Category Archive for: Monetary Policy [Return to Main]

Thursday, June 03, 2010

"The Mankiw Rule Today"

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

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

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

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

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

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

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

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

Wednesday, June 02, 2010

"Does Washington Care About Unemployment"

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

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

Tuesday, June 01, 2010

Tyler Cowen: Is There a General Glut?

Tyler Cowen argues that:

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

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

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

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

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

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

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

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

Kevin Drum on fiscal stimulus, by Tyler Cowen:

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

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

The full link is here.

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

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

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

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

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

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

Monday, May 31, 2010

Paul Krugman: The Pain Caucus

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

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

Sunday, May 30, 2010

Growth Policy versus Stabilization Policy

I posted this at Maximum Utility a few days ago:

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

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

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

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

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

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

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

Thursday, May 27, 2010

Maximum Utility: What Economic Policies Should Government Pursue During the Recovery?

[I am going to start reposting entries from my Maximum Utility blog a few days after they are posted at MoneyWatch. This one is a bit older than that, and it was first noted here.]

What Economic Policies Should Government Pursue During the Recovery?, Maximum Utility: Now that the economy appears to be turning around, how should the government react? What types of policies are needed for the recovery period?

1. Things look better now. Almost all economic indicators are beginning to point upward, but we don't know yet if the recovery will be strong or weak, or if we might be headed for a double dip. For that reason, don't pull back on monetary and fiscal stimulus too soon. It will be tempting to listen to the deficit and inflation hawks as things start to improve, but it's important that the stimulus not be withdrawn before the economy can stand on its own.

2. If the recovery seems to be very slow or stagnating, don't be afraid to give the economy the additional help it needs. Output is starting to grow, but labor markets are lagging behind. It's not yet clear if the lag will be as large as in the previous two recessions, but it's certainly something to keep an eye on.

3. Similarly, there is a huge jobs backlog -- millions and millions of people have lost jobs during this recession -- and it will take a considerable amount of time to reemploy these workers even under strong labor market conditions. Workers will still need unemployment compensation, help with health care, and other social services until they can find work. They are not lazy or playing the system, it's just that the applicant to jobs ratio will remain high until the backlog is cleared, so don't cut them off too soon.

4. If the government does try to take an active rather than a passive role in the recovery, try to anticipate what the post-recession economy will look like and help with the adjustment. For example, there is lots of structural unemployment due to the scaling down of the housing and financial industries. Where will these workers go and what can the government do to help them get there? Will we need to rely upon exports to a greater degree than before the recession in order to maintain robust growth? If so, what can the government do to help this sector to develop? I don't mean the the government should try to manage the economy with a heavy handed industrial policy approach, but when it's clear that change is coming to a particular sector, then the government should do what it can to help (or at least get out of the way).

5. As the economy recovers, it will be easy to forget about the problems we had and what caused them. Don't let exuberance over the recovery get in the way of making the changes that need to be made to try to prevent this from happening again. All of the promises to do better that are made when things are really bad are easily forgotten once things improve.

6. When the time comes -- but not a moment before that -- policy must be reversed. The fiscal policy measures involving both government spending and tax cuts were sold as "targeted, timely, and temporary."  We could have done better at the targeted and timely part, but it's not too late to make it temporary. It will be difficult to cut the stimulus once it's clear that the economy has recovered, there will be an outcry about the jobs that will be lost, the decline in growth, etc., but it's important that we do it. First, there are theoretical reasons to believe that temporary fiscal policy has a much larger effect than permanent changes within modern, New Keynesian structures. Second, we may need fiscal policy again someday. If we don't keep out promises and reverse the spending and tax cuts, the next time fiscal policy is needed nobody will believe that will actually be temporary no matter what is promised, and that will make it much more difficult to pursue the policy that is needed.

Update: 7. State and local governments are still having trouble, and are likely to continue to struggle at least through the next fiscal year. If they don't get more help, this create a big drag on the recovery.

This is surely incomplete. What else should be on the list?

Tuesday, May 25, 2010

Growth Policy versus Stabilization Policy

I have a new post at MoneyWatch:

Growth Policy versus Stabilization Policy: In economics, as in other disciplines, the important questions change over time. In macroeconomics, there are two big questions and our attention to one or the other changes with the economic events of each era. One question concerns stabilization policy -- keeping the economy as close as possible to the long-run growth path -- and the other is growth policy, i.e. policy that attempts to maximize the long-run growth rate. (There is also work on whether stability and growth are related. More stable economies could grow faster due to reduced uncertainty, but government intervention to stabilize the economy could also stifle growth according to some models, so the relationship is not clear a priori.)

We could go back further than this, but let me pick the story up in the 1970s. ...[continue reading]...

The argument is that we have paid too much attention to growth policy, and not enough to stabilization. Even if the growth policies do pay off in the long-run, the over emphasis on growth has caused a slower recovery and it's not at all evident that's a desirable trade off.

Friday, May 21, 2010

Fed Watch: Fed Disconnect

Tim Duy reacts to Federal Reserve Governor Daniel Tarullo's recent testimony on the European debt crisis:

Fed Disconnect, by Tim Duy: Federal Reserve Governor Daniel Tarullo's recent testimony on the European debt crisis illustrates a significant inconsistency with between the Fed's outlook and its policy.  Honestly, if Tarullo actually believes with he says, the Fed needs to be pursuing a much more aggressive policy.  But the FOMC is actually debating the opposite - when and how to reverse its swelling balance sheet.

Tarullo highlights the two obvious negative channels by which the European crisis will feed into the US economy.  The first is financial:

These effects on U.S. markets underscore the high degree of integration of the U.S. and European economies and highlight the risks to the United States of renewed financial stresses in Europe. One avenue through which financial turmoil in Europe might affect the U.S. economy is by weakening the asset quality and capital positions of U.S. financial institutions...

...In addition to imposing direct losses on U.S. institutions, a heightening of financial stresses in Europe could be transmitted to financial markets globally. Increases in uncertainty and risk aversion could lead to higher funding costs and liquidity shortages for some institutions, and forced asset sales and reductions in collateral values that could, in turn, engender further market turmoil. In these conditions, U.S. banks and other institutions might be forced to pull back on their lending, as they did during the period of severe financial market dysfunction that followed the bankruptcy of Lehman Brothers.

 The second is via trade linkages:

Another means by which an intensification of financial turmoil in Europe could affect U.S. growth is by reducing trade. Collectively, Europe represents one of our most important trading partners and accounts for about one-quarter of U.S. merchandise exports. Accordingly, a moderate economic slowdown across Europe would cause U.S. export growth to fall, weighing on U.S. economic performance by a discernible, but modest extent. However, a deeper contraction in Europe associated with sharp financial dislocations would have the potential to stall the recovery of the entire global economy, and this scenario would have far more serious consequences for U.S. trade and economic growth. A resultant slowdown in the United States and abroad would likely also feed back into the health of U.S. financial institutions.

Tarullo acknowledges that the European crisis is largely a European problem, while the Fed is reduced to a limited supporting role.  What caught my attention was first this section regarding the potential for financial disruption:

The timing of such an event in the current instance would be unfortunate, as banks generally have only recently ceased tightening lending standards, and have yet to unwind from the considerable tightening that has occurred over the past two years. Moreover, aggregate bank lending, particularly to businesses, continues to contract. The result would be another source of risk to the U.S. recovery in an environment of still-fragile balance sheets and considerable slack. Although we view such a development as unlikely, the swoon in global financial markets earlier this month suggests that it is not out of the question.

The fact that aggregate bank lending continues to contract, that the Fed is obviously aware of this, and that, according to Tarullo, the European crisis has the potential to aggravate an already existing problem all clearly point toward a more aggressive quantitative easing program than in place.  Actually, what is happening is the Fed is considering a quantitative tightening program:

Meeting participants agreed broadly on key objectives of a longer-run strategy for asset sales and redemptions. The strategy should be consistent with the achievement of the Committee's objectives of maximum employment and price stability. In addition, the strategy should normalize the size and composition of the balance sheet over time. Reducing the size of the balance sheet would decrease the associated reserve balances to amounts consistent with more normal operations of money markets and monetary policy. Returning the portfolio to its historical composition of essentially all Treasury securities would minimize the extent to which the Federal Reserve portfolio might be affecting the allocation of credit among private borrowers and sectors of the economy.

Tarullo also presses for a hawkish fiscal stance:

The United States is in a very different position from that of the European countries whose debt instruments have been under such pressure. But their experience is another reminder, if one were needed, that every country with sustained budget deficits and rising debt--including the United States--needs to act in a timely manner to put in place a credible program for sustainable fiscal policies.

Interestingly, Tarullo seems to suggest that the US response to fiscal problem in Europe should be to tighten US fiscal policy on roughly the same timetable the Fed is looking forward to tightening US monetary policy.

To summarize, the Fed believes we are facing another threat to demand, either via financial or real trade linkages, at a time when lending activity continues to fall, suggesting that monetary policy is too tight to begin with.  But the Fed stance is to believe that monetary policy is on the verge of being too loose, and, if anything, planning needs to be made to tighten policy.  At the same time, Fed policymakers also believe fiscal policy needs to turn toward tightening as well. Meanwhile, unemployment hovers just below 10%, nor is it expected to decline rapidly,  and inflation continues to trend downward.

All of which together suggests that the Fed's policy stance is seriously out of whack with policymaker's interpretation of actual and potential economic developments.  And I have trouble explaining the disconnect.

Tuesday, May 18, 2010

"Ooooo...'out of thin air!'"

David Andolfatto reacts to Ron Paul's worries that the Fed can create money "out of thin air":

On Ron Paul and the Fed, by David Andolfatto: ...The Fed has the ability to create money "out of thin air!" Whenever I hear this expression, I chuckle. We all have the power to create debt out of "thin air." When Microsoft creates shares to finance an acquisition, it creates the shares "out of thin air." If you bum a beer from a friend and promise to repay him next week, you create a debt obligation "out of thin air." Ooooo..."out of thin air!" ...

Tuesday, May 11, 2010

Congress and the Fed: Why the Bark is Worse Than the Bite

New post at MoneyWatch in reaction to today's 96-0 vote in the Senate to audit the Fed:

Congress and the Fed: Why the Bark is Worse Than the Bite

I argue that Congress should try to look like it is being very tough on the Fed, but it's not in Congress' interest to take a big bite out of the Fed's authority.

"Banks Failing to Lend is Not the Problem"

Dean Baker takes on the "banks not lending" explanation for the persistence of the downturn and sluggish movement toward recovery:

Banks failing to lend is not the problem, by Dean Baker: One of the big myths of the current downturn is that the reason the slump persists is that banks are refusing to lend. The story goes that because the banks have taken such big hits to their capital as a result of the collapse of the housing bubble and record default rates, they no longer have the money to lend to small- and mid-sized businesses.
We then get the story about how small businesses are the engine of job creation, responsible for most new jobs. Therefore, if they can't get capital, we can't expect to see robust job growth.
This story of banks not lending is used to justify all sorts of special policies to help out small businesses and banks. In fact, the Obama administration has plans to make a special $30bn slush fund available to banks if they promise to lend it out to small businesses.
In reality, every part of this argument is completely wrong. First, small businesses are not special engines of job growth. Small businesses do create most new jobs, but they also lose most new jobs. Half of new businesses go under within four years after being started. Jobs do get created when the businesses start, but jobs are lost when the businesses fail.
The reality is that businesses of all sizes create jobs. There is no special reason to favor small businesses in promoting job creation. We should favor businesses that create good paying jobs with good benefits and conditions, regardless of their size.
The other parts of this story make even less sense. Let's hypothesize that many banks are crippled in their ability to lend because of the large hits to their balance sheets from bad mortgage debt. Well, not all banks got themselves over their heads with bad mortgages. There are banks with relatively clean balance sheets.
If it were the case that a substantial portion of banks are now unable to issue many new loans because of their inadequate capital, we would expect to see the healthy banks rushing in to fill the lending gap. There should be accounts of dynamic banks that are taking advantage of this once-in-a-lifetime opportunity and rapidly gaining market share.
While this may be happening, there certainly have not been many accounts in the media of banks that fit this description. In other words, it does not appear to be the view among banks, including those with plenty of capital, that there are many good potential customers who are unable to borrow money.
The other missing part of the story has to do with the nature of competition between small firms and their larger competitors. We know that large firms have no difficulty attracting capital at present. They can issue bonds at near record-low interest rates. They can also borrow short-term money at extraordinarily low interest rates in the commercial paper market.
If small and mid-sized companies were being prevented from expanding due to their inability to raise capital then we should be seeing larger companies rushing in to take market share. Retail stores should be opening up new outlets everywhere. Factories should be rapidly increasing output and transportation companies should be rushing into new markets.
Of course, we don't see any of this happening. If anything, most large businesses are expanding at a slower rate than they did before the crisis. If their competitors have been hamstrung due to a lack of credit, no one seems to have told Wal-Mart, Starbucks and the rest. They have both slowed the rate at which they are adding new stores, not sped it up as the credit-shortage story would imply.
There is truth to the credit-squeeze story, but it goes in the other direction. Stores that have seen their business plummet as a result of the downturn are, in fact, worse credit risks from the standpoint of banks. Many businesses that were profitable in 2006 and 2007 are now highly unprofitable and may not be able to stay in business. As a result, the banks that were happy to lend money just a few years ago are no longer willing to lend money to the same business. This drying up of credit happens in every downturn. It is just more serious this time because of the severity of the downturn.
The moral of this story is that we should not think that "fixing" the banks will get us out of the downturn. The problem is that we have to generate demand, which means having the government spend more money to stimulate the economy. Unfortunately, the politicians in Washington are scared to talk about larger deficits, so more spending seems off the table at the moment – therefore we get this nonsense about insufficient bank lending.
But hey, at the rate we created jobs in April, we should be back at full employment in seven years anyhow. Who could ask for anything more?

This is not a supply problem, banks are sitting on mountains of excess reserves (some of which are serving as insurance against unexpected contingencies, but even so the excess reserves in the system are voluminous). But the ample supply of loans available to be loaned out at the right terms does not automatically create a demand for them.

I think the problem is on both sides. Supply has tightened up due to poor economic conditions -- as noted above banks are unwilling to loan to firms who look shaky during the downturn, firms that might have looked very solid and worthy not all that long ago. But the demand for loans has fallen as well since firms have little reason to invest in such bad economic conditions. So if the goal is to generate more investment, the solution is twofold. First, the demand for loans must be present. Additional government spending as called for above can help, but so can measures such as an investment tax credit or other financial incentives for firms that undertake to new investment. Second, banks must have the money to lend and be willing to do so at reasonable terms. Available reserves are not the problem, it's the fear of losses due to poor economic conditions that is making banks hesitate. One way over this hurdle is for the government to share in losses that banks realize on these loans. With lower expected losses through the loss sharing arrangement, the banks would be more willing to part with funds.

But the big question for me is the desirability of promoting investments that the private sector does not think are a good idea. If the result of this intervention is a bunch of failed investments and wasted resources, then this is not the best way to stimulate the economy. If there's some sort of market failure that is preventing firms and banks from entering into productive deals, then there is clearly a role for government to step in and fix the problem. One could make an argument that, say, risk is artificially elevated (disconnected from its "fundamental" value) and hence some sort of intervention is needed to restore the market, and I think there's some merit to the market failure arguments. Still, rather than helping firms in this way, I'd prefer to have more help for those households suffering the most from the downturn, i.e. additional government spending, transfers, and job creation -- that means a far bigger stimulus program than we got -- and then let firms respond to the additional demand as they see fit.

Finally, this is a bit different -- it involves investment in basic research rather than investment by firms -- but some types of government intervention appear to be productive:

Federal investment in basic research yields outsized dividends -- innovation, companies, jobs, EurekAlert: How can the United States foster long-term economic growth? A new report suggests that one of the best ways is through investment in the basic research that leads to innovation and job creation. ...
"There is no question that the public benefit gained from funding basic research is exponentially greater than the initial investment," said Susan Desmond-Hellmann, Chancellor of University of California San Francisco. "The success stories highlighted in this report demonstrate that fact and are a reminder that the continued scientific and technological leadership of the United States – and our economic well-being – depends on consistent, strong funding for research." ...
These success stories include global industry leaders like Google, Genentech, Cisco Systems, SAS and iRobot, as well as relative newcomers such as advanced battery manufacturer A123 Systems; network security company Arbor Networks; AIDS vaccine developer GeoVax Labs; and Sharklet Technologies, which has developed a novel surface technology based on the qualities of shark skin to combat hospital-acquired infections.
The report illustrates the substantial economic benefits the U.S. reaps when companies are created as a result of discoveries in federally funded university laboratories. One example of this return on investment is TomoTherapy Incorporated, based in Madison, Wisconsin. A $250,000 grant from the National Institutes of Health's National Cancer Institute to two researchers at the University of Wisconsin-Madison enabled the development of ... a highly advanced radiation therapy system that targets cancerous tumors while minimizing exposure and damage to surrounding tissue. Each year the technology is used to help improve the outcomes of tens of thousands of difficult to treat cancer patients around the world.
"That original investment generates many times its value in salaries and taxes returned to both the U.S. and Wisconsin governments," says University of Wisconsin-Madison professor and TomoTherapy Co-founder and Chairman Rock Mackie. TomoTherapy employs 600 people. ...
"University-launched startups can be powerhouses for value creation, becoming public companies at a far greater rate than the average for new businesses," according to Krisztina "Z" Holly, vice provost for innovation at the University of Southern California (USC). "Higher education can play a crucial role not just in spurring pioneering ideas, but in creating entrepreneurs who turn breakthroughs into innovations." The results benefit everyone, she says. Holly points to 24 USC startup companies that currently employ 500 full-time workers, more than half of whom are in Los Angeles. Sixteen of these companies have raised at least $148 million in financing over the past two years, during the height of the recession. ...

Monday, May 10, 2010

"Checks and Balances at the Fed"

Jon Faust is worried that the Dodd proposal to change the selection process for members of the FOMC (the committee that sets monetary policy) will lead to too much political control of the Fed and all the problems that come with it:

Checks and Balances at the Fed, by Jon Faust, RTE: The financial crisis has provided, among other things, a civics lesson about the Federal Reserve. Some people have been surprised to learn that 5 of 12 votes on the Fed’s main policy committee–the Federal Open Market Committee (FOMC)–are cast people who are not politically appointed. The 7 politically appointed Fed Governors vote on the FOMC, but the remaining 5 votes rotate among the Reserve Bank Presidents, who are chosen by the Board’s of the Reserve Banks. People on those Boards are, themselves, mainly chosen by the member banks of the Federal Reserve System. Senator Dodd’s reform bill attempts to fix this problem.
This supposed fix is dangerously naïve and ignores the lessons of the last great financial crisis.
The bill as reported states: “To eliminate potential conflicts of interest at Federal Reserve Banks, the Federal Reserve Act is amended to state that no company, or subsidiary or affiliate of a company that is supervised by the Board of Governors can vote for Federal Reserve Bank directors…”
The current arrangement of the FOMC was framed as a response to the Great Depression. The framers viewed the conflicts of interest over Fed policy as fundamental and saw no way to eliminate them. Historical precedent suggested (and still suggests) that political control of a central bank leads to lack of discipline and inflation. But complete absence of political influence is also inappropriate in a Democracy.
Thus, the FOMC’s framers looked to the uniquely American solution of checks and balances. In particular, they called upon two widely despised groups during the depression—bankers and politicians—to balance each other’s worst impulses.
Representative Glass and Senator Steagall, of Glass-Steagall fame, fought tenaciously over the balance. Steagall proposed that only the politically-appointed governors would vote on the FOMC. Glass responded that Steagall was “without peer in his advocacy of inflation.” After heated debate, Congress arrived at the 7 to 5 split we have today. Senator Glass summarized the reasoning, “[The vote on the FOMC] will stand 5 to 7 giving the people of the country, as contradistinguished from private banking interest, control by a vote of 7 to 5…” There can be no doubt that the Congress sought to achieve a balance of fundamentally conflicting interests.
I am not arguing that Congress got the balance right, and the recent crisis is certainly reason enough to re-visit what the correct balance would be. But naively fiddling with the balance in the name of eliminating conflicts of interest misses the real civics lesson from the founding of the Fed’s FOMC.

I've written about this topic as well. This is from a post at Maximum Utility, my blog at CBS MoneyWatch:

What’s Wrong With the Dodd Proposal to Restructure the Fed?: A proposal from Senate Banking Committee Chairman Christopher Dodd changes the selection process for key positions within the Federal Reserve system. Unfortunately, this proposal makes the selection process worse, not better. If this proposal is passed into law, it would further concentrate power within the Federal Reserve system, and it would politicize the selection process, both of which are the opposite of where reform should take the system.
The Current Structure of the Federal Reserve System
The Federal Reserve System consists of a Central Bank in Washington and twelve Federal Reserve District (or regional) Banks. The Central Bank's authority resides with the seven member Board of Governors, one of which serves as chair (currently Ben Bernanke). Each of the District Banks has a nine member Board of Directors along with a bank President. It is the selection of the Board of Directors that is at issue.
Currently, the nine member Board of Directors at each of the District Banks consist of three Class A directors, three Class B directors, and three Class C directors. Class A directors are elected by member banks within the district and are professional bankers. Class B directors are also elected by member banks in the district, but these are business leaders, not bankers. Finally, Class C directors are appointed by the Board of Governors and are intended to represent the public interest.
Class B and Class C directors cannot be officers, directors, or employees of any bank, and Class C directors may not be stockholders of any bank. One Class C director is selected by the Board of Governors to serve as Chair of the Board of Directors. The Board of Directors selects the President of each District Bank, but the President must be approved by the Central Bank's Board of Governors.
What is the reasoning behind this structure? When the Fed was created in 1913, there was a concerted attempt to distribute power across geographic regions; between the public and private sectors; and across business, banking, and the public interests. The geographic distinctions were important because it's not unusual for economic conditions to differ regionally -- conditions can be booming in some places and depressed in others -- and the regions would favor different monetary policies. Thus, it's important to bring these different preferences to the table when policy is being determined so that the best overall strategy can be implemented.
Changes in the Distribution of Power over Time
In the early days of the Fed, power over monetary policy -- which at that time was mainly discount rate policy within each Federal Reserve District -- was shared between Washington and the District Banks, so the intent of the system was largely realized.
However, the shared power arrangement within the Federal Reserve system changed after the Great Depression. The Fed did not perform well during the great Depression and one of the problems, it seemed, was that the deliberative, democratic nature of the institution prevented it from taking quick, decisive action when it was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances rather than problems with individual banks (the discount window is well-suited to help individual banks, but it's not an effective tool to combat system wide disruptions; on the other hand, open-market operations -- a policy tool the Fed obtained after the Great Depression -- can inject reserves system-wide and are much more useful to deal with system-wide problems).
The result was that after the Great Depression, power was concentrated in the Central Bank's Board of Governors in Washington D.C., and increasingly over time, in the hands of one person -- the Chair of the Federal Reserve. Thus, over time the Fed has evolved from a democratic, shared power arrangement at its inception to a system that functions, for all intents an purposes, as a single bank in Washington, D.C,. with twelve branches spread across the U.S.
The Dodd Proposal
How would the Dodd proposal change this? Under the proposal, the Board of Directors for each District Bank would be chosen by the Central Bank's Board of Governors (who are themselves chosen by the President with the advice and consent of the Senate). The chair of the Board of Directors at each District Bank would be chosen by the President and confirmed by the Senate.
This means that the key figures within each District Bank would be chosen by Washington, and unlike the present system, there is no attempt at all to represent geographic, business, banking, and public interests explicitly in this arrangement. In addition, it no longer has the explicit safeguards contained in the current rules to prevent bankers from dominating the directorships (e.g. under the new rules the Chair of the Board of Directors could be a banker, currently that can't happen). Given that the appointments are coming from Washington (as opposed to a vote of banks within the District for six of the nine positions on the Board like we have now), there is no guarantee that the District bank Boards won't be stacked with one special interest or another. Thus one of the main reasons given by Dodd for the change in the selection process -- to remove the influence of bankers -- is actually undermined by his proposal because it removes the safeguards against the Board being dominated by banking interests.
I believe that the current structure of the Fed already gives too much power to Washington and not enough to the District Banks, and this has helped to feed the perception that the Fed does not represent the interests of the typical person. Unfortunately, the Dodd proposal further concentrates power in Washington and adds more political elements to the selection process thereby making these problems even worse.
Thus, I agree with this:
Bullard, 48, the St. Louis Fed’s president since April 2008, said ... the Fed is ultimately controlled by political appointees as it stands... “We don’t want to put all the power into Washington and New York,” Bullard said. “That’s just the opposite of what this crisis is teaching us. So you want the input from around the country, and I think it’s really important for informing monetary policy.”
Richmond Fed President Jeffrey Lacker said ... “I wouldn’t want to see the reserve bank governance mechanism politicized in any way,”... Asked if Dodd’s plan would politicize the process, Lacker said: “I think it could.”
Finally, while the proposal claims to insulate the Fed's monetary policy decision from political pressure, this quote from the same article illustrates the dangers of political interference. The quote is in response to another part of the Dodd proposal that would take away some of the power the District Bank Presidents have in setting monetary policy (which is already much less than the power of the Board of Governors):
“I doubt very much that by a year from now Fed presidents are going to have as big a role as they now have,” Financial Services Committee Chairman Barney Frank told reporters... He has said the presidents too often vote in favor of higher interest rates.
That last sentence means he believes the Fed has favored low inflation over low unemployment as it has set interest rate policy. That may or may not be true, but do we really want members of the House setting interest rate policy or changing the structure of the Fed whenever they disagree? I don't.
I fully agree that the selection process for the Directors and the District Bank Presidents could and should be changed (that includes redrawing geographic districts). It's not clear that the present system does the best possible job of representing the array of interests that have a stake in the outcome of policy decisions. But concentrating power in Washington is not the way to solve this problem. Instead we need to redistribute power over a wider range of interests, including geographic interests, and make sure the selection process for key positions within the Federal Reserve system brings those interests to the table when policy is determined.
[Update: See also Alan Blinder's "Threatening the Fed's Independence".]

And one more post from Maximum Utility:

Why The Federal Reserve Needs To Be Independent, by Mark Thoma: There are several bills that have been proposed in Congress directed at the Federal Reserve. The two most prominent proposals are Senate Banking Committee Chairman Christopher Dodd's bill to take away most of the Fed's regulatory authority, and Congressman Ron Paul's bill to force the Fed to allow its monetary policies to be audited by the Government Accountability Office (GAO).
Many people worry, rightly in my opinion, that if these proposals or others like them are passed into law, then the Fed's independence would be threatened.
Political business cycles and inflation
Why is the Fed's independence so important? One reason is the control of inflation. As former Federal Reserve Governor Frederic Mishkin wrote this week in an op-ed coauthored with Anil Kashyup of the University of Chicago:
Economic theory and massive amounts of empirical evidence make a strong case for maintaining the Fed's independence. When central banks are subjected to political pressure, authorities often pursue excessively expansionary monetary policy in order to lower unemployment in the short run. This produces higher inflation and higher interest rates without lowering unemployment in the long term. This has happened over and over again in the past, not only in the United States but in many other countries throughout the world.
What Mishkin and Kashyup are referring to are "political business cycles." The idea is that monetary policy acts faster on output and employment than it does on inflation. To take a concrete example, suppose that the impact of a change in the money supply on output peaks about six months after the change in policy, and then fades after that. And also suppose that the impact of the change in the money supply on prices is delayed six months and is not fully felt until eighteen months after the policy change (these are roughly consistent with econometric estimates of the impact of changes in money on output and prices).
This situation opens up the possibility for a politician in control of the money supply to manipulate the economy in an attempt to increase the chances of getting reelected. If votes depend upon output growth, as they seem to, then the politician can pump up the money supply around six months before the election so that output will peak just as the election is held. Then, the politician could plan to reduce the money supply just after the election to avoid having inflation problems down the road.
So the politician implements this strategy, gets reelected, and now comes the time to cut back on the money supply. But there's a problem. Output peaked the month of the election, and has been falling ever since. Will the politician actually cut the money supply and raise interest rates to avoid inflation -- which would reduce output and employment growth even further, something that is sure to bring protests -- or decide to live with the inflation? The choice is often to live with inflation, and as the cycle repeats with each election, inflation slowly ratchets upward.
Budget deficits and inflation
But political manipulation of the money supply is not the problem most people are worried about, it's the expected increase in the government debt that is creating the inflation worry.
When the government purchases goods and services, those purchases must be financed in one of three ways--raising taxes, borrowing from the public (i.e., issuing government debt), or printing new money. Thus, if government spending is much larger than taxes, and if raising taxes is political poison, then the deficit must be financed by either printing money or issuing new government debt. However, increasing the government debt is often a bad choice politically, so when faced with this decision politicians often choose to increase the money supply rather than increase the debt, and the result is inflation. The inflation is a hidden tax--in essence the government spending is paid for by inflating away the value of the dollar, but the blame for the inflation can often be displaced onto things like oil and other commodity prices, and thus the political consequences are not as large as for changes in taxes or in the debt.
The hope is that an independent Fed can overcome the temptation to use monetary policy to influence elections, and also overcome the temptation to monetize the debt, and that it will do what's best for the economy in the long-run rather than adopting the policy that maximizes the chances of politicians being reelected.
Independence threatened
Many people are worried that if the US does not get its long-run debt problem under control, a problem driven mainly by escalating health care costs, then politicians worried about their reelection chances will begin pressuring the Fed to finance the debt by printing money. And if the Fed is uncooperative, its independence may be taken away legislatively.
I believe these threats are real, and as noted above, experience shows that once politicians get involved in monetary policy, inflation generally becomes a problem. For that reason, I am very opposed to anything that threatens the Fed's ability to assert its independence and keep the economy on the best long-run path.

(For more discussion of the pros and cons of Fed independence, see here; for more on the degree of the Fed's independence in the U.S., see the bottom of this post.)

Wednesday, May 05, 2010

Fed Watch: Still Unbalanced

Tim Duy on the prospects for global rebalancing:

Still Unbalanced, by Tim Duy: The recent flow of data is interesting to say the least. While headline numbers are generally solid, the underlying story looks shaky. Shaky enough that disinflationary trends remain firmly entrenched in the US, whereas inflationary risks appear to be growing in emerging markets. The former suggests the Fed is set to remain on hold, while the latter will push foreign central banks to tighten. In a perfect world, that combination would put downward pressure on the Dollar and support a shift to a more balanced pattern of growth for both the world in general and the US in particular. Yet we persistently fall short of a perfect world. Will this time be any different? The Greek crisis is saying it won't.

Manufacturing remains a clear bright spot in the economic environment, a point reiterated by the most recent ISM survey. The headline 60.4 was the strongest since 2004, and the underlying details were solid. Employment continues to expand, providing at least a modicum of relief for the beleaguered labor market. The inventory drain became apparent, with more firms than not reporting stockpiles as too low. This suggests further room for manufacturing expansion. The proportion of firms reporting rising prices edged up again, not unexpected considering the complete lack of pricing power and drop in commodity prices at the low point of the recession. Note too that the strength in the ISM numbers is consistent with the solid manufacturing report, with a strong gain in new orders for nonair, nondefense capital goods.

Although the positive tenor to manufacturing is welcome, the first quarter read on GDP reveals a more uneven pattern of recovery, and more worrisome, a recovery that looks a little too dependent on US households. Consumer spending gained 3.6%, contributing 2.55 percentage points to the headline 3.2% gain. The sustainability of such spending, however, remains in doubt. Note that spending growth was heavily supported by falling savings rates, while income growth less transfer payment remains stagnant. This suggests that consumers are once again leveraging up the balance sheets while the deleveraging outside of housing was likely not as deep as initially believed, once bank loan write-offs are accounted for. In short, it looks like we have come full circle. The US economy is again excessively dependent on consumer spending, and that spending is fueled by anything but organic income growth.

The next largest contributor was inventories, which add 1.57 percentage points - clearly part and parcel of the manufacturing revival. Also supportive of that sector was the 13.4% gain in equipment and software category, down from the previous quarter. But a closer look reveals that category, a small part of overall spending, contributed only 0.83 percentage points to growth, and the bulk of that was information technology; industrial and transportation were basically flat. Residential and nonresidential structures were both a drag on growth, illustrating the ongoing weakness of both sectors - weakness that prevents a true V-shaped recovery. Growth, yes, and even sustainable growth. But growth that leaves the economy limping along, heavily dependent on policies to stimulate consumer spending.

With overall investment still falling short of fully supportive of recovery, attention turns to the export story. And, yes, export growth is supportive. The problem is the import drag swamped the export push, leaving the external sector a net negative for growth, sapping 0.61 percentage points from the headline number. This drag throws a wrench into hope that external growth will support the recovery or a rebalancing of global activity. We need to acknowledge the possibility (likelihood) that outsourcing during the past twenty years has left the US structurally dependent on trade deficits. Fueling consumer spending simply translates into a substantially offsetting import increase, thereby preventing the external sector from contributing to growth on net.

Presumably, what we need is policy supportive of a real rebalancing, in which the US consumer is comparatively subdued, keeping a lid on import growth, while the rest of the world is firing on most cylinders. And here is where exchange rate adjustment is important. Faster growth abroad should translate into higher foreign interest rates, which should in turn be Dollar negative. Part of that story is in play. From the Wall Street Journal:

Prices across Asia are rising faster than expected, highlighting the region's strong recovery compared with the West and raising the likelihood for tighter monetary policy.

South Korea and Indonesia reported higher-than-expected inflation Monday, coming a day after China raised banking reserve requirements in a bid to cool its economy. In a sign that inflation is becoming entrenched, core prices, which exclude volatile food and energy, are ticking up.

Meanwhile, the Fed last week reiterated its commitment to ultra-low rates, which should come as no surprise given the uneven and inventory cycle dependent nature of US growth so far - note that real final sales posted another anemic reading of 1.6% in the first quarter. There is simply not enough growth to rapidly alleviate stress in the labor market, thereby keeping disinflation in play. The March read on core-PCE inflation confirmed the downward trend:

FW050510

A declining Dollar is the signal to shift production to US shores and alleviate inflationary pressures abroad (while stimulating such pressure domestically), thereby limiting the need for foreign monetary policymakers to hit the brakes so fast that they stifle growth. There is no such thing as immaculate adjustment; a Dollar decline is critical to this process.

It should be a nice, textbook story. Alas, the US external adjustment is anything but textbook. The challenges I see to this adjustment:

  1. Export supporting foreign policymakers. Foreign policymakers could attempt to simply shift demand away from internal sources and to the US by raising rates while accelerating reserve accumulation (and sterilizing the subsequent domestic money growth). Indeed, emerging Asian nations would be hesitant to hobble their exporting industries, more so if China does not first revalue the renminbi.

  2. The Greek crisis. The Greek drama is obviously far from over; it is not clear that the threat of contagion is even significantly reduced, let alone eliminated. Nor would it be until all the PIIGS committed to a growth sapping fiscal stance, which the Greek public are finding hard to accept. That stance, while perhaps necessary, weighs against global growth and tends to strengthen the Dollar, slowing the rebalancing process. Moreover, I find it difficult if not impossible to believe that the impacted nations can adjust without a significant devaluation. Which suggests the Euro has further to fall. But it is reasonable to believe that, given the German weight in the Eurozone, any decline in the Euro would fall short of what is necessary for the PIIGS to fully adjust. Are we really down to just two choice then? Either Northern Europe commits to perpetual fiscal transfers to Southern Europe (not going to happen), or the Eurozone shrinks? Both suggest a weaker Euro, but the latter points to an outright collapse.

  3. The size of the Dollar adjustment. Given the substantial fixed costs of offshoring, it is possible that very large adjustments in the Dollar are necessary to give a lift to importing competing industries in particular. Policymakers may not have the stomach for such an adjustment, resulting in a slow pace of Dollar decline that the support provided net growth is almost negligible.

  4. The dependence of everyone on the US consumer. Any rebalancing requires the importance of the US consumer to decline from the current 71% of US GDP. Yet US officials welcome the consumer recovery, and would be hesitant to accept renewed consumer weakness without a clear offset (which they could provide via increase public investment, if they wanted to). And foreign officials, faced with a political class of exporters dependent on US consumers, would be hesitant to risk angering that constituency with a substantial adjustment (see point 1 above).

These are challenges, and are not meant to imply that adjustment cannot occur. Only that so far that recovery has seen precious little such adjustment, with net exports subtracting from growth two of the last three quarters. The combination of tepid US consumer growth, rapid foreign growth, and a steady although not disruptive decline in the Dollar - the combination of factors that present in 2006 and early 2007 - appears difficult to achieve and sustain. I fear it requires a much more substantial global commitment to rebalancing than we have seen to date. And that commitment will be sorely lacking given the Greek crisis. Where the American-led financial crisis forced global policymaker to pull together, the European crisis may push them back apart.

Friday, April 30, 2010

Paul Krugman: The Euro Trap

Deficit hawks are trying to use the "euro-mess" to support their case for austerity. But that's not the real lesson of the European crisis:

The Euro Trap, by Paul Krugman, Commentary, NY Times: Not that long ago, European economists used to mock their American counterparts for having questioned the wisdom of Europe’s march to monetary union. ... Oops..., right now it does seem to have been a bad idea for exactly the reasons the skeptics cited. And as for whether it will last — suddenly, that’s looking like an open question.
To understand the euro-mess — and its lessons for the rest of us — you need to see past the headlines. Right now everyone is focused on public debt, which can make it seem as if this is a simple story of governments that couldn’t control their spending. But that’s only part of the story for Greece, much less for Portugal, and not at all the story for Spain.
The fact is that three years ago none of the countries now in or near crisis seemed to be in deep fiscal trouble. ... And all of the countries were attracting large inflows of foreign capital, largely because markets believed that membership in the euro zone made Greek, Portuguese and Spanish bonds safe investments.
Then came the global financial crisis. Those inflows of capital dried up; revenues plunged and deficits soared; and membership in the euro ... turned into a trap.
What’s the nature of the trap? During the years of easy money, wages and prices in the crisis countries rose much faster than in the rest of Europe. Now that the money is no longer rolling in, those countries need to get costs back in line.
But that’s a much harder thing to do now than it was when each European nation had its own currency. Back then, costs could be brought in line by adjusting exchange rates... Now..., however, the only way to reduce Greek relative costs is through ... deflation. ...
The problem is that deflation — falling wages and prices — is always and everywhere a deeply painful process. It invariably involves a prolonged slump with high unemployment. And it also aggravates debt problems, both public and private, because incomes fall while the debt burden doesn’t.
Hence the crisis. ... All this is exactly what the euro-skeptics feared. Giving up the ability to adjust exchange rates, they warned, would invite future crises. And it has.
So what will happen to the euro? Until recently, most analysts, myself included, considered a euro breakup basically impossible, since any government that even hinted that it was considering leaving the euro would be inviting a catastrophic run on its banks. But if the crisis countries are forced into default, they’ll probably face severe bank runs anyway... This would open the door to euro exit.
So is the euro itself in danger? In a word, yes. If European leaders don’t start acting much more forcefully, providing Greece with enough help to avoid the worst, a chain reaction that starts with a Greek default and ends up wreaking much wider havoc looks all too possible.
Meanwhile, what are the lessons for the rest of us?
The deficit hawks are already trying to appropriate the European crisis, presenting it as an object lesson in the evils of government red ink. What the crisis really demonstrates, however, is the dangers of putting yourself in a policy straitjacket. When they joined the euro,... governments ... denied themselves the ability to do some bad things, like printing too much money; but they also denied themselves the ability to respond flexibly to events.
And when crisis strikes, governments need to be able to act. That’s what the architects of the euro forgot — and the rest of us need to remember.

Thursday, April 29, 2010

Fed Watch: We Can't All Be (Net) Exporters

Tim Duy:

We Can't All Be (Net) Exporters, by Tim Duy: The Greek crisis, which helped further extend the Dollar's uptrend in place since the beginning of the year, is a reminder that global imbalances are still with us - and, if not corrected, will eventually threaten the sustainability of the global recovery. Indeed, how sustainable can any recovery be if the vast majority of nations are pursuing an export oriented growth strategy? After all, clearly that is not a game all can play - there needs to be a net importer to offset the net exports. Who wants to fill that role? If the US is pushed into filling that role, we have simply come full circle over the past three years.

The Administration is clearly aware of this challenge, but concerns are growing that any action will fall short of what is necessary to bring about real change. From Sudeep Reddy at the Wall Street Journal:

President Barack Obama's goal of doubling U.S. exports over the next five years will be difficult to meet, business leaders and economists say, because of the lack of momentum on demolishing trade barriers and the shift by more American companies toward producing overseas.

U.S. exporters want Washington to put more pressure on trading partners to eliminate tariffs, crack down on intellectual-property violations and take a harder line on trading partners' currency policies. American firms say stronger action by the federal government could substantially boost prospects for U.S. exports.

Policymakers argue that it is far too early to admit defeat:

Christina Romer, chair of the White House Council of Economic Advisers, calls the administration's export target "an ambitious but reasonable goal."

"Going up 100% over a five-year period is not such a radical idea when you think about historical experience," she said, noting that exports increased more than 75% between 2003 and 2008. "It is going to be a gradual process. We are just starting the concrete steps in terms of what we can do to lower the fixed costs associated with exporting through trade promotion and commercial diplomacy."

Am I the only one that finds the Administration's focus on doubling exports somewhat disingenuous? Economic growth depends on net exports - doubling exports is a fine goal, as long as import growth is contained, such that the net effect is positive. But with the economy bouncing back, will import growth remain contained? Recent signs are not supportive - the recovery so far has ended the improvement in the real trade gap:

FW042910

Moreover, Romer claims the process will be "gradual." Will it be so gradual that US firms will resume expansion of overseas capacity at the expense of domestic production? Back to the Wall Street Journal:

But the shift by more U.S. companies toward producing goods overseas is one of the factors that makes doubling exports tougher. These firms have built more factories in fast-growing foreign countries to serve emerging markets, so they often supply the goods and services from an overseas arm—not by loading shipping containers in the U.S.

American businesses say they must contend with a long list of disadvantages, from higher tax rates than in many countries to rising costs for benefits such as health care. U.S. producers also say an artificially low Chinese currency makes Chinese goods especially cheap in foreign markets and therefore tougher competitors for American goods.

Once that production leaves, I suspect it is largely gone for good, barring a very large, sustained, and broad-based shift in the value of the Dollar. To be sure, the Administration is pressing China to revalue the renminbi, but the pace of any appreciation is likely to disappoint. Moreover, the uptrend in the Dollar raises a new concern. From Yves Smith:

A further source of trouble is political. If the euro continues on its expected slide and the pound is devalued, the dollar’s strength will put a major dent in the US ambitions to increase exports. Moreover, the rise in the greenback relative to other currencies will no doubt make China much more reluctant to revalue the renminbi against the dollar

Also, further pressure on the Euro is likely necessary to compensate for the fiscal drag of deficit containment in the PIIGS. Note too that recent events are driving capital to the US, holding down interest rates. From the Wall Street Journal:

Mortgage rates stayed flat last week, rising just slightly to 5.08% from 5.04% one week earlier, according to the Mortgage Bankers Association. So far, the big rise in rates that some had expected when the Federal Reserve ended its mortgage-backed securities purchase program last month hasn’t materialized.

In fact, the instability in Europe amid looming debt woes for Greece and Portugal on Tuesday sent investors looking for safer assets such as the 10-year Treasury, to which fixed-rate mortgages are closely tied. That has helped to keep rates down.

Sustained low rates will help keep US demand from waning, so much the better for to fuel the flow of imports necessary to meet the needs and wants of US consumers (it is not coincidence that the trade deficit began improving when the faltering housing market took the steam off consumer spending). And, intriguingly, Japan looks ready to resume the export push. Also from the Wall Street Journal:

As many Japanese enjoy their annual "Golden Week" holidays starting Thursday, some of Japan's economic ministers will be traveling to the U.S. and Asia to pitch what they hope will become a new driver of the nation's growth: infrastructure exports.

Transport Minister Seiji Maehara will spend Thursday and Friday in Washington to promote Japan's superfast bullet-train system as it chases part of President Barack Obama's high-speed railway project, which has an initial $8 billion price tag. Central Japan Railway Co. is among the hopefuls on some projects.

Meanwhile, Economic Strategy Minister Yoshito Sengoku will be wooing officials in Vietnam to choose a consortium of Japanese nuclear-power companies over French and South Korean rivals. Vietnam last year approved a resolution to build its first two nuclear-power plants, estimated to cost about $10.5 billion at current rates.

"In the past, Japanese ministers were too proud to go out there and cheer for our companies as they worried about failing to deliver successful results," Mr. Maehara said. "I intend to play the role of the top salesman for Japanese companies as their success equals the nation's economic growth."

Tokyo has begun a push to help Japanese companies win multibillion-dollar infrastructure projects abroad as its domestic economy continues to slump and a population decline threatens to sink demand further.

At the same time, rising environmental concerns in developed nations and rapid expansion of emerging economies are resulting in bumper crops of projects in areas like railways, nuclear power and clean energy.

"There is no growth for Japan unless we enhance exports," says Hiroki Mitsumata, director of nuclear-energy policy at the Ministry of Economy, Trade and Industry. "No matter how superior our technology is, if it's confined within Japan, it will become obsolete like the species in the Galapagos."

Given the consistent global policy theme of "more exports," at least one US firm recognizes the potential for disappointment with the Administration's goal:

Todd Teske, chief executive of Briggs & Stratton Corp., a Wauwatosa, Wis.-based small-engine maker, says he is partly counting on more exports to rebuild his sales after the recent downturn. Briggs & Stratton already receives about a fifth of its $2 billion in revenue from sales abroad, particularly in Europe. Mr. Teske calls the U.S. goal of doubling exports a "lofty goal" and one worth pursuing. But he's realistic. "It seems like every country or region wants to fuel their recovery plan with exports," he said.

Bottom Line: My gut tells me that in any battle for export oriented growth, the US will come up the loser. When push comes to shove, the US will do nothing in response to the accumulation of dollar assets abroad. Ultimately, nations need to do more to support domestic demand to drive economic growth. But the risk is that as the broad global financial crisis continues to fade, nations will increasingly attempt to withdraw fiscal support for their economies - even more so with the Greece example now so vivid - and attempt to rely on external growth to compensate. It is not a game everyone can win. But if it deteriorates into competitive devaluations, it is a game everyone can lose.

Wednesday, April 28, 2010

The Fed at a Crossroads

Here's the video from The Fed at a Crossroads panel discussion that I said I'd post:

The FOMC Holds the Target Interest Rate "at 0 to 1/4 Percent"

Since, at the moment, I'm listening to Vincent Reinhart talk about when the Fed will tighten in a session entitled The Fed at a Crossroads -- he says rates will stay low for an "extended period" -- I should note that the FOMC announced today that rates will stay low for, again, an extended period. (Reinhart was more specific and said he thinks rates will start to increase late this year or, more likely, early in 2011 -- Update: at the end of the session, he gave May 2011 as the most likely date.)

One side note: Jon Hilsenrath of the WSJ noted that the phrase "extended period" was coined by Reinhart when he was the Director of the Division of Monetary Affairs at the Federal Reserve Board.

[I'll post the video from this session later. Update: Posted here.]

Thursday, April 22, 2010

Is the Six Percent Rise in Producer Prices a Signal that Inflation is Coming?

At MoneyWatch, why the 6 percent headline inflation number for producer prices announced this morning does not signal that inflation is imminent, and why core inflation rate of .9 percent is a better measure to look at:

Is the Six Percent Rise in Producer Prices a Signal that Inflation is Coming?, by Mark Thoma: Many news reports are noting the six percent increase in the producer price index on a year over year basis and wondering if it signals that inflation is back. However, this report should not be read as a warning that inflation is just around the corner.

Why? The pass through from producer prices to consumer prices is less than 100 percent in any case, and in some cases it is close to zero. Pass through to consumer prices is smaller when the change in producer prices is temporary, and core inflation measures indicate that most of the rise in producer prices was due to a rise in food and energy prices. Once the temporary changes in food and energy prices are stripped out, the core inflation rate only increased .9 percent over the previous year, and that isn't much different from previous measures.

But which measure of inflation should we pay attention to if we want to predict future inflation? Why do we use core inflation instead of "headline" inflation for this purpose?...[...continue reading...]...

Tuesday, April 20, 2010

Fed Watch: The Sweet Spot

Tim Duy:

The Sweet Spot, by Tim Duy: Last week I described the economy as stuck in the middle, a description of the recovery from the perspective of middle America - improving, but not at a pace to make much progress in the labor market. This week I offer an alternative assessment: For market participants, this economy is in a sweet spot. Fast enough to push corporate profits upward, not fast enough to attract the attention of the Fed. The combination of steady, solid growth with low interest rates and no inflation is about as good as it can get for Wall Street - the sudden work ethic on the part of SEC officials notwithstanding.

Consider this piece from Bloomberg last week:

The latest surge in U.S. stocks may have more to do with historically low interest rates than any rebound in the economy and corporate earnings, according to Peter Boockvar, an equity strategist at Miller Tabak & Co.

As the CHART OF THE DAY illustrates, the Federal Reserve’s benchmark interest rate has been negative since November in real terms, adjusted for inflation. The Standard & Poor’s 500 Index, also included in the chart, showed a 17 percent gain for the period as of yesterday.

The central bank’s target rate for overnight loans between banks, or federal funds, currently stands at minus 2 percent on an inflation-adjusted basis. This figure is based on the upper end of the Fed’s range, zero to 0.25 percent, and the year-to- year change in consumer prices.

Yesterday, the S&P 500 closed above 1,200 for the first time since September 2008. The milestone followed a two-month rally that accounts for most of the index’s advance since the real rate fell below zero.

“What’s real and what’s artificial, what’s organic growth and what’s juiced by easy money” can’t be determined with rates at current levels, Boockvar wrote today in an e-mailed note. The question will only be answered, he added, when rates start to increase and the economy must function “without the crutch of cheap money.”

Yes, monetary policy works. On Wall Street, if not enough on Main Street. One intent of low rates and easy money is to push market participants into riskier assets. Does this make it more difficult to discern between real and artificial? Probably, yes. Should we care? Depends on who you are asking. You care if you are looking three or four years down the road or if you are a policymaker debating the end of stimulus. Should investors care as long as they can ride the trend up? Probably best not to think too much about it, and instead just enjoy the ride.

The real question is when will the easy money end. And on that point, Fed officials last week suggested they intend to let the good times roll and remain on the sidelines. Atlanta Federal Reserve President Dennis Lockhart provided a rather tepid assessment of the recovery, obviously still worried about the anticipated drags on activity later this year:

The Atlanta Fed's base case forecast for the near term looks for growth to continue. The pace of growth will probably be somewhat slow. I expect moderate growth because the economy is working through some formidable adjustments that act as drags on growth….

...Given the current state of the economy, I am very comfortable taking a personal position that is neither sanguine about these potential torpedoes nor unduly alarmist or defeatist. I take comfort that each big problem that is actionable is being addressed, and the recovery is moving forward. As I said earlier, so far so good.

Having said that, I believe the recovery requires continued support of accommodative monetary policy. I think there is risk associated with starting a process of tightening too soon. In my view, the strong medicine of low rates should remain in place to facilitate adjustment processes that are by their nature gradual.

St. Louis Fed President James Bullard is arguably slightly more optimistic:

Bullard said that he expects growth in the second quarter to be better than the first, and said that while the recovery is not “superstrong” it is “very reasonable.

Sound like the "stuck in the middle" story - very reasonable would be near trend growth, but falls short of the momentum necessary to generate a true V-shaped recovery. San Francisco Fed President Janet Yellen, offers a pretty optimistic view of the recovery, although, like Bullard, it falls short of a V:

It’s fair to say that my own thinking has recently turned a corner and I am becoming more and more confident that the economy is on the right track. For some time, we were confronted with about the grimmest economic landscape we had ever seen. But about the middle of last year, the economy stabilized and then returned to growth. The latest indicators show a broadening and deepening of the recovery, and point to solid, if not spectacular, expansion in the first half of this year. We won’t get an official reading of the nation’s first-quarter gross domestic product until the end of this month. But based on the information we have in hand, it looks like inflation-adjusted GDP grew somewhere around 3 percent during the first three months of 2010. Assuming that holds up, we’ve now got three straight quarters of growth under our belts. I expect the pace of recovery to gain momentum over the course of this year and next as households and businesses regain confidence, overall financial conditions continue to improve, and lenders increase the supply of credit. For the full year, my forecast calls for output to rise about 3½ percent, picking up to about 4½ percent in 2011. Those are decent numbers, but nowhere as strong as some past V-shaped recoveries, for reasons I’ll go into in a few minutes.

Yellen - often considered to be a dove - is confident enough to place a little uncertainty in the "extended period" language:

I’d like to close with a few words about monetary policy. As I noted earlier, we have pushed the federal funds rate down to zero for all practical purposes. Such an accommodative policy is appropriate because the economy is operating well below its potential, inflation is subdued, and such conditions are likely to continue for a while. Consistent with that view, the Fed’s main policymaking body, the Federal Open Market Committee, last month repeated its statement that it expects low interest rates to continue for an extended period. I agree with this assessment. At some point though, as the economy continues to expand, the Fed will have to pull back some of this extraordinary stimulus.

When will "some point" arrive? Job growth is critical on this point, and the last week's initial unemployment claims do not provide much hope that the jobs situation is changing soon. This, of course leaves us with an unhappy mix of data for job seeker, as while the Fed is not inclined to pump additional money into the economy in this environment. Mathew Yglesias repeats a now long-standing criticism:

... policymakers aren’t just supposed to offer grim forecasts, they’re supposed to take action to improve things.

The complacency around these issues continues to be staggering, and I can only [con]clude that the sociological concentration of unemployment among non-whites, young people, and those without college degrees is responsible. My guess is that few members of congress, or top FOMC members, or newspaper editors, spend a great deal of time socializing with members of the hardest-hit demographic groups which makes it a lot psychologically easier to keep glossing over the fact that they’re planning to do nothing about a problem that they recognize is severe.

Bottom Line: A more aggressive policy stance might be correct for Main Street, but I suspect would upend what is currently a nice little equilibrium on Wall Street. Raising the prospect that the Fed was trying to raise the inflation target would cement fear that interest rates will move dramatically higher in the years ahead. In contrast, the current state of the economy, with steady growth combined with low inflation and high unemployment, offers considerable certainty for market participants by putting the Fed on the sidelines. And that certainty is a valuable commodity.

Thursday, April 15, 2010

Fed Watch: Consumers Come to Life

Tim Duy is cautiously optimistic:

Consumers Come to Life, by Tim Duy: Today's retail sales report should dispel any lingering concerns that American consumers remain huddled in their basements, clutching a bar of gold with one hand and a loaded shotgun with the other. Indeed, even a relative pessimist like me has to admit that recent trends (log differences) look pretty good:

FW041410

Yes, at current rates of growth it will be a long time to hit the old trend. And it is clear that the consumer has suffered - the gap between the old trend and the actual level of retail sales less gas is now just about a trillion dollars of foregone spending. Something of a disaster, at least for retailers (but helping deleverage the household balance sheet). The data appears to have left Federal Reserve Chairman Ben Bernanke's outlook intact:

On balance, the incoming data suggest that growth in private final demand will be sufficient to promote a moderate economic recovery in coming quarters.

The Beige Book appears to be catching the retail trend, yet provides a tepid assessment of the general economy:

Overall economic activity increased somewhat since the last report across all Federal Reserve Districts except St. Louis, which reported "softened" economic conditions.

Which begs the question: Is the Fed too pessimistic (not to call the kettle black)? To be sure, even four percent growth is not enough to quickly pull unemployment rates lower. And, for the moment, the Fed appears to be content to let lingering doubts about the second half of the year to keep any emerging optimism in check. Not to mention a sustained disinflationary trend. From Bernanke:

On the inflation front, recent data continue to show a subdued rate of increase in consumer prices. For the three months ended in February, prices for personal consumption expenditures rose at an annual rate of 1-1/4 percent despite a further steep run-up in energy prices; core inflation, which excludes prices of food and energy, slowed to an annual rate of 1/2 percent. The moderation in inflation has been broadly based, affecting most categories of goods and services with the principal exception of some globally traded commodities and materials, including crude oil. Long-run inflation expectations appear stable; for example, expected inflation over the next 5 to 10 years, as measured by the Thomson Reuters/University of Michigan Surveys of Consumers was 2-3/4 percent in March, which is at the lower end of the narrow range that has prevailed for the past few years.

As the Wall Street Journal notes, this doesn't sound like a guy eager to hike rates anytime soon. The Beige Book concurs with the inflation assessment.

Retail prices generally remained level, but some input prices increased. Where producers faced cost pressures on inputs, they were largely unable to pass those prices downstream to selling prices, although in Kansas City some manufacturers were considering raising selling prices due to higher raw materials costs.

But if we have learned one thing about Bernanke over the past three years, it is that he is not married to any particular forecast. If conditions change, he will as well. And, arguably, at this juncture, the risks to the forecast are feeling a little bit on the upside. Just a bit (it is OK to admit it). If this trend persists for much longer, it has got to work into Fedspeak sooner rather than later.

Bottom Line: The retail sales report was strong, pointing to both pent-up demand and sustainability. Yet the Fed remains on hold, realizing that a long, sustained period of high growth is necessary to soak up the un- and underemployed and relieved disinflationary pressures. Moreover, financial markets remains hobbled, leaving small firms in particular starved for credit. Still, FOMC members eye the balance sheet warily; it should make any respectable central banker nervous. Faster than expected growth only makes them more nervous.

Tuesday, April 13, 2010

Fed Watch: What Could Derail the Recovery?

Tim Duy:
What Could Derail the Recovery?, by Tim Duy: Increasingly, the recovery looks sustainable - sustainable in the sense that a double dip recession looks unlikely. As Bloomberg reports, this is the message of the inventory cycle, which appears to have largely run its course. Inventories surged as the recession intensified, leaving firms scrambling to bring output in line with the new level of sales. Now, firms have inventories under control:

 

At this juncture, production becomes increasingly dependent on the ability of the economy to sustain demand growth, and one critical sector, households, look capable of doing at least part of the job. Wednesday morning we get retail sales for March, with expectations for a solid 0.5% gain excluding autos - a continuation of a string of generally positive reports that reaches back to the middle of last year. That's not to say sales have recovered; consumers are far from recapturing the prerecession trend. Instead, it looks like spending has reset along a lower growth path. And it is the growth, not the level, that is important to sustaining aggregate demand going forward.

The retort for any even remotely optimistic assessment of consumer spending is that the weight of the consumer debt burden - not to mention tighter lending conditions - will curtail spending power. True enough, but that speaks more to the ability, or lack thereof, of regaining the past trend. Moreover, household balance sheets are actually improving, with household financial obligations reverting to 2000 levels:

Finally, the growing stability of the job market (even if still subpar) will further support consumer spending, not just by adding jobs, but also by releasing the pent-up demand via improved confidence.

To derail the recovery at this juncture, look for factors that are not merely weights on the outlook, but will actually reverse the positive momentum. For example, it is not enough to say that lending is constrained. To reverse momentum, one needs a story by which lending actually tightens further from the current situation (really, how many more ways can your local banker say "No"?). What are such stories? Some floating in the background:

1.) Renewed surge of foreclosures. Mounting anecdotal evidence points to a renewed surged by lenders to get failing mortgages off their balances sheets, and the ensuing fire sales will stop the housing recovery in it tracks. Moreover, falling prices will further cripple household wealth. This story, however, is most important if you were actually forecasting a housing recovery. But the lack of the typical post-recession building surge is already one of the factors keeping a lid on the pace of the recovery and preventing the rapid rebound in growth necessary to bring unemployment down quickly. Will additional foreclosures cause new residential construction to fall dramatically from already rock bottom levels? Or, as I lean toward, delay and weaken new construction activity? And note that while additional foreclosures will weigh on housing prices further, much of the big adjustment in prices is likely already behind us. Also note that foreclosures will accelerate the healing of household balance sheets; dumping an underwater mortgage improves net wealth (one of my central complains about modification programs is that they are efforts to trap households in negative net wealth positions).

2.) Waning fiscal stimulus. No doubt about it, a significant concern, but one that is already built into most forecasts for the second half of this year and next year, again preventing the sustained above trend growth of a true v-shaped recovery. More of a risk - that deficit discipline prompts fiscal authorities toward a greater retrenchment than currently expected (perhaps, for example, the Administration does little to offset the expiration of the Bush tax cuts) . Still, it is tough to see the need for rapid retrenchment when interest rates remain below the 4% mark. Or the 5% mark, for that matter.

3.) Energy price shock. Jim Hamilton ably handles this issue, noting that the current rise in oil prices does not look sufficient to derail the recovery. I would agree, but note that we saw oil prices quickly spike in 2007 and 2008, and ongoing and accelerating global growth could prompt a return of the $4 dollar gasoline that undermined the consumer in early 2008. Note that saving rates remain relatively low; while I increasingly believe the consumer rebound is sustainable, the lack of cash cushion still leaves households vulnerable to unexpected shocks.

4.) The external bogeyman. A Chinese collapse that ripples through the global economy hangs as a seemingly ever present threat, one that I have difficulty gauging. In my opinion, this is one of those issues that pessimists can cite for years (and have already) before it manifests itself into a real concern. Not unlike some of the other threats we have been living with for over a decade - like the Japanese "bond bubble."

In short: I don't consider myself particularly optimistic; the forecast of persistent high unemployment rates leaves me feeling pessimistic. But even a subpar outcome (one that argues for more policy action, not less) could be consistent with sustainable growth. To undermine sustainability, it is not enough to focus on factors already weighing on the economy- weak lending, fiscal stimulus waning, crippled housing sector, etc. We already know those factors are preventing a rapid return to past trends. Instead, look for factors that are not already baked into the forecast. Most likely, wait for ongoing growth to create an environment that makes the current dynamic untenable for policymakers - in other words, wait for central bankers to start tightening policy aggressively. We just are not there yet.

Monday, April 12, 2010

Fed Watch: Stuck in the Middle

Tim Duy:

Stuck in the Middle, by Tim Duy: Note to readers: Sorry for the long absence. Work and family commitments moved blogging to the back seat in recent weeks - unfortunate but necessary.

The US economy shifted into an interesting middle ground in recent months. The broadening of the manufacturing recovery into activity more generally, coupled with sustained growth in that bulwark of the US economy, consumer spending, supports a stream of data increasingly suggestive of a - gasp - sustainable recovery. To be sure, doubters remain. On the more pessimistic side, via Bloomberg:

The U.S. jobless rate may rise above 10 percent at the end of the year and the contraction in consumer credit will persist, said David Rosenberg, chief economist of Gluskin Sheff & Associates Inc. in Toronto.

“I think we’ll finish the year above 10 percent,” Rosenberg said in an interview with Tom Keene on Bloomberg Radio. “The credit contraction continues unabated in the household sector.”

Economic growth is being fueled by the government’s $787 billion stimulus program, which has been offsetting slumping demand, Rosenberg said. “Final sales lag far behind,” he said. “There’s been no income growth in the personal sense in the past year.”

Yes, there are indeed enough warts on the US economy to make uncharitable comparisons to the skin of a toad. Chief among those, in my mind, is the ability to make a smooth pass off from federal stimulus to other sectors later in the year. Add to that list still tight credit conditions, ongoing deterioration in commercial real estate, and a housing market that looks to remain subdued by another wave of foreclosures (although I tend not to fear foreclosures so much in general, viewing them as an effective mechanism to clean household balance sheets). But even putting all those things together, what appears to be emerging is an economy reverting back to trend growth, maybe a little above, maybe a little below.

And therein lies the rub, the problem that leaves policymakers in something of a quandary. Trend growth just isn't good enough. Trend plus one percent isn't good enough. Of course, not anywhere near the more apocalyptic visions of the most pessimistic procrastinators, but far short of the fable V-shaped recovery of Floyd Norris:

The American economy appears to be in a cyclical recovery that is gaining strength. Firms have begun to hire and consumer spending seems to be accelerating.

That is what usually happens after particularly sharp recessions, so it is surprising that many commentators, whether economists or politicians, seem to doubt that such a thing could possibly be happening.

Norris apparently believes that we can't see the truth on the strength of the recovery because we have forgotten the experience of the 1980's:

But there are, I think, a number of reasons for the glum outlook that are unrelated to the actual economic data.

First, the last two recoveries, after the downturns of 1990-91 and 2001, were in fact very slow to pick up any momentum. It is easy to forget that those recessions were also remarkably shallow. If you are under 45, you probably don’t have much recollection of the last strong recovery, after the recession that ended in late 1982….

Goodness, even a cursory look at the data would dispel the myth that the current episode bore any familiarity with 1982. Absent the inventory correction, the 5.6% gain in 4Q09 GDP looks paltry by comparison:

For the nine quarters beginning in 4Q82, real final sales growth averaged more than three times the 1.7% rate (red line) of the final quarter of 2009, the blowout quarter for the V shape optimists. And, arguably, this even understates the domestic strength of the mid-80's recovery as the GDP figures were lessened by a surging trade deficit. (Free Exchange continues the Norriscritique here.)

In short, yes, given that the US economy has been growing now for three quarters, and is most likely to grow for the next three quarters, room for optimism is surely growing as well, something the pessimists need to accept, lest they fall into the trap of incoherent mumbling for the five years until the next recession provides them with an "I told you so" opportunity.

Where the pessimists have room to complain, as I am wont to do, is on the employment issue. Even the most more optimistic forecast of former IMF Chief Economist Michael Mussa is not sufficient to drive rapid improvement in the labor market. Again, think of a real V-shaped recovery like the mid-80's. Hence the widespread disappointment with the March labor report. On the surface, the numbers were not terrible. Subtract out, however, the private and Census temporary workers, adjust for the fact that this supposedly represented a "bounce" from the weather impacted February report, and then recognize that the US economy has been growing for three quarters. Then you start to think that this is a better report, but not good enough to alleviate the pain in the labor market anytime soon. But it is not bad enough that anyone is eager to commit to additional stimulus, almost guaranteeing a continuation of the status quo, a job market that will not recoup lost jobs for years, leaving perhaps an indelible mark on a generation of workers.

Expectations of persistent labor market weakness - given that even optimistic forecasts fall well short of the V-shaped recovery bar - leaves the Federal Reserve in a holding pattern regarding their key policy rate. Calculated Risk notes:

For some reason, market participants keep thinking the Fed will raise rates soon (last summer it was by the end of 2009, this year it was by summer).

The reason is that market participants lack the option of betting on a reduction of rates. Only one way to bet. This, of course, is why the Federal Reserve has a challenge trying to communicate the lack of policy meaning behind changes to the discount rate. Every action, every official utterance is subject to analysis regarding one thing, the eventual end of the zero rate policy. As CR notes, however, Fed officials - with the exception of Kansas City Federal Reserve President Thomas Hoenig - do not appear predisposed to raise rates in the near term.

The expectation - and so far realization - of subpar labor market outcomes leaves monetary policy steady for the time being. How much improvement do we need to see before policymakers more quickly move in the direction of tightening (which, by the way, will likely begin with quantitative tightening rather than rate tightening). Federal Reserve Chairman Ben Bernanke laid down an interesting marker in a speech last week:

More than 40 percent of the unemployed have been out of work six months or longer, nearly double the share of a year ago. I am particularly concerned about that statistic, because long spells of unemployment erode skills and lower the longer-term income and employment prospects of these workers.

One can infer that Bernanke would prefer to see the share of long term unemployment drop dramatically prior to a clear policy shift. One can also infer the possibility of a measurable, albeit, small, structural increase in the unemployment rate. From the soon to be departing Vice Chairman Donald Kohn:

An ongoing concern in this recovery is whether unemployed workers may experience unusual difficulties in re-entering the workforce. The duration of unemployment has been exceptionally long in this business cycle, a development that could erode worker skills and decrease re-employment probabilities. In addition, it may take some time for those who are unemployed to move or retrain for the new jobs that the recovery will bring. For these and other reasons, part of the increase in unemployment over the past two years may be structural, and this part would tend to reverse only slowly.

Even if a portion of the rise in unemployment is structural, however, most appears to be cyclical, suggesting that the economy is operating well below its productive potential. This conclusion is supported by other measures of slack, such as capacity utilization in manufacturing, and by the ongoing deceleration in wages and prices.

Finally, the other impediment to policy tightening is the inflation outlook. The Fed appears to have abandoned its earlier flirtation with the notion that deflationary pressures can be dismissed as a consequence of the housing downturn. From the most recent minutes:

Participants referred to a wide array of evidence as indicating that underlying inflation trends remained subdued. The latest readings on core inflation--which exclude the relatively volatile prices of food and energy--were generally lower than they had anticipated, and with petroleum prices having leveled out, headline inflation was likely to come down to a rate close to that of core inflation over coming months. While the ongoing decline in the implicit rental cost for owner-occupied housing was weighing on core inflation, a number of participants observed that the moderation in price changes was widespread across many categories of spending. This moderation was evident in the appreciable slowing of inflation measures such as trimmed means and medians, which exclude the most extreme price movements in each period.

Still, Kohn at least sees little room for additional downward pressure on inflation:

With only a moderate recovery likely on tap, I expect unemployment to come down only slowly from its currently elevated level. Although the persistent high level of unemployment will tend to restrain inflation further, the effect of resource slack on inflation does not appear to be as great as some previous episodes might have led us to expect. The difference is that inflation expectations now appear to be much more firmly anchored than they once were, probably reflecting the extended period of low inflation that we have experienced and a credible monetary policy directed at sustaining this performance. I anticipate that inflation will remain low for a while, with core PCE inflation not likely to fall much further from the subdued pace I cited a few minutes ago.

Which leaves him, like I suspect the FOMC in general, still inclined to look only toward a tightening of policy in the future, not any additional loosening that would arguably be appropriate given the current forecasts for both unemployment and inflation.

Bottom Line: It is difficult to argue with the steady stream of data that increasingly suggests the recovery is sustainable. It is also difficult to argue with the proposition that even if sustainable, the recovery is disappointing from the jobs perspective. That disappointment, coupled with the lingering concern that the economy will not sufficiently transition from fiscal stimulus to sustain the meager labor market improvements to date, leaves monetary policy on hold for the foreseeable future. The transition from fiscal stimulus would be greatly improved if we could reliably expect the external sector to pick up the slack. And the economy remains at risk to that familiar gremlin, the exogenous shock. I find myself a bit more concerned than Jim Hamilton on the risk from oil prices. But both oil and external trade are issues I intend to follow up with later in the week.

Wednesday, April 07, 2010

Federal Reserve Bank of New York President Dudley Calls for the Fed to Take Action Against Bubbles

At MoneyWatch, my reaction to Federal Reserve Bank of New York President Dudley Calls for the Fed to Take Action Against Bubbles:

Federal Reserve Bank of New York President Dudley Calls for the Fed to Take Action Against Bubbles

[Boarding time -- going here -- guess that's the end of airport blogging for now.]

Bernanke: In the Long-Run, We’re All on Social Security, Medicare

[From the airport...] Ben Bernanke is worried about entitlement programs:

Bernanke on Deficits: In Long Run, We’re All on Social Security, Medicare, RTE: This morning Jon Hilsenrath noted the Fed Chairman Ben Bernanke was likely to highlight the importance of deficit reduction in a series of speeches. The following is an excerpt on the issue from the chairman’s remarks in Dallas today:
The economist John Maynard Keynes said that in the long run, we are all dead. If he were around today he might say that, in the long run, we are all on Social Security and Medicare. That brings me to two interrelated economic challenges our nation faces: meeting the economic needs of an aging population and regaining fiscal sustainability. The U.S. population will change significantly in coming decades with the combined effect of the decline in fertility rates following the baby boom and increasing longevity. As our population ages, the ratio of working-age Americans to older Americans will fall, which could hold back the long-run prospects for living standards in our country. The aging of the population also will have a major impact on the federal budget, most dramatically on the Social Security and Medicare programs, particularly if the cost of health care continues to rise at its historical rate. Thus, we must begin now to prepare for this coming demographic transition.
The economist Herb Stein once famously said, “If something cannot go on forever, it will stop.” That adage certainly applies to our nation’s fiscal situation. Inevitably, addressing the fiscal challenges posed by an aging population will require a willingness to make difficult choices. The arithmetic is, unfortunately, quite clear. To avoid large and unsustainable budget deficits, the nation will ultimately have to choose among higher taxes, modifications to entitlement programs such as Social Security and Medicare, less spending on everything else from education to defense, or some combination of the above. These choices are difficult, and it always seems easier to put them off–until the day they cannot be put off any more. But unless we as a nation demonstrate a strong commitment to fiscal responsibility, in the longer run we will have neither financial stability nor healthy economic growth.
Today the economy continues to operate well below its potential, which implies that a sharp near-term reduction in our fiscal deficit is probably neither practical nor advisable. However, nothing prevents us from beginning now to develop a credible plan for meeting our long-run fiscal challenges. Indeed, a credible plan that demonstrated a commitment to achieving long-run fiscal sustainability could lead to lower interest rates and more rapid growth in the near term.
Our economic challenges, both near term and longer term, are daunting indeed. Nonetheless, I remain optimistic that they can be met. ...

The CBO has argued persuasively (scroll down) that demographics is not the main problem:

In addition, Social Security can be fixed relatively easy. It is health care costs rising independent of the aging of the population that must be addressed.

But there may be a solution:

Delayed retirement among Americans may bolster future of Social Security and Medicare, EurekAlert: An unprecedented upturn in the number of older Americans who delay retirement is likely to continue and even accelerate over the next two decades, a trend that should help ease the financial challenges facing both Social Security and Medicare, according to a new RAND Corporation study.

While government projections suggest the number of older Americans who remain employed is likely to plateau over the coming decade, RAND researchers say a more likely scenario is that the increase in delaying retirement that began in the late 1990s is likely to gain speed.

Because the trend holds broad benefits for the nation, lawmakers may want to consider reforms that would dismantle barriers that discourage some older people from remaining employed and even consider changes that would encourage employers to hire older workers. ...

In a report published in the Journal of Economic Perspectives, RAND researchers examine a wide array of evidence that suggests that delayed retirement or partial retirement are likely to increase...

A principal reason why retirement rates have dropped is because of an evolution in the skill composition of the nation's workforce, according to the study. As American workers have gained more education, they have achieved jobs that are more fulfilling, they face fewer physical demands in the workplace and they are paid more for their efforts.

Adding to this phenomenon is the rise in the number of dual-earner families. Since couples tend to retire together and men often are older than their spouse, men may stay in the work force longer to accommodate their wives' work lives, according to the study.

While there have been several changes made to Social Security that encourage people to work longer, researchers say those changes appear to be a secondary force behind the trend observed thus far. ...

Additional incentives are on the horizon that may fuel the future growth of the number of older Americans delaying retirement.

Changes to Social Security that delay full benefits from age 65 to age 67 will not be fully in force until 2022, and there have been discussions about further extending the threshold as well. In addition, as labor force participation among younger women has risen over time, women have become increasingly likely to qualify for Social Security benefits on their own work record. As a result, women now more than ever face direct incentives to extend their work lives in order to qualify for higher benefits.

In addition, as people live longer more Americans may need to extend their work lives to accumulate wealth to provide for their needs during old age.

Researchers say that lawmakers may want to consider policies that would further aid older Americans who want to delay retirement. Such measures include eliminating measures in some pension plans that penalize recipients who continue working and improving the public's understanding of retirement and pension rules. ...

Though they downplay it a bit, bad economic policy that creates lots of uncertainty -- something Congress is expert at -- extends their working lives. That's not a recommendation, just an observation.

Tuesday, April 06, 2010

Giving Up on Policymakers

I've been pushing hard for more help for labor markets for quite awhile -- at times I've thought it was a bit repetitive, but necessary -- but it's probably time for me to give up and accept that we are going to have a slower recovery than we could have had with more aggressive fiscal policy. Unless there is a dramatic reversal of recent indications that we are at the beginning of a recovery, Congress is not going to provide anything more than token help from here forward.

The fiscal policy response to the crisis has been disappointing. Monetary policy loses its effectiveness in a recession. There are some things monetary policy can do -- important things such as injecting liquidity into fearful, frozen financial markets to prevent a complete meltdown of the system. But when it comes to providing a big shock to aggregate demand sufficient to turn the economy around and propel it back toward full employment, monetary policy alone isn't enough. It's true that monetary policy can lower real interest rates -- even at the zero bound for the federal funds rate, it's still possible to use quantitative easing to nudge long-term interest rates downward -- the problem is that all this does is create an incentive for more investment and consumption (mainly of durables), there is nothing to guarantee that people will actually respond. My reading of the evidence is that to the extent that households and businesses do respond to lower real interest rates during a recession by consuming or investing more, the response is not very strong.

Because monetary policy loses effectiveness in a deep recession -- something I've been teaching for decades -- I was among the first to call for aggressive fiscal policy. Fiscal policy creates demand directly, it does not rely upon incentives and the hope that people will respond to them. When the crisis hit, we needed fiscal policy right away. Given the lags between changes in policy and actual effects on the economy, which were known to be lengthy, and given that monetary policy was not going to be enough, there was no time to "wait and see" (as many people I respect were calling for). But the reality is that fiscal policy didn't get put into place until much, much later, far too late to stop the worst of the downturn (and it wasn't big enough anyway). The way too slow policy process, and the way too small policy that came out of it, was frustrating to watch.

I think we'd be much better off today if we'd done what is necessary right away instead of hoping and hoping that things weren't going to be so bad, and that we could escape the need for an aggressive policy intervention. This crisis has taught me that policy of that magnitude is nearly impossible to put in place based upon what looks to be happening, i.e. before the recession actually occurs. There must be clear evidence that a severe recession is actually underway before policy will be considered. Unfortunately, by that time it's too late to prevent the worst part of the downturn.

Now that we are hitting the other side, I'm feeling frustrated again with the lack of action from policymakers. I expect the recovery to proceed at a snail's pace, labor markets in particular. If employment rebounds quickly, great, but that's not what I think is going to happen, and that's not what the evidence suggests. If the recovery is going to be slow, then it's not too late to provide more help. Instead of getting back to full employment by, say, 2013, we could get there sooner if we act now. I'm not the greatest artist in the world, but I even drew a picture:

Help-Wanted

Why settle for the blue line recovery when the green line is possible? Frustration over the fact that we seem to be headed on the blue-line trajectory explains why I've been reluctant to highlight what little good news there has been about labor markets recently. I don't want to jump on the "things are getting better" bandwagon when there is still more that policymakers can do to help, and when there are still considerable uncertainties about the strength of the budding recovery.

But, as I said at the beginning, even though it's not too late for more help to make a difference, it's not going to happen. Now that the recovery seems to have started and the budding optimism is apparent, we will turn our attention elsewhere, to financial reform, to global warming, and to other issues. We'll forget about all the people who could have been working, but instead have to hope Congress doesn't cut off their unemployment insurance before they can find a job.

I'll still complain -- there's no reason to let policymakers off the hook -- but it's time to give up the hope that anything more will be done to help the unemployed find jobs.

Monday, April 05, 2010

The Housing Drag on Core Inflation?

Let me start with this:

Inflation Fears Cut Two Ways at the Fed, by Jon Hilsenrath, WSJ: The Federal Reserve's decisions to keep interest rates near zero and to flood the financial system with credit are sparking fears of an eventual outbreak of inflation.
But inside the Fed, an influential band of policy makers is fretting over the opposite: that the already-low rate of inflation is slowing further.
The presidents of the New York and San Francisco regional Fed banks, William Dudley and Janet Yellen, see the abating inflation rate as convincing evidence the economy still is burdened by excess capacity and needs to be sustained by the Fed.
Others, led by Philadelphia Fed President Charles Plosser, argue that current inflation measures are distorted by an epic decline in housing costs and could mask a buildup of inflationary pressures. ... Recent developments have given the inflation-rate-is-dropping camp an upper hand. ...
The opposing camp believes the combination of low rates and more than $1 trillion the Fed has pumped into the financial system is a formula for inflation down the road. "As the economy improves and as lending picks up, the longer-term challenge we face will not be worrying about inflation being too low," Mr. Plosser said in an interview. "The risk is really to the upside of inflation over the next two to three years."
This camp focuses less on the amount of slack in the economy ... and more on the risk that consumers and businesses will anticipate inflation and act accordingly. At the Fed's mid-March meeting, Thomas Hoenig, president of the Kansas City Fed, argued for an increase in short-term interest rates "soon" to "lower the risks of...an increase in long-run inflation expectations." ...
Mr. Plosser also argues that the recent decline in the inflation rate is a mirage, greatly influenced by an unusual decline in housing costs, which are heavily weighted in many price indexes. ...
Researchers at the San Francisco and New York Fed are scheduled to release a retort to this argument Monday that shows that among 50 different categories of consumer spending—from computers to hotels to jewelry—inflation rates have slowed over the past 18 months from the earlier trend. ...

My view on this is summarized here (echoed here and here):

Trimmed
[click to enlarge]

"The trimmed mean PCE inflation rate is an alternative measure of core inflation in the price index for Personal Consumption Expenditures"

In the short-run, i.e. right now, disinflation/deflation is the worry. In the longer run, we should be concerned about inflation, but not at the expense of killing the recovery that appears to be at the beginning stages. I believe the Fed can unwind the stimulus measures when the time comes without a serious inflation problem, and that moving against inflation too soon would be a big mistake (in fact, if anything, right now we could use more stimulus from the Fed).

Here is the report from the SF and NY Feds:

The Housing Drag on Core Inflation, by Bart Hobijn, Stefano Eusepi, and Andrea Tambalotti, FRBSF Economic Letter: Some analysts have raised the question of whether the unprecedented declines in house values, which have been the hallmark of the recent recession, might be artificially dampening core inflation readings. However, a close examination of recent inflation data shows that the weakness in housing costs is representative of a broad pattern of subdued price increases across most consumption goods and services and is not distorting the broad downward trend in core inflation measures.
Measures of consumer prices such as the consumer price index (CPI) and the personal consumption expenditures price index (PCEPI) are closely watched by the Federal Reserve. The focus in this Letter is on the core PCEPI. This index covers consumer expenditures, excluding food and energy, which are used to calculate gross domestic product. The core PCEPI is one of four macroeconomic variables featured in the Summary of Economic Projections published by the Federal Open Market Committee, the Fed’s monetary policymaking body, four times a year.
Core PCEPI inflation has shown a clear downward trend since mid-2008. Declines in house prices have contributed to that trend. However, it is important to realize that house price declines themselves do not directly show up in measured inflation. This is because the price of a house not only reflects the cost of living in it, but also the returns on investment in the house as an asset. The PCEPI aims to capture the cost of living in a house and to filter out changes in house prices due to changes in their returns as investment assets. For renters, the result is that the housing part of the PCEPI is measured by the change in the monthly expense for living in a house or apartment, that is, their rent. For people who own their living space, such rental payments do not occur and thus cannot be directly measured. Instead, the Bureau of Labor Statistics collects data on rents that people pay for comparable living units. These data are then used to estimate the rent that people who own their homes would pay if they were renting their dwellings. McCarthy and Peach (2010) describe the statistical methods used for this purpose in detail. The resulting imputed rent level is known as owners’ equivalent rent and is used in the core PCEPI to measure the cost of housing for homeowners.
Thus, the price of housing in the core PCEPI is made up of both rents and owners’ equivalent rents. The expenditures on these two categories add up to 18% of total consumer spending covered by the core PCEPI.

Core inflation with and without housing

One way to consider the effect of the price of housing on core inflation is to calculate a core PCEPI that excludes housing. This is done in Figure 1, which contains three time series. The first is 12-month growth in the core PCEPI. The second is a comparable measure of inflation for the housing component of the core PCEPI. The final time series is a core PCEPI that excludes housing expenditures.

Figure 1
Core PCE inflation with and without housing
January 2005 through February 2010
Core PCE inflation with and without housing
Source: Bureau of Economic Analysis, authors' calculations.
Three things stand out in this figure. First, the standard core inflation measure shows substantial disinflationary pressures at work. Twelve-month annualized core PCEPI inflation has come down from 2.7% in August 2008, immediately before the financial crisis reached a crescendo, to 1.3% in February 2010. Core inflation dipped even deeper during the midst of the crisis, when plummeting demand for consumer goods, especially such consumer durables as cars, electronic goods, and furniture, led retailers to lower prices drastically to get rid of excess inventories. This is the source of the September 2009 trough in 12-month core inflation. Twelve-month core inflation briefly increased at the end of 2009, and has since resumed its downward course. This indicates that the upward move of core inflation late in 2009 was temporary and that the disinflationary trend that started in the fall of 2008 continues.
Second, part of the drop in measured core inflation is undoubtedly due to the deceleration in the price of housing. The declines in housing inflation have been more profound than in core inflation. The 12-month percentage change in rents and owners’ equivalent rents has come down from 4.5% in February 2007, at the height of the housing bubble, to 0.3% in February 2010. This decline in the rate of housing price increases reflects reduced upward pressure on rents, which in turn is due to historically high vacancy rates for rental properties. Because house price inflation is now below core inflation, it drags down the overall level of core inflation.
Third, it turns out that this drag is rather small. The decrease in housing inflation only accounts for a small part of the overall disinflationary pressure on core PCEPI. This can be seen by comparing the core inflation rate with the PCEPI inflation rate that excludes housing, shown in Figure 1. The core PCEPI inflation measure without housing displays a very similar trend to core inflation. From July 2008 to February 2010, it has fallen from 2.6% to 1.6%. Just like core PCEPI inflation, 12-month core inflation without housing temporarily increased after the trough in September 2009 and has started to come down again in recent months. The current difference of 0.2 percentage point between core PCEPI inflation and core PCEPI without housing is not large by historical standards.
Consequently, the evidence in Figure 1 offers little cause for concern that the recent behavior of core inflation might be a misleading signal of the underlying inflation trend. Instead, Figure 1 reveals that, no matter whether housing is included or not, core inflation exhibits a noticeable disinflationary tendency since August 2008. This is not only true for the core PCEPI, but also for core CPI, which is not shown here. For core CPI, the difference between the index with and without the two PCEPI housing components, rent and owners’ equivalent rent, is slightly larger due to the higher weight of these in the CPI.

Disinflation beyond housing

Figure 2 provides more direct evidence in support of the view that the weakness in housing inflation is not an outlier to be discounted, but rather a reflection of a widespread deceleration in inflation during the acute phase of the recession. The figure compares the annualized inflation rates of about 50 goods and services that make up core personal consumption expenditures before and after August 2008.

Figure 2
Annualized inflation in core PCE components before and after August 2008
Annualized inflation in core PCE components before and after August 2008
Source: Bureau of Economic Analysis, authors' calculations.
Notes: Comparison periods are January 2005 to August 2008 and August 2008 to February 2010.
In the figure, each circle corresponds to a particular category of consumer spending, and the size of the circle reflects the expenditure share of that category. Circles below the dashed line correspond to spending categories for which the average annualized rate of inflation has decreased in the past 1½ years compared to the prior 3½ years. The majority of circles lie below the dashed line, confirming that disinflation has been a widespread phenomenon in the recent period. Moreover, the large red circle that represents housing sits more or less at the center of the picture, close to many other large expenditure categories. This is evidence that the deceleration in housing inflation over the past 1½ years was not an outlier, but rather a fairly typical reflection of broad-based deceleration in core inflation.
Some individual spending categories are worth pointing out. Used and new motor vehicles have been among the goods with the highest acceleration in prices. However, this acceleration was partly due to government support of the vehicle market through the cash-for-clunkers program. With the expiration of the program, it is unlikely that car prices will continue to rise at the same rates.
Public transportation, including airfares, has experienced severe disinflation. Fares have fallen in response to a decline in demand for air transportation and the fall in oil prices since the summer of 2008. The latter is not surprising in light of the evidence in Hobijn (2008) that transportation services have the highest oil share of any category in the core PCEPI.
Several categories with the largest declines in inflation are luxury goods, such as jewelry, luggage, and multimedia equipment. Another group with declining inflation can be classified as highly discretionary spending items, such as hotel accommodations. This suggests that disinflation in these categories in large part reflects very low demand for these goods and services.
Conclusion

Weakness in the housing market has reduced the inflation rate of the housing components of core inflation. Yet, this very substantial decline in the rate of housing inflation has not been isolated. Rather, it is indicative of a much wider decrease in inflationary pressures observed since the peak of the financial crisis. Even if we take housing out of core PCEPI, inflation has come down substantially over the past 1½ years. As a consequence, there is little reason to reduce the emphasis on core inflation as the main gauge of underlying price pressures in the economy. Recent core inflation trends reflect substantial and widespread disinflationary pressures, which, as Liu and Rudebusch (2010) point out, is likely due to a large amount of slack in the economy.

Right now, with labor markets struggling just to tread water, inflation is not the problem we should be most worried about.

Wednesday, March 31, 2010

"Prospects for Sustained Recovery and Employment Gains"

I'm encouraged that at least one Federal Reserve policymaker (though not a voting member of the FOMC) is linking increases in the target federal funds rate, i.e. moving away from a zero interest rate policy, to improvements in the labor market. However, if expected inflation begins increasing, all bets are off.

That's the part that concerns me. How quickly will policymakers abandon efforts to stimulate employment by maintaining a zero interest rate policy if they start to get worried about inflation? What, exactly, is the tradeoff here? Will any sign of inflation whatsoever cause policymakers to panic and start aggressively raising interest rates even if unemployment remains elevated, or will concerns over employment cause them to be patient and accept some inflation in the short-run? Again, it's encouraging that employment concerns are coming to the forefront of the policy decision, but will those concerns carry sufficient weight if there are signs that inflation expectations are increasing? I'm worried that they won't:

Prospects for Sustained Recovery and Employment Gains, by Dennis P. Lockhart, President and Chief Executive Officer, Federal Reserve Bank of Atlanta: After the deepest and longest recession in the past half century ... the U.S. economy is now in recovery. Today I want to discuss the prospects that the recovery ... is sustainable—and the implications ... for perhaps the most vexing current problem coming out of the recession: unemployment. ...
The economy remains in a transitional phase from a period that depended on support of public sector programs to a period of resumed growth based on private spending. For the recovery to be sustained, we need consumers to consume and businesses to spend on inventory, investment goods, and human resources. Economic forecasts hinge on how formidable those positive forces will be and on the strength of countervailing headwinds.
Views about the economic outlook fall roughly into two narratives. The more optimistic scenario is a V-shaped bounce back from severe recession. ... By contrast, the second scenario is a relatively modest recovery, with slow reduction of unemployment. ... In ... Atlanta..., our outlook is closer to the second narrative.
Perspective on labor markets
As already suggested, an implication of this slow recovery scenario is the very gradual decline of today's unacceptably high rate of unemployment. ... Today, the rate stands at 9.7 percent, down from a high of more than 10 percent in October.
I view unemployment as a daunting economic challenge—and very likely a dominant political issue—of the period ahead. ... Today, there are about 130 million payroll jobs in the United States, and that number is about 8.4 million lower than at the beginning of the recession. ...
About 15 million people in the United States are unemployed. ... Also, underemployment is prevalent. The underemployed include both discouraged workers...  as well as individuals who are working part-time but want to work full-time. The unemployment rate that combines the fully unemployed and underemployed workers is about 17 percent.
Another indication of underemployment is reduced hours of work. Average hours of work per week are still well below prerecession levels...
Despite the weak state of labor markets, there are signs that the worst may be behind us. The rate of job loss is slowing. The rate of decline in payroll employment has been close to zero in the last couple of months. Also, while initial and continuing unemployment claims are at historically high levels, both have fallen.
Another bright spot is temporary employment. The temporary services sector shed more than 800,000 jobs during the recession but has seen a notable increase since last fall. This improvement is noteworthy as temporary employment is often viewed as a leading indicator.

The normal state of affairs in the country's labor market is a dynamic mix of separations from employment and new job creation. There are two causes of separations—layoffs and voluntarily quitting a job, or so-called quits. ... Today's slow pace of employment gains is due more to the slow pace of job creation, not the high rate of layoffs.

Job gains, as conventionally understood, require two things: a vacancy and a worker able to fill that vacancy. For most of 2009, vacancies were relatively flat while unemployment continued to rise. This condition suggests the existence of what labor economists call "match inefficiencies."

There are two key types of match inefficiency. One is geographic mismatch. In 2008, the percentage of individuals living in a county or state different than the previous year was the lowest recorded in more than 50 years of data. People may be reluctant to relocate for a new job if the value of their house has declined. In addition, many who would like to move are under water in their mortgage or can't sell their homes.
The second inefficiency is skills mismatch. In simple terms, the skills people have don't match the jobs available. Coming out of this recession there may be a more or less permanent change in the composition of jobs. Skill mismatches require new training, and there is evidence that adult education institutions have responded to this need. For instance, officials at Miami-Dade College in Florida, which is the largest college in the country and a grantor of associate and vocational degrees, told us they have recently seen a strong increase in enrollment, especially of men in their 20s.

This evidence of retooling is encouraging, but, to be realistic, structural adjustment takes time. ...

All things considered, labor market trends appear to be headed in the right direction. But it's quite possible the recovery could be well advanced before any significant reduction of unemployment materializes. It's also quite possible circumstances justifying the start of a cycle of policy tightening will develop well before the unemployment rate has found a satisfactory level. ... So let me now comment on how I'm thinking about the relationship between the Fed's employment mandate and monetary policy.

Implications for monetary policy
As you know, monetary policy is highly accommodative. And I think this stance is appropriate at present. I continue to support ... a low federal funds rate target for an extended period. ... As long as inflation remains subdued and inflation expectations anchored, a key factor for me is improvement of employment markets.
Going forward, I will be looking for signs that employment gains are likely to repeat and accumulate and, once achieved, are likely to be durable.
What might such signs be? One indication would be that the process of job creation is improving. In January, we saw a sizable increase of job openings, according to the BLS. I'm looking for that to become a trend. A second sign would be a decline in the measured rate of underemployment. And the third sign would be a string of employment gains large enough to appreciably move the unemployment rate down over time.
There are hopeful, if tentative, signs of improvement in employment markets. We have a long way to go, and for that reason I believe it is premature to assume an imminent reversal of the Fed's accommodative policy. But you can interpret the fact that I am here discussing the conditions under which such a reversal will be appropriate as an indication of my conviction that we are, finally, moving in the right direction.

Tuesday, March 30, 2010

Disinflation Continues...

Despite all the worries about inflation, the latest release of the Dallas Fed's Trimmed mean PCE inflation calculations (a measure of the core rate of inflation) indicates that inflation is still headed downward:

Trimmed
[click to enlarge]

"The trimmed mean PCE inflation rate is an alternative measure of core inflation in the price index for Personal Consumption Expenditures"

Here are the recent data for the 12-month inflation rate (3/29 release):

  12-month
Mar-09 2.26
Apr-09 2.24
May-09 2.08
Jun-09 1.94
Jul-09 1.66
Aug-09 1.60
Sep-09 1.45
Oct-09 1.51
Nov-09 1.40
Dec-09 1.37
Jan-10 1.18
Feb-10 1.04

Monday, March 22, 2010

"Target the Cause Not the Symptom"

David Beckworth:

Target the Cause Not the Symptom, by David Beckworth: Olivier Blanchard of the IMF recently made the case for monetary policy targeting a 4% inflation target instead of the standard 2% target. His main argument for doing so is that it would make the zero bound on the policy interest rate less of an issue. Here is how the Wall Street Journal summarized his view:

At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

There was a lot of push back on this argument in the blogosphere from folks like Ryan Avent, Mark Thoma, and David Altig who countered that (1) the zero bound isn't really a constraint for monetary policy, (2) higher inflation will lead to increased relative price distortions, and (3) there is mixed evidence and thus less certainty on the benefits of higher inflation. While all of these points are valid, I think there is a more fundamental problem with Blanchard's view: inflation targeting at any rate is merely responding to the symptom not the underlying causes--shocks to aggregate demand (AD) and shocks to aggregate supply (AS)--of macroeconomic volatility. This is problematic because monetary policy can only meaningfully counter AD shocks and therefore, it must be able to discern which shock is driving inflation. Inflation, however, can be hard to interpret. For example, if there is a sudden burst of inflation is it due to a positive aggregate demand shock (e.g. sudden, unsustainable increase in household spending) or a negative aggregate supply shock (e.g. temporary spike in oil prices)? In the former case inflation targeting would act appropriately by reigning in excess spending while in the latter case inflation targeting would only make matters worse by further restricting economic activity. Rather than targeting inflation, then, monetary policy should directly target the underlying  source of macroeconomic volatility over which it has real influence, AD.  Doing so would have gone a long way in making  the U.S. economy during the 2000s more stable, a point I have made repeatedly during this crisis.

The importance of targeting AD can easily be illustrated using an AD-AS model. Here I use the AD-AS model developed by Tyler Cowen and Alex Tabarrok in their new macroeconomic textbook. Their version of the AD-AS model places growth rates on the two axis rather than levels. Below is the model in equilibrium with an AD growth rate of 5% that can be split up into an inflation rate of 2% and a real growth rate of 3%.  (Click on figure to enlarge.)

Now consider four shocks  to the economy when monetary policy is solely targeting an inflation rate of 2%.  First, let see what happens when there is a positive AD shock driven by say expansionary fiscal policy (click on figure to enlarge):

The positive AD shock pushes the economy beyond full employment, increases inflation to 3%, and real growth jumps to 4%.  AD is now growing at an accelerated rate of 7%.  Fed officials seeing the higher inflation tighten monetary policy to get back to 2% inflation and in so doing push the economy back to full employment. Here the 2% inflation target worked just fine and effectively served to stabilize AD at 5% growth.

Now consider a negative AD shock caused by say a sudden collapse in economy certainty (Click on figure to enlarge).

Continue reading ""Target the Cause Not the Symptom"" »

"Monetary Policy Can Do More"

Joseph Gagnon has been frustrated with those of us who have not fully embraced further action by the Fed to lower long-term interest rates. Here's his description of some new research on this issue:

Monetary Policy Can Do More, by Joseph Gagnon, Peterson Institute for International Economics: A new study in which I participated has been posted on the website of the Federal Reserve Bank of New York. It documents how the Federal Reserve lowered long-term interest rates about 50 to 60 basis points last year through its purchases of $1.7 trillion of longer-term bonds. The study reinforces an argument I have previously made: that the Federal Reserve and other central banks can apply further monetary stimulus by lowering long-term borrowing costs even when short-term interest rates are stuck at zero. (For the wonkish, the effect appears to work though the term premium rather than through expectations of future short-term interest rates.)
The reduction in long-term interest rates applies not only to Treasury securities, but also to mortgages and corporate bonds. Households buying and refinancing their homes took out mortgages worth over $2 trillion in 2009 and they will save about $11 billion in interest payments each year because of the lower interest rates. With interest rates remaining low for new borrowers in 2010, these benefits will continue to grow and will help to support consumer spending and economic recovery. Thanks to the low interest rate environment, corporate bond issuance (net of redemptions) reached a record $381 billion in 2009, helping to finance a turnaround in capital spending late last year that exceeded most private forecasts.
With unemployment projected to remain far above most estimates of its equilibrium for the next few years and with core inflation having fallen to 1 percent over the past 6 months, the US economy clearly needs more of this medicine. As I argued last December, the Fed could push down long-term yields another 75 basis points by buying a further $2 trillion of long-term bonds. Current yields on 10-year Treasury notes, at 3.7 percent, are far above the zero rates on short-term Treasury bills. The benefits to the economy would be rapid and similar to those already observed from the first round of Fed purchases. Moreover, lower long-term interest rates and a faster recovery would also reduce our national debt.
Does additional Fed action mean that inflation is going to come roaring back? Not unless the Fed forgets everything it learned from the 1970s. But right now, inflation is below the Fed’s target of 2 percent and heading lower. The immediate problem is deflation. As Japan shows, acting too weakly against deflation is a serious error. Yes, the Fed may have to reverse course in a couple years, but that would be better than facing a decade of excess unemployment and entrenched deflation.

I have been working on a write-up of how the crisis will affect monetary and fiscal policy in the future based upon my discussion at the Kaufman Center's recent Economic Bloggers' Forum. Here's the draft version of what I wrote on this issue:

Quantitative Easing: Whether or not the Fed embraces more aggressive quantitative easing the next time a crisis hits depends critically upon how gracefully the Fed can exit from the policies implemented during this crisis. If, as I believe, the Fed can exit without an outbreak of inflation, then one conclusion that will most likely be drawn is that the Fed was way too timid with its quantitative easing policy. However, if inflation does turn out to be a problem, it will call the whole policy procedure used during the crisis into question.

I was among the people who (probably) had too much fear of inflation and hence was unwilling to fully embrace more aggressive policy (though I did give lukewarm support). The Fed's credibility is shaky, and I was worried that if there was an inflation problem, it would further undermine the Fed's credibility and cause Congress to take more control over monetary policy, something I thing would be a big mistake and lead to worse policy outcomes in future recessions. I was also skeptical that a fall in long-term real interest rates would induce much in the way of new investment and the consumption of durables due to poor economic conditions, so the benefits of the policy seemed small relative to the potential costs. As I said above, right now I don't expect inflation to be a problem, but the Fed's exit is just beginning, so we will have to wait and see.

Sunday, March 21, 2010

"Toward a More Competitive, Efficient, and Innovative Financial System"

In a speech today, Ben Bernanke says the financial system is far from the "competitive ideal," and that the too-big-to-fail problem is the primary cause of the "insidious barriers to competition" and "competitive inequities" that currently exist in these markets.

One thing I'd add is that there is reason to be concerned about the size of these firms over and above the too-big-to-fail problem, i.e. for traditional reasons involving the exercise of market power. Bernanke says that:

our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope

But I'd like to have more precise information about how large these firms need to be until the economies of scope and scale begin bottoming out. If it's so large that firms can gain a substantial market share by moving down the cost curve, then regulators need to ensure that firms do not exploit their market power:

...Toward a More Competitive, Efficient, and Innovative Financial System The United States has a financial system that is remarkably multifaceted and diverse. Some countries rely heavily on a few large banks to provide credit and financial services; our system, in contrast, includes financial institutions of all sizes, with a wide range of charters and missions. We also rely more than any other country on an array of specialized financial markets to allocate credit and help diversify risks. Our system is complex, but I think that for the most part its variety is an important strength. We have many, many ways to connect borrowers and savers in the United States, and directing saving to the most productive channels is an essential prerequisite to a successful economy.
That said, for the financial system to do its job well, it must be an impartial and efficient arbiter of credit flows. In a market economy, that result is best achieved through open competition on a level playing field, a framework that provides choices to consumers and borrowers and gives the most innovative and efficient firms the chance to succeed and grow. Unfortunately, our financial system today falls substantially short of that competitive ideal.
Among the most serious and most insidious barriers to competition in financial services is the too-big-to-fail problem. Like all of you, I remember well the frightening weeks in the fall of 2008, when the failure or near-failure of several large, complex, and interconnected firms shook the financial markets and our economy to their foundations. ... It is unconscionable that the fate of the world economy should be so closely tied to the fortunes of a relatively small number of giant financial firms. If we achieve nothing else in the wake of the crisis, we must ensure that we never again face such a situation.
The costs to all of us of having firms deemed too big to fail were stunningly evident during the days in which the financial system teetered near collapse. But the existence of too-big-to-fail firms also imposes heavy costs on our financial system even in more placid times. Perhaps most important, if a firm is publicly perceived as too big, or interconnected, or systemically critical for the authorities to permit its failure, its creditors and counterparties have less incentive to evaluate the quality of the firm's business model, its management, and its risk-taking behavior. As a result, such firms face limited market discipline, allowing them to obtain funding on better terms than the quality or riskiness of their business would merit and giving them incentives to take on excessive risks.
Having institutions that are too big to fail also creates competitive inequities that may prevent our most productive and innovative firms from prospering. In an environment of fair competition, smaller firms should have a chance to outperform larger companies. By the same token, firms that do not make the grade should exit, freeing up resources for other uses. Our economy is not static, and our banking system should not be static either.
In short, to have a competitive, vital, and innovative financial system in which market discipline encourages efficiency and controls risk, including risks to the system as a whole, we have to end the too-big-to-fail problem once and for all. But how can that be done? Some proposals have been made to limit the scope and activities of financial institutions, and I think a number of those ideas are worth careful consideration. Certainly, supervisors should be empowered to limit the involvement of firms in inappropriately risky activities. But even if such proposals are implemented, our technologically sophisticated and globalized economy will still need large, complex, and internationally active financial firms to meet the needs of multinational firms, to facilitate international flows of goods and capital, and to take advantage of economies of scale and scope. The unavoidable challenge is to make sure that size, complexity, and interconnectedness do not insulate such firms from market discipline, potentially making them ticking time bombs inside our financial system.
To address the too-big-to-fail problem, the Federal Reserve favors a three-part approach.

Continue reading ""Toward a More Competitive, Efficient, and Innovative Financial System"" »

Tuesday, March 16, 2010

FOMC Meeting: Rates Steady for an Extended Period, Asset Purchase Programs to End

I have a quick reaction to the Press Release from today's FOMC meeting at MoneyWatch:

FOMC Meeting: Rates Steady for an Extended Period, Asset Purchase Programs to End

Friday, March 12, 2010

Is Janet Yellen Really a Dove?

Larry Meyer on Janet Yellen's nomination as Vice Chair of the Federal Reserve Board:

Meyer on Yellen as Fed Vice Chair: "The best possible choice", by Larry Meyer, MacroAdvisors: President Obama is reported to soon announce his decision to nominate Janet Yellen as Vice Chair of the Federal Reserve Board... My reaction to the President's choice: an enthusiastic Hurray! ... I am biased. Janet is one of my favorite people, a good friend, a former colleague (both at the Board and briefly at Macroeconomic Advisers) ... I want to say a few ... words about ... how her appointment could affect monetary policy decisions. ...
Many in the markets ... will be interested in only one question: How will the nomination affect monetary policy decisions, specifically the timing of exit from the current near-zero rate? Janet Yellen is today, certainly, among the doves on the Committee. I will be posting a commentary soon ... where I explain what makes one a hawk or a dove ... and whether it matters. The conclusion is that it does not matter... The reason is, as said to me by a member of the Board: "The Chairman owns the room." When the Chairman wants to move away from the near-zero funds rate, the Committee will do so. Until that time, he will always enter the room with at least eight votes in his pocket and with assurance that there will be several more each time. As Vice Chair, Janet can never vote against the Chairman. She can never take a substantially different view than the Chairman around the table. This is the etiquette of being a Vice Chair... It goes with the territory. You don't take this position if you cannot abide by this rule. Fortunately, this won't be a problem for Janet. First, she holds views that are not very different than the Chairman's. Second, she has utmost confidence in his judgment, and the feeling is mutual. She will, almost alone on the FOMC, continue to have the opportunity to help shape that judgment. Janet surely appreciates ... that the only way she can affect the policy decision is to convince the Chairman to alter his recommendation to the Committee is to reach him before the meeting. What we can say for sure is that Janet will surely help the Chairman make the best decision, even in those occasions when he ends up disagreeing with her.
The final question is whether Janet is really a dove. Let me tell you a story. Janet and I held very similar views when we were colleagues on the Committee, despite the fact that I was immediately viewed as a hawk and she was already viewed as a dove. (I thought of myself at the time as being a "hawkish dove.") In any case, when it comes to ensuring price stability and maintaining well-anchored inflation expectations, there are no doves on the Committee. Before the September 1996 FOMC meeting, Janet and I went to see the Chairman to talk about the policy decision at that meeting and at following meetings. This was the only time I ever visited the Chairman (at my initiative) to talk about monetary policy, before or after a meeting. Janet and I were both worried about inflation, even though it was very well contained at the time. We told the Chairman that we loved him but could not remain at his side much longer if he continued, as he had been doing for some time, to push the next tightening action into the next meeting, and then not follow through. He listened, more or less patiently. I recall, though this may have not been the case, that he just smiled and didn't say a word. After an awkward silence, we said our good-byes. Needless to say, we didn't win this argument. Yet, we never dissented. That is another matter of etiquette for the entire Board, at least since when I was there: The Board is a team, always votes as a block, and, therefore, always supports the Chairman.
Yes, Janet is a dove today. But this is so principally because she passionately believes in the dual mandate (price stability and full employment). ... Given the Fed's mandate, and because she expects the unemployment rate to be very elevated for a long time and inflation to be very low for quite some time, she wants to make a "late" exit from the near-zero rate policy. How could you not be a dove under these circumstances? Certainly I would be a dove if I were on the Committee today. But Janet would quickly switch camps, unquestionably along with all her dove colleagues, if the outlook or her forecast changed such that a serious threat to price stability emerged. There simply are no doves at central banks under these circumstances, and certainly not on the FOMC.

In any case, the minute she was nominated to the Committee she became a centrist. Now, more than ever, she will be side-to-side with the Chairman, who, by definition, is always the center of the Committee. ...

Update: On another topic, in September 2005 post, she was not a fan of Fed intervention to pop bubbles:

Presentation to the members of Parliament at the Conference on US Monetary Policy, by Janet L. Yellen, President, FRBSF: ... I want to focus my remarks today on another longer-term issue, namely, the housing market ... The question is: ...Is there a house-price "bubble" that might collapse, and if so, what would that mean for the U.S. economy? To answer this question, let me begin by clarifying what I mean by the term "bubble." A bubble does not just mean that prices are rising rapidly—it's more complicated than that. Instead, a bubble means that the price of an asset—in this case, housing—is significantly higher than its fundamental value.

One common way of thinking about housing's fundamental value is to consider the ratio of housing prices to rents. ... Currently, the ratio for the U.S. is higher than at any time since data became available in 1970 ... Higher than normal ratios do not necessarily prove that there's a house-price bubble. House prices could be high for some good, fundamental reasons. ... Probably the most obvious candidate for a fundamental factor ... is low mortgage interest rates. ... While the fundamentals I've mentioned do play a role, the consensus seems to be that much of the unusually high price-to-rent ratio for housing remains unexplained. Moreover, with controversy over exactly why long-term interest rates have remained so low, we can't rule out the possibility that they would rise to a more normal relationship with short-term rates, and this obviously might take some of the "oomph" out of the housing market. So, while I'm certainly not predicting anything about future house price movements, I think it's obvious that the housing sector represents a risk to the U.S. outlook.

This brings me to the debate about how monetary policy should react to unusually high prices of houses—or other assets, for that matter. ... As a starting point, the issue is not whether policy should react at all; I believe there is quite general agreement that policy should be calibrated to the wealth effects of house prices on output and inflation. The debate lies in determining when, if ever, policy should be focused on deflating the asset price bubble itself. In my view, the ... decision to deflate an asset price bubble rests on positive answers to three questions. First, if the bubble were to collapse on its own, would the effect on the economy be exceedingly large? Second, is it unlikely that the Fed could mitigate the consequences? Third, is monetary policy the best tool to use to deflate a house-price bubble?

My answers to these questions in the shortest possible form are, "no," "no," and "no." ... In answer to the first question on the size of the effect, it could be large enough to feel like a good-sized bump in the road, but the economy would likely to be able to absorb the shock... In answer to the second question on timing, the spending slowdown that would ensue is likely to kick in gradually... That would give the Fed time to cushion the impact with an easier policy. In answer to the third question on whether monetary policy is the best tool to deflate a house-price bubble, ... For one thing, no one can predict exactly how much tightening would be needed, or by exactly how much the bubble should be reduced. Beyond that, a tighter policy to deflate a housing bubble could impose substantial costs on other sectors of the economy that would lead to equally unwelcome imbalances. Finally, it's possible that other strategies, such as tighter supervision or changes in financial regulation, would not only be more tailored to the problem, but also less costly to the economy. Taking all of these points into consideration, it seems that the arguments against trying to deflate a bubble outweigh those in favor of it. ... But let me stress that the debate surrounding these issues is still very much alive.

By June 2009, her views had evolved:

Panel discussion for the Federal Reserve Board Journal of Money, Credit, and Banking conference on "Financial Markets and Monetary Policy," by Janet Yellen, President FRBSF: My second point concerns asset prices. The role of the house price bubble in precipitating the current financial crisis places new urgency on a long-standing question: Should central banks attempt to deflate asset price bubbles before they grow large enough to cause big problems? Until recently, most central bankers would have said monetary policy should respond to an asset price only to the extent that it will affect the future path of output and inflation. In essence, if you believe that financial markets work well most of the time, then you would be highly reluctant to target asset prices, let alone pop asset price bubbles. But, as I have discussed, we have vivid proof that markets sometimes don't work, and that the unwinding of a bubble can dramatically harm economic performance and threaten financial stability.
Four main issues define this debate... First, some question whether bubbles even exist. They argue that asset prices reflect the collective wisdom of traders in organized markets who best understand the fundamental factors underlying asset prices. It seems to me that this argument is difficult to defend in light of the poor decisions and widespread dysfunction we have seen in many markets during the current turmoil.
Second, it's an open question whether policymakers can identify bubbles in time to act effectively...
Third, even if we can identify bubbles as they happen, using monetary policy to address them will reduce our ability to attain other goals, so it makes sense for monetary policy to intervene only if the fallout is likely to be quite severe and difficult to deal with after the fact. ... By their nature, credit booms are especially prone to generating powerful adverse feedback loops between financial markets and real economic activity.4 If all asset bubbles are not created equal, policymakers could decide to intervene in those cases that seem especially dangerous.
Fourth, if a dangerous asset price bubble is detected and action to rein it in is warranted, is conventional monetary policy the best tool to use? Going forward, I am hopeful that capital standards and other tools of macroprudential supervision will be deployed to modulate destructive boom-bust cycles, thereby easing the burden on monetary policy.5 However, I now think that, in certain circumstances, the answer as to whether monetary policy should play a role may be a qualified yes. In the current episode, higher short-term interest rates probably would have restrained the demand for housing by raising mortgage interest rates, and this might have slowed the pace of house price increases. In addition, tighter monetary policy may be associated with reduced leverage and slower credit growth, especially in securitized markets.6 Thus, monetary policy that leans against bubble expansion may also enhance financial stability by slowing credit booms and lowering overall leverage.
Certainly there are pitfalls to trying to deflate bubbles. At the same time, policymakers often must act on the basis of incomplete knowledge, and it is now patently obvious that not dealing with some bubbles can have grave consequences. I would not advocate making it a regular practice to lean against asset price bubbles. But, in my view, recent painful experience strengthens the case for using such policies, especially when a credit boom is the driving factor.

"Fed Vacancies and the Monetary Challenge"

Having made the same points, I have no choice but to agree:

Fed Vacancies and the Monetary Challenge, by Alan S. Blinder, Commentary, WSJ: ...Federal Reserve Vice Chairman Donald Kohn's recent announcement that he will retire in June will bring the Federal Reserve Board down to four members—unless the Obama administration gets some new members in place by then. Recent history is not propitious. While the law states that the board has seven governors, vacancies have become the norm in recent decades. ... Let's hope Mr. Obama breaks that pattern—soon.
Why? Because ... Chairman Ben Bernanke and his four (soon to be three) colleagues, along with the presidents of the 12 district Reserve Banks, face two enormously complex and consequential sets of decisions. One has to do with the Fed's exit from its hyper-expansionary monetary policies—a process that is just beginning. The other pertains to the post-crisis regulatory system—provided Congress keeps the Fed in that business.
Each of these two areas is replete with hazards and numerous questions... And in each, mistakes can be quite consequential. As the Fed grapples with its many difficult decisions..., it would be nice if the estimable Mr. Bernanke were supported by a full, talented team. ...
That said, the Fed is formulating exit plans... Doing so adroitly will require both consummate technical skills and good seat-of-the-pants judgments. Yet, remarkably, once Vice Chairman Kohn retires, the Federal Reserve Board will be down to just one ... trained economist. That member, of course, is a very talented guy named Bernanke. But not even Derek Jeter carries the Yankees alone.
So it is imperative that President Obama appoint two distinguished and knowledgeable economists to the board as soon as possible. Such talent is often found in academia..., but that is not the only source. In selecting nominees, the president should be mindful ... that ... the Federal Open Market Committee ... is, on average, pretty hawkish. Mr. Obama will, I believe, want to create more balance.
The Fed's second big task will be creating and adapting to the new financial regulatory system. The ... Fed must be prepared for either of two challenging contingencies. If a major financial-reform bill passes, the Fed will likely have to reorganize itself and, in concert with other agencies, write scores of rules and regulations to implement the new regulatory framework. The other possibility is that no legislation passes. Since maintaining the regulatory status quo ante is unthinkable, the Fed and other agencies would then have to think through and promulgate dozens of regulatory changes that fall within their existing authority...
In either case, the Fed has a major regulatory job ahead of it. Economics will be useful here, too. But ... economists who would be most helpful on monetary policy will probably have little expertise on financial regulation. So President Obama would be wise to use one of his three nominations for someone deeply experienced in banking or financial regulation. Having three vacancies ... gives the president the luxury of being able to hire a diversified portfolio of talented people.
One last but important point: Confirmations of Federal Reserve governors have not traditionally been political events. ... Fed nominees are rarely highly political people. That's a tradition that both parties should cherish and nurture. ... Senate Republicans should refrain from turning his nominations into a political circus. Well, a man can hope, can't he?

It looks like there may finally be some action on this issue:

Report: Yellen to Fed vice-chair, by Tracy Alloway, FT Alphaville: Janet Yellen, president of the Federal Reserve Bank San Francisco, has been chosen by US president Barack Obama to replace Donald Kohn as vice chairman of the central bank, Bloomberg reports, citing two people with knowledge of nomination process. The selection is “pending completion of vetting by the Obama administration,” Bloomberg said.

Brad DeLong says "A very good person for the job. Not, however, a good move as far as strengthening the FOMC is concerned..." I also think Yellen is a very good choice, and if the new president at the SF Fed is chosen wisely, the FOMC will be improved over its present composition.

Wednesday, March 10, 2010

Why Do Federal Reserve Board Seats Remain Unfilled?

At MoneyWatch:

Why Do Federal Reserve Board Seats Remain Unfilled?, by Mark Thoma

The administration has not taken full advantage of the opportunity to shape monetary policy during the crisis.

Tuesday, March 09, 2010

Monetary Policy and Unemployment: Should the Fed have Done More?

Should the Fed have done more to combat the unemployment problem? In examining the costs and benefits of further easing, I have made almost all of the arguments against further easing by the Fed made below, i.e. that further easing by the Fed may not have much additional effect on long-term real interest rates, that even if rates could be brought down, consumers and businesses would be unlikely to respond by increasing investment and the consumption of durables -- firms already have considerable idle capacity, so why build more, and consumers are pessimistic about their futures, so why buy on credit -- and that there is an inflation risk from further easing.

One additional argument against more aggressive action by the Fed is that there is considerable uncertainty about the effects of further easing because they do not yet have "a robust suite of formal models to reliably calibrate interventions of this sort." But as with climate change, uncertainty does not necessarily translate into inaction. If the uncertainty includes much worse outcomes for employment than expected, and if the costs we attach to that outcome are very large, then uncertainty may prompt more aggressive rather than less aggressive intervention.

Yet another argument concerns the degree to which current productivity changes are permanent of temporary and how that translates into the degree of slack in labor markets. However, on this point I agree that "the sheer magnitude of unemployment today is so large that there is little doubt in my mind that there is considerable slack in the economy." Thus, however this debate comes out, it does not much change the degree and urgency of the unemployment problem.

In the end it comes down to the relative weights placed on the cost of inflation and the cost of unemployment, and I don't think policymakers are placing enough weight on the unemployment term (particularly given the uncertainty about the speed of recovery).

The Fed has the ability to help -- something needs to be done -- and a responsibility to help to the unemployed. The Fed is not alone in not doing enough, fiscal policymakers bear even more responsibility for failing to act aggressively, but that doesn't excuse the Fed's less than full bore attack on the unemployment problem.

This is the last part of a speech given today from Charlie Evans, President of the Chicago Fed, along with a graph from the speech showing the severity of the long-term unemployment problem:

Labor Markets and Monetary Policy, by Charles Evans, President, Chicago Fed: ...Productivity and resource slack The other side of an economy experiencing growing output but low labor utilization is high productivity growth. Indeed, productivity has been quite strong of late, particularly over the past three quarters. This is often the case in the early stages of a recovery, as firms first meet higher demand for their products and services without expanding their work force.
A key question today is the degree to which the recent productivity surge reflects a temporary cyclical development or a more enduring increase in the level or trend rate of productivity. If the gains are predominantly driven by intense cost cutting, then they may be unsustainable once demand revives more persistently. In this case, we would expect hiring to pick up quickly as the economic expansion takes hold. However, if the level or trend in productivity has risen due to technological or other improvements, then higher average productivity gains will continue.  In this case, the implications for hiring are not clear. Higher levels of productivity will show through in both higher potential and actual output for the economy, and so need not necessarily come at the cost of lower labor input.
The relative importance of these factors also has consequences for our assessment of the degree to which resource slack exists in the economy. Since a higher level or trend of productivity implies a higher path for potential output, a given level of actual GDP would also be associated with a greater degree of economic slack. That is, the good news on productivity, if sustained, suggests that as of today we have a larger output gap to fill In contrast, some are skeptical that the economy really is operating far below sustainable levels. They argue that much of the drop in output during the recession was the result of a permanent reduction in the economy’s productive capacity, perhaps because certain financial market practices that had for a time enabled additional investments have now been discredited. According to this view, the strong productivity growth of recent quarters only goes a fraction of the way toward offsetting this decline in the level of potential output.
Of course, the unemployment rate gives us another way to infer the degree of slack in the economy. My earlier discussion of the sharp rise in unemployment duration and decline in labor force attachment may lead one to think that slack is even greater than what is implied by the unemployment rate itself.
However, it is possible that longer durations and lower labor force attachment could reflect broader structural changes in the economy, such as a mismatch between the skills of the unemployed and those demanded by employers. There may also be other impediments that currently prevent workers from shifting to the industries or locations where jobs are available. Under these scenarios, labor market slack might actually be lower than what one might infer from the unemployment rate alone.
I have just given you 2 minutes of classic two-handed economist speak. In the final analysis, however, the sheer magnitude of unemployment today is so large that there is little doubt in my mind that there is considerable slack in the economy. Incorporating alternative views about productivity and labor market behavior do not alter this general conclusion. The debate really boils down to whether the amount of slack in the economy is large or is extremely large.
Should the Fed have done more?
Given this large degree of slack, there is a legitimate question of whether monetary policy could, and more fundamentally should, have done more to combat the deterioration in labor markets. As we all know, a lot was done. As the crisis arose, we first used our traditional tools, substantially cutting the federal funds rate and lending to banks through our discount window. As we neared a zero funds rate, we turned to nontraditional tools to clear up the choke points, providing liquidity directly to nonbank financial institutions and supporting a number of short-term credit markets. Finally, we reduced long-term interest rates further by purchasing additional medium- and long-term Treasury bonds, mortgage-backed securities, and the debt of government-sponsored enterprises.
These nontraditional actions helped us avoid what easily could have been an even more severe economic contraction. But the unemployment rate still hit 10 percent this fall.
Had we done more, the most plausible action would have been to expand our Large Scale Asset Purchases (LSAP) program. Precisely quantifying the effect this would have had is difficult. A good place to start, though, is to look at the recent empirical evidence.[3] When significant new asset purchases were announced, our big, fluid financial markets built that information immediately into asset prices. For example, right after the March 2009 Treasury purchase announcement, ten-year Treasury yields fell about 50 basis points. Comparable declines occurred in Option Adjusted Spreads (OAS) on the announcement of agency mortgage-backed securities (MBS) purchases in November 2008. It might be reasonable to infer that say, doubling the size of the LSAPs might have doubled this impact on rates.
However, I would attach more than the usual amount of uncertainty to such an inference. Part of my hesitation reflects our lack of understanding about the interactions between nontraditional monetary policy, interest rates, and economic activity. While research efforts at the Federal Reserve and elsewhere to assess the effects of nonstandard monetary policy have been ramped up considerably, to date we do not have a robust suite of formal models to reliably calibrate interventions of this sort.
Moreover, there are reasons to expect that the impact of recent nontraditional policy actions might not have scaled up so simply. We initially responded to the financial crisis with our highest-value tool—a reduction in the funds rate—and then moved to our best alternative policies as interest rates approached zero. Finally, we turned to the LSAPs, which were designed to further lower long-term interest rates and thus stimulate demand for interest-sensitive spending, such as business fixed investment, housing, and durables goods expenditures. But the influence of lower rates on private sector decision-making may have reached the point of second-order importance relative to the countervailing forces of the housing overhang, business and household caution, and considerably tighter lending standards.
Moreover, although it is impossible to quantify, a portion of the impact of our nontraditional actions may have come simply from boosting confidence. In those very dark times, I believe households, businesses, and financial markets were reassured that policymakers were acting in a decisive manner. Further asset purchases would not have had an additional effect of this kind.
In addition, on a practical level, the portfolio of future purchases likely would have looked different and therefore their overall effectiveness might have deviated from our recent experience. The Fed’s typical monthly purchases of new issuance MBS were so large that it left very little floating supply for private investors. This could have forced a larger LSAP program to concentrate more heavily in Treasuries or existing MBS. Though the empirical evidence is limited, these assets likely are less close substitutes than new MBS for many of the instruments used to finance spending on new capital goods, housing, and consumer durables. Consequently, the effect of their purchase on economic activity may be less.
Finally, we must also keep in mind that more monetary stimulus also has costs. These could be considerable at higher LSAP levels. Many are already worried about the inflation implications of the Fed’s expanded balance sheet and the associated large increase in the monetary base. Currently, most of the increase in the monetary base is sitting idly in bank reserves—and because banks are not lending those reserves, they are not generating spending pressure. But leaving the current highly accommodative monetary policy in place for too long would eventually fuel inflationary pressures. Likewise, if the monetary base was expanded much beyond where we are today, the risk that such pressures would build as the economy recovers would be significantly increased. Furthermore, policymakers already face the task of unwinding a sizable balance sheet at the appropriate time and pace. Substantially increasing the size of asset purchases could have further complicated the exit process down the road.

That said, changes in economic conditions could alter the cost–benefit calculus with regard to the LSAP. Hopefully the recovery will progress without any serious bumps in the road and the inflation outlook will remain benign. But, as we have repeatedly indicated in the FOMC statements, the Committee will continue to evaluate its purchases of securities in light of the evolving economic outlook and conditions in financial markets. ...

[Dual posted at MoneyWatch]

Tuesday, March 02, 2010

Fed Watch: Is the Fed Eager to Dismiss Deflationary Pressures?

Tim Duy:

My attention this morning was drawn to the inflation numbers in the January Personal Income and Spending release, specifically the recent downward trend in core PCE inflation:

PCE

Coupled with a sizable output gap that yields very high human cost in the form of high rates of labor underutilization - and forecasts that such underutilization will persist for years - would lead one to believe that policymakers still have work left ahead of them. Policymakers, however, do not appear to agree, and instead focus on the fact that output is growing again, even if the 5.9% pace in the final quarter of last year was inflated by inventory correction. Indeed, with the recovery taking hold, there is no imperative for more action. Fiscal policy looks hamstrung by deficit concerns, while monetary policy is poised to turn contractionary as asset purchase programs are wound down. To be sure, few expect the Fed to start raising the Federal Funds rate in the near term. But the Fed is throwing up its hands on unemployment, effectively saying they have done all they can do. Dallas Federal Reserve President Richard Fischer, via the Wall Street Journal:

But the Fed has space to maintain its current policies. “Inflation is not the issue,” given that it is so low right now, Fisher said. “The real issue right now is how patient the people can be, how patient the Congress can be with regard to this slow healing of the employment situation. It’s going to be a slow path.”

True, inflation is not an issue, so there is no rush to tighten policy. But is it too early to dismiss deflation, or at least consider that persistently low inflation demands additional monetary firepower, not less? Fed officials look increasingly poised to dismiss the central deflationary pressure, the cost of housing. This first jumped out in the minutes of the January 2010 FOMC meeting:

One participant noted that core inflation had been held down in recent quarters by unusually slow increases in the price index for shelter, and that the recent behavior of core inflation might be a misleading signal of the underlying inflation trend.

Is it smart to ignore roughly a quarter of the CPI? Laurel Graefe of the Atlanta Fed responded on macroblog:

However, once we've opened the door for pruning sectors that have displayed unusual price behavior in recent months, we can find a slew of outlying components to pare.

She concludes:

The Cleveland Fed uses a more methodical approach to exclude the CPI components that show the most extreme price changes each month. Their calculations show a more subdued underlying inflation environment, with median and trimmed mean CPI hovering around 1 percent for the past several months (chart 3). I'm not endorsing this method as a perfect estimation of “true” underlying inflation, but it does provide an example of indiscriminately trimming the outliers to see what's beneath.

Today we learned that Philadelphia President Charles Plosser was likely the dismissive participant:

I’m not as worried about deflation particularly. We’ve had a huge shock in housing. If you look at the components in CPI, a lot of the softness in the CPI is coming from the huge decline in rents and housing prices and housing costs. We want to be careful not to necessarily just count on certain relative prices to keep inflation in line.

Would he be as dismissive if only "certain relative prices" were keeping inflation high? I think not. Is it just Plosser? I found it interesting that Fed Chairman Ben Bernanke drew attention to the price of shelter in his semiannual trek to Capitol Hill:

Increases in energy prices resulted in a pickup in consumer price inflation in the second half of last year, but oil prices have flattened out over recent months, and most indicators suggest that inflation likely will be subdued for some time. Slack in labor and product markets has reduced wage and price pressures in most markets, and sharp increases in productivity have further reduced producers' unit labor costs. The cost of shelter, which receives a heavy weight in consumer price indexes, is rising very slowly, reflecting high vacancy rates. In addition, according to most measures, longer-term inflation expectations have remained relatively stable.

Note that it is not just low inflation that needs to be explained away. From the minutes:

Though participants agreed there was considerable slack in resource utilization, their judgments about the degree of slack varied. The several extensions of emergency unemployment insurance benefits appeared to have raised the measured unemployment rate, relative to levels recorded in past downturns, by encouraging some who have lost their jobs to remain in the labor force. If that effect were large--some estimates suggested it could account for 1 percentage point or more of the increase in the unemployment rate during this recession--then the reported unemployment rate might be overstating the amount of slack in resource utilization relative to past periods of high unemployment. Several participants observed that the necessity of reallocating labor across sectors as the recovery proceeds, as well as the loss of skills caused by high levels of long-term unemployment and permanent separations, could reduce the economy's potential output, at least temporarily; historical experience following large adverse financial shocks suggests such an effect. On the other hand, if recent productivity gains were to be sustained, as some business contacts indicated they would be, potential output currently could be higher than standard measures suggested, and the high level of the unemployment rate could be a more accurate indication of slack in resource utilization than usual measures of the output gap.

Some at the FOMC appear ready to dismiss high unemployment rates on the basis that extended unemployment benefits are pulling people into the labor force. But wouldn't that simply be the same thing as saying that we are underestimating underemployment? If we label a person as discouraged rather than unemployed is there really less slack in the economy? It seems that Fed officials actively looking to avoid the inconvenient truth that inflation remains well below target while unemployment remains high even as their attention shifts to weaning the economy from their balance sheet.

Interesting that we should be debating the necessity of raising inflation targets when we can't even get the Fed to direct policy at the target we already have. But I suspect the Fed believes that doing anything more would be the equivalent of raising inflation expectations, a bridge they are not ready to cross. Policymakers are likely to view inflation as a greater concern that the zero bound. David Altig argues a similar point:

To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous....

...my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.

I am not quite so sanguine. While David is correct, the Fed did find ways to maneuver around the zero bound constraint this time, I am more concerned with the next recession than this one. Recent history suggests that each recession necessitates lower interest rates than the last. I would prefer to pull the economy up to a point where we had some distance from the zero bound such that we did not have revert back to managing economic activity via ballooning the balance sheet. And while the balance sheet proved to be an effective tool for defrosting frozen financial markets, would it be as effective if the next time around the problem was simply too little demand in the presence of functioning financial markets? I would rather not endure the experiment.

Moreover, years of watching the Japan experience has left me leery of ignoring the dangers of persistently low inflation. From Bloomberg:

Japan’s consumer prices fell for an 11th month in January, putting renewed pressure on policy makers to eradicate deflation that hampers the recovery.

Prices excluding fresh food slid 1.3 percent from a year earlier, the same pace as December, the statistics bureau said today in Tokyo. The figure matched the median estimate of 29 economists surveyed by Bloomberg News.

Bank of Japan Deputy Governor Hirohide Yamaguchi said this week that prices may not be improving as quickly as he had expected. Finance Minister Naoto Kan today reiterated that the central bank should help the government beat deflation.

An interesting conundrum in Japan. A central bank so afraid of its independence - note the clear pressure from the Ministry of Finance - that it will not aggressively combat deflation, combined with fiscal authorities concerned about the deficit:

Bank of Japan Deputy Governor Hirohide Yamaguchi said yesterday that investors are closely monitoring fiscal policies as “Japan’s fiscal balance is in a very severe state.”

“It’s key that the nation recover its fiscal balance and exercise fiscal discipline,” Yamaguchi told reporters in Kagoshima, southern Japan. “Financial markets are always watching what the government is doing on these fronts.”

The fiscal authorities in Japan need to spend more money, and the monetary authorities need to print more money. One would think an obvious policy solution was at hand.

The US is not Japan. The US has that persistent current account deficit, for example. But we increasingly share some striking similarities. Dual equity and property bubbles. Zero interest rate monetary policy. Deficit concerns. Indeed, I would prefer to take more aggressive action to ensure that we do not share more similarities in the future. But like in Japan, US policymakers have reached the limit of their perceived abilities. Hopefully the similarities will end there.

Wednesday, February 24, 2010

Ben Bernanke's Testimony before the House Financial Services Committee

I have to go teach my classes, but in case you want to talk about Ben Bernanke's testimony before the House Financial Services Committee today, here are a few links (there's not much discussion of the testimony on blogs yet -- I won't be able to update this, so please feel free to add additional links in comments):

Tuesday, February 23, 2010

“Should Monetary Policy and Banking Regulation be Conducted Separately?”

I have argued many times that the Fed should have two roles. It should conduct monetary policy, and it should be the primary regulator of the financial system. However, not everyone agrees. When I was at the What's Wrong with Modern Macro Conference in Munich recently, I met Hans Gersbach -- we were on a panel together -- and he passes along his argument that monetary policy and banking regulation should be conducted by separate bodies:

Double targeting for Central Banks with two instruments: Interest rates and aggregate bank equity, by Hans Gersbach, Vox EU: The current crisis has placed a fundamental question at the centre of policy discussion: “Should monetary policy and banking regulation be conducted separately?” Opinions differ – see Adrian and Shin (2009), Goodhart (2008), and De Larosière et al. (2009).

  • Brunnermeier et al. (2009) argue that central banks should be tasked with macroprudential regulation.
  • De Grauwe (2007) argues that central banks should be responsible for the supervision of all institutions involved in the business of creating credit and liquidity.
  • Linking both policy areas directly, however, might endanger the exceptional success of many central banks in creating low and stable inflation of the kind observable during the last two decades (Gerlach et al. (2009)).

There is thus a pressing need to clarify the objectives and instruments of central banks and banking supervisory authorities, and also to inquire how they should ideally interact. Here I present a new framework aimed at such a clarification.

Continue reading "“Should Monetary Policy and Banking Regulation be Conducted Separately?”" »

Monday, February 22, 2010

"The Fed's Discount Rate Hike"

The Fed's recent decision to increase the discount rate does not signal an intent to tighten policy:

The Fed's discount rate hike, econbrowser: The Federal Reserve Board announced on Thursday that it is raising the interest rate at which banks borrow from the Fed's discount window to 0.75%, a 25-basis-point increase, and intends to return discount lending primarily to the traditional overnight loans. "The rate hike cycle begins," declared 24/7 Wall St...
But I don't believe that's what the discount rate hike means at all. The Fed sometimes has used discount rate changes as a signal of its intentions for interest rates more broadly. But the Fed press release accompanying the move stated flatly that's not the case this time...
The same message was emphatically repeated in statements by Fed Governor Elizabeth Duke and Federal Reserve Bank of New York President William Dudley. Maybe you have a theory that the way the Fed communicates that it intends to raise rates is by denying that it intends to raise rates. If so, I can't help you. ...

The Wall Street Editorial page was upset because the move didn't signal an intent to begin raising interest rates sooner rather than later. The editorial page gang would also like to balance the budget beginning right now with spending cuts "to demonstrate that those who can be trusted with small things—cutting back what can be removed now—can be trusted with larger things." It's all part of their quest to repeat the 1937-38 experience.

Thursday, February 18, 2010

Europe’s Sovereign Debt Problem

At my blog at CBS MoneyWatch:

Europe’s Sovereign Debt Problem: Causes and Solutions, by Mark Thoma

Fiscal Federalism

Here's something I wrote for Free Exchange's Round Table in response to a proposal from Daniel Gros and Thomas Mayer to create a European Monetary Fund:

Try a European Fiscal Fund, by Mark Thoma

Tuesday, February 16, 2010

Do We Need to Rethink Macroeconomic Policy?

David Altig, research director at the Atlanta Fed and someone I've found to be very much worth listening to (even if I don't always agree), has a dissenting view on adopting a 4% inflation target in order to give central banks more room to maneuver in times of crisis:

Do we need to rethink macroeconomic policy?, by David Altig: The aftermath of a crisis is always fertile ground for big thoughts. Big thinking is exactly what we get from Olivier Blanchard (the International Monetary Fund's director of research) and his colleagues Giovanni Dell'Aricca and Paolo Mauro, in their new overview of the financial crisis and what it means for how we think about and, more importantly, practice macroeconomic policy. Titled, appropriately enough, "Rethinking Macroeconomic Policy," one of the more provocative parts of their analysis was highlighted in the Wall Street Journal:
"Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

"At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further."
Paul Krugman approves, as does Ken Houghton at Angry Bear, who concludes with this comment:
"None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation."
I suppose that the modifier "major" provides something of an escape clause, but as a general proposition there is at least some evidence that 2% is preferable to 4%. From the IMF itself, for example, there is this
"The threshold level of inflation above which inflation significantly slows growth is estimated at 1–3 percent for industrial countries and 11–12 percent for developing countries. The negative and significant relationship between inflation and growth, for inflation rates above the threshold level, is quite robust..."
… which confirms the results of an earlier IMF study:
"Our more detailed results may be summarized briefly. First, there are two important nonlinearities in the inflation-growth relationship. At very low inflation rates (around 2–3 percent a year, or lower), inflation and growth are positively correlated. Otherwise, inflation and growth are negatively correlated…"
To be sure, there are plenty of studies suggesting modest increases in the rate of inflation from the levels currently targeted by many central banks would not be problematic—here, for example. But the point is that the evidence is not clear cut that an increase from an average rate of inflation in the neighborhood of 2 percent to the neighborhood of 4 percent would be innocuous. And there is always this element, noted by John Taylor in the aforementioned Wall Street Journal article:
"John Taylor, a Stanford University monetary-policy specialist who served in the Bush administration Treasury department, says that inflation could become hard to constrain if the target is raised. 'If you say it's 4%, why not 5% or 6%?' Mr. Taylor said. 'There's something that people understand about zero inflation.' "
So, the issue comes down to whether the uncertain costs of raising the average inflation rate is justified by the goal of avoiding the zero bound. At Free Exchange, the blog of The Economist, there is some skepticism:
"… the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.
"There is a concern that with a higher level of inflation, inflation will become more volatile and expectations less anchored. At the same time, the higher target might not be enough to handle a recession as deep as the most recent downturn; to achieve the equivalent of a Taylor rule indicated -5% federal funds target without being constrained by the zero lower bound, the Fed would need to target inflation at at least 7%. Separately, these criticisms seem compelling, but taken together they cancel each other out."
Those are good arguments in my view, but my doubts about running policy to avoid the zero bound run even deeper. Among the lessons taken from the financial crisis, I include this: The "zero bound problem" was not all that big of a problem at all.
The Federal Open Market Committee moved the federal funds rate target to its effective lower bound (0 to ¼ percent) on Dec. 16, 2008. After a very rough start to 2009, gross domestic product (GDP) growth improved substantially in the second quarter. By the third quarter, growth was positive and, as far as we currently know, clocked in near 6 percent in the fourth. Is this the stuff of zero bound disaster?
In fact, Blanchard and company acknowledge that…
"It appears today that the world will likely avoid major deflation and thus avoid the deadly interaction of larger and larger deflation, higher and higher real interest rates, and a larger and larger output gap."
… but follow up with this:
"But it is clear that the zero nominal interest rate bound has proven costly."
Clear? Proven? I don't see it, and the IMF authors, in my view, explain why the zero bound problem was of limited relevance in the recent crisis:
"Markets are segmented, with specialized investors operating in specific markets. Most of the time, they are well linked through arbitrage. However, when, for some reason, some of the investors withdraw from that market (be it because of losses in some of their other activities, loss of access to some of their funds, or internal agency issues), the effect on prices can be very large. In this sense, wholesale funding is not fundamentally different from demand deposits, and the demand for liquidity extends far beyond banks. When this happens, rates are no longer linked through arbitrage, and the policy rate is no longer a sufficient instrument for policy." (I added the emphasis.)
The highlighted passage, of course, does not say "the policy rate is no longer a necessary instrument," and I certainly cannot prove that the trajectory of the economy in 2009 wouldn't have been better if only we had another 100 to 200 basis points in the tool kit. But color me a skeptic, and put me down on the petition to not experiment with higher inflation to avoid a problem that was not so clearly a problem.

I'm not yet on the 4% bandwagon, but I haven't ruled it out either. I'm still considering arguments on both sides of the issue. I do agree, however, with this point from Free Exchange. It's something I've worried about as well:

On the other hand, a higher inflation rate brings with it its own difficulties. Chief among these, according to Mssrs Billi and Kahn, are relative-price distortions. Not all prices inflate at the same rate, and so inflation generates some relative-price distortions which lead to resource misallocation. The higher the inflation rate, the greater these distortions (you can see a helpful discussion of these issues by James Hamilton here). After reviewing the costs and benefits, Mssrs Billi and Kahn conclude that a target just below 2% is optimal.
But the value of avoiding the zero bound depends on the seriousness of the macroeconomic situation. From the vantage point of 2010, a higher target rate seems like a great idea, but economic crises this severe are rare events. Even if there are only small costs to a 3% target relative to a 2% target, they may not be worth the trouble if the goal is to avoid serious trouble once every 80 years.

Just to be clear, the relative price of good A to good B is PA/PB. If there is inflation and one of the two prices is stickier than the other, then the two prices will change at different rates in response to inflation. This pushes relative prices away from their fundamental values, and this in turn distorts resource flows (which leads to losses and unemployment as resources are subsequently reallocated). The higher the inflation rate, the faster these prices become distorted and the higher the subsequent costs. This is not the only cost of inflation, but on this basis alone it's likely that at some point the costs of inflation will exceed the benefits. The hard question is where the breakpoint is (partly because we don't have good estimates of either the costs or the benefits, so it's possible to support most any position by picking and choosing among the empirical studies). I'd be very uncomfortable with a rate over 4%, 4% itself seems a bit high, but 3% isn't so hard to accept.

On the benefits, I agree with David, it's not that clear that the zero bound was the main impediment to policy action. This was a case where fear not high interest rates was the main factor causing investment to fall, and starting from a higher inflation rate target doesn't change that. Reducing fear means reducing risk, and that required the Fed to use other innovative policies rather than the standard interest rate policies that work during normal times. Fed purchases of toxic assets removes risk from the marketplace, various policies that amount to insurance policies on financial investments reduce fear, and so on -- these were the policies that made the most difference in terms of getting money flowing through these markets once again.

Maybe a higher inflation target will help. As I said my mind is open. People I respect greatly are on both sides of this issue -- there is no clear answer as to whether this would help -- and for me that is the problem. If I was more certain about the benefits, and less fearful of the costs, supporting a higher inflation target would be an easy call. But until the benefits are established more firmly than they are presently, I find it hard to support this without hedging on the recomendation.

Wednesday, February 10, 2010

The Fed's Exit Strategy

Here's an explanation of the Fed's exit strategy, including why the Fed is planning to raise the interest rate it pays on reserves rather than the more traditional strategy of using open market operations to control the federal funds rate:

The Fed's Exit Strategy, by Mark Thoma

Friday, February 05, 2010

Fed Watch: Devil's Advocate

Tim Duy tries to explain why the Fed might be hesitant to pursue a more aggressive policy stance:

Devil's Advocate, by Tim Duy: Commentators, including myself, have been critical of a Federal Reserve policy stance that appears to place uncertain inflation concerns ahead of a very real unemployment problem. Playing devil's advocate, one can argue that Federal Reserve members are showing remarkable patience in keeping interest rates at rock bottom levels. Even more remarkable is that there is not a greater push to aggressively contract the balance sheet to a more traditional state. Central bankers are simply a very conservative lot, and the Fed is operating at the boundary of what many policymakers can stomach. Indeed, recent data must be somewhat disconcerting, with the US economy under the influence of an inventory correction that is having a very real positive impact on the manufacturing sector. And if the January employment report yields a substantial increase in nonfarm payrolls - something not out of the question in the wake of 5.7% growth in the fourth quarter of last year - policymakers may start to think that the balance of risks are turning rapidly toward inflation. Remember, the chief obstacle to tighter policy is the forecast of persistently high unemployment. Data flow that runs contrary to that expectation will raise fears among some policymakers that they are already dangerously behind the curve.

It is hard not to flag the flow of manufacturing data as a warning that a V-shaped recovery is at hand. The ISM manufacturing report was solid across the board as firms are caught in the midst of a traditional inventory correction. Particularly disconcerting to Fed officials will be the price data, with 44% of firms reporting higher prices, while only 4% seeing declines. No commodities were reported down in price. This follows a strong showing in manufacturing orders for December, with a clear upward trend established in the data:

FW0204103

Furthermore, highlights of the GDP report included a gain in equipment and software spending in addition to a positive contribution from net exports. Sustained improvement in the latter would be a very significant development, helping the US adjust to a less consumer-dependent economy and providing a basis for additional investment in export oriented and import competing industries. I have, however, been somewhat skeptical that US authorities would actually challenge the fundamentally currency "misalignments" that help perpetuate the still significant trade imbalance. President Obama's SOTU address, however, and its pledge to pursue export led growth looks to have lit a fire under policymakers. Perhaps the external sector will be a sustained source of growth. That said, talk is cheap - this Administration is not known for policy follow-through.

To be sure, I would be amiss if I did not identify less strong data. The ISM nonmanufacturing report was weaker than hoped for, throwing cold water on the notion that inventory correction is spreading more broadly into the service sector. Initial unemployment claims have backed up in recent weeks, a reminder of the still precarious state of the labor market. Auto sales slipped a notch, suggesting that the road to sustained improvement remains elusive. Finally, while retails sales posted solid gains in January, we really wouldn't have expected much else given the decline at this time last year. Overall, while none of this data is particularly strong, I would not describe it as particularly weak, nor should it alter the perception the economy is on a sustained upward trend.

But what is the pace of that trend? We always come back to this question, because it is the key to policy evaluation. If the pace is sufficiently high, then we would expect unemployment to come down quickly, and the Fed would be behind the curve, in which case the Treasury market will be in a world of pain. The expected path of activity, however, remains such that unemployment rates will come down gradually, thus alleviating the danger of a rapid reversal of monetary. What kind of growth would we need to send the Fed scrambling for the exits? On this issue, Brad DeLong provides some guidance by depicting the path of unemployment beginning in 1982 - the so-called "Morning in America" - versus the actual beginning in 2009 and the Administration projection for 2010 and beyond:

FW0204102

A good opportunity to look at real final sales - GDP excluding inventory changes - during the mid 80's:

FW0204101

As can be seen, the underlying rate of growth enjoyed a sustained surge from 4Q82 onward - an average of 5.4% growth through 1984. That is the kind of growth needed to drive down unemployment rates quickly. In contrast, real final sales climbed just 2.2% in 4Q09. We need to see sustained growth at more than twice that rate to bring unemployment quickly down to acceptable levels. But there is simply no faith that such a feat can be achieved. Most doubt there is sufficient pent up demand in the consumer to do the job, while Calculated Risk has repeatedly stated the case against a quick rebound in housing. With fiscal stimulus set to slow, that leaves investment and the external sector to big up the slack - neither of which packs the weight of the consumer. Consequently, the Fed can hold policy steady on the back of the current forecast, which lacks the post-1982 surge. But given the amount of cash sloshing around in the banking system, they will be sweating out the data, more concerned about the upside risk than the downside. In their defense, arguably the rapid and tepid recovery scenarios are observationally equivalent in the inventory correction phase of the recovery.

Bottom Line: An improvement in labor markets would not be unexpected given the GDP surge at the end of 2009. But sustainability is the key, and sustainability requires 4Q09 GDP numbers in the absences of inventory effects. Few forecasts are looking for such growth, certainly not yet at the Fed. Indeed, the recent travails of the stock market and sustained sub-4% level on 10 year Treasuries argues against such growth as well. Interestingly, at this juncture, I place more weight on the upside risk than the downside, although I suspect that is a factor of my relatively low expectations than any real optimism on my part. I don't see an actual return to recession short of another negative demand shock, but I am expecting the economy to settle into an anemic pace of growth. In this environment, I don't see how the Fed is interested in substantially tightening policy - but I can see how some policymakers could perceive that their hand was forced if they see a string of upside surprises in growth indicators, especially if the January read on employment is better than anticipated. Still, I think only clear evidence that a 1983 recovery is emerging would prompt a sudden policy shift at the Fed.

Wednesday, February 03, 2010

Chris Sims on Policy at the Zero Lower Bound

Chris Sims talks about difficulties of policy at the zero lower bound (wonkish). In particular, he discusses the difficulty of credible commitment to higher future inflation that is necessary in most New Keynesian models, the difficulty in achieving fiscal and monetary policy coordination, and the problems that may arise when the central bank takes quasi-fiscal actions:

Commentary on Policy at the Zero Lower Bound, by Christopher A. Sims, Princeton University, CEPS Working Paper No. 201, January 2010: I. ROBUST IMPLICATIONS OF CONVENTIONAL NEW KEYNESIAN MODELS FOR POLICY AT THE ZERO LOWER BOUND Monetary policy has been thought of, at least for several decades up until the fall of 2008, as interest rate policy. Certainly New Keynesian policy models treat it this way. At the zero lower bound (ZLB), the interest rate is stuck, so long as policy makers would like to be taking a more stimulative stance. This would seem on the face of it to imply that monetary policy is paralyzed. New Keynesian models like those in this volume generally agree that monetary policy can be effective, though, if policy can take the form of credible commitments to future interest rate paths. This optimistic conclusion was developed by Christiano, Motto, and Rostagno (2004), Eggertsson and Woodford (2003), and Eggertsson (2008), and emerges in this volume’s papers as well.

But the conclusion is less optimistic than it looks. In models, it is easy to specify an announced future policy stance and assume the public believes the announcement. In practice, there is inevitably uncertainty about exactly how firm are commitments to future policy, even if the future policy is announced in detail. The uncertainty implies volatility, as newly arriving information shifts the public’s perception of how easy it will be to deliver on the commitment.

Central banks in most developed countries have succeeded in convincing the public that they are committed to maintaining low and stable inflation. But this credibility has built up over decades as the central banks have acted to deliver on their commitment. In the presence of a binding ZLB, the result from the models is that the central bank ought to commit to expansionary future policy. A bank that has built up inflation-fighting credibility may find this is a liability if it tries to convince the public that it is temporarily committed to increasing the inflation rate.

Announcements about future policy at a time when the short rates that ordinarily are seen as set by the central bank are stuck at zero are particularly subject to doubt, just because they are accompanied by no current action.

Continue reading "Chris Sims on Policy at the Zero Lower Bound" »

Tuesday, February 02, 2010

Fed Policy and Mortgage Choice

The Fed has been purchasing mortgage backed securities, but only those containing fixed interest rate mortgages. Mortgages with variable interest rates have not been part of the Fed's mortgage backed security purchase program. Coinciding with this, and probably caused by the Fed's intervention, has been a change in the composition of mortgage purchases by households toward fixed rate loans:

Mortgage Choice and the Pricing of Fixed-Rate and Adjustable-Rate Mortgages, by John Krainer, Economic Letter, FRBSF: In the United States throughout 2009, the share of adjustable-rate mortgages among total mortgage originations was very low, apparently reflecting the attractive pricing of fixed-rate mortgages relative to ARMs. Government policy could have changed the relative attractiveness of the fixed-rate mortgages and ARMs, thereby shifting the market share of these two housing finance instruments.

Arm-Share

One of the notable features of the current U.S. mortgage market is the predominance of fixed-rate mortgages. The interest rate differential between fixed-rate mortgages (FRMs) and adjustable-rate mortgages (ARMs) has fallen from a recent high of about 2.5 percentage points in the summer of 2004 to about 0.5 percentage point at the end of 2009. These changes in the interest rate differential have coincided with the collapse of mortgage securitizations other than those mediated by government-sponsored enterprises (GSEs), including Fannie Mae, Freddie Mac, and Ginnie Mae (see Krainer 2009). In addition, the Federal Reserve began large-scale purchases of GSE mortgage-backed securities (MBS) starting in January 2009, adding significant secondary market demand for fixed-rate mortgages. The Fed's purchase program has not included MBS containing ARMs.

This Economic Letter reviews some of the factors determining consumer mortgage choices. It shows that ARM share has declined in ways that parallel the behavior of several key mortgage market interest rates. These developments have coincided with, among other things, Fed intervention in the market through large-scale MBS purchases. Thus, the Fed program, while supporting the functioning of the residential mortgage market overall, could have affected the composition of the mortgage market. To help understand this dynamic, this Letter estimates what the ARM share might have been under alternative scenarios in which fixed mortgage rates were higher, which would likely have been the case if the Fed had not been intervening in the market to the extent that it did. ... [continue reading]

Thursday, January 28, 2010

Ben Bernanke Reconfirmed: Will He Get the Message?

Here's my reaction to the vote to reconfirm Ben Bernanke as Fed Chair:

Ben Bernanke Reconfirmed: Will He Get the Message?

Wednesday, January 27, 2010

Fed Watch: Dissent

Tim Duy reacts to today's FOMC meeting:

Dissent, by Tim Duy: The FOMC statement contained a mini-bombshell, the dissent of Kansas City Fed President Thomas Hoenig. I am skeptical, however, that this dissent is a significant shift in the policy environment. Instead, I view the statement as taking another baby step forward to a normalization of monetary policy now that the financial crisis has eased and that the economic environment has firmed. Many policymakers will simply find themselves increasingly uncomfortable holding rates at rock bottom levels while sitting on a bloated balance sheet -- regardless of the unemployment rate. Short of a significant reversal of recent economic gains, I would be hard pressed to see the Fed back away from a policy stance that is growing tighter, albeit slowly tighter.
The opening sentence of the statement maintains the position that the economy continues to strengthen while labor markets firm. Some may be surprised about the latter point given the disappointing December employment report. The Fed, however, will be expecting the road to sustained improvement to be bumpy; one month will not significantly impact their outlook given the sharp decline in the pace of job losses in the second half of 2009. The trend is clear. The Fed also upgraded slightly its assessment of business spending, consistent with data such as new orders for capital goods.
The opening paragraph, however, omitted mention of the housing market improvements as noted in the December statement. Are they less confident of a sustained rebound given the drop off that followed this summer's tax credit induced boom? Or do they just want to avoid mention of housing given that they intend to halt stimulus for that sector? In my opinion, of all the Fed interventions over the past year, the decision to acquire $1.25 trillion of mortgage securities is the most politically risky; more on that later.

Continue reading "Fed Watch: Dissent" »

"The Quarrel Over Bernanke"

There's always room for more debate on Ben Bernanke's reconfirmation:

The Quarrel Over Bernanke, Room for Debate: The Senate is expected to vote this week on whether to confirm Ben Bernanke to a second term as the Federal Reserve chairman. Though it appears that he will overcome a filibuster threat, opposition to Mr. Bernanke has grown, along with worsening jobs numbers and public anger over the Fed’s failure to regulate banks before the financial crisis. His Democratic and Republican opponents have criticized him as the architect of the Wall Street bailout and being out of touch with the woes of Main Street.

How much is Mr. Bernanke to blame for the regulatory failures, the weak recovery and high unemployment numbers? Could a new Fed chairman make a difference?