since short-run y* is cycling back to trend, and since it takes time for policy to work, policymakers are shooting at a moving target (a target that might move even faster with effective stimulus). And in any case, there's nothing wrong with catching short-run y* as soon as possible -- in fact that's desirable.

The fear, of course, is that once the economy catches short-run y*, trying to push beyond that constraint would be inflationary. Some argue we are close to that situation already, and additional policy could well cause prices to increase, but I just can't see significant inflation risks at the present time, in part because of my differing views on where the recovery of capacity.

Finally, the discussion about inflation brings up another point. One of the puzzles in the macroeconomic literature about business cycles is that prices don't move anywhere near as much as a gap analysis implies they should. But the gap used in this analysis of often the distance between long-run potential output and actual output (i.e. the difference between the dotted line and the solid black line in figure 1 or figure 3). But if price pressure depends upon the gap between short-run capacity and actual output (the blue and black lines), as you would expect it would, and if output and short-run capacity co-vary positively after a shock (I gave reasons above why this could happen), then the gap and hence prices could be relatively constant throughout the cycle. The gap between the blue and black lines doesn't change much and hence inflation doesn't change much either.

One last point about the diagram. I drew the long-run line so there is a long-run decline in the trend of our productive capacity after the recession (i.e. a permanent shock). However, it's hard to see because, consistent with my beliefs, I do not think the change in our long-run capacity to produce goods and services will be as negative as many others. So the effect is not large in the diagram (I acknowledge I'm more optimistic on this point than many others that I respect). But even if the long-run trend had fallen by more than shown in the diagram, say by 50%, the points above would still hold. If the capacity to produce recovers as the economy recovers, and does so relatively fast, then policymakers should not be constrained by the belief that the natural rate of output is relatively low at the present time. Aggressive policy is still the best course of action.

Thursday, March 15, 2012

Testing the Inflation "Floodgates"

Simon Wren-Lewis on fear of inflation:

The inflation floodgates, mainly macro: Mark Thoma bemoans the attitude of inflation hawks on the FOMC (the US equivalent of the Bank’s Monetary Policy Committee). He writes “Unfortunately, the hawks on the committee seem to be afraid that if they allow inflation to creep up even a little bit over their long-run target, the inflation flood gates will open and they won’t be able to help themselves from a repeat of the 1970s.” From this profile by Roger Lowenstein, the floodgates view may not be confined to the hawks (HT Karl Smith). It occurred to me that we have just had a little experiment in the UK to test this floodgates view, and it looks like being completely rejected. ...[continue reading]...

Robert Waldmann also comments.

Wednesday, March 14, 2012

Fed Watch: FOMC Recap

Tim Duy:

FOMC Recap, by Tim Duy: The FOMC met today, and delivered the widely expected result of no policy shift. Wait and see mode continues. Arguably, the statement has a slightly hawkish tinge compared to the January statement in that it recognizes the improve flow of data and reduced financial strains. Most of the action is in the second paragraph. The growth/employment sentence (perhaps we should call this the Okun's Law sentence?) from January:

The Committee expects economic growth over coming quarters to be modest and consequently anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate.

morphed into:

The Committee expects moderate economic growth over coming quarters and consequently anticipates that the unemployment rate will decline gradually toward levels that the Committee judges to be consistent with its dual mandate.

"Modest" growth became the more optimistic "moderate" growth, suggesting some more certainty in the outlook, downgrades to Q1 forecasts notwithstanding. Also, the modifier "only" before "gradually" disappeared - a very slight positive shift. Fears of a European collapse shifted from:

Strains in global financial markets continue to pose significant downside risks to the economic outlook.


Strains in global financial markets have eased, though they continue to pose significant downside risks to the economic outlook.

I find this sentence interesting given the relative calm in financial markets, both here and across the Atlantic. The Fed, it appears, is less confident than their European counterparts that the crisis has been brought to a halt once and for all. Finally, the inflation outlook, which was:

The Committee also anticipates that over coming quarters, inflation will run at levels at or below those consistent with the Committee's dual mandate.


The recent increase in oil and gasoline prices will push up inflation temporarily, but the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate.

The Fed did recognize the impending rise in headline inflation, but wisely emphasized its temporary nature and thus reaffirmed their view that inflation would remain contained. This is also reiterated in the first paragraph where they noted stable inflation expectations. We will see headline inflation rise, but no need to panic. Nothing to see here, move along.

I see this statement as a double-edged sword. On one hand, the improved economic outlook argues against additional easing. Unless the unemployment rate starts trending sideways or inflation takes a downward turn, it is hard to see the Fed advancing with plans for additional easing. That said, they are making an effort not to suggest a tightening is imminent. They do not overemphasize the improvements in recent data, nor do they suggest that energy prices should be a concern. And, despite Richmond Federal Reserve President Jeffrey Lacker's objection, they did not retreat from their expectation that rates will remain low though at least late 2014. This is important, as a commitment to low rates would have more of an effect when there exists upward pressure on interest rates, as opposed to being simply another confirmation that the economy is operating at a decidedly sub-par equilibrium. Moreover, they telegraphed that additional easing is still a possibility, indicating that tightening is not the only game in town. Perhaps they have learned a lesson from last year's turn toward hawkishness in the spring.

Bottom Line: The Fed isn't ready to ease further, but isn't ready to tighten either. If you are looking for the Fed to leverage the current momentum with another blast of easing in an effort to lift us well clear of the lower bound, you are likely to remain disappointed. But at least you can find some comfort, however small, in their obvious effort to make clear they remain far from taking a more hawkish turn anytime soon.

Tuesday, March 13, 2012

Can the Doves Cage the Hawks?

What I think the Fed should do:

Can the Doves Cage the Hawks?

Why does overshooting the inflation target in the short-run induce such fear in so many members of the Fed's monetary policy committee?

Monday, March 12, 2012

Stiglitz: The US Labor Market is Still a Shambles

Joe Stiglitz:

The US labour market is still a shambles, by Joseph Stiglitz, Commentary, Financial Times: It is understandable, given the number of times green shoots have been seen since the downturn began in December 2007, that there might be some skepticism about claims the recovery is finally under way. To me the question is what does it imply for policy? Does it mean we can be more relaxed about the demands for budget cuts emanating from fiscal conservatives? Or that the US Federal Reserve should start paying more attention to inflation, and begin contemplating raising interest rates? Even if this is not one of the many green shoots that soon turn brown, the economy will almost certainly need more stimulus if it is to return to full employment any time soon.
This is the inevitable conclusion from looking at the state of the labour market today. It is a shambles. ...
Today the American economy faces three big risks. First, a steeper European downturn, as a result of the excessive austerity and the euro crisis. Second, complacency that the economy will recover quickly without government support. Though every downturn comes to an end, that should not be of much comfort. Third, that we accept that an unemployment rate above 7 per cent is inevitable.
If my Cassandra forecast turns out to be wrong, stimulus can be cut. But if it turns out to be right, and we do too little, we will live to regret it.

I hope you know by now that I agree.

Friday, March 09, 2012

Fed Watch: Another Positive Employment Report

I missed this post from Tim Duy earlier today:

Another Positive Employment Report. by Tim Duy: It is increasingly difficult if not impossible to deny the real improvements in labor markets in recent months. First, the ongoing declines in initial jobless claims clearly suggested the recovery was gaining depth and sustainability:


Then comes the February employment report along with upward revisions to the December and January numbers:


Nonfarm payroll gains are averaging a solid 245K per month over the last three months. Does this mean the Federal Reserve can pull back on the throttle? No, although I am sure you will hear the more hawkish policymakers using this report as evidence that policy reversal will happen sooner than markets anticipate. To be sure, that may still turn out to be true, but this data still reveals the depth of the hole left behind by the recession. But he majority of the FOMC will notice the stagnant unemployment rate (8.3%), a consequence of a small gain in labor force participation. If labor force participation rates begin to rebound, the improvement in the unemployment rate will stall, and the Fed could find itself willing to ease again later this year as suggested in this week's well documented Wall Street Journal article.
Moreover, note that wage gains remain anemic, both for all workers:


and for non supervisory and production workers:

The lack of substantial wage gains, combined with relatively low labor force participation rates suggests that we still have a long way to go before labor markets normalize:


Of course, if labor force participation rates stagnate while job growth continues unabated, the Fed will find themselves facing a more rapid drop in unemployment. That would certainly take QE3 off the table, and turn attention back to the timing of the next tightening cycle. This is not my expectation, but it certainly bears watching.
Bottom Line: Another good report, although still suggestive of the beginning of recovery. In my mind, true recovery will come when the cyclical declines in labor force participation are further reversed. At this point, there is no reason for the Fed to pull their foot off the gas. On net though, the employment report does push back the timing of any additional easing. The Fed will move to the sidelines while policymakers assess the level of slack in labor markets. If the cyclical downturn resulted in sustained structural damage, there may be little slack. But if an influx of returning workers puts a floor under the unemployment rate, the Fed will have more work still to do.

Thursday, March 08, 2012

The Fed's Latest Plan to Boost the Economy

I have an explanation of the sterilized bond purchases the Fed is considering, and how this differs from "operation twist":

The Fed's latest plan to boost the economy

The Fed is still unduly afraid of inflation and that is limiting its options.

Wednesday, February 29, 2012

Has the Fed Learned Its Lesson?

I have been pretty critical of the Fed throughout the crisis. I still don't think policy is aggressive enough, and the Fed has been behind the developments in the economy due to its propensity to see green shoots that aren't actually there. But at least it's leaning in the right direction:

Has the Fed Learned Its Lesson?, Mark, Thoma, CBS News: COMMENTARY Federal Reserve Chairman Ben Bernanke seems to have learned an important lesson. In his appearance before House Committee on Financial Services, Chairman Bernanke said the monetary policy committee does "not anticipate further substantial declines in the unemployment rate over the course of this year. Looking beyond this year, FOMC participants expect the unemployment rate to continue to edge down only slowly toward levels consistent with the Committee's statutory mandate." In addition, "participants agreed that strains in global financial markets posed significant downside risks to the economic outlook." There were other cautionary statements as well.

That is quite a change from Bernanke's pronouncement that the Fed was seeing "green shoots" in the economy back in 2009, and similar optimistic statements about the prospects for recovery many times after that. Time and again, however, the green shoots withered and policy ended up in catch up mode rather than out in front of the economy as it ought to be. Policymakers were consistently behind.

I don't think either monetary or fiscal policymakers have been aggressive enough throughout the crisis, and I have also worried that policymakers in Congress and at the Fed would withdraw support for the economy too soon and harm the recovery. There's little chance that policy will march the aggressiveness I believe is called for, especially this late in the game, and I'm still very worried about Congress turning to budget balancing before the economy is ready to handle it. Premature austerity could damage our recovery prospects.

But I'm becoming less concerned that the Fed will withdraw support too soon. It has committed to keeping interest rates low through the end of 2014, an extension of an earlier commitment through mid 2013. However, the commitment has wiggle room, and there are voices on the Fed who are calling for interest rate increases now. But as Chairman Bernanke made clear today, the Fed as a whole remains cautious and monetary policymakers as a whole are not ready to conclude our troubles are over. I think that's exactly the right stance to take -- hope for the best, but prepare for the worst. In the past the Fed let its hopes interfere with its preparation, but this time does indeed appear to be different.

Monday, February 27, 2012

Fed Watch: Oil Prices - It's What Everyone is Talking About

Tim Duy:

Oil Prices - It's What Everyone is Talking About, by Tim Duy: Via Ryan Avent, Matt Yyglesias opines on the link between oil prices and monetary policy:

But it looks to me as if a demand-side oil issue is really just the same old issue of the trade deficit and the international balance of payments and not the second coming of a 1970s-style oil price shock. Perhaps it's a monetary policy issue. We send dollars abroad in exchange for oil, but then the dollars get sent back in exchange for bonds. That ought to lower interest rates and induce investment in the United States, but nominal interest rates are already at zero so the loop is cut. Even so, higher gas prices should push the price level up which pushes real interest rates down which induces investment in the United States. The chain will only be broken here if the Fed decides to ignore its own self-guidance and target headline inflation instead of core inflation.

There is a lot going on in these few sentences, but I am going to focus on the last two lines. As a point of clarification, the Fed does not target core inflation. Refer to the Fed's freshly printed statement on long-run goals and strategy:

The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

That's headline inflation, not core inflation. Of course, there is a near-term focus on core inflation, but not as a target, but as a guide to the path of headline inflation. Monetary policymakers should be wary about overreacting to movements in headline inflation if they are not evident in core inflation.

Consider also that the Fed is setting inflation expectations at 2 percent. Technically, expected, not current, inflation should be a determinant of investment spending. Which means that a spike in headline inflation should not stimulate investment spending via this channel assuming inflation expectations remain anchored. And, at this point, inflation expectations appear anchored:


Still below what we saw last spring. To be sure, we could see inflation expectations edge up, but anything significant would draw the attention of the Federal Reserve. I think they are pretty serious about that 2 percent target. In other words, I would be cautious about reading too much into a drop in ex-post real interest rates due to a rise in energy costs.

Note that this is a criticism of Fed policy at the zero bound, that by locking in inflation expectations at 2 percent they have effectively placed their most powerful remaining policy tool off-limits.

I could imagine that higher-gas prices induce additional investment via some other mechanism, such as increased purchases of energy efficient machinery, etc. But this would not necessarily be a sufficient offset to other, negative impacts of higher energy prices.

In any event, we are all struggling to extract a signal from the data - is this primarily a "good" shock that indicates improving global activity, or a "bad" shock due to a supply constriction? Arguably, both factors are at play - see Jim Hamilton here. Putting aside the possibility of a bad shock for the moment (I think we all agree that a supply disruption stemming from a conflict with Iran would be fairly negative, especially for Europe), I tend to see the challenge in terms similar to this from Reuters:

Looking past the near-term uncertainty surrounding Iran, Andrew Sentance, a former member of the Bank of England's Monetary Policy Committee, said high and fluctuating prices for energy were part of a "new normal" economic climate in which Asia is the main engine of global growth.

Periodic bursts of inflation would add to the volatility of what was likely to be disappointing growth in the West for quite some time, according to Sentance, a senior economic adviser to PricewaterhouseCoopers, an accounting and advisory firm.

"This strong growth in Asia and other emerging markets is putting considerable pressure on markets for energy and other commodities and that is one of the reasons why we are finding growth so difficult to achieve," he told a conference organized by the Institute of Economic Affairs, a free-market think tank in London.

"That's not just a short-term phenomenon. It's a secular issue that's going to persist through the middle of this decade," he said.

Even if higher oil prices are a symptom of improving global growth (a "good" shock) and do not trigger a US recession, they will certainly place some additional strain on US household budgets, which will in turn depress growth relative to what it would have been in the absence of the higher oil prices (consider instead the relatively low and stable prices of oil during much of the US boom during the 1990s). In effect, we could be running up against a global bottleneck that places something of a speed-limit on US (and global) growth.


As to the international finance story Yglesias tells, I think this does come back to a monetary policy story, but I think the direction might be backwards. I am still working this one out:

Yglesias is telling a story of recycling petro-dollars. In order to finance a given level of trade deficit, the dollar outflow must be recycled back into the US economy as a dollar inflow that supports some type of domestic absorption. I shy away from using the term "investment" strictly as it could support government spending or even consumption spending (think of households borrowing against home equity to buy a boat). If foreigners don't not want to recycle their dollars back into the US economy via financial inflows, the value of the dollar falls to stimulate exports and deter imports, thus improving the external deficit.

Now, to Yglesias' point, we may have something of an interesting situation whereby foreign investors find themselves holding dollar assets as cash or near-cash equivalents (low yielding Treasuries). And unless the federal government utilizes that potential via expanded borrowing (note that in the private sector, savings exceeds investment already), little additional demand is supported. Now it is interesting that foreign investors would prefer to hold relatively low-yielding assets rather than using their dollars to purchase US goods and services, but such is the outcome of so many dollars being held for central banks around the world.

As Yglesias' says, the "loop" is cut, but not necessarily because of the zero bound, but by the global demand for dollars, which arguably is the cause of the zero bound. Which then does brings us back to Yglesias' point that this is a monetary policy issue - policymakers could more actively drive down the value of the dollar by raising inflation expectations, thus making it increasingly unattractive for foreigners to hold cash or cash equivalents, and force the funds into either demand for US goods and services or investment goods. Certainly, however, policymakers would view this as a risky strategy, and thus have not gone down this road.

Thursday, February 23, 2012

Strategic Forecasting at the Fed

Minimizing the forecast error, i.e. providing the best possible forecast of future variables such as output, inflation and employment, does not appear to be the main goal of some members of the Fed's monetary policy committee. Instead, the forecasts appear to be set strategically in an attempt to influence policy decisions:

Federal Open Market Committee forecasts: Guesses or guidance?, by Peter Tillmann, Vox EU: On 25 January 2012, the Federal Open Market Committee (FOMC), the decision-making body of the US Federal Reserve, took yet another step towards higher transparency of US monetary policy. Besides publishing the usual set of macroeconomic forecasts, the FOMC for the first time also published the interest-rate projections formulated by its members...
A week later ... Richard W Fisher, president of the Federal Reserve Bank of Dallas ... argued that “at best, the economic forecasts and interest-rate projections of the FOMC are ultimately pure guesses”. Furthermore, he said that “forecasts issued by the FOMC are tactical judgments of the moment, made within a broader strategic context”...
Given the enormous attention Fed watchers pay to every piece of information officially endorsed by the Fed, the interpretation of the economic projections is a highly topical question. If projections were just “guesses”, the ability to guide market expectations would eventually suffer.
FOMC vs private-sector forecasts ...Gavin and Mandal (2003) ... show that the FOMC’s real growth forecasts are at least as good as those provided by the private sector. The inflation forecasts were more accurate than private-sector forecasts. In light of these findings, Fisher’s (2012) first conjecture seems less convincing.
But what about Fisher’s (2012) other claim..., are motives other than achieving maximum forecast accuracy reflected in FOMC projections? One interpretation is that members pursue strategic motives to have an additional leverage on policy decisions of the committee. ... McCracken (2010) argues that “... an inflation hawk has an incentive to forecast very high inflation regardless of whether that outcome is the most likely, and an inflation dove has a similar set of incentives to forecast lower inflation.”
Strategic forecasting: Voting vs non-voting members’ forecasts ...While all regional presidents take an active part in the policy deliberation, the formal voting right rotates across Federal Reserve districts. ... While only a subgroup of members votes on interest-rate policy, all FOMC members regularly submit forecasts for important macroeconomic variables. The incentives to pursue strategic motives are stronger for members without a direct say on policy. ...
I show that non-voters systematically over-predict inflation relative to the consensus forecast if they favor tighter policy and under-predict inflation if they prefer looser policy. These findings are consistent with non-voting members following strategic motives in forecasting ... to influence policy.
This line of research is extended in my research with Jan-Christoph Rülke... We test whether these forecasts exhibit herding behavior, a pattern often found in private-sector forecasts. While growth and unemployment forecasts do not show herding behavior, the inflation forecasts exhibit strong evidence of anti-herding, i.e. FOMC members intentionally scatter their forecasts around the consensus. Interestingly, anti-herding is more important for non-voting members than for voters. Put differently, non-voting members submit forecasts that are systematically further away from the forecast consensus. ...
Are FOMC forecasts special? Taken together, there is indeed evidence suggesting that motives other than forecast accuracy play a role in the forecasting process. Is this a case for concern? Probably not. It ... is well known that professional forecasts are affected by factors other than accuracy (see Lamont 2002 and Pons-Novell 2003). The available empirical evidence suggests that FOMC members are prone to similar incentives. While individual forecasts might be affected by those factors, the distribution of views among committee members can still be a valuable source of information...

Tuesday, February 21, 2012

"Political Constraints in the Aftermath of Financial Crises"

Political constraints limit the options for rescuing the financial sector after a meltdown:

Political constraints in the aftermath of financial crises, by Atif Mian, Amir Sufi, and Francesco Trebbi, Vox EU: Financial crises of all colors (banking, currency, inflation, or debt crises) leave deep marks on an economy. ... What exactly occurs in the aftermath of financial crises that makes recovering from such shocks so hard? This column argues that the answer may lie mostly with the politics, not the economics.

Let us start with some stylized facts. One thing that happens with some regularity, but seems not to have been systematically documented, is an association of financial crises with ...  increases in income inequality...

Although the relationship between higher inequality and persistent contractions is not conceptually straightforward, the evidence is consistent with the view of a financial crisis damaging certain constituencies in society more than others.

As an example we can look at ... the disparity of how the value of real estate assets, mostly held by middle- and low-income indebted households, is still far from having recovered to pre-crisis levels, while financial assets, mostly held by the wealthy, have already bounced back. Some may be hit harder than others in a financial crisis, and this is a consequential phenomenon. ...

Individuals differentially affected will probably support different policy responses to the crisis. Agreement on unified reactions to the negative financial shock may become harder to achieve or nonexistent. This may stall potentially beneficial macro-financial reform, which could speed up the recovery. ...

A systematic analysis of ‘politics after the crisis’ fits this logic. ... Voters become more ideologically polarized... Government coalitions become weaker... Opposition coalitions become larger. Party fragmentation increases across the board. ...

As one would expect,... after the crisis hits, the moderate middle sinks and the extremes rise. This is reminiscent of the rise of the Tea Party on the right and of Occupy Wall Street on the left in the post-Great Recession US. ...

Political gridlock and lack of reform are natural outcomes of polarization. Gridlock delays reform and possibly makes recovery slower (explaining the long recessions and sluggish recoveries). ... Crises are occasionally thought of as critical junctures where macroeconomic reform unlocks by shattering entrenched conditions (Drazen and Easterly 2001). The opposite seems true.

The list of potential negative implication does not stop here though.

  1. Gridlock brings selective intervention. In the aftermath of a financial crisis, any type of reform, including bailouts, faces a higher bar for passage. Unfortunately, if a reform overcomes political gridlock, it may well be not because of efficiency or merit, but because of strong political organization by its constituency... Is it surprising that concentrated special interests (such as large US banks...) got a sizeable bailout through TARP, while diffused special interests (such as mortgage debtors) did not? This selective intervention may then feed back into further increasing economic and political polarization.
  2. Gridlock brings political uncertainty. Markets for sovereign debt do not seem particularly appreciative of governments engaging in stalemate or political bickering at the time a country needs decisive intervention the most. Recent credit rating downgrades of US or European debt fit this interpretation. ...
  3. In the same way that financial crises appear to polarize constituencies at the national level, it is not hard to envision polarization at the international level playing an important role. ...

In conclusion, to those of us interested in efficient policy response in the aftermath of financial crises, understanding the logic of political constraints may be useful. The chances are that a country will not achieve reform precisely when it needs it the most. Any model of post-crisis macro intervention that leaves this political feature aside forgoes an important dimension. ...

We didn't have until after the fact to learn this lesson. At the time, many of us were urging the administration to consider the distributional consequences of the financial bailout -- who was helped and who wasn't -- and to adjust policy accordingly (e.g. the banks could have been saved without rewarding financial executives who had a hand in creating the problems). But the administration was afraid that if it took the steps required to do this, i.e. if it nationalized the banks temporarily, removed the management, put the good assets in one pile, the junk in another, and then sold the good assets back to the private sector, Republicans would have been upset. They might have called the administration socialists, criticized the bailout, something like that, you know --like they did anyway.

The administration argues it had little choice about how to conduct the bailout due to legal restrictions that prevented it from taking over shadow banks in the same way it could traditional banks, and there was an urgent need of an intervention of some sort. Nevertheless, there were other options it could have pursued even within the structure the administration adopted, e.g. more aggressive clawback on profits resulting from the bailout through warrants and other means. In any case, I just wish more had been done for the households that were struggling every bit as much as the banks. A lot more.

Saturday, February 18, 2012

Potential Output: Measuring the Gap

There's been quite a bit of discussion recently about the output gap. I want to make a simple point in this post, how the gap is measured can have a big impact on the estimate of the state of the economy, and hence on the need for policy. Below, three different gap measures are presented, one that measures a large gap and hence implies the need for a large stimulus, one that measures a "medium size" gap, and one where the gap is absent altogether. In fact, according to this model we have already exceeded the full employment level of output.

In the first model, the trend is assumed to be linear, i.e. Ytrend = b0 + b1*t. Recall that the gap is measured as (Y - Ytrend), i.e. as the distance between the red and blue lines in the following diagram showing the estimated trend for GDP (click on figures for larger versions):

Continue reading "Potential Output: Measuring the Gap" »

"Heartening News About What Economists Think"

Brad DeLong is heartened by the response of economists to the question "Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill":

Effects of the 2009 Recovery Act: Heartening News About What Economists Think--Although Caroline Hoxby and Ed Lazear Do Go All-in for Team Republican..., by Brad DeLong: The University of Chicago's IGM Forum:

Poll Results | IGM Forum: Question A: Because of the American Recovery and Reinvestment Act of 2009, the U.S. unemployment rate was lower at the end of 2010 than it would have been without the stimulus bill.

At the time, back at the start of 2009, arguments that the Recovery Act would not push the unemployment rate down over the two years after its enactment took one of three lines:

  1. Unemployment is really not cyclical but structural, so whatever boost to spending it might generate would show up in higher prices and wages as businesses trying to satisfy demand bid against each other for a fixed pool of non-zero-marginal-product workers.
  2. Government purchases must be financed by issuing government debt, and debt issues would push up interest rates and so would discourage private investment spending.
  3. Government purchases must be financed by issuing government debt, and the future taxes needed to amortize the extra debt would frighten businesses and investors, so we would see equity prices tank as this fear would discourage private investment.

None of those things happened. And that is why the Chicago panel agrees 80%-4% with the statement that the Recovery Act the unemployment rate in 2010 below what it would otherwise have been.

And in this context it is worth noting that the two members who want to go on record agreeing with the Republican Party line and disagreeing with the statement appear to do so very carefully... Caroline Hoxby and Ed Lazear, both of Stanford [disagree]. Note that Hoxby appears to be evaluating a different statement--that the ARRA was worth doing--rather than the question asked--that the ARRA reduced the unemployment rate in 2010 below what it would otherwise have been. ...

And note that Lazear's comments--"the estimates [of the Recovery Act's effects] are varied and the highest are based on ex-ante models, not experience-based data. The upper bound estimate is low"--appear to justify the position that he is uncertain about the truth of the statement, not that he disagrees with the statement.

From one perspective, this is quite heartening: 183 years after John Stuart Mill and Jean-Baptiste Say agreed that Say's Law applies in the long run but not in the short business-cycle run, 4 years after what John Quiggin calls its zombie-like rising from the grave, the claim that increases in government purchases must by the metaphysical necessity of the case--no matter what happens to asset or commodity prices--crowd out an equal and opposite amount of private spending appears to be dead.

And staked.


To Be Continued...

I don't know that we've learned one important lesson about the use of fiscal policy to attenuate the effects of a downturn. For the most part, even economists who supported fiscal policy as an option insisted that we try monetary policy first and give it a chance to work. Monetary policy alone, we were told, would likely get the job done. And in the unlikely case that it didn't, we could then turn to fiscal policy for help.

That was the wrong advice (and I get annoyed when people who insisted that we wait pat themselves on the back over their support of things like infrastructure spending). By the time we realized that monetary policy would help, but wouldn't be enough to turn things around by itself, it was very late in the game to be applying fiscal policy. Fiscal policy still had an impact, but had it been put in place much earlier -- before problems had a chance to worsen and gel making them harder to overcome -- it would have been much more successful.

When this happens again, we need to to use both monetary and fiscal policy tools to full effect instead of trying one policy, realizing it's not enough, and then turning to the other. But it's not at all clear we've learned this lesson (and, to refine it a bit, we need to get help to state and local governments immediately -- the failure to effectively backfill the budget problems at the state and local level was a big mistake).

Let me emphasize that I'm not saying fiscal policy did not work -- see the following from Jeff Frankel -- only that it could have been much more effective if we hadn't waited so long to put the policies into place:

... The full force of the fiscal stimulus package began to go into effect in the second quarter of 2009, with the NBER officially designating the end of the recession as having come in June of that year. Real GDP growth turned positive in the third quarter, but slowed again in late 2010 and early 2011, which coincides with the beginning of the withdrawal of the Obama administration’s fiscal stimulus.
Other economic indicators, such as interest-rate spreads and the rate of job loss, also turned around in early 2009. ... Again, such data do not demonstrate that Obama’s policies yielded an immediate payoff. In addition to the lags in policies’ effects, many other factors influence the economy every month, making it difficult to disentangle the true causes underlying particular outcomes.
Given that difficulty, the right way to assess whether the fiscal stimulus enacted in January 2009 had a positive impact is to start with common sense. When the government spends $800 billion on such things as highway construction, salaries for teachers and policemen who were about to be laid off, and so on, it has an effect. Workers who otherwise would not have a job now have one, and may spend some of their income on goods and services produced by other people, creating a multiplier effect.
Those who claim that this spending does not boost income and employment (or that it causes harm) apparently believe that as soon as a teacher is laid off, a new job is created somewhere else in the economy, or even that the same teacher finds a new job right away. Neither can be true, not with unemployment so high and the average spell of unemployment much longer than usual. ...
Economists’ more sophisticated forecasting models also show that the fiscal stimulus had an important positive effect... Allowing for a wide range of uncertainty, the CBO estimates that the stimulus added 1.5-3.5% to GDP by the fourth quarter, relative to where it otherwise would have been. The boost to 2010 GDP, when the peak effect of the stimulus kicked in, was roughly twice as great.
Of course, econometric models do not much interest most of the public. A turnaround needs to be visible to the naked eye to impress voters. Given this, one can only wonder why basic charts, such as the 2008-2009 “V” shape in growth and employment, have not been used – and reused – to make the case.

Friday, February 17, 2012

Fed Watch: Will They Or Won't They?

Tim Duy:

Will They Or Won't They?, by Time Duy: Calculated Risk reads this passage in a recent speech by San Francisco Federal Reserve President John Williams:

This is a situation in which there’s no conflict between maximum employment and price stability. With regard to both of the Fed’s mandates, it’s vital that we keep the monetary policy throttle wide open.

and concludes:

QE3 is coming.

Dallas Federal Reserve President Richard Fisher states:

“In my view, it’s not going to happen,” he said. “It’s a fantasy. Wall Street keeps dangling QE3 out there [but] I just don’t see it happening.”

I guess we are going to see who knows more about monetary policy - CR or Fisher. My instinct tells me CR, but Fisher seems just a little too certain to dismiss entirely. Reviewing the most recent minutes, one find to the now oft-repeated line:

A few members observed that, in their judgment, current and prospective economic conditions--including elevated unemployment and inflation at or below the Committee's objective--could warrant the initiation of additional securities purchases before long.

Presumably, Williams is among the few. I would like the Fed to publish their definition of a "few." In my book that is three or less, which is well short of the the majority necessary to shift policy. That said, the next line of the minutes is:

Other members indicated that such policy action could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

Now you have a solid majority willing to move forward with QE3 if the economy sags or inflation remains below 2%. The recent US data flow, however, has been generally positive, and it is hard to ignore the steady drop in initial unemployment claims. To be sure, we have been fooled by seemingly upbeat data in the past. But I suspect the median FOMC member will be wary about dismissing the generally positive data - sooner or later, some parts of the US economy, such as home building, are going to come back on line. Which leaves us pondering inflation data. With gasoline prices marching higher, headline inflation will head in that direction as well. Typically, however, the Fed will look toward core inflation as a gauge of where headline will eventually settle, and recently core has been soft:


Still, notice the recent uptick. And if FOMC members want to focus on the year-over-year numbers, it looks like core and headline are set to converge at the 2% mark:


All in all, I tend to view the Fed as generally in wait and see mode. I doubt very much the case is as clear cut as Fisher or CR believes. However, I tend to think the general mood of the FOMC favors CR's position, as long as core inflation stays on the weak side of 2%. But if inflation ticks up and general economic data remains solid, hope of QE3 may quickly be dashed.

Update: In a second post, Tim adds:

Who Thinks Unemployment Isn't Too High, by Tim Duy: I noticed this line in the most recent Fed minutes:

While overall labor market conditions had improved somewhat further and unemployment had declined in recent months, almost all members viewed the unemployment rate as still elevated relative to levels that they saw as consistent with the Committee's mandate over the longer run.

"[A]lmost all" means that as least one FOMC member does not believe that the unemployment rate is not well above the natural rate. Who is it?

Thursday, February 16, 2012

Tug of War at the Federal Reserve

I have a few general comments on the Fed at CBS News on the policy divide between hawks and doves:

Tug of war at the Federal Reserve

"I believe the most likely outcome is that the Fed will live up to its commitment to keep rates low through 2014." But if the economy continues to show improvement and prices begin ticking upward, that's not assured.

Wednesday, February 15, 2012

Fed Watch: Again With Potential Output

Tim Duy:

Again With Potential Output, by Tim Duy: St. Louis Federal Reserve President James Bullard graciously responded to my most last post regarding his much considered speech. I actually do not enjoy drawing Bullard's attention, in that it makes me fear that one day I will find that my access to FRED has been disabled.

On what Bullard and I agree on is this: There are different estimates of potential GDP. I discussed this point last year:

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

In that post I discussed some possible reasons we might consider a downward shock to potential GDP. Near the end, I concluded with this:

While not discounting the probability that some structural factors are at play, the primary challenge facing the US economy is insufficient demand. Optimally, I think the best solution to this challenge is that demand emerges from the external sector – and here I mean NET exports, export and import competing industries. This source of demand would support needed structural change, ultimately for the good of the US and global economies. This adjustment requires a relatively complicated expenditure-switching story on a global basis. I don’t know how to avoid such a story. Barring this outcome, one falls back on fiscal policy, which can surely do the job, but risks maintaining the current pattern of global imbalances. And perhaps such concerns are overblown; after all, so far the fears of a Dollar/current account crisis have not emerged.

Bullard takes a different approach. First, he rejects the CBO estimate offhand because it is not the outcome of "full DSGE model" and "there is nothing about the CBO potential calculation that allows "bubble" levels of output." Before we reject the CBO model outright, it is worth considering it basic effectiveness as a guide:


I see two recent episodes of output in excess of CBO potential, both of which were associated with what I believe were asset-price bubbles and also induced monetary tightening to stem inflationary pressures (which seems to contradict Bullard's assertion that the CBO estimate leaves no room for bubbles). If this was a significant overestimate of potential output in during the housing bubble, I would have expected more severe inflationary pressures.

Of course, even if the CBO estimates were roughly correct during the bubble, perhaps there has been a significant downward shift in potential. And here again I think Bullard and I can find common ground - potential output is not a measured variable, it is estimated. We really shouldn't blindly follow such estimates, but instead look for corroboration in other data. I tend to fall back on unit labor costs for a signal that wages pressures are outstripping productivity growth and threatening to sustain an inflationary dynamic:


I don't see a reason for concern at this point. But put aside the CBO estimate for a moment, and move onto the crux of Bullard's argument:

If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important. But our rhetoric about the decade suggests otherwise. Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived. Output went up, and labor supply was higher than it otherwise would have been.

There are two parts to this theory. One is a demand side story - the debt-fueled housing bubble supported consumption and investment, supporting actual GDP growth. I don't think anyone disagrees with that view. The second part of the story is supply side, that the extra activity induced additional labor supply. With the housing bubble now popped, all of the related output and labor supply now melts away:

So, what Irwin's picture is doing is taking all of the upside of the bubble and saying, in effect, "this is where the economy should be." But that peak was based on the widespread belief that "house prices never fall." We will not return to that situation unless the widespread belief returns. I am saying that the belief is not likely to return--house prices have fallen dramatically and people have been badly burned by the crash. So I am interpreting your admonitions on policy as saying, in effect, please reinflate the bubble. First, I am not sure it is possible, and second, that sounds like an awfully volatile future for the U.S., as future bubbles will burst once again.

Now, I agree that the bubble cannot be reflated, nor should it. But this leads into what I don't like about Bullard's story housing bubble story. From my post last July:

Also arguing for a largely demand side explanation to the current weak employment numbers is what looks like a pretty obvious link between asset bubbles and full employment over the last decade. As long as households had a mechanism to support demand, achieving full employment was not a problem. If not households, then why can’t another form of demand fill the gap?

In Bullard's model, the housing bubble popped, and millions of people who were employed are no longer employed, nor should we expect them to be employed (or to reenter the labor force) as there is no way to do so absent another bubble. This seems to me an obvious place for fiscal policy and monetary policy to step into the breach and compensate for the lost demand. That millions of people's labor and output be lost simply because they no longer believe that housing prices don't always rise is a gross waste of resources.

You can tell a story in which that bubble-driven demand was necessary to compensate for negative equilibrium interest rates for risk free assets (driven by excessive saving by Asian central banks and aging demographics in the developed world). Rather than wait for another asset bubble to come along and lift demand, or twiddle your thumbs hoping another recession doesn't hit while you are at the zero bound, you could pull out the old-Bernanke playbook and implement an even more aggressive mix of fiscal and monetary policy to compensate for the lost demand and flood the world with risk free assets.

Now, as to Bullard's appeal instead to a New Keynesian framework, I am more sympathetic. Basu and Fernald opine:

..the major effects of the adverse shocks on potential output seem likely to be ahead of us. For example, the widespread seize-up of financial markets has been especially pronounced only in the second half of 2008. We expect that as the effects of the collapse in financial intermediation, the surge in uncertainty, and the resulting declines in factor reallocation play out over the next several years, short-run potential output growth will be constrained relative to where it otherwise would have been.

This is similar to my thoughts that somewhere in the background there is need for some structural change, toward export and import competing industries. That said, I still find it hard to believe that this is the primary story given that the downturn negatively affected employment across almost all industries. If structural adjustment was the primary issue, I would have anticipated a narrower range of affected industries.

Bottom Line: Bullard and I agree that there are different estimates of potential output. I think that if he wants to throw out the CBO estimate, he needs to provide another estimate to serve as a policy guide. And I would agree that any estimate, CBO included, needs to be continuously monitored in the light of actual incoming data. I still disagree with his asset-bubble model of potential GDP shifts. At its core it is a demand story with maybe a second-order labor supply aspect, and does not explain why no other source of demand can compensate for the lost housing bubble and induce higher labor supply. In the past I have considered reallocation stories similar to what can be derived from a time-varying NK measure of potential output, but again question that this is the primary concern at the moment.

And if you just can't get enough of this debate, Barkley Rosser argues there are arguments in favor of Bullard's position.

Let me add one note of my own. Bullard argues that the difference between the flexible and sluggish price outcomes in a New Keynesian model, measured by the difference between the "sticky price and flexible price level of output," is superior to the standard output gap measure. I have no argument with that in the context of a standard NK model. However this measure is based upon the assumption that Calvo type price rigidity (or something similar) is driving economic fluctuations. If this is not the way in which shocks are being transmitted to the real economy in this crisis, then this measure may not be the right index for setting monetary policy. I think stickiness in housing prices is part of the story, and perhaps wage rigidity as well -- so price stickiness is part of the slow recovery (though it's not clear that housing really fits the Calvo framework) -- but I'm not convinced this fully captures the breakdown in financial intermediation, balance sheet losses, and solvency/liquidity issues (for banks, businesses, and individuals) that characterized the recession, and that are still holding back the recovery. If we haven't captured the important ways in which shocks are affecting the real economy in our models, then the models won't serve as effective guides to policy.

Tuesday, February 14, 2012

James Bullard Responds to Tim Duy

This is a letter from James Bullard, president of the St. Louis Fed, in response to this post from Tim Duy:

14 February 2012

Dear Tim,

I appreciate your commentary, and all the commentary, on my Chicago speech from last week.  I take the gist of these comments to be "you didn't show us a model."  That is fair enough, I did not.  (Readers may also wish to check Scott Sumner, Noah Smith, Paul Krugman, David Andolfatto, Brad DeLong, David Beckworth, and Steve Williamson at their respective blogs, and possibly others I have not seen yet.)

As you know, I am not too keen on "output gap" ideas as they are knocked around in the business press and in policy circles.  I just do not think the output gap rhetoric matches up very well with the state of knowledge in the macroeconomics literature, either conceptually or empirically.

Neil Irwin at the Washington Post does an excellent job of telling the standard story concerning the output gap.

I know you like this story, and you have a lot of company, because it dominates much of the discussion about the U.S. economy.  I said this potential output calculation is basically an extrapolation of real GDP from 2007Q4 using growth rates from the years immediately preceding.  Of course it is not, it is just ... statistically indistinguishable from an extrapolation of real GDP from 2007Q4 using growth rates from the years immediately preceding!  

For more detail on approaches to measuring potential output, see the St. Louis Fed's 2008 conference "Projecting Potential Growth: Issues and Measurements," published in 2009.

Readers might be especially interested in the paper by Susanto Basu and John Fernald, "What Do We Know (And Not Know) About Potential Output?"

As Basu and Fernald make clear, a lot rides on what is meant by potential output, and one really needs an explicit general equilibrium model to give an appropriate definition.

First, I want to restate my bubble idea in more geeky terms based in part on the basic story presented by Irwin.  I know I am an army of one on this issue, but I think it is important to debate the output gap concept because it is having a huge impact on policy choices.  And, I think my approach makes more sense given the very damaging housing bubble in the U.S. during the mid-2000s.

Second, as I am under no illusions that I can get you to come to reason on the fallacies behind the Irwin graph any time soon, I want to make a plea to at least use the available literature to define potential output appropriately for monetary policy purposes.  As Basu and Fernald stress, we need a full DSGE model to be able to discuss the appropriate measure of the output gap for monetary policy.  Fortunately, outstanding work by Mike Woodford at Columbia and co-authors has at least given us a benchmark model.  In that work, the key gap concept is the difference between the sticky price and flexible price level of output, not the difference between actual output and a measure of trend output as in the Irwin graph.

The housing bubble in the 2000s

Here is a shorter and geekier version of the Chicago talk:  If we look at Irwin's graph, actual output is essentially at CBO potential during 2005, 2006, and 2007.  There is nothing about the CBO potential calculation that allows "bubble" levels of output.  That is just not part of the analysis--it is off the radar screen.  Potential in this picture is simply a projection based on a production function approach.

At the same time, we often say that these years were characterized by a bubble in housing.  One way to interpret this is that fluctuations in real variables were driven by beliefs alone.  We certainly have a very good candidate for what this widespread belief was--namely, "house prices never fall."

If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important.  But our rhetoric about the decade suggests otherwise.  Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived.  Output went up, and labor supply was higher than it otherwise would have been.

Rhetorically, this is consistent with what most analysts say happened.  But we also have a large literature on so-called sunspot equilibria which tells us that fluctuations can be self-fulfilling (driven by beliefs alone) and consistent with rational expectations.  According to that literature, the technology for the production of goods would not have to change at all, but the amount of output, consumption, labor supply and other real variables would fluctuate solely in response to the belief.  These fluctuations lower welfare for risk-averse households.  Potential output via a production function approach would then be sensibly described as that amount of output which would have been produced in the absence of the belief.  I think it is plausible that such a line would be lower than the CBO potential line in Irwin's picture, and thus that the current output gap even by a production function metric would be smaller than the one in the picture.

So, what Irwin's picture is doing is taking all of the upside of the bubble and saying, in effect, "this is where the economy should be."  But that peak was based on the widespread belief that "house prices never fall."  We will not return to that situation unless the widespread belief returns.  I am saying that the belief is not likely to return--house prices have fallen dramatically and people have been badly burned by the crash.  So I am interpreting your admonitions on policy as saying, in effect, please reinflate the bubble.  First, I am not sure it is possible, and second, that sounds like an awfully volatile future for the U.S., as future bubbles will burst once again.

This is admittedly a qualitative story, but much of the rhetoric about the U.S. economy during this period fits this description.  So it is not that the bubble destroyed potential, instead it is that actual output was higher than properly-defined potential during the mid-2000s, and then it crashed back as the bubble burst.

The macroeconomic literature on sunspot equilibria is dense and filled with conditions under which such phenomena could occur.  But I will say that one key condition keeps recurring:  low real interest rates.

As I noted earlier, the Irwin description is the dominant view of the U.S. economy.  But, as you and many others have stressed, we have not seen the bounce back toward potential that would be suggested by that picture.  That is giving me pause, and frankly I think it is giving everyone who follows the U.S. economy pause.  We owe it to ourselves to at least consider alternative possibilities.

Basu and Fernald

Ok, let's now forget about self-fulfilling beliefs and simply assume that whatever was going on in housing during the mid-2000s was more benign.

As Basu and Fernald discuss, "... few, if any, modern macroeconomic models would imply that, at business cycle frequencies, potential output is a smooth series."  One possibility would be to use the leading monetary policy literature (e.g., Woodford [2003, Interest and Prices, Princeton University Press]) available to tell us what potential output should be.  According to the New Keynesian literature, the relevant output gap is the distance between the actual level of output under sticky prices and the flexible price level of output.  It is the flexible price level of output that represents the potential in the economy.  The flexible price level of output would fluctuate continuously in response to shocks hitting the economy.  This gap has been estimated in the literature, and I think it is fair to say that the concept is quite different from what is in the traditional story as told by Irwin.  There are also unemployment versions of this (that is, NK models with search unemployment included)--I might recommend papers by Mark Gertler at NYU and co-authors.  But the concept is the same.

So, if you do not believe my sunspot story, then fine, we can assume that housing price appreciation during the 2000s did not importantly affect output and other key macroeconomic variables.  But let's at least use the appropriate definition of the output gap according to the available NK literature.

I know this last point was not in my talk in Chicago, but it is a theme that I often return to because I think is important in the output gap context.

Thanks again for the comments.  As always, I find them stimulating and insightful.  I think ongoing debate concerning these difficult issues is important.

Best regards,


Monday, February 13, 2012

Fed Watch: It's Worse Than You Think

Tim Duy:

It's Worse Than You Think, by Tim Duy: The last few days have seen a number of reactions to St. Louis Federal Reserve President James Bullard's recent speech, inflation targeting in the USA. Critical reactions came from Scott Sumner, Noah Smith, Mark Thoma, and Paul Krugman. I think so far the only real support for Bullard comes from David Andolfatto here and here.

Bullard was moving in this direction last month, but he really didn't outline his thinking. Now he has, and sadly revealed that there really wasn't that much thinking at all. Bullard attempts to argue against the "output gap" framework shaping monetary policy:

The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation.

First off, Bullard just flat out does not understand the definition of potential output:

The key to the large output gap story is the use of the fourth quarter of 2007 as a benchmark for where we expect the economy to be today. The idea is to take that level of real output, assume the real GDP growth rate that prevailed in the years prior to 2007, and project out where the “potential” output of the U.S. should be.

Estimates of potential GDP are not simple extrapolations of actual GDP from the peak of the last business cycles. They are estimates of the maximum sustainable output given fully employed resources. The backbone of the CBO's estimates is a Solow Growth model. So I don't think that Noah Smith is quite accurate when he says:

So, basically, what we have here is Bullard saying that the neoclassical (Solow) growth model - and all models like it - are wrong. He's saying that a change in asset prices can cause a permanent change in the equilibrium capital/labor ratio.

Bullard can't be saying the Solow growth model is wrong because he doesn't realize that such a model is the basis for the estimates he is criticizing.

Second, as as already been widely circulated, Bullard then attempts to use a demand side shock to justify his contention that estimates of potential GDP are too high:

A better interpretation of the behavior of U.S. real GDP over the last five years may be that the economy was disrupted by a permanent, one-time shock to wealth. In particular, the perceived value of U.S. real estate fell substantially with the 30 percent decline in housing prices after 2006. This shaved trillions of dollars off of the wealth of the nation. Since housing prices are not expected to rebound to the previous peak anytime soon, that wealth is simply gone for now. This has lowered consumption and output, and lower levels of production have caused a significant disruption in U.S. labor markets.

Follow the links above to Sumner and Krugman for rebuttals to this line of thought. Brad DeLong tries to give Bullard a little help by noting that the bubble may have influenced labor force participation rates, but DeLong also notes these are at best small and were not Bullard's argument in any event. Bullard's chain of thinking is not so sophisticated. Sure, you can argue that he does have labor in the equation:

I mentioned that a wealth shock significantly upsets labor market relationships. This is because output declines, so less labor is required. It takes a long time for those displaced by the shock to find new working relationships.

But again, this is a demand side story. If output were higher, then so too would be the demand for labor. Simply put, Bullard simply moves from the wealth effect to a drop in consumption, and assume that drop in consumption represents a shock to potential GDP, inexplicably confusing demand and supply.

I don't think there is much of a viable defense of Bullard - he gets both the empirics and the theory wrong. He doesn't attempt to define a change in the factors of production that would lead to a shift in potential GDP, nor does he attempt to argue that the estimates of potential GDP are wrong, either from a time series trend/cycle decomposition framework or a CBO Solow growth framework. But note that it gets worse when he extends his faulty logic to policy:

I have argued that the large output gap view may be keeping us all prisoner—tethering our expectations for output, in effect, to the collapsed bubble in housing. It is setting a very high bar for the U.S. economy, one that may not be appropriate given the nature of the shock that the economy has suffered. Importantly, it may influence the FOMC’s near-zero rate policy far into the future, since output is continually viewed as falling short of the high-bar benchmark.

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.

In particular, the lengthy near-zero rate policy punishes savers in the economy...

According to Bullard, monetary policy is stuck at near zero-interest rates because of overestimation of the output gap, and as a consequence savers are suffering. First, if the output gap is smaller than estimated, or the economy outperforms, the Fed can change course and raise interest rates. They have only issued a forecast, not a commitment.

And, second, I have been through this before - while I am very sympathetic to the plight of savers, Bullard does not consider that the Fed is merely following the lead of the economy. Another way to think about the situation is that the supply of savings and the demand for investment currently would clear only at a negative interest rate - see Paul Krugman here. Also note the excess of private saving over private investment, which is exactly what you would expect if the market clearing interest rate was below the zero bound:


If the Fed's zero-interest rate policy is leading to fundamental distortions in the economy, it is because the Fed is not taking seriously enough the need to lift the economy away from the zero-bound. And I don't know that they can push the economy off the zero-bound if they limit their policy options with a strict two percent inflation target.

Bullard also shows significant sympathy for the notion that Fed policy is a net drag on activity:

These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back. In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today. However, this demographic group faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption. Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive.

If you truly believe this argument, then you must believe that a higher Federal Funds rate will have a net positive impact on output. But I have yet to see a convincing argument as to why this should be so - raising rates will only make matters worse if the market clearing rate is already negative. Note also that the ECB's last two forays into the realm of tighter policy have not been particularly successful, to say the least.

Bottom Line: Bullard really went down an intellectual dead end last week. He criticized the focus on potential output, but revealed that he doesn't really understand the concept of potential output either empirically or theoretically. He then compounds that error by arguing against the current stance of monetary policy, but fails to provide an alternative policy path. And the presumed policy path, tighter policy, looks likely to only worsen the distortions he argues the Fed is creating. I just don't see where Bullard thinks he is taking us.

Wednesday, February 08, 2012

"What Output Gap?"

I have been more optimistic than most about the return to long-run trend, i.e. that the shock we experienced is mostly temporary rather than permanent, but here's another view arguing that we have had a substantial decline in the natural rate of output:

What output gap?, by David Andolfatto, Macromania: In case you haven't seen it, you may be interested in this speech given recently by Jim Bullard, president of the St. Louis Fed: Inflation Targeting in the USA.

This speech is really about how to interpret the recent performance of the U.S. economy. Is the conventional interpretation, that we are far below "potential" GDP owing to "deficient demand," the correct view? Or should we instead be thinking in terms of a large negative shock to "potential" GDP, with unemployment returning slowly to its natural rate, according to its normal dynamic (see here)?

I think that Bullard makes a persuasive case that the amount of household wealth evaporated along with the crash in house prices should likely be viewed as a "permanent" (highly persistent) negative wealth shock. Standard theory (and common sense) suggests a corresponding permanent decline in consumer spending (with consumption growing along its original growth path). The implication is that the so-called "output gap" (the difference between actual and "trend" GDP) may be greatly overstated by conventional measures.

The view that one takes here is likely to influence what one thinks about monetary policy. The conventional view seems to support the Fed's current policy of keeping its policy rate close to zero far into the future. In his speech, Bullard worries that this may not be the appropriate policy if, in fact, potential GDP has experienced a level shift down (or, what amounts to the same thing, if conventional measures treat the "bubble period" as the economy being at, and not above, potential). Among other things, he says:

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.
Precisely how such a policy "distorts fundamental decision-making" needs to be spelled out more clearly (though he does offer a couple of examples that hinge on a presumed ability on the part of the Fed to influence long-term real interest rates). I am sure that many of you have your own favorite examples.
At any rate, I think this is a nice speech because it challenges us to think about the recent U.S. recovery dynamic in a different way. And if recent history has shown us anything, it's shown that we shouldn't grow complacent over what we think we understand.

I believe that costs are asymmetric -- doing too little to help the economy is worse than doing too much -- and the conclusion that the shock is mostly permanent rather than temporary is more likely to lead to policymakers giving up too soon (resulting in the more serious error). Thus, those that hold this view need to recognize the asymmetric nature of the mistakes they are likely to make and adjust their policy recommendations accordingly.

However, inflation hawks see the costs as more symmetric, and they are convinced the shock is mostly permanent, so they would disagree with the need to adjust their policy recommendations. But as noted above, I think the shock is highly persistent but ultimately mostly temporary, and I just don't see the equivalence between a marginal increase in inflation versus a marginal decrease in unemployment. For me, unemployment is a much higher priority (and yes, I understand the argument that inflation problems ultimately impact employment).

Update: There are two concerns here that I may not have done enough to separate in the comments above. First, there is the concern that the asymmetric nature of the costs of inflation and unemployment is being ignored in policy recommendations (though, again, inflation hawks see inflation as more costly than I do, and hence see the costs as more symmetric, and they believe that a short burst of inflation to fight a recession is likely to lead to a long-run inflation problem -- I have more faith in the Fed than that). This means, for me anyway, that policy ought to tilt toward unemployment (i.e., I disagree with Ben Bernanke's recent assertion in testimony before Congress that inflation and unemployment should be and are weighted equally).

The second concern is the assumption that the natural rate has fallen permanently. Making this assumption when in fact the shock is largely temporary will lead to a miscalculation of the chance that we will face an inflation problem -- the calculated odds will be too high -- and the undue fear of inflation will cause policy to tighten too soon. This results in an error where unemployment rather than inflation is higher than desired. The opposite belief -- the belief that the shock is temporary when it turns out to be permanent -- leads to the opposite policy error, i.e. unemployment lower and inflation higher than desired, but to me that is more tolerable. That's not why I hold the view it's mostly a temporary shock -- that's a conclusion based upon economic considerations -- but given that the costs are asymmetric the belief that the shock is temporary does result in a less serious policy error if it is wrong.

Monday, February 06, 2012

Stiglitz: Capturing the ECB

A quick post between appointments -- Joe Stiglitz is unhappy with the ECB. He says, "The ECB’s behavior should not be surprising: as we have seen elsewhere, institutions that are not democratically accountable tend to be captured by special interests":

Capturing the ECB, by Joseph Stiglitz, Commentary, Project Syndicate: Nothing illustrates better the political crosscurrents, special interests, and shortsighted economics now at play in Europe than the debate over the restructuring of Greece’s sovereign debt. Germany insists on a deep restructuring – at least a 50% “haircut” for bondholders – whereas the European Central Bank insists that any debt restructuring must be voluntary.
In the old days – think of the 1980’s Latin American debt crisis – one could get creditors, mostly large banks, in a small room, and hammer out a deal, aided by some cajoling, or even arm-twisting, by governments and regulators eager for things to go smoothly. But, with the advent of debt securitization, creditors have become far more numerous, and include hedge funds and other investors over whom regulators and governments have little sway.
Moreover, “innovation” in financial markets has made it possible for securities owners to be insured, meaning that they have a seat at the table, but no “skin in the game.” They do have interests: they want to collect on their insurance, and that means that the restructuring must be a “credit event” – tantamount to a default. The ECB’s insistence on “voluntary” restructuring – that is, avoidance of a credit event – has placed the two sides at loggerheads. The irony is that the regulators have allowed the creation of this dysfunctional system. 
The ECB’s stance is peculiar. ... There are three explanations for the ECB’s position, none of which speaks well for the institution and its regulatory and supervisory conduct. ...[continue reading]...

Old versus New Keynesian Models

In response to Tyler Cowen, if the alternative hypothesis to his null that Old Keynesian models have failed is New Keynesian models, and he has rejected the Old in favor of the New, then I don't have many problems with his overall conclusion (which is not to say I agree with every detail of his argument). I thought his alternative hypothesis was broader than just the New Keynesian model, i.e. that he was arguing against Keynesian models of all varieties, but he says "I very much prefer New Keynesianism over Old." So if he is really saying the data support the New Keynesian model, I don't have much to disagree with. (See here for a post highlighting the difference between Old and New Keynesian IS-LM models. I posted this when people tried to claim I support Old Keynesian models as a way of discrediting what I have to say, and I've posted lots of New Keynesian work on fiscal multipliers as well. But people like Williamson, who Tyler points to authoritatively for reasons that escape me, still make the false charge that I promote old-fashioned Keynesian ideas.)

A few notes:

People seem to forget that the federal fiscal policy efforts were almost entirely offset by declines in spending and/or tax increases at the state and local level. Given that, it's not clear why we should expect to see a big effect in the data on output and employment. Fiscal policy at the federal level simply stopped things from getting even worse that they already were -- the bottom would have been much worse without it. Thus, when natural recovery finally began to take hold, it did so from a higher base than without the federal effort (and perhaps started sooner). Think of it this way -- fiscal stimulus allowed us to hold ground we would have lost otherwise -- again things would have been much worse without it -- until the natural recovery process was ready to begin.

I don't see how the fact that the economy is presently recovering at a rate where we will get to full employment by 2019 (or a few years earlier with very optimistic projections) says much about the effectiveness of fiscal policy. It kept things from getting worse, then it ran out, and now we are still looking at a relatively slow recovery by historical standards. What we want to know, but won't find out due to opposition in Congress, is if the recovery would be even faster from this point forward with additional fiscal policy efforts. Nobody ever said the economy wouldn't recover without stimulus, it's the rate of recovery that is at issue. Past efforts have kept GDP and employment from declining even more and made it easier for the natural recovery process to take hold, and additional fiscal policy timed correctly could have helped even more.

On the "timed correctly" point, people also seem to forget about policy lags. The same people who were arguing that infrastructure spending would take too long, that by the time it took hold the economy would already be recovering and it wouldn't be needed, now criticize policy as though it happens instantaneously. It doesn't. How much of the recovery is being driven by the lagged effects of our fiscal policy efforts? That will need to be teased out of the data -- a difficult task since monetary policy easing was going on at the same time and those effects have to be separated from fiscal policy and other factors that affect output and employment. For example, a firm that sees extra spending as a result of tax cuts may do a bit better than otherwise, and then decide to invest in an expansion of the business. It takes time to realize things are a bit better, plan the expansion, and then build it. The expansion is properly attributed to fiscal policy efforts, but this is very hard to see in the data (note that many of the tax measures are still in place, and that spending can also generate these types of effects). Tyler says "Frankly, it is a bit of an embarrassment for many commentators that the (admittedly weak) recovery is coming right after the end of the fiscal stimulus," but I don't see why that necessarily proves the case. Again, past policy efforts allowed us to take off from a higher base, and likely sooner than otherwise, and policy lags (plus the continuation of many tax breaks) imply that fiscal policy could still be active. I think the main effect of fiscal policy was to stop things from getting worse, I am not saying that fiscal policy is still necessarily present to a significant extent, only that we can't rule out that it is still helping without doing the economtric analysis.

Finally, in passing, liquidity traps exist, at least in theory, in both Old and New versions of the model (e.g. see the discussion in Carl Walsh's text on monetary economics). I disagree on with Tyler's point on the liquidity trap -- I think the evidence suggests we did enter a liquidity trap and that it is still a problem -- but in any case the failure to find a liquidity trap does not distinguish one model from the other (though to be fair, it's possible to construct versions of both models where a liqudity trap does not exist, but this is easier in the New Keyneisan model than in thye Old).

Update: Paul Krugman (this is part of a longer post):

...Tyler Cowen now says that he was making the case for New Keynesianism in a recent post that actually said,

The big winners, apart from the American public?: real business cycle theory.

Oh well. I guess we’ve always been at war with Eastasia.

Paul Krugman: Things Are Not O.K.

We seem to have turned the corner, but policymakers should not relax yet -- we still have a long way to go to get back to full employment:

Things Are Not O.K., by Paul Krugman, Commentary, NY Times: ...So, about that jobs report:... for once falling unemployment was the real thing, reflecting growing availability of jobs rather than workers dropping out of the labor force... That said, our economy remains deeply depressed. As the Economic Policy Institute points out,... even at January’s pace of job creation it would take us until 2019 to return to full employment.
And we should never forget that the persistence of high unemployment inflicts enormous, continuing damage on our economy and our society,... in particular,... that long-term unemployment ... means more Americans permanently alienated from the work force, more families exhausting their savings, and, not least, more of our fellow citizens losing hope.
So this encouraging employment report shouldn’t lead to any slackening in efforts to promote recovery. ... Policy makers should be doing everything they can to get us back to full employment as soon as possible.
Unfortunately, that’s not the way many people with influence on policy see it. Very early in this slump — basically, as soon as the threat of complete financial collapse began to recede — a significant number of people within the policy community began demanding an early end to efforts to support the economy. Some of their demands focused on the fiscal side, with calls for immediate austerity... But there have also been repeated demands that the Fed ... raise interest rates.
What’s the reasoning behind those demands? Well, it keeps changing. Sometimes it’s about the alleged risk of inflation... And the inflation hawks ... seem undeterred ... by the way the predicted explosion of inflation keeps not happening...
But there’s also a sort of freestanding opposition to low interest rates, a sense that there’s something wrong with cheap money and easy credit even in a desperately weak economy. I think of this as the urge to purge, after Andrew Mellon, Herbert Hoover’s Treasury secretary, who urged him to let liquidation run its course, to “purge the rottenness” that he believed afflicted America.
And every time we get a bit of good news, the purge-and-liquidate types pop up, saying that it’s time to stop focusing on job creation. ... And the sad truth is that the good jobs numbers have definitely made it less likely that the Fed will take the expansionary action it should.
So here’s what needs to be said about the latest numbers: yes, we’re doing a bit better, but no, things are not O.K. — not remotely O.K. This is still a terrible economy, and policy makers should be doing much more than they are to make it better.

I'm also worried that "Policymakers are Too Anxious to Reverse Course."

Saturday, February 04, 2012

Policymakers are Too Anxious to Reverse Course

I am worried that policymakers are too anxious to reverse course. That is, despite recent communications suggesting that policy will remain on hold or even be eased further, I'm worried that the Fed will increase interest rates too soon. In the past, any sign of green shoots has brought inflation worries to the forefront, and this time is unlikely to be different even though those fears have been groundless to date. But I'm even more worried that large scale deficit reduction will begin before the economy is strong enough to withstand a large negative shock to demand. Congress is clearly anxious to get on with it.

So here are two views of why we shouldn't relax just yet about the employment situation (beyond risks such as oil price spikes from trouble in the middle east and fallout from rekindled troubles in Europe), and why we should do more, not less, to promote recovery of employment:

Employment: Some good news, some bad news, by Julie Hotchkiss, macroblog:  ...The median three-digit..AICS ... industry lost 7 percent of its jobs during the most recent recession. ... Industries faring the worst (those in the 75th percentile of job losses) shed 13 percent of their jobs. And what might be considered "fortunate" industries (those in the 25th percentile of job losses) saw only 3 percent of their jobs disappear over this time period. ... At the current rate of growth, those industries that experienced above-median job loss during the recession will not regain prerecession employment levels until the end of 2015. ... [note: prerecession levels is not full recovery since it ignores subsequent population growth.]
Does the projected labored employment recovery among these particularly hard-hit industries suggest there are more serious structural impediments to the efficient operation of the labor market today than there were after the previous two recessions? ...
Plotting the annual growth rates back to 1990 illustrates that the industries that were hardest hit during the most recent recession were also those with the greatest job losses during the previous two recessions. So there appears to be nothing special about these industries that led to their suffering during the most recent recession.
Additionally, the pattern of recovery of these hardest-hit industries is similar to that experienced after the previous two recessions. Like before, the worst performing industries (those with job losses in the 75th percentile) ... added jobs in 2011 at an average monthly rate of 0.22 percent; industries with below-median losses added jobs at an average monthly rate of 0.12 percent. This analysis does not suggest to me that unique structural features of this recession or recovery are holding employment growth back—it appears that the culprit is simply the extraordinarily deep hole the economy, and thus the job market, fell into this time around. The bad news, then, is that time may be the only answer for those industries to fully recover.

Time, or more help from policymakers (however, as noted above, forget about more help -- we'll be lucky if policymakers don't reverse course too soon). Here's more on why we shouldn't turn our backs on the unemployed anytime soon:

Still losing the war on unemployment, by Mohamed A. El-Erian, Commentary, Washington Post: ...While the [employment] numbers have markedly improved over the past year, too much of the commentary has been overly partial and, sometimes, dangerously misleading...
The pace of job creation is certainly picking up but, as yet, is insufficient to overcome our unemployment crisis. ... Meanwhile, attention is diverted from something critical to the future of the economy — namely, what is happening to the composition of U.S. joblessness.
The composition indicators have been flashing yellow, if not red, for a while. With 43.9 percent of the unemployed (5.5 million people) out of work for 27 weeks or more, today’s America faces the unusual challenge of “long-term unemployment”: The longer people are unemployed, the harder it is for them to return to the labor force at the same level of productivity and earnings, and the poorer the prospects for national competitiveness and prosperity.
The numbers for youth unemployment are even more disturbing. A staggering 23.2 percent of 16- to 19-year-olds in the labor force do not have jobs. A prolonged period of inactivity at that stage of life risks turning these younger adults from unemployed to unemployable.
These disturbing realities ... don’t cover the significant number of workers who are no longer counted because they have dropped out of the labor force... The longer that corrective measures are delayed, the harder the task at hand will be and the greater the eventual costs to society. ... In fact, our current unemployment crisis ...will ... further polarize an unusually dysfunctional political discourse, worsen income inequality, and fuel protest movements around the country. ...
Congress and the administration need to [do more]... Have no doubt, this is a complex, multiyear effort... One would think that, given all this, it has become more than paramount for Washington to elevate — not just in rhetoric but, critically, through sustained actions — the urgency of today’s unemployment crisis to the same level that it placed the financial crisis three years ago. ...

[Time to hit the road -- will post again when I can...]

Friday, February 03, 2012

Fed Watch: Good News on Employment

Tim Duy:

Good News on Employment, by Tim Duy: With only a minimal drag from the government sector, the February employment report shined on the back of a solid gain in private sector hiring:


The last couple of months look more like the optimistic numbers seen early in 2011 before the mid-year slowdown raised the specter of another recession. As has been widely noted, there is little to complain about in this report. To be sure, in many respects we are still deep in the hole. Long-term unemployment remains a challenge:


Wage growth is meager:


And the employment to population ratio remains sits a levels not seen since the early 1980s:


Still, as noted earlier, these issues should be alleviated if job growth is sustained. And as a precursor to such improvements, the unemployment rate is falling, and at a reasonably quick pace:


What will this mean for the Fed? As I discussed earlier, the unemployment rate looked to be the weak link in the Fed's most recent forecast of 8.2-8.5% by year end. We are at 8.3% in January, and unless either waves of workers re-enter the job market or the economy shifts gears dramatically soon, we will be easily below 8% in just a couple of months. Under such a trajectory, I have to imagine that another round of QE, as well as the Fed's interest rate projection, are not sure bets at all.
To be sure, one can argue the Fed should seize this opportunity to entrench the recovery with more easing. After all, the employment to population ratio suggests plenty of slack in the labor market, as does minimal wage growth. And unit labor labor costs are moving sideways as well:


We know that at least one policymaker, Chicago Federal Reserve President Charles Evans, would already be easing much more aggressively, but we also know that others, such as Philadelphia Federal Reserve President Charles Plosser thinks the current rate outlook is not consistent with an improving economic environment. A couple of reports like this will find others in his camp as well.
I think it still premature to expect the Fed to dramatically shift forward their own expectations of a rate hike. That said, since the recession ended, Federal Reserve officials have tended to shift expectations away from more easing and toward tightening every time the data shows a little life, only to have to backtrack six months later when hopes are dashed. Assuming the Fed follows the same pattern, watch for a shift in tone from Fed officials.

I'm starting to wonder how the Fed will wiggle out of its interest rate commitment should the economy turn out to be stronger than the Fed's forecast. I still think the Fed needs to insure against potential problems -- it's far too soon to conclude our troubles are over, we're still in a deep, deep hole and a slower than tolerable recovery is certainly still possible, perhaps even likely -- but it does look as though there's a chance the Fed will have to reconsider its recent interest rate commitment ("exceptionally low levels for the federal funds rate at least through late 2014"). The FOMC does give itself an out by saying conditions are "likely to warrant" this policy, but it seems to me it has been interpreted as a pretty firm commitment. (Note: To be clear, I am not advocating interest rate increases any time soon -- I think the Fed is likely to pull the interest rate trigger too early rather than too late -- but given the Fed's inclination to raise rates sooner rather than later, how will it explain itself if that time to raise rates comes earlier than projected?)

Thursday, February 02, 2012

How Did the Fed Get Things So Wrong?

[Busy day today -- teaching then travel -- so another quick "hit and run" post.]

A column from a couple of weeks ago:

How Did the Fed Get Things So Wrong?, by Mark Thoma: The public’s faith in the Fed’s ability to protect the economy from economic problems has been shaken by the Fed’s failures before and during the Great Recession. The recent release of the transcripts from 2006 monetary policy meetings where Federal Reserve policymakers discuss and ridicule the suggestion that the economy is threatened by a dangerous housing bubble has undermined its reputation even further.
How did the Fed get things so wrong? How can policy be improved?
The first step in the policy process is for policymakers to be aware that there’s a problem in the economy, and access to reliable, timely, and informative data is critical. Unfortunately, there are substantial lags in the availability of data that indicate where the economy is headed, and it can be six months or longer before key variables such as GDP are known. This is a problem that doesn’t get enough attention, and in the information age we ought to be able to do better.
The fact that these data are not very timely, and are often revised substantially after they are released is not the Fed’s fault. But that doesn’t mean that the Fed can’t do more on its own. The Fed needs to do a much better job than it did before the crisis of using the data at its disposal to construct stress indices, measures of network reliability, price-rent ratios, credit measures, and so on to figure out what is happening in financial markets.
Prior to the crisis, policymakers were not asking the right questions and hence saw no need to collect such data, or to believe what the data they did have was telling them. Policymakers did not believe a severe financial meltdown was possible in modern economies featuring modern policy tools –those problems had been overcome long ago – so they hardly bothered to look for signs of bubble trouble. They are beginning to bring these measures into play now, and seem to have a better understanding of their importance, but only time will tell if they’ve truly learned their lesson.
But even if the Fed recognizes that a problem exists, how it responds to trouble depends critically upon the relative weights it attaches to its goals of low inflation, low unemployment, and financial stability.
When the public looks at the Fed’s recent policy choices, it sees a Fed that appears to place worries about inflation – which is a big concern of finance and business – over the high levels of unemployment that have caused so much misery for the working class. Is there a reason why financial and business interests, banking interests in particular, might be overrepresented at the policymaking table?
Yes, there is. The problem, in large part, is the way in which the presidents of the twelve Federal Reserve District banks are chosen. The district bank presidents, who are an important part of the monetary policymaking committee, are chosen by the Board of Directors for individual banks. The make-up of those boards is dominated by wealthy business and banking leaders, and that leads to suspicions that these interests are overrepresented in monetary policy decisions. The Dodd-Frank legislation recognizes this problem, but it’s not clear that the proposed solution of eliminating bankers from the selection process goes far enough.
A final problem policymakers must confront is the time it takes for policy to have an effect after it is put into place. It can take several months for policy to fully impact the economy after it is enacted, so it’s important for the Fed to react quickly in response to changing economic conditions. Unfortunately, policymakers were far too slow and timid in reacting to problems they encountered as the crisis unfolded. Had the Fed been more concerned about unemployment and less concerned about inflation, there might have been more urgency in its response.
The Fed’s errors can be placed into two broad categories, the failure to ask the right questions before the crisis, and the failure to act quickly and aggressively enough once the crisis began. The first problem had a lot to do with economists’ undue faith in their own models and abilities – the financial meltdown problem had been solved so no need to worry about that – while the second problem is at least partly due to the way in which the public interest is represented on the Fed.
I don’t know how to insulate economists from themselves, every few decades we seem to have the need to declare that we have solved important problems only to be spectacularly wrong, but the representation of the public interest in policy decisions can certainly be improved. That won’t fully overcome the Fed’s tendency to hesitate and take small steps when bold action is needed, but better representation would certainly give more weight to the public’s desire for the Fed to do its utmost to bring an end to the many problems that households face when the economy is operating at subpar levels.

Monday, January 30, 2012

Fed Watch: Europe Needs a Real Fiscal Union

Tim Duy:

Europe Needs a Real Fiscal Union, by Tim Duy: The rhetoric is heating up as we head into Monday's European Union's summit. On one hand, we see rumors circulating that a deal in the Greek debt talks is in the works. Via the Wall Street Journal:

But in Athens, the mood Saturday was upbeat. "We really are one step away from a final agreement [on the debt deal]," Finance Minister Evangelos Venizelos told reporters following a day of hectic talks in the Greek capital. "Next week we will be in a position to complete this procedure along with the talks we are holding on the new loan program."

Note, however, that these negotiations are just one piece of the puzzle. Via the New York Times:

Though a debt agreement may spur Greece’s next bailout installment, the deeper loss being inflicted on bondholders carries the risk that many investors, in particular hedge funds that in recent months have loaded up on cheap Greek bonds in hopes of a payday this March, will refuse to participate in the deal.

Greece will try to impose the terms on all investors by writing collective-action clauses into the contracts of its old bonds. By doing this, the hope is that the holdouts, estimated to sit on 10 percent to 15 percent of the 206 billion euros ($272 billion) in outstanding securities, will exchange their old bonds for new bonds — preferring the new discounted bonds to their old ones, which may become worthless.

Some hedge funds that have bought at rock-bottom prices may decide to pursue legal action, although such a process could take years with small certainty of success.

Also undecided is what the European Central Bank, which owns 55 billion euros of Greek bonds, will do. Despite public pressure that it, along with investors, accept a loss on its bonds, the bank has not budged.

It seems to me more accurate to state that one portion of the debt deal may be in place, but in the interest of unity on the eve of the EU summit, we will pretend that the issues of holdouts and the ECB are not relevant. In any event, given the steady deterioration of the Greek economy, I find it unlikely that this is the last word in the debt story.

More interesting, however, is German demands that Greece cede its budgetary authority to the Troika. Athens of course was a bit perturbed by the escalation of demands. Via the Financial Times:

The Greek finance minister has lashed out against a German proposal for its budget to be controlled by a eurozone commissioner as a condition for receiving a second €130bn bail-out, saying the country was already prepared to “implement tough but necessary decisions”...

...The German plan, widely circulated in Athens and dubbed “the document of shame” by a local newspaper, would require Greece to pass legislation making debt repayments a budget priority, and would also give the new commissioner a veto over large-scale spending.

Perhaps the Greeks are not moving ahead swiftly enough with reforms, but consider that they are stuck between a rock and a hard place - anything positive in the long-run looks to be devastating in the short run. For example:

One main sticking point has been demands by EU and International Monetary Fund negotiators for a 25 per cent cut in the €750 minimum monthly wage and the abolition of an annual bonus paid as 13th and 14th salaries – measures that would improve competitiveness and bring Greece in line with minimum wages in Spain and Portugal.

George Koutromanis, labour minister, argued that the measure would reduce output by about 1.5 percentage points of gross domestic product and prolong the country’s recession, now in its fifth year.

Greece needs more carrots to move forward; Germany offers only the stick. Speaking of which, Germany subsequently responded to Athens indignation. Via the Wall Street Journal:

Germany's finance minister issued an unusually blunt warning that the euro zone might refuse to grant Greece a fresh bailout, pushing Athens into default unless it persuades Europe it can overhaul its state and economy...

...Europe is "prepared to support Greece" with the new loan package, Mr. Schäuble said, but he warned: "Unless Greece implements the necessary decisions and doesn't just announce them ... there's no amount of money that can solve the problem."

The options for Greece are narrowing quickly - either willingly accept German rule, or exit the Euro. And perhaps plans for the latter are already well established. Via The Examiner (hat tip Ed Harrison):

Greece plans an orderly exit out of the Eurozone according to two sources close to Mr. Papademos, Greek Prime Minister, who spoke on condition of anonymity earlier today.

The sources confirmed that plans are ready to return to a legacy currency given the current circumstances and that such exit would be dealt with, quote “in as orderly a fashion as possible” unquote.

I am starting to wonder if Greece is going through the motions to get one more tranche of aid before they come to the conclusion that they must exit the Eurozone. Absent real transfers from Germany, staying in the Eurozone now means crushing recession under German rule. Exiting just means crushing recession. Germany, however, is playing a dangerous game testing Greek nationalism. Either outcome is bad for Greece, but I suspect pushing Greece out of the Euro is ultimately bad for Germany as well.

Meanwhile, other nations need to pay attention to how this all plays out, because austerity is just not working anywhere. Take Spain for example, where unemployment is at a depression-like level of 23%. A clear symbol of the failure of European economic policy, to be sure. Spain gets a pass, however, as for now it is playing the German game. Via the Wall Street Journal:

In an interview this week with Spain's El Pais newspaper, German Chancellor Angela Merkel noted Spain's high unemployment rate, and said her country was willing to help the region's fiscally frail countries, but that they must take steps to solve their own problems.

Soraya Sáenz de Santamaría, spokeswoman for Spain's new government, repeated that a sweeping overhaul of Spanish labor laws is coming in weeks. "To all those millions of people who are looking for a job, I want to tell them...we are speeding up the reforms that are necessary to turn this situation around," she told journalists after the weekly cabinet meeting.

The story is that high dismissal costs deter hiring. To be sure, a real issue. I would note, however, that this did not seem to be a problem a few years back when the construction boom fostered unemployment rates below 10%. While structural reforms are important, so to is demand. And where will that demand come from in the short run?

Even more pressing is the issue of Portugal, which will almost certainly need another bailout. Moreover, the 15.2% rate of 10 year debt calls into question the EU claim that the Greek PSI was an isolated event. Via Business Insider:

While on some level it is crucial for the country to sustain the idea that it is meeting its debt obligations until it has more aid in the bag, the truth might be that the gig is up; it's just unlikely that Portugal will continue to meet its debt and deficit goals amid mounting pressures, even if it complies with the troika plan.

This is much the same psychological development that took place in Greece last summer, as EU politicians realized that a managed default might be the best way to return Greek debt levels to sustainability.

Note that swift passage of an even watered-down commitment to EU-wide fiscal austerity may not be as easy as it sounds. Perhaps the Irish are no longer willing to suffer in silence, via the Financial Times:

The Irish government faces intense pressure to hold a referendum on the eurozone fiscal treaty after a poll that showed almost three quarters of the public want a vote on the agreement.

Months of uncertainty lie ahead. That said, perhaps their is some hope that Europe leaders will actually move where they need to go - true fiscal union. On the eve of the summit, we learned that EU leaders are starting to see the writing on the wall. Via the New York Times:

Bowing to mounting evidence that austerity alone cannot solve the debt crisis, European leaders are expected to conclude this week that what the debt-laden, sclerotic countries of the Continent need are a dose of economic growth.

A draft of the European Union summit meeting communiqué calls for ‘‘growth-friendly consolidation and job-friendly growth,’’ an indication that European leaders have come to realize that austerity measures, like those being put in countries like Greece and Italy, risk stoking a recession and plunging fragile economies into a downward spiral.

But the devil is in the details:

The difficulty, however, is that reaching such a conclusion is not the same as making it happen.

Instead, leaders will discuss long-term structural reforms and better use of E.U. subsidies, while avoiding mention of the one thing that could change the climate: a fiscal stimulus from Germany, the euro currency zone’s undisputed powerhouse.

Easy to say, tough to do given Europe's political makeup. At what point will Germany be willing to justify fiscal transfers to the rest of Europe. For now, the EU appears able to come up with little more than token sums of cash to support growth. According to Reuters:

The summit is expected to announce that up to 20 billion euros ($26.4 billion) of unused funds from the EU's 2007-2013 budget will be redirected toward job creation, especially among the young, and will commit to freeing up bank lending to small- and medium-sized companies.

A paltry sum when placed in context of 23 million unemployed in Europe.

Bottom Line: The European Central Bank's LTRO dramatically eased financial market tensions throughout Europe, revealing the important role of a lender of last resort. But underneath those tensions exist some very real and deep economic and political fractures in the European economy. And unless those fractures are quickly healed via a real fiscal union - not just an agreement to balance budgets, but a union in which rich countries transfer, not lend, resources to poor - the Euro experiment will be torn asunder.

Thursday, January 26, 2012

Fed Watch: Notes on the Fed Meeting

Tim Duy:

Notes on the Fed Meeting, by Tim Duy: Just a quick note today – I am swamped with classes and travel this week, and sadly cannot really do justice to the wealth of information provided today by the Fed.
The basics are well known at this point. The Fed extended its expectation for low rate out through the end of 2014, with the new hawk on the FOMC, Richmond Fed President Jeffrey Lacker, dissenting. The growth and inflation forecasts for 2012 were downgraded, while the unemployment forecast was upgraded slightly. Individual forecasts of the path of the Federal Funds rate were revealed, with six participants anticipating interest rate hikes in 2012 or 2013, in contrast to the broader expectation for low rates through 2014. The Fed now has an explicit inflation target of 2%. No new QE at this time.
Some initial thoughts:
First, the forecast for unemployment and inflation, combined with the restatement of the dual mandate with an explicit inflation target, scream for additional QE at this time. This is especially so when you realize the range of 2014 inflation forecasts remains centered on something south of the 2% target. Simply put, the Fed is clearly falling short of both mandates at this point. We need to be patient for the minutes where we can expect to learn more about QE options, and I agree with Calculated Risk that the Chairman paved the way for additional QE, assuming of course that the economy does not show immediate signs of improvement. Still, the delay is frustrating given the forecasts. That said, I think in the last minutes it was clear the Fed was moving in stages, and the communication stage is now complete. Now we can focus on the next round of QE. In addition, most participants would not see a need for immediate action given the improvement in the data flow combined with still stable inflation expectations.
Second, the unemployment forecast appears vulnerable given how quickly the rate decreased in recent months. If the rate of job growth necessary to keep with labor force growth is significantly less than the 125k-150k estimates often used, then I would expect even tepid growth would send the unemployment rate lower than the Fed’s forecast. The Fed is likely expecting a rebound in the labor force participation rates, but is that likely given the tepid growth forecasts? And how much of a decline of unemployment over the next month or two would prompt Bernanke to put a hold on QE3?
Third, I don’t read too much into the divide between the hawks and the doves regarding the timing of a rate increase. That timing is based on each participant’s individual forecasts, with the hawks likely having somewhat more optimistic forecasts for growth and employment compared to the doves. If forecasts disappoint, then the hawks will not be in a position to push for a more aggressive path of tightening. Likewise, the doves will modify their position relative to how their forecasts evolve. Which is why I am looking at that unemployment rate forecast – it seems the most vulnerable.
Bottom Line: The Fed is poised for additional easing, but the next round of QE is not quite a certainty yet. But I think we would need to see some significant upside surprises in the data in the near term to put plans for additional easing on hold. Watch the unemployment rate. We are already at 8.5%, the upper end of the Fed’s forecast. The lower end is just 8.2% - not far away, and something that is plausible at early as next week. The Fed’s forecast just doesn’t feel right given the 0.6 percentage point decline over the past four months.

Wednesday, January 25, 2012

The Fed will Keep Rates at "Exceptionally Low Levels" Through Late 2014

The Press Release describing the decisions of the Fed's monetary policy committee decisions was released this morning, and it is very similar to the press release from its last meeting in mid December with one notable exception. The Fed announced a commitment to "maintain a highly accommodative stance for monetary policy" by keeping the federal funds rate at "exceptionally low levels" at least through late 2014. The previous policy was to keep rates low through "at least through mid-201," so this extends the commitment by a year and a half and represents an easing of policy (I would have preferred more aggressive easing, it's not clear how much effect extending the commitment will have -- I don't expect it to be large -- but this is certainly a step in the right direction).

As for the tone of this statement relative to the statement in December, there is not much of a difference. There are a few minor changes, for example the statement about business investment is slightly more negative this time, and the committee dropped a statement about continuing to monitor inflation and inflation expectations closely (the "subdued outlook for inflation over the medium run" is one of the reasons the Fed decided to ease policy further), but beyond the change described above the two statements are very similar.

Here's the latest release:

Continue reading "The Fed will Keep Rates at "Exceptionally Low Levels" Through Late 2014" »

Thursday, January 19, 2012

Fed Watch: Japan Revisited

Tim Duy:

Japan Revisited, by Tim Duy: I haven't had a chance to comment on the recent debate regarding Japan's lost decades, so I am coming to the party a bit late. A view is forming that the situation is not as dire as many believe. Paul Krugman notes:

This picture suggests that the Japanese economy was indeed depressed for about 16 years, and deeply so after the slump of the late 1990s. But it may have returned to more or less potential output on the eve of the current crisis.

Just to be clear, this is not a picture of policy success; it is, in fact, a picture of enormous waste. But the condition wasn’t permanent.

Yes, the lost years surely indicate a policy failure. But arguably there is some success. On one hand, we can see this as vindication of massive deficit spending. But is this really success? Because on the other hand, there is no end in sight of such deficit spending. On Japan's 2012 budget, via the FT:

Even by current grim international fiscal standards, Japan’s budget for the year from April 1 makes scary reading.

For the fourth year in a row, government revenue from bond issuance is set to exceed that from all taxes. Outstanding government debt is expected to hit an extraordinary Y937tn.

I don't intend to go down the "Japan's bond market is about to collapse" path. But what I am wondering about is Krugman's description of the condition as not permanent. Do we need to see a reversal of debt to GDP ratios to declare victory? Well, even on that metric it looks like there was some hope heading into the recent downturn:


But such hopes have since been dashed.

Where does this leave me? Yes, fiscal policy can work - it can back fill missing demand. But we haven't seen enough activity in Japan to really jump start the economy to a point that fiscal policy is no longer an economic necessity. And I am not sure we can expect such a jump start without more explicit help from the central bank. In which case, Japan has not truly "recovered." Thus, we cannot yet conclude their condition is not permanent.

In short, before we can declare recovery in Japan, we need to define what a successful recovery should look like. Is it just about returning to potential output (adjusted, in this case, for demographics), or should it be recovery to the point that deficit spending is no longer necessary to support that output?

Tuesday, January 17, 2012

How Did the Fed Get Things So Wrong?

We are, as they say, live:

How Did the Fed Get Things So Wrong?

It's about the Fed's mistakes before and during the crisis, and how it might improve going forward.

Thursday, January 12, 2012

There Is No Bubble and Even if There Is It's Not a Problem...

The big story today seems to be the Fed's comments about the housing bubble in transcripts from their meetings in 2006. The transcripts show what we already knew, that the Fed was never fully convinced there was a housing bubble, and asserted that even if there was the dmage could be contained -- they could easily clean up after it pops without the economy suffering too much damage:

Greenspan image tarnished by newly released documents, by Zachary A. Goldfarb, Washington Post: The leaders of the Federal Reserve went around the room saluting Alan Greenspan during his last major meeting as chairman of the central bank Jan. 31, 2006. ...
Some six years later, Greenspan’s record — sterling when he left the central bank after 18 years — looks much more mixed. Many economists and analysts say a range of Fed policies contributed to the financial crisis and resulting recession. These included keeping interest rates low for an extended period, failing to take action to stem the bubble in housing prices and inadequate oversight of financial firms.
The Thursday release of transcripts of Fed meetings in 2006 shows that top leaders of the Fed — several of whom continue to hold key positions today — had a limited awareness of the gravity of the threat that the weakness in the housing market posed to the rest of the economy. And they had what turned out to be an excessive optimism about how well things would turn out. ...
A Fed economist reported in a 2006 meeting that “we have not seen — and don’t expect — a broad deterioration in mortgage credit quality.” That turned out to be incorrect. ...

Wednesday, January 11, 2012

Democrats are Not Anti-Market

A recent column (on the claim that Democrat are anti-market, socialists, see here too):

Democrats are Not Anti-Market, by Mark Thoma: Republican hopefuls are attempting to portray the coming presidential election as a battle between people who believe in free markets and those who want to turn the U.S. into a socialist state. Michele Bachmann has been quite explicit  with this charge, and Mitt Romney Newt Gingrich, and the other leading Republican candidates have made similar claims.

There are certainly those on the left who call for radical change, including the elimination of the market system, just as there are those on the right who have extreme views on a variety of topics. But the Democratic Party is not calling for the overthrow of capitalism, and the claim that Democrats prefer a socialist state is false. Democrats support markets too. The disagreement is about the best way to bring about a well-functioning market system, and whether that system produces an equitable distribution of income and opportunity.

Conservatives believe that markets work best when government involvement is minimal or absent altogether. They don’t deny that individual markets can fail for a variety of reasons, and they acknowledge that the aggregate economy is subject to cyclical swings that bring periods of high unemployment. However, with patience markets and the macroeconomy will fix themselves. If the government steps in and tries to help, on net it will make things worse, not better. Thus it’s almost always best to wait for the economy to heal itself, even if the wait is a long one.

Democrats have different ideas about what it takes for markets to fully realize their potential. They believe that individual markets work best when government takes an active role to prevent market failures. They also believe that monetary and fiscal policies are useful tools to offset cyclical swings in the aggregate economy.

Democrats also differ from Republicans on the need for government to redistribute income. Republicans believe that redistributing income reduces the incentive to pursue economic gains, and this lowers long- run economic growth. Democrats believe that a more equitable distribution of income is desirable in some instances, and that worries about the impact redistribution will have on economic growth are overstated. Democrats also believe there are significant concentrations of political power and market failures that distort the distribution of income, and these distortions should be corrected through government action.

Which of these two visions is correct? Republicans have tried to blame the financial crisis on the government, in particular government programs to support housing for low-income households, but the evidence overwhelmingly refutes this claim.  The problem wasn’t too much government, it was that government did not do enough.

We would be much better off today if government had ignored Alan Greenspan and other advocates of deregulation who argued that financial markets are self-policing, and had instead provided strong regulatory oversight of both the traditional and shadow banking sectors. We would also be better off if the Fed had intervened and popped the housing bubble as it was inflating rather than denying there was a bubble and arguing it could always clean up the mess quickly and neatly in any case.

And in assessing the two views, it’s important to note that the things the government did do were helpful. Though the design of the Bush administration’s bailout of the financial sector left much to be desired, it prevented a much worse outcome. There’s also little doubt that the fiscal stimulus put in place during the Obama administration helped the economy. Things would be better today if we had resisted the austerity minded and done even more to stimulate output and job creation.

In the coming year, we will have to choose between these competing views of the government’s proper role in the economy. The Republican view is that the economy can take care of itself. There’s no need for government to intervene, and the distribution of income – no matter how skewed – should also be left alone.

We’ve already tried Republican policies in recent decades and the promised economic growth, stability, and widely shared prosperity did not materialize. Instead we had a Great Recession, inequality widened substantially, and market and political power became more and more concentrated.

In addition, the recent recession challenges the GOP’s “markets are magic” point of view. During the time when the housing bubble was inflating, markets misdirected resources and too much of our intellectual talent, labor, and raw materials were drawn into housing and finance. Markets also failed to optimally hedge against risks, they have been very slow to self-correct – labor markets in particular – and the fact that the extraordinarily high profits in the financial sector have not been eroded away through new entry is a sign of excessive and persistent market imperfections.

The other view, that of Democrats, speaks directly to these problems. It embraces active oversight of markets to ensure they are operating to maximize social good, it encourages the use of countercyclical monetary and fiscal policies to stabilize output and employment, and it advocates correcting the inevitable inequities in income and opportunity that arise in imperfect, real world market systems.

Thus, contrary to the charge from Republicans that Democrats are anti-market, there’s a strong argument to be made that it’s the policies of Democrats rather than Republicans that do the best job of allowing markets to reach their full potential.

Fed Watch: Output Gaps and Inflation

Tim Duy:

Output Gaps and Inflation, by Tim Duy: Regarding, again, the size of the output gap, this remark is found in the most recent Fed minutes:

However, a couple of participants noted that the rate of inflation over the past year had not fallen as much as would be expected if the gap in resource utilization were large, suggesting that the level of potential output was lower than some current estimates.

I think this has less to do with the size of the output gap and more to do with downward nominal wage rigidities. Note that wages are still rising, although the pace of wage growth for production and nonsupervisory workers is still falling:


Perhaps a better example is the relatively new series, wages for all workers:


Overall private wage growth bottomed out in 2009 and held around 1.75%, perhaps just beginning to rise in recent months.
Despite very high unemployment and underemployment, wage growth is still positive. It tends to be very difficult to induce workers to take wages cuts (think also how the newly unemployed will resist taking new jobs with a substantially lower pay), which in-turn helps put a downside to inflation. In other words, one would expect the relationship between the output gap (or, similarly, high unemployment) and inflation to flatten as inflation rates fall toward zero.
This is also covered by Paul Krugman here and here.
Also note that rising wages doesn't necessarily imply higher inflation. Between the two is productivity growth. To account for the latter, we can look at unit labor costs:

Not exactly a lot of inflationary pressures stemming from unit labor cost growth. Presumably, high real wages could come by redistributing productivity gains to workers in the context of low inflation. For that to happen, however, I think we will need a lot more upward pressure on the labor market than we are seeing right now.

Monday, January 09, 2012

Fed Watch: More on the Output Gap

Tim Duy:

More on the Output Gap, by Tim Duy: Only time for a quick post between classes today...

Hoisted from the comments from my last piece, Steve notes:

In an interview with Bloomberg last week, Bullard explicitly said he expected the economy to follow a new output trend out of the base of the recession rather than a recovery to a trend from the previous peak. The written media didn't pick up on these quotes; rather they focused his comments that explicit inflation targeting is near.

I missed that interview, but found it here. And yes, St. Louis Federal Reserve President James Bullard does say that estimates of the output gap are too high and will be revised downward. He says the outcomes of the last expansion were not related to economic fundamentals and thus we should not expect to be able to return to those levels of output and, presumably, employment. He does not aim to return to the pre-recession trend of output growth and is instead ready to manage the economy along the new path. Bullard does admit, however, that he has gotten little traction for his view.

On the other end of the spectrum, San Francisco Federal Reserve President John Williams offers an interview to the Wall Street Journal, and sounds dovish even after the most recent employment report:

In a follow-up email exchange, Mr. Williams wrote that the report didn't fundamentally alter his views on the economy.

"My view of it is inflation is going to be for a sustained period below target," he said. "Unemployment is going to be sustained above a reasonable estimate of the natural rate of unemployment, which is closer to 6.5% than the 8.5% that we have now. That does make an argument that we should have more stimulus."

There is a caveat, however:

Mr. Williams also hedges, though, adding that it "really depends in how much confidence you have in that forecast. And also there are costs to taking greater policy action. There are always trade-offs that have to be weighed."

This is frustrating, because if there is indeed an argument further stimulus, what is holding the Fed back? Why hedge by questioning the forecast? And what are the costs? Presumably the cost is higher inflation, but Williams already says he expects inflation to be below target. So why pull your punches?

I am starting to wonder if the whole "we can do more" meme from the dovish side of the FOMC has more to do with just offering a counterweight to the hawks who seem to see an imminent need for tightening rather than a push for an actual policy change.