Category Archive for: Monetary Policy [Return to Main]

Tuesday, October 25, 2011

Fed Watch: Floating Rate Treasuries

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

Sunday, October 23, 2011

"Coordinated Fiscal and Monetary Policy"

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

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

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

Point taken.

Touché.

I will report to the reeducation camp tomorrow...

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

But I have not been saying so loudly enough.

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

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

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

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

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

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

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

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

What asset is most different from cash?

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

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

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

Friday, October 21, 2011

Signs that the Fed Will Provide More Stimulus for the Economy

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

The Fed Is Laying the Groundwork for Further Easing

A Ticker-Tape Parade?

This caught my eye:

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

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

Wednesday, October 19, 2011

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

Brad DeLong:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, October 06, 2011

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

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Wednesday, October 05, 2011

Solow: Keynesian Economics Has Become Dramatically Relevant Again Today

Robert Solow:

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

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

Tuesday, October 04, 2011

Fed Watch: The Fed Drops the Ball

Tim Duy:

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

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

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

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

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

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

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

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

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

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

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

the reality is likely less optimistic:

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

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

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

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

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

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

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

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

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

Cold comfort, according to ECRI:

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Bernanke: Fiscal Policy is of Critical Importance

A few remarks on Bernanke's testimony before Congress:

Bernanke: Fiscal Policy is of Critical Importance

Saturday, October 01, 2011

Fed Watch: Too Late for the Unemployed?

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Thursday, September 29, 2011

Plosser: Recent Stimulus Will Hurt the Fed's Credibility

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

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

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

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

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

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

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

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

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

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

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

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

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

Wednesday, September 28, 2011

Ben Bernanke and the Washington Consensus

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

Ben Bernanke and the Washington Consensus

Fed Watch: Opinions and Rumors

Tim Duy:

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

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

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

What I gleaned from those conversations was as follows:

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

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

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

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

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

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

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

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

Fisher1

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

Fisher2

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

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

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

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

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

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

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

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

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

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

Finally, Fisher channels former Federal Reserve Chairman Paul Volker:

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

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

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

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

Tuesday, September 27, 2011

How the GOP Assault on the Fed Could Backfire

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

How the GOP Assault on the Fed Could Backfire

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

Friday, September 23, 2011

Mankiw: I am Not Very Worried about Inflation Just Now

Greg Mankiw:

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

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

Thursday, September 22, 2011

Fed Watch: Working on the Wrong Margins

Tim Duy:

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

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

Still, the outcome is too little:

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

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

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

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

There is no calvary coming to the rescue.

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

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

"The Fed's Latest Moves May Fall Flat"

I have some comments at NPR:

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

[Story, Listen]

Fed Watch: FOMC Reaction – The Extended Version

Tim Duy:

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

Moreover, downside risks to the economic outlook have increased.

was changed to:

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

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

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

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

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

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

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

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

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

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

Wednesday, September 21, 2011

FOMC Decides to Implement Operation Twist

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

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

On the run, so very quick reaction:

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

2. It's not big enough.

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

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

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

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

Update: Tim Duy reacts to the decision.

Update: Via Daniel Indiviglio:

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

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

McConnell, Boehner, Kyl, and Cantor's Letter to the Fed

This letter from Senators McConnell, Boehner, Kyl, and Cantor crosses a line that shouldn't be crossed:

Dear Chairman Bernanke,
It is our understanding that the Board Members of the Federal Reserve will meet later this week to consider additional monetary stimulus proposals. We write to express our reservations about any such measures. Respectfully, we submit that the board should resist further extraordinary intervention in the U.S. economy, particularly without a clear articulation of the goals of such a policy, direction for success, ample data proving a case for economic action and quantifiable benefits to the American people.
It is not clear that the recent round of quantitative easing undertaken by the Federal Reserve has facilitated economic growth or reduced the unemployment rate. ...
We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems or further harm the U.S. economy. ...
Sincerely,
Sen. Mitch McConnell, Rep. John Boehner, Sen. Jon Kyl, Rep. Eric Cantor

I think speaking out individually is fine, e.g. a member of Congress stating his or her views on monetary policy in a speech is not a problem. That's part of the public dialogue.

But an official letter from members of the House and Senate to the Fed is more official, and more threatening to the Fed's independence than a speech from an individual member of Congress. Robert Reich explains the objections:

The Republican’s Latest Ploy to Keep the Economy Lousy through Election Day, by Robert Reich: ...To say it’s unusual for a political party to try to influence the Fed is an understatement.
When I was Secretary of Labor in the Clinton Administration, it was considered a serious breach of etiquette — not to say potentially economically disastrous — even to comment publicly about the Fed. Everyone understood how important it is to shield the nation’s central bank from politics.
If global investors suspect the Fed is responding to political pressure of any kind, investors will lose trust in the nation’s monetary policies. Even if the pressure is to tighten the money supply and keep interest rates high, it’s still politics. And once politics intrudes, lenders of all stripes worry that it will continue to intrude in all sorts of ways. The inevitable result: Lenders charge more for lending us money.
The letter puts Bernanke and his colleagues in a huge bind. If they decide against another round of so-called “quantitative easing” to lower long-term rates and boost the economy, they may look like they’re caving to congressional Republicans. If they decide to go ahead notwithstanding, they’re bucking the Republicans and siding with Democrats. Either way, they’re open to the charge they’re playing politics.
Congressional Republicans evidently don’t care. They want Obama out, whatever the cost. Besides, they’ve never met a government institution they don’t mind trashing.

There's more to it than higher interest rates. History tells us that politicizing monetary policy is a bad idea -- giving control of the money supply to politicians generally leads to high inflation -- and for this reason most countries have a monetary authority with some degree of independence. Thus, the GOP's politicization the Fed in the name of preventing inflation is puzzling (unless of course, inflation hawkery is cover for another agenda).

Tuesday, September 20, 2011

Fed Watch: Not the 1970s

Tim Duy:

Not the 1970s, by Tim Duy: Today former Federal Reserve Chairman Paul Volker pulled out the specter of the 1970’s to rail against those suggesting room for a higher inflation target, holding special contempt for the obviously insidious President of the Chicago Federal Reserve Charles Evans:

So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.

It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.

Not so remarkably given that this idea has been making the rounds for some time – Olivier Blanchard suggested a 4% inflation target early last year, and Greg Mankiw wrote this in early 2009:

Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.

Of course, Volker’s amazement that someone might suggest a higher inflation target is a consequence of his conviction that the 1970’s was the worst economic decade ever:

…Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability…

…Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth…

…It is precisely the common experience with this inflation dynamic that has led central banks around the world to place prime importance on price stability. They do so not at the expense of a strong productive economy. They do it because experience confirms that price stability — and the expectation of that stability — is a key element in keeping interest rates low and sustaining a strong, expanding, fully employed economy.

Note the conviction that high inflation is not compatible with strong growth. Now take a quick look at some of the economic outcomes of periods beginning with 1970 and 2000:

Voler1

Volker2

Volker3

Volker4

I don't want to romanticize the 1970s. I think we all recognize that the 2.5% unemployment rate at the end of the 1960’s was below the natural rate and thus incompatible with low inflation. The subsequent decade of economic mismanagement did permit both inflation and unemployment to rise, although certainly some of the latter can be attributed to the unusually low unemployment at the beginning of the decade. That said, the above numbers stack up pretty impressively compared to the 2000s. Arguably in recent years productivity did accelerate, at least temporarily, but didn’t appear to translate into better job or wage growth. But overall, I am thinking the inflationary 1970s look pretty good right now relative to the price stability of the last decade.

Of course, in the background, the unexpected inflation of the 1970s drove a redistribution of wealth, and it is this that is probably Volker’s real complaint. My first undergraduate economics professor told a story of how all the student loans he took out in the late 60s and early 70s evaporated in real terms a decade later. Perhaps Volker would have preferred that he had been weighed down by those debts instead - a situation not unlike today, were the debt overhang is a weight on household spending.

What is even more sad is that Volker fails to recognize why some argue for higher inflation:

My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.

I don’t think I have heard anyone who believes that inflation is a cure to sluggish productivity. Indeed, see above – during the recession productivity was anything but sluggish. No one thinks that higher inflation will spark higher productivity, only that higher inflation can be a tool to lift the economy from the lower bound allowing output to rise to the productivity-enhance level of potential output. Excessive leverage is a real problem, and in fact one that can be addressed via inflation. A commenter on an earlier piece notes that even what I perceive as lower levels of inflation could quickly erode the debt overhang, albeit not as quickly as I might like. How a central banker cannot recognize that unanticipated inflation erodes real debt loads is simply unfathomable.

And Volker uses the general term “economic imbalances,” but offers no explanation to what he is referring. Arguably, the major economic imbalance is the foreign central bank-induced trade deficit, which has contributed to a global imbalance in patterns of production and consumption. Recall that he appears to recognize the role of the dollar in any rebalancing:

If the dollar is weakened, that’s a good thing; it might even help close the trade deficit.

But seems to lose sight of this later:

At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.

I thought the purpose of the Federal Reserve was to promote the economic interest of the United States – that is its primary responsibility. And how can any economic imbalances be resolved if we remain dependent on borrowing from abroad? Wouldn’t we be better off discouraging those capital flows and allowing for export and import-competing industries to expand? And wouldn’t the rest of the world be better off if the US helped ease their inflationary pressures by providing additional goods and services to the global economy rather than attempting to absorb the excessive production of other nations? (And if you believe that those capital inflows represent confidence in the US economy, I have a bridge to sell you. Take out the purchases by foreign central banks and see what happens.)

Bottom Line: The constant comparisons to the 1970s are increasingly tiresome. At the end of the day, in the 1970s we were not in a liquidity trap. Today we are. The world is simply different. And we need policymakers that recognize that difference, not dinosaurs who refuse to do anything but live in a narrow view of their youth.

Monday, September 19, 2011

Fed Watch: Rearranging the Deck Chairs

Tim Duy says he has "trouble seeing the FOMC doing anything really big at this point":

Rearranging the Deck Chairs, by Tim Duy: Here we are, again staring down the barrel of an FOMC meeting while deeply entrenched in a subpar equilibrium, with output well below the pre-recession trend and unemployment stuck in the high single digits. What will the Fed bring to the table this time around? Considering the magnitude of the economic challenge, expectations are low: A modification of the FOMC statement to reflect an increasingly pessimistic outlook couple with some version of “Operation Twist,” an effort to reduce longer-term interest rates by extending the duration of the Fed’s portfolio of Treasury securities. There is an outside change the Fed lowers interest on reserves, but I view that as unlikely at this juncture. Even more unlikely is another round of quantitative easing. I don’t think there is much appetite at the Fed for additional asset purchases given the inflation numbers and the stability of longer-term inflation expectations relative to the events that prompted last fall’s QE2.

Will additional Fed action accomplish much if anything? I admit to being increasingly skeptical that the Fed is doing much more than pushing on a string. Interest rates on are less than 1 percent out to five year, which pretty much means whatever the Fed is doing at that horizon is just shifting around the composition of risk free assets. There is some room as you move to the 10-year horizon – at least there you have 200 basis points to play with. But even with some room to maneuver, in order to have significant impact, I think they need to be throwing around some big numbers when it comes to Operation Twist. Via Marketwatch, former Federal Reserve Vice-Chair Alan Blinder:

Blinder agreed that “some version of twist” is “the likely next step.” The Federal Open Market Committee will meet for two days next week to determine whether and how to ease further.

Blinder said the program needed to be large to have a meaningful impact.

“The twist is a sufficiently weak instrument so to do it in tiny amounts it almost becomes laughable,” he said.

Likewise, the same holds for another round of quantitative easing. Recall that estimates of the interest rate effect of QE2 were relatively modest, on the order of 20bp. I am not sure that any of us believe that another 20bp will be the bullet that pulls us out of the slump.

So if the Fed wants to have any meaningful impact, it needs to do something really, really big, and even then, a “meaningful” outcome is not assured. And, in any event, I have trouble seeing the FOMC doing anything really big at this point – it seems the center of the Fed questions the basic effectiveness of policy to do much more than raise inflation given what are increasingly perceived as structural impediments to growth. It could be the Fed is inclined to take additional actions only to look like they are doing something.

Moreover, there is this ongoing concern the Fed is doing nothing more than aggravating the lending situation by crushing down longer-term yields. The logic is that banks need some interest rate spread to justify lending. In the current environment, they see no reason to take on additional lending to any but the safest clients – not enough margin to justify the risk of a loan default.

What can be done to steepen the yield curve and this induce additional lending while at the same time holding long term rates low to encourage borrowers to line up at the bank? Override the zero lower bound to induce negative short-term interest rates. Blinder again:

Blinder said the Fed could first cut the interest rate on excess reserves to zero “just to make sure that there are not some unintended consequences that are horrendous,” he said.

The rate could then be pushed into negative territory.

The notion is strongly opposed by banks, who view it as a tax.

Blinder doesn’t disagree with that characterization.

“The whole notion is you should tax things you don’t like people to do, and subsidize things that are essential,” he said.

“One thing we don’t like is banks just piling up idle reserve,” he said. “We would like to push that money out of the banks and have them do something with it.”

Although some money will undoubtedly go into super-safe money funds, “the hope is that some fraction goes into increased lending,” he said.

You get the idea – whatever money the Fed has injected into the economy via QE2 has been reabsorbed by the Fed in the form of excess reserves rather than supporting loan growth in the economy. To solve that problem, charge banks for holding reserves at the Fed, thus inducing them to get their acts together and start lending.

Will it work, or will there be some serious, negative unintended consequences? Consider this story of soaring bank deposits (hat tip to CR):

Americans are pumping money into bank accounts at a blistering pace this year, sending deposits to record levels near $10 trillion on escalating fears that the U.S. economy is on the verge of another implosion.

There's no sign that the flood into checking, savings and money market accounts is slowing down. In the last three months, accounts at U.S. commercial banks have increased $429 billion, or 10%, almost double the increase for all of last year.

The money is coming in fast! Good news? No:

There's one big problem: Banks don't want your money.

"Banks and credit unions are doing everything they can to get rid of the cash except make loans," said Mike Moebs, a Lake Bluff, Ill., banking consultant.

He said banks are driving away deposits by refusing to renew CDs at higher rates and by imposing fees on checking accounts for depositors who don't use other, profitable financial services as well.

The banking sector is reacting to a flood of money by trying to push back the tide, not by opening up the loan spigot. If the Fed pushes the interest on reserves into negative territory, will that be enough to spur lending? Or will banks simply do more of what they are already doing? The path of least resistance is to keep doing more of the same.

And if consumers are only charged for money they hold in the bank, effectively earning negative interest rates themselves, will they spend more money, or just start stuffing their mattress? And maybe start stuffing it twice as fast. You know its bad when banks won’t take your money. Time to dust off the Roubini portfolio – dried food, ammunition, and gold. I guess that is how gold can go off the charts in both an inflationary or deflationary environment.

In short, it is not evident that more monetary policy will make its way down to the heart of the problem:

Bankers such as Robert H. Smith, former chairman of L.A.'s Security Pacific Corp., say the industry is being throttled by a combination of the weak economy and regulations that were tightened in the aftermath of the financial crisis.

"What little demand that is out there for loans is regarded very skeptically [by the banks] because of the pressures from the regulators," said Smith, who sold Security Pacific to Bank of America 20 years ago and is now a founding director of Commerce National Bank in Newport Beach.

Which came first, the chicken or the egg? Is the economy weak because lending is tepid, or vice-versa? The lack of potential borrowers with sufficient cash flow who actually want to borrow money clearly hampers the effectiveness of monetary policy through either traditional or nontraditional channels.

So what is left? I keep coming back to the same conclusion. That to be effective at this juncture, additional monetary policy must be coordinated with additional fiscal policy. The Fed creates the money, fiscal policymakers ensure it gets into the hands of someone who will spend it, boosting demand until interest rates rise and the pool of ready and willing borrowers swells. At that point the banking sector has someone to loan to and a spread to work with.

Bottom Line: When the Fed meets this week, will they accommplish anything more than rearranging the deck chairs? I increasingly see the need for dramatic action to decisively lift the economy off the zero bound. The comparisons to Japan and getting a little too close for comfort; it is easy to how the US economy limps along for the next decade characterized by rock-bottom interest rates and never-ending fiscal deficits.

Wednesday, September 14, 2011

"How to Do More"

Adam Posen urges central banks to take aggressive action:

How to do more, by Adam Posen, External Member of the Monetary Policy Committee, Bank of England: We do want more, and when it becomes more, we shall still want more. And we shall never cease to demand more until we have received the results of our labor. - Samuel Gompers, May 2, 1890

Something's better than nothing, yes! But nothing's better than more.
- Stephen Sondheim, Sung by Madonna in the movie, Dick Tracy, 1990

Both the UK and the global economy are facing a familiar foe at present: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the US and elsewhere in the 1930s, or in Japan in the 1990s, every major financial crisis-driven downturn has been followed by premature abandonment—if not reversal—of the macroeconomic stimulus policies that are necessary to sustained recovery. Every time, this was due to unduly influential voices claiming some combination of the destructiveness of further policy stimulus, the ineffectiveness of further policy stimulus, or the political corruption from further policy stimulus. Every time those voices were wrong on each and every count. Those voices are being heard again today, much too loudly. It is the duty of economic policymakers including central bankers to rebut these false claims head on. It is even more important that we do the right thing for the economy rather than be slowed, confused, or intimidated by such false claims.

Make no mistake, the right thing to do right now is for the Bank of England and the other G7 central banks to engage in further monetary stimulus. If anything, it is past time for us to do so. The economic outlook has turned out to be as grim as forecasts based on historical evidence predicted it would be, given the nature of the recession, the fiscal consolidations underway, and the simultaneity of similar problems across the Western world. Sustained high inflation is not a threat in such an environment, and in fact the inflation that we have suffered due to temporary factors in the UK is about to peak.1 If we do not undertake the stimulative policy that the outlook calls for, then our economies and our people will suffer avoidable and potentially lasting damage. I will recap the argument for doing more in a moment.

My main purpose in speaking to you today is to explain how the Bank of England, and by extension other central banks, should do more to ease monetary policy at this juncture. I hope to convince you that doing more would be not only desirable, but constructive for the economy as a whole, effective as stimulus, and feasible without political compromise. A large part of this argument rests on asking you as sensible listeners to see through the distortions and falsehoods that have cropped up again in the aftermath of this crisis as in the past. Some common sense can be just as useful in appraising monetary policy as in evaluating the overall worth and likely success of other services for which the public contracts with technical experts. After such appraisal, I hope that you will agree with my arguments that:

  • More monetary ease will lead to greater restructuring of the economy in the right and necessary direction;
  • More of the same Quantitative Easing [QE] program that the Bank already undertook would be where to start, especially if done on sufficient scale;
  • More cooperation between the Bank and HM Government to promote investment and credit to small and medium business should be the beneficial next step.

Monetary policymakers must also free themselves from unfounded concerns and take these necessary actions. There are too many excuses for passivity being offered, none of which stand up to scrutiny or to the data. In essence, central banks can improve matters by doing more, even if we have to act alone. In so doing, we would make constructive actions by other policymakers in the fiscal and financial arenas outside of our remit more – not less – likely, and those actions more likely to succeed when undertaken.

Almost certainly, even if we were to do everything right on monetary policy (and we certainly will not get everything right, despite the best of intentions), there will still be suffering and ongoing problems from economic adjustment. And the benefits of our right policies may not turn out to be self-evident. But it is our responsibility and our duty to make things better if we can. Central bank officials have wasted too much time over the last year worrying about how their institutions would appear to markets, to politicians, and to the public, were we to undertake more stimulus. Sometimes you have to do the right thing even if it may be misperceived. I believe that by explaining how doing more would work, as I am trying to do today, the chances may increase that we will do the right thing on monetary policy now, and that it will be recognized as right later if not immediately.

1 Unless there is a sufficiently persistent supply shock to energy prices to more than offset the influence of declining rates of global growth on those prices for the next couple of years – something oil futures markets do not price in at present (in fact, they price in the opposite). ...[continue reading]...

Monday, September 12, 2011

Fed Watch: A Modest Monetary Proposal

Tim Duy:

A Modest Monetary Proposal, by Tim Duy: I have been reading and rereading Raghuram Rajan’s piece questioning the effectiveness of proposals to raise inflation targets. I tend to be pretty sympathetic to such proposals; traditional monetary policy obviously hit it limit long ago, and active commitments to higher inflation to depress real rates seems to be a logical next step. That said, Rajan has a number of good points questioning both the implementation and efficacy of higher inflation targets. Can the Federal Reserve credibly commit to higher inflation? Can they credibly commit to regain control over inflation at some later time? Most striking, I think, was Rajan’s reflection, that a small inflation increase really will not do much good at all:

Moreover, the central bank needs rapid, sizeable inflation to bring down real debt values quickly – a slow increase in inflation (especially if well signaled by the central bank) would have limited effect, because maturing debt would demand not only higher nominal rates, but also an inflation-risk premium to roll over claims.

A mechanism to rapidly accelerate the process of household rebalancing would be extremely helpful. It is not clear that an inflation target of 3 percent is such a mechanism. Something more dramatic is required.

Would that something more dramatic be QE3? I see that over the weekend, St. Louis Federal Reserve President James Bullard came out in favor of QE3 should more easing be necessary. From the Wall Street Journal:

In an interview with the Business News Network, James Bullard said “I still think our most potent weapon is to do more QE3 if necessary,” in a reference to the QE2 bond buying program that ended in the summer.

He goes on to undermine the policy that Fed seems to be coalescing around:

Bullard said the experience of the 1960s-era “Operation Twist,” when the Fed and Treasury together worked to try to push down long-term borrowing rates, should be cautionary. Bullard said that effort was not particularly effective, which is why more outright purchases would most likely be the way to go.

My sense is that Bullard prefers whatever policy option produces the biggest headline for him. That said, he is probably right on this one – a portfolio rebalancing is a move in the right direction, but don’t expect miracles. But could any miracles really be expected from more quantitative easing? As Rajan notes:

Start with the question of whether central banks that have spent decades establishing and maintaining anti-inflation credibility can generate faster price growth in an environment of low interest rates. Japan tried – and failed: banks were too willing to hold the reserves that the central bank released as it bought back bonds.

To be most effective, monetary policy needs to push on some variable that will have a substantial impact on demand. Trading safe assets for cash at near zero interest rates just doesn’t accomplish that. But it’s the only biggish lever we seem to have left, but it simply is not direct enough. What is needed is to get the money in the hands of someone who will use it, rather than just sloshing around banks as excess reserves. If it is stuck in the banking system, it can’t create demand that at least causes a big shift in the prices of both goods and wages.

Maybe at this point we need to be thinking about something a little more direct – one of the proposals floating around is to use Fannie and Freddie to purchase nearly all the outstanding mortgages and refinance them at lower interest rates regardless of loan to value ratios. Better yet, to apply some consistent system of principle reduction for everyone, not just underwater mortgages. Lift the entire boat at once, rather than trying to discern between the most and least deserving lifeboats.

Something like this is not a new idea, but it gets held up by, among other things, by the issue of the cost. So maybe the Treasury needs to issue a class of bonds the Federal Reserve agrees to purchase and hold – essentially monetizing the rebuilding of household balance sheets and freeing future tax payers from the burden of repaying the debt.

I suspect that this entails a sharp, one time increase in the price level, and this is the tricky part. The Fed would have to both accept that increase and make clear they are committed to return to their 2 percent target. I don’t think this is impossible, but it might be difficult to accomplish quickly. Also note that once we can lift up off the zero-bound, traditional monetary policy can come back into play to manage inflation. Moreover, they have room to reduce the remainder of the balance sheet, but, when all is said and done, they should not expect to return to the pre-crisis trend, and instead acknowledge the one-time shock to the balance sheet.

Bottom Line: Rather than the more indirect approaches left to monetary policy, maybe there is room for a one-time effort to monetize the rebalancing of household balance sheets, which perhaps can be viewed as a more “modest” alternative to monetization of general government spending. Perhaps the former can be more credibly contained to a one-time event.

Friday, September 09, 2011

Fed Watch: Ben Speaks

Tim Duy:

Ben Speaks, by Tim Duy: Federal Reserve Chairman Ben Bernanke took the stage today, providing few hints about the path of monetary policy in the months ahead. Market participants were hoping for more specific details on what the Fed has up its sleeve at the next meeting, but got more of the same:

In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. My FOMC colleagues and I will continue to consider those and other pertinent issues, including, of course, economic and financial developments, at our meeting in September and are prepared to employ these tools as appropriate to promote a stronger economic recovery in a context of price stability.

More interesting was his extended comments on inflation:

However, inflation is expected to moderate in the coming quarters as these transitory influences wane. In particular, the prices of oil and many other commodities have either leveled off or have come down from their highs. Meanwhile, the step-up in automobile production should reduce pressure on car prices. Importantly, we see little indication that the higher rate of inflation experienced so far this year has become ingrained in the economy. Longer-term inflation expectations have remained stable according to the indicators we monitor, such as the measure of households' longer-term expectations from the Thompson Reuters/University of Michigan survey, the 10-year inflation projections of professional forecasters, and the five-year-forward measure of inflation compensation derived from yields of inflation-protected Treasury securities. In addition to the stability of longer-term inflation expectations, the substantial amount of resource slack that exists in U.S. labor and product markets should continue to have a moderating influence on inflationary pressures. Notably, because of ongoing weakness in labor demand over the course of the recovery, nominal wage increases have been roughly offset by productivity gains, leaving the level of unit labor costs close to where it had stood at the onset of the recession. Given the large share of labor costs in the production costs of most firms, subdued unit labor costs should be an important restraining influence on inflation.

A couple of points. First, he takes the inflation boogeyman off the table for the time being. Not only are temporary factors easing, but long-term expectations remain stable and wage gains are subdued. Focus more, however, on the inflation expectations story – clearly Bernanke is not phased by the deterioration in the five and ten year-forward breakevens. The ten year in particular still hovers well above the levels that triggered QE2.

So where are we at? The deterioration in the real economy coupled with moderating inflation suggests more easing is at hand. Indeed, we know there is a growing dovish FOMC group that desires more aggressive policy. But how aggressive? Chicago Federal Reserve President Charles Evans desires a relatively aggressive stance that includes allowing inflation to drift up to 3% at least temporarily. But I don’t think we will get something like that. And I can’t see a return to quantitative easing short of a real deflation threat – I don’t see the core of the FOMC or Bernanke himself supportive of such a step at this time. Ditto for allowing the inflation target to drift upward.

If higher inflation targets and an open-ended program of quanitative easing are off the table, what’s left? As I noted earlier this week, the usual suspects, with the extending the duration of the Fed’s portfolio high on the list of market expectations. See Neil Irwin's piece at the Washington Post.

What I have trouble seeing is a strong commitment about the path of monetary policy. More soft commitments, yes. But not a locked in stone, willing to endure higher inflation commitment. Consider, for example, this week’s speech by San Francisco Federal Reserve President John Williams. He seems open to additional policy:

Despite these efforts, the recovery slowed to a crawl this year. But what does this mean for monetary policy? After all, monetary policy cannot cure all that ails our economy, which in large measure involves the aftereffects of the mortgage lending boom, the housing crash, and the resulting financial crisis. But, monetary policy can help limit the damage and provide support to other areas of the economy.

Williams sounds supportive of additional action, which he made more clear in comments. Via Reuters:

"There's still considerable room for monetary accommodation to improve financial conditions," San Francisco Federal Reserve Bank President John Williams told reporters after a speech to the Rotary Club of Seattle. "My main concern is really not the concern that inflation is going to be too high over the medium term. I think my main concern really is the pace of recovery and the high degree of unemployment."

"If anything more monetary accommodation seems appropriate than not," he added.

Still, something dramatic, moving into the relm of Evans? Note the mixed message. Yes, there is more we can do to prevent the patient (his analogy later) from deteriorating further, but the medicine is limited. How does this play into monetary policy? He continues:

The monetary policy situation is similar. Like the hospital patient, the economy took a turn for the worse and faces heightened risks. In addition, inflation is expected to drift down. These circumstances called for additional monetary easing. At our August meeting, the FOMC took a step in that direction, issuing a statement that we are likely to keep the federal funds rate at exceptionally low levels at least through mid-2013.

Arguably, if data continues to disappoint heading into the next meeting, the same logic will hold true, and the Fed will embrace some additional easing. So far, so good. But then he undermines the FOMC statement, first by dismissing it relevance:

In one respect, this wasn’t such big news. Even before the announcement, financial market participants generally didn’t expect the Fed to raise rates much earlier than mid-2013.

Then he backtracks and claims:

But it was news in the sense that it removed uncertainty and helped financial markets better understand our intentions.

I like that, removing uncertainty is a good thing. But then he puts the uncertainty right back into the mix:

Note also that we are not tying our hands by making this announcement. We haven’t made a guarantee. We will alter our policy as appropriate if circumstances change.

When is a commitment not a commitment? When made by the Federal Reserve. Which makes me wary of any supposed policy guidelines. Most policymakers - even increasingly dovish ones such as Williams - don’t want to have their hands tied, and few other than Evans are interested in seeing inflation drift above 2%. Williams on inflation, via Bloomberg:

When asked by reporters whether he would be willing to tolerate higher inflation if it brought down unemployment, Williams said, “I don’t think there’s a tradeoff. I don’t think that’s really a choice we can make over the long term.”

“We have to focus on keeping inflation relatively low over the medium term and again keeping employment as close as we can to the maximum sustainable level,” he said.

Still others don’t believe additional policy will do much good. And quite frankly, I am sympathetic with that view. If the Fed is going to have an impact, policymakers need to go big time. 20 basis points on the long-end of the yield curve through a maturity extension just is not going to cut it. Allowing inflation to drift up to 3% is not going to cut it. Chopping the interest rate on reserves in half is not going to cut it. Half commitments to policy paths are not going to cut it. I am not even confident committing to a rate of 1% on the ten year will cut it, unless fiscal policymakers take advantage of such a gift and step up government spending. I am not sure the private sector will want to make many 1% loans – financial institutions need some spread to make a profit. These are all things that probably won’t hurt and should be tried, but don’t expect miracles either.

What would work? I am sympathetic to the notion that if fiscal policymakers can address the mortgage mess, then lower interest rates that encourage refinancing can help. But this isn't something the Fed can do alone. I am also sympathetic to targeting an asset price that you are very confident will stimulate demand. And that brings you to the hand played by the Swiss National Bank – commit to currency depreciation. Set a target for the dollar, and purchase foreign assets in unlimited quantities to achieve that goal.

Bottom Line: Bernanke continues to hold his cards close to his chest. The data flow, and the subsequent forecast implications, justifies additional easing. Indeed, Bernanke’s inflation view appears to take out one impediment to such easing. That said, the lack of concern about the path of longer-term inflation expectations still suggests additional easing will fall short of what we saw during last year's deflation scare. The composition of the portfolio seems high on the list, although I am hesitant to believe there is a lot of traction to be gained when the ten year rate is hovering around 2%. Steps in the right direction, to be sure, but, as Federal Reserve officials continue to emphasize, nothing that will rapidly restore economic vibrancy.

Wednesday, September 07, 2011

The Fed's Dual Mandate: Responsibilities and Challenges Facing U.S. Monetary Policy

It's nice to see that at least one member of the FOMC gets it, and is willing to act:

The Fed's Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy, by Charles Evans, President, FRB Chicago: In the summer of 2009, the U.S. economy began to emerge from its deepest recession since the 1930s. But today, two years later, conditions still aren’t much different from an economy actually in recession. GDP growth was barely positive in the first half of the year. The unemployment rate is 9.1%, much higher than anything we have experienced for decades before the recession. And job gains over the last several months have been barely enough to keep pace with the natural growth in the labor force, so we’ve made virtually no progress in closing the "jobs gap".

The Federal Reserve has responded aggressively to the deep recession and weak recovery, cutting short-term interest rates to essentially zero and purchasing assets that expanded its balance sheet by a factor of three. But since undertaking the so-called QE2 round of asset purchases last fall, the Fed’s aggressive policy actions have been on hold.

Some believe that this pause is entirely appropriate. They claim that the economy faces some kind of impediment that limits how much more monetary policy can do to stimulate growth. And, on the price front, they note that the disinflationary pressures of 2009 and 2010 have given way to inflation rates closer to what I and the majority of Fed policymakers see as the Fed’s objective of 2%. These considerations lead many to say that when adding up the costs and benefits of further accommodation, the risk of over-shooting our inflation objective through further policy accommodation exceeds the potential benefits of speeding the improvement in labor markets.

I would argue that this view is extremely, and inappropriately, asymmetric in its weighting of the Fed’s dual objectives to support maximum employment and price stability.

Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.

In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.

The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment. ...[continue reading]...

Tuesday, September 06, 2011

Fed Watch: Questions and Answers

Tim Duy:

Questions and Answers, by Tim Duy: I thought this might be an easier way to get back into the game after an extended hiatus.

Does the economy need more stimulus?

Always good to start with a softball question - YES! The US economy is two years into an economic expansion, and yet the unemployment rate remains above 9 percent. National output growth averaged just 0.7 percent in the first two quarters of the year. Job growth was zero in August, albeit with some downward pressure from the Verizon strike. Output is $1 trillion below CBO potential – and the gap is expanding. The 30-year inflation indexed Treasury bond just traded at 90 basis points. None of which should be happening two years into an expansion. Yet here we are.

Will the private sector provide the needed stimulus?

Federal Reserve President Dennis Lockhart summarizes the situation:

It is necessary that the process of deleveraging plays itself out, which may take several more years. When economies are deleveraging they cannot grow as rapidly as they might otherwise. It is obvious that as consumers reduce spending they divert more of their incomes to paying off debt. This shift in consumer behavior increases the amount of capital available for financing investment. But higher rates of business investment are not likely to fully offset weakness in consumer spending for some time, as businesses continue to grapple with uncertainties about the future.

Lacking the equity wealth provided by the housing bubble, households are simply unable to sustain the debt loads of years past. Hence, deleveraging continues. Without anyone else to pick up the slack, it is tough to see how we eek out anything other than subpar growth, trend growth (2.5 - 3.0%) at best. Not enough to quickly lift the economy back to trend output.

Will the government provide the needed stimulus?

On the fiscal side, the answer is no, or at least not yet. As Paul Krugman points out, fiscal policy is already contractionary, while the recently passed budget deal promises only more austerity. And, via Brad DeLong, Macroadvisors predicts that President Barack Obama’s impending jobs plan is not likely to provide much if any of an economic boost. That leaves monetary policy as the only game in town. And here we can anticipate that more easing is coming. But will it be enough to pull the economy from its slump? At this point, almost certainly not.

Why will monetary policy fall short?

Here again it is useful to refer back to Lockhart’s recent speech:

Given the weak data we've seen recently and considering the rising concern about chronic slow growth or worse, I don't think any policy option can be ruled out at the moment. However, it is important that monetary policy not be seen as a panacea. The kinds of structural adjustments I've been discussing today take time, and I am acutely aware that pushing beyond what monetary policy can plausibly deliver runs the risk of creating new distortions and imbalances.

Lockhart is not ruling out additional policy responses, but makes obvious his view the Fed is nearly, if not already, out of bullets to deal with a balance-sheet recession. Moreover, he shows his sympathy with the camp, I think best identified with the views of Kansas City Federal Reserve President Thomas Hoenig, that the Fed at this point risks doing more harm than good. This, I believe, represents the center of FOMC thought at the moment. This group is simply not inclined to initiate a new large scale easing in the absence of clear deflationary pressures. The five and ten-year TIPS breakevens are 1.81 and 2.05 percent, respectively. Combined, I believe they argue, at least from the Federal Reserve point of view, for more easing, but nothing dramatic.

But didn’t the most recent FOMC minutes reveal a more dovish constituency?

Yes. From the minutes:

A few members felt that recent economic developments justified a more substantial move at this meeting, but they were willing to accept the stronger forward guidance as a step in the direction of additional accommodation

Chicago Federal Reserve Bank President Charles Evans is a good example of this group. Via a recent CNBC interview:

In his view, QE needs to stay in place until unemployment plunges to 7 percent or if inflation gets past 3 percent. Core inflation, which strips out food and transportation, is about 1.8 percent, though the number is 3.6 percent including the more volatile measures.

Evans is a voting member on the fed Open Market Committee and traditionally has been among its more dovish members when it comes to interest rates and inflation.

"Strong accommodation needs to be in place for a substantial period of time," he said. "If we could sort of make everybody understand that this is going to be in place for a longer period of time, we could knock out some of that restraint that comes about when people talk about premature tightening."

As far as I am concerned, he is preaching to the choir. There has been a remarkably irresponsible tendency of Fed policymakers to turn hawkish at the slightest hint of economic improvement. I think this belies their discomfort with the expansion of the balance sheet, and renders the rest of us unsure of their commitment to the dual mandate. And I believe the Fed needs to accept the possibility of higher inflation.

What can the Fed do at this point?

The usual suspects: Reduce the interest paid on reserves, extend the maturity of the Fed’s portfolio, expand the balance sheet further, shift the portfolio in favor of mortgage-backed securities to support the housing market, make a firm commitment to zero interest rates regardless of the inflation outcome, or raise the inflation target from 2 percent to 3 or 4 percent. I suspect the first three are most likely in play, although the magnitude of an additional balance sheet expansion will likely fall short of what is needed.

Wait a second. Didn’t the Fed already commit to zero interest rates until 2013?

No – they just said that given current forecasts, they anticipated an extended period on low interest rates. This does have some value in marginalizing the hawks. That said, the minutes make clear this is only a soft commitment:

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

What we really need is a hard commitment that can weather a period of higher inflation.

Where is Federal Reserve Chairman Ben Bernanke is this mix?

It appears that Bernanke is right of the dovish contingent revealed in the most recent FOMC minutes. I think this first became evident in his June press conference, when he made clear the bar to QE3 was high. The bar was high because inflation expectations had rebounded, and inflation was the only clear target the Fed had control over. This basic idea was evident in Bernanke’s Jackson Hole speech:

The Federal Reserve has a role in promoting the longer-term performance of the economy. Most importantly, monetary policy that ensures that inflation remains low and stable over time contributes to long-run macroeconomic and financial stability. Low and stable inflation improves the functioning of markets, making them more effective at allocating resources; and it allows households and businesses to plan for the future without having to be unduly concerned with unpredictable movements in the general level of prices.

Once inflation is close to the Federal Reserve’s target, Bernanke apparently sees little else monetary policy can do to relieve the cyclical pressures on the economy:

Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.

I think the Bernanke’s focus on the 2 percent inflation target will severely limit the magnitude of additional easing to support job growth. It is increasingly my opinion that to lift the economy beyond the zero bound, we need a commitment by the Fed to lift inflation above 2 percent to allow nominal spending to return to the pre-recession trend. This is policy the Fed Chair appears dead set against, leaving only half-measures.

Note, however, the above only applies when inflation and inflation expectations are near the Fed’s target. I do believe Bernanke will press for more dramatic action should deflationary pressures become evident. I just don’t think we are there yet.

Would a shift to additional mortgage-backed assets help?

It wouldn’t hurt, and could push mortgage rates down further and thus encourage additional refinancing. Back in the day I would have been worried that the Fed risked looking like it was trying to sustain bubble-level prices, but I think we are beyond that. Still, note the problem in mortgage markets is deeper than interest rates – the problem is the inability to finance due to tougher underwriting standards and underwater mortgages. I am not confident that lower rates would alleviate these challenges. This seems more like the purview of the US Treasury, which could push for all federally guaranteed mortgages to be refinanced at a lower interest rate, regardless of the loan to value ratio.

Are we headed for recession?

I would not discount the possibility of recession given the US economy was clearly operating near stall-speed in the first half of the year. That said, it would be easier to embrace the recession story had the US economy ever returned to trend output during the recovery. As noted earlier, the economy is operating well below trend, and typical sources of strong downdrafts in demand – housing and autos – remain below pre-recession levels. Indeed, the absence of any rebound in housing is striking. Under these circumstances, I find it easier to embrace the “Japan” scenario, a sustained period of choppy and low growth. Recession or not, a tragedy by any measure.

What’s going on in Europe?

The Europeans are vexed with a political establishment that is not conducive to maintaining a single currency (of course, we too in the US are vexed with a dysfunctional political establishment, just a different one). In particular, they lack a mechanism to make sizable fiscal transfers within the Euro area. This is simply an important element of running a “one size fits all” monetary policy. As it stands, Euro-policymakers are attempting to enforce IMF-style austerity packages on troubled economies without the usual currency depreciation that helps offset the resulting fiscal contraction. It is obvious this approach is not working – Greek two-year debt is trading at 50 percent and the spread on Italian and Spanish debt widens. Paul Krugman asks where is the ECB? Where indeed? Perhaps they see their earlier debt-buying efforts as a failure, thus concluding the problem is a solvency problem, not a liquidity problem. And there is no European solution for a solvency problem, other than more austerity for troubled economies. Where does this end? Either the Euro-area comes together as a strong fiscal union or the periphery is jettisoned from the Euro. It really looks like the smart money is on the latter outcome. Drachmas anyone?

Update:  10:09PM PST

I see the ECB was not completely asleep at the wheel and was buying bonds. From the Wall Street Journal:

The ECB purchased Italian and Spanish government bonds Monday in a bid to keep 10-year borrowing costs from rising further above 5%—a threshold analysts say is key to their ability to finance their high debt loads. The ECB has purchased over €50 billion in bonds since reactivating the program four weeks ago.

Friday, September 02, 2011

How Will the Fed Respond to Today's Bad News on Employment?

There is a lot of discussion on how the Fed will react to the jobs report in its meeting this month, e.g. here and here. My view is that if the Fed is moved to action by the report -- and it is not at all certain that they will be -- they will do the least they possibly can while still looking like they are doing something about the problem.

What is the least they can do while still satisfying the demand for action? One option is to change the average duration of the assets they hold on their balance sheet by trading short-term for long-term assets (i.e. lengthen the average duration of the portfolio). This could bring down the long end of the yield curve a bit -- not much as there isn't all that much room for long-term rates to fall -- and perhaps stimulate economic activity. However, it's hard to see how a fall in long-term interest rates of such a small magnitude will produce a change in investment and a change in the consumption of durables such as cars and refrigerators of the magnitude that is needed. If there is a response from consumers and businesses to a small drop in the long-term rate, it will be far, far short of what we need.

Another option would be to cut the rate the Fed is paying on reserves held in banks. Ben Bernanke has stated this would disrupt the overnight federal funds market, so I think this is unlikely, but it could be cut, say in half from its current level of 0.25%, or even to zero. Any change in this rate can be reversed quickly if needed, so it's not a very risky option -- that's why I think it is one potential response -- but again I don't think it would do a lot of good. The problem isn't the supply of loans, it's the demand, and this wouldn't do much to stimulate new demand.

The Fed has already used up another option that doesn't require much actual action -- committing to low interest rates for an extended period of time -- but so far that hasn't seemed to have helped much. The options after that such as QE3 or adopting (and then trying to hit) a higher inflation target require much more action from the Fed and are likely to be resisted.

But things are much worse than the Fed thought they would be, the green shoots they keep pointing to whither away as soon as they depend upon them, and it's time -- way past time actually -- to quit hoping things improve and take the possibility of an extended period of stagnation seriously. I blame fiscal policymakers more than the Fed, fiscal policy is our best hope for job creation and we should have had a large job creation program in place long ago. But we need both policy barrels pointed at this problem, it's too large to solve without both policies working together, and it's time for the Fed to quit hoping a miracle saves them from the hard decisions they need to make and to move forward with more aggressive policy.

[Also posted at MoneyWatch.]

Wednesday, August 31, 2011

Posen: No Excuse for Inaction from Central Banks

Adam Posen says there's no excuse for inaction from the Fed and other central banks:

No excuse for inaction, by Adam Posen, Reuters: It is past time for monetary policy to be doing more to support recovery. The Jackson Hole conference has come and gone, and no shortage of excuses was provided for central banks to hold their fire — even though most economists acknowledged the grim outlook for the advanced economies. ...
It is also past time to stop fearing inflationary ghosts. There is no credible threat of sustained higher inflation in the advanced economies that should restrain central bank action. ...
The evidence is clear that the Bank of England’s and the Federal Reserve’s asset purchases had a positive significant effect on consumption, on the relative prices of riskier assets, on credit availability, and on liquidity in the financial system. If the improvement was insufficient, because the response to a given injection was less than some hoped, increase the dose.
There are no negative side-effects to speak of from greater asset purchases, beyond some politically induced nausea (which central bankers simply have to suffer through). ...

The Balanced Budget Multiplier: Job Creation without Increasing the Deficit

[Here is an op-ed I started, and then abandoned in favor of another topic (so it hasn't been thoroughly edited and is several hundred words too long). I decided to post it because I want to at least raise the possibility of using the balanced budget multiplier as a way of using budget neutral policies to stimulate the economy. As explained below, those policies would work best if we ask the wealthy to finance job creation programs. It's not as powerful as deficit spending, but it's better than nothing at all:]

Despite the advice from many economists urging the Fed to do more to help the economy, and despite hopes in the business community that the Fed would follow this advice, Ben Bernanke made it clear in his speech at Jackson Hole last Friday that policy is on hold. He noted they will discuss this at their September meeting, but I am not very hopeful that policy will change at that time. I disagree strongly with the Fed's decision to remain on hold, we need to attack the employment crisis with all the policy tools at our disposal, but the Fed disagrees.

With the Fed unlikely to ease policy any further, what about fiscal policy? Would another round of fiscal policy be helpful, or would it do more harm than good? There are very clear political problems involved with fiscal policy, more on that below, but what about the economics? Would further stimulus be beneficial?

The economics does provide a further case for intervention. As I’ve explained previously on these pages, not all recessions are alike. They have different causes, e.g. recessions can be caused by oil price shocks, productivity shocks, monetary policy shocks, and bursting asset price bubbles. When a bubble bursts wiping out household retirement, education, and other savings households rely upon for security it is known as a balance sheet recession. Recovering losses from this type of recession, i.e. rebuilding the balance sheet, are notoriously difficult and “lost decades” such as Japan experienced in the 1990s are not uncommon.

What to do? The slow recovery can be attributed in large part to the fact that households must reduce consumption and increase savings in order to recover their losses, and so long as consumption remains low the economy will continue have problems. In ordinary, mild recessions monetary policy is the best approach, and it can generally handle the problem on its own. But in a deep balance sheet recession monetary policy alone isn’t enough. In large recessions fiscal policy that targets the problem – balance sheets in this case – has an important role to play.

How can fiscal policy be used to attack the type of recession we are having?  Mortgage relief, and debt relief more generally, is first on the list. Debt relief improves household balance sheets, and hence directly targets the problem. There were a few half-hearted attempts to do something like this, but nothing like what is needed.

Thus, fiscal policy directed at two goals, balance sheet repair and job creation, would do a lot to ease current conditions and to allow us to exit the recession sooner.

But is there any way at all to get more fiscal policy through Congress? Probably not. But the problem is important enough, and the crack in the door is open just enough (and opening more with each new piece of information indicating a sluggish recovery at best), that it’s worth it to at least try.

We do have a long run debt problem to bring under control, but in the short-run we need more, not less deficit spending. But the political atmosphere will not allow any further increase in government debt. If anything, it will move in the other (and wrong) direction. However, there is something called the balanced budget multiplier that could still be useful and would perhaps -- emphasis on perhaps -- find political support.

How could, say, an increase in government spending of $100 on new goods and services financed by a $100 increase in taxes stimulate the economy? The $100 purchase by the government increases aggregate demand by the same amount. But the increase in taxes does not fully offset the increase in demand because the tax bill will be paid, in part, from savings. For example, suppose that the household pays its tax bill by reducing consumption by $80 and reducing saving by $20. Then the net impact on aggregate demand will be the $100 in government spending minus the $80 reduction in consumption for a net change of $20. That’s not as large as the $100 we could get from deficit spending, i.e. increasing government expenditures without increasing taxes, but it’s better than not doing anything at all (and this is just the impact effect, the $20 will create more than $20 in spending due to standard multiplier effects).

This also tells us who should be asked to pay these taxes if we want to have the maximum impact on the economy. If more of the bill is paid from saving, e.g. $30 instead of $20, then the net impact will be bigger. Thus taxes that are levied on those most likely to pay out of saving, the wealthy, will have the largest impact on aggregate demand (e.g. if it is paid fully out of saving, there is no offset at all). I don't have any illusions about the difficulty of getting a tax increase on the wealthy through Congress, but it could be done -- perhaps -- by closing loopholes, credits, deductions, exclusions, etc. which seems to have a bit more support.

On the other side, what should the government spend its money on? The usual answer is infrastructure since it stimulates the economy in the short-run and also helps with long-run growth. But one thing we learned from the previous round of infrastructure spending is that infrastructure construction has a relatively low labor intensity per dollar spent. But long-run growth is not the only goal of this spending, job creation is just as important. In addition emphasizing employment keeps people connected to the labor market, and this can also have positive effects on long-run growth (by, for example, keeping people from permanently dropping out of the labor force). The first round of spending emphasized long-run growth, but I would like to see this round concentrate spending in areas where it is likely to have the most effect on employment.

The spending programs should end once the economy improves, e.g., I would link the spending to the unemployment rate and end it once unemployment falls below some threshold (and include automatic, distasteful cuts in the legislation if the two sides do not reverse the spending to help to ensure it is temporary -- that will help to mollify the concerns of those who worry about using stabilization policy to increase the size of government). But the tax increases/closed loopholes, credits, deductions, etc. on the wealthy should continue so that in the long-run the tax increase can help with deficit reduction.

I don’t have any doubt about the need for such initiatives, nor do I have any illusions about politicians endorsing this or any other stimulus plan – raising taxes on the wealthy is most likely a non-starter. But taxes on the wealthy are going to go up, if not sooner than later. Our long-run budget picture demands it and recent polls show that the public is behind this. So why not do it now when it can help with the employment, household debt, infrastructure problems immediately and improve our long-run debt outlook instead of waiting until we can only help with a subset of those problems? The answer, of course, is that helping households overcome debt problems and helping the unemployed would cause taxes on the wealthy to go up, and that is very unlikely to happen. And the dismal chances of providing help to middle and lower class households struggling with debt problems and high unemployment by asking the wealthy to pay more says a lot about who has power in Washington.

[Update: I probably should have noted that both Robert Shiller and Joe Stiglitz, among others, have suggested the same thing.]

Tuesday, August 30, 2011

More Dovish Than We Thought?

There is news from the Fed. First, from Narayana Kocherlakota of the Minneapolis Fed:

Fed’s Kocherlakota Suggests Dissent Won’t Be Repeated, by Michael S. Derby, WSJ: One member of the troika who opposed the Federal Reserve‘s recent decision to keep rates at rock bottom levels for two years suggested he won’t be repeating his disagreement at coming central bank gatherings.
In a speech, Federal Reserve Bank of Minneapolis President Narayana Kocherlakota said Tuesday “I see no reason to revisit the decisions” made last month, and added “I plan to abide by the August 2011 commitment in thinking about my own future decision.”
The reason? With the Fed having made its pledge, “I believe that undoing this commitment in the near term would undercut the ability of the Committee to offer similar conditional commitments in the future.” ...
That said, the official spent a considerable amount of his speech — his comments came from remarks prepared for delivery before the National Association of State Treasurers in Bismarck, N.D. — explaining why he did not think the Fed made the right decision on its forward interest rate commitment. He indicated there was even a case to be made for going the other way on policy and tightening it. ...

Brad Delong comments here, and also notes (approvingly) remarks by Charles Evans of the Chicago Fed:

Fed official makes plea for more stimulus, by Robin Harding, FT: A leading Fed policymaker made an aggressive call for more monetary stimulus on Tuesday as it emerged that staff of the US central bank have permanently cut their growth forecasts. In an interview with CNBC, Charles Evans of the Chicago Fed said that he would “favour more accommodation” and became the first policymaker on the rate-setting Federal Open Market Committee to explicitly countenance letting inflation rise above the Fed’s target of 2 per cent in the short-term. ...

I don't think it's a secret that I favor more accomodative policy as well. Finally, the minutes from the last FOMC meeting were released today, and they showed a divided committee, but more dovishness than most people expected:

Participants discussed the range of policy tools available to promote a stronger economic recovery should the Committee judge that providing additional monetary accommodation was warranted. Reinforcing the Committee's forward guidance about the likely path of monetary policy was seen as a possible way to reduce interest rates and provide greater support to the economic expansion; a few participants emphasized that guidance focusing solely on the state of the economy would be preferable to guidance that named specific spans of time or calendar dates. Some participants noted that additional asset purchases could be used to provide more accommodation by lowering longer-term interest rates. Others suggested that increasing the average maturity of the System's portfolio--perhaps by selling securities with relatively short remaining maturities and purchasing securities with relatively long remaining maturities--could have a similar effect on longer-term interest rates. Such an approach would not boost the size of the Federal Reserve's balance sheet and the quantity of reserve balances. A few participants noted that a reduction in the interest rate paid on excess reserve balances could also be helpful in easing financial conditions. In contrast, some participants judged that none of the tools available to the Committee would likely do much to promote a faster economic recovery, either because the headwinds that the economy faced would unwind only gradually and that process could not be accelerated with monetary policy or because recent events had significantly lowered the path of potential output. Consequently, these participants thought that providing additional stimulus at this time would risk boosting inflation without providing a significant gain in output or employment. Participants noted that devoting additional time to discussion of the possible costs and benefits of various potential tools would be useful, and they agreed that the September meeting should be extended to two days in order to provide more time.

The last part where they say they need more time to discuss "the possible costs and benefits of the various potential tools" is a bit worrisome. We all know what the policy options are, and they should have been prepared with that information coming in. I think what they're really saying is that thay've gone as far as they're willing to go for now, and they want to wait to see what happens to the economy and then discuss it further. Should things get worse, they want to make sure that they have enough time to thoroughly review their options. But they're hoping things stabilize or get better so they don't have to seriously confront the question.

The release of the minutes seems to have raised the expectation that more action is coming, so it will be interesting to see if Fedspeak tries to reduce expectations in coming days.

DeLong: Ben Bernanke’s Dream World

Brad DeLong is unhappy with Ben Bernanke:

Ben Bernanke’s Dream World, by Brad Delong, Commentary, Project Syndicate: US Federal Reserve Board Chairman Ben Bernanke is not regarded as an oracle in the way that his predecessor, Alan Greenspan, was before the financial crisis. But financial markets were glued to the speech he gave in Jackson Hole, Wyoming on August 26. What they heard was a bit of a muddle. ...[continue reading]...

Monday, August 29, 2011

Fed Watch: Brief Hiatus

Tim Duy:

Brief Hiatus, by Tim Duy: I remained under the radar for the past two weeks. Summer finally got the best of me, perhaps just as well, as I did not have the opportunity to backtrack from my last assessment of Fed policy:

All in all, this is pretty weak medicine given the condition of the patient. I would have preferred to see an open-ended commitment to asset purchases - buying up anything not nailed to the floor at a rate of $10 or $15 billion a week until achieving the dual mandate is in clear sight. But policymakers, on average tend to think they have relatively weak ammunition to stimulate growth. Their tools are more effective against deflation. And until the former turns into the latter, expect the Fed to do little more than modifications of the basic zero interest rate / hold balance sheet constant policy combination.

As was widely noted, Federal Reserve Chairman Ben Bernanke emphasized the Fed’s “wait-and-see” position, offering only an extended September meeting to consider the available options. Nothing specific to hang our hats on, no clear guidance as to the next move – suggesting the next "move" is likely to be more of the same, especially if financial markets stabilize and growth lifts off the first and second quarter floors. I believe we need to see even weaker growth, coupled with a steeper drop in long-term inflation expectations to prompt additional action.

The failure of Bernanke to push for more aggressive action is even more puzzling in the wake of this speech. According to the Fed chair, the situation is becoming urgent:

Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.

I suppose I should be happy that someone in Washington considers unemployment to be a crisis, both near and long term. That said, Bernanke follows up with this:

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

So he passes the ball to fiscal policy. With good reason, to be sure. Congress and the Administration are failing miserably at macroeconomic policy. The debt debate was an unnecessary, destabilizing, pointless disaster. Does this mean the Fed should be let off the hook? Consider that question in the context of Bernanke’s speech on February 3 of this year:

Although large-scale purchases of longer-term securities are a different monetary policy tool than the more familiar approach of targeting the federal funds rate, the two types of policies affect the economy in similar ways…By easing conditions in credit and financial markets, these actions encourage spending by households and businesses through essentially the same channels as conventional monetary policy, thereby supporting the economic recovery.

A wide range of market indicators supports the view that the Federal Reserve's securities purchases have been effective at easing financial conditions. For example, since August, when we announced our policy of reinvesting maturing securities and signaled we were considering more purchases, equity prices have risen significantly, volatility in the equity market has fallen, corporate bond spreads have narrowed, and inflation compensation as measured in the market for inflation-indexed securities has risen from low to more normal levels…Interestingly, these developments are also remarkably similar to those that occurred during the earlier episode of policy easing, notably in the months following our March 2009 announcement of a significant expansion in securities purchases. The fact that financial markets responded in very similar ways to each of these policy actions lends credence to the view that these actions had the expected effects on markets and are thereby providing significant support to job creation and the economy.

Funny that additional quantitative easing yielded “significant support to job creation” in February, when Bernanke wanted to justify QE2, yet now “most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.” Sometimes I think the only person who doesn’t read Bernanke’s past speeches is Bernanke himself. In any event, it seems the key difference between then and now, from the perspective of the Federal Reserve, is that the recent burst of inflation spooked them badly, raising in their minds the possibility of any central banker’s worse fear, an inflation spiral.

The bottom line: We are playing a data game as we approach the next FOMC meeting – lacking a more extensive collapse of growth forecasts and or inflation expectations, the Fed looks likely to stay the course.

As to my absence alluded to earlier, this summer finally caught up with me. My son being out of school was no small issue – parents are well aware with the requirements of summer camps. New schedule, new location each week. A bit different than I recall of my summers growing up, which were much more of the “go away and try not to wind up in the hospital” variety.

In addition, my wife was in trial in late July. For those of you married to a litigator, you understand what happened to July, and by my recollection, half of June (although I am confident the latter claim will be subject to family debate for years). Household production shifted to my corner.

Most importantly, my father passed away ten days ago after a sixteen-month battle with leukemia. I feel compelled to put a something in words, but none of you should feel compelled to keep reading (the Fed Watch part is obviously done for the day). The battle began at the end of winter term 2010 when I drove him to OHSU for an initial diagnosis and ended on August 18 at his home with his immediate family (my mother, my sister, and myself). As I am sure any of you who have faced the illness of a family member understand, the process is draining. I surely have a greater appreciation of both the possibilities and limitations of modern medicine. We were sure we lost him last September, when he fell into a coma during the first round of treatment. It is tough to forget my mother and I trying to understand the difference between “life-supporting” and “life-extending” treatments when one doctor wants to push forward yet another, just before moving onto dialysis, assured us that no one ever walks away at that point.

As it turns out, at least one person walked away, and my Dad recovered to dictate his own treatment for the next year, right up to the point when he knew he ran out of options and the end was near. We were lucky that my family moved to Eugene after my first child was born, giving us the opportunity to support each other through this ordeal. Still, throughout the year, my mother and sister were the real heroes. It was a year of sorrow, pain, uncertainty, and unexpected opportunities. My father passed on his woodworking skills to my sister as they completed projects such as a beautiful maple coffee table:

Table

Moreover, there was a furious effort to produce a large quantity of end-grain cutting boards as “goodbye presents” to friends and family:

Boards

We had some very good times even during the last week. That week he managed to convince me to take a trip to introduce his friend and former business associate to cask conditioned ale (you do need to have your priorities straight). An unambiguously fun night regardless of the circumstances. Another night with just the two of us. And a final trip to the family cabin. Good memories to add to a long list.
In short, more nights with family left fewer nights for blogging. And I will most likely sink below the radar again for the next week. My calendar tells me I am supposed to be walleye fishing in Canada – a trip planned by my father after he recovered from the coma – but instead we will be taking our traditional summer-end vacation near home. For the next few days we will disappear into Central and Eastern Oregon where, much to my wife’s dismay, I have planned a rock-hunting trip in the desert. Moreover, not one of her carefully planned (and almost certainly successful) trips; more one of my “vague, have-car-will-travel, sort of know where the campgrounds are, hope I can get 3G reception as a backup” kind of trip. This is really for my son, who became interested in rocks after a presentation in his kindergarten class. Supporting that interest is a small price to pay given the teacher managed to get him reading at a third grade level after just nine months. Any attempt by his parents to accomplish the same were worse than pulling teeth. That and Oregon is a vast and diverse state, and I want to get to a few places I have yet to see.
Enjoy the end of summer, and look forward to all the possibilities of the next year.

Saturday, August 27, 2011

How Long Will It Take for the Economy to Recover?

I don't think we'll attain the growth rates the CBO is forecasting -- an average of 3.6% from 2013 to 2016 is a lot to ask for (especially if there is substantial deficit reduction over that time period). But even the CBO's optimistic estimates imply we won't fully recover until 2017. And if growth is a bit slower, well, yikes!:

Lots of ground to cover: An update, David Altig: ...There are two pieces of information that emphasize the economy's recent weakness and potential slow growth going forward. The first is this week's revised forecasts and potential for gross domestic product (GDP) from the Congressional Budget Office (CBO), and the second is today's revision of second quarter GDP from the U.S. Bureau of Economic Analysis (BEA). Though estimates of potential GDP have not greatly changed, the CBO's downgrade in forecasts and BEA's report of much lower than potential growth in the second quarter have the current and prospective rates of resource utilization lower than when macroblog covered the issue just about a month ago.

Key to the CBO's estimates is a reasonably good outlook for GDP growth after we get past 2012:

"For the 2013–2016 period, CBO projects that real GDP will grow by an average of 3.6 percent a year, considerably faster than potential output. That growth will bring the economy to a high rate of resource use (that is, completely close the gap between the economy's actual and potential output) by 2017."

The margin for slippage, though, is not great. Assuming that GDP ends 2011 having grown by about 2.3 percent—as projected by the CBO—here's a look at gaps between actual and potential GDP for different, seemingly plausible growth rates:

Attaining 3.5 percent growth by next year moves the CBO's date for closing the output gap up by about a year. On the other hand, a fall in output growth to an average of 3 percent per year moves the date for eliminating resource slack back to 2020. If growth remains below that—well, let's hope it doesn't.

Maybe policymakers should do something to try and improve the odds?

Friday, August 26, 2011

Bernanke: We'll Wait and See

Here's a quick response to Bernanke's speech:

Bernanke: We’ll Wait and See, but No Changes in Policy for Now

Paul Krugman: Bernanke’s Perry Problem

I came to the same conclusion:

Bernanke’s Perry Problem, by Paul Krugman, Commentary, NY Times: As I write this, investors around the world are anxiously awaiting Ben Bernanke’s speech at the annual Fed gathering at Jackson Hole, Wyo. They want to know whether Mr. Bernanke ... will unveil new policies that might lift the U.S. economy out of what is looking more and more like a quasi-permanent state of depressed demand and high unemployment.
But I’ll be shocked if Mr. Bernanke proposes anything significant... Why...? In two words: Rick Perry. ... I’m using Mr. Perry — who has famously threatened Mr. Bernanke with dire personal consequences if he pursues expansionary monetary policy before the 2012 election — as a symbol of the political intimidation that is killing our last remaining hope for economic recovery.
To see what I’m talking about, let’s ask what policies the Fed actually should be pursuing right now. ... Well, in 2000 ... Ben Bernanke offered a number of proposals for policy at the “zero lower bound.” True, the paper was focused on policy in Japan... But America is now very much in a Japan-type economic trap, only more acute. ...
Back then, Mr. Bernanke suggested that the Bank of Japan could get Japan’s economy moving with a variety of unconventional policies...: purchases of long-term government debt (to push interest rates, and hence private borrowing costs, down); an announcement that short-term interest rates would stay near zero for an extended period, to further reduce long-term rates; an announcement that the bank was seeking moderate inflation, “setting a target in the 3-4% range for inflation, to be maintained for a number of years,” which would encourage borrowing and discourage people from hoarding cash; and “an attempt to achieve substantial depreciation of the yen”...
So why isn’t the Fed pursuing the agenda its own chairman once recommended for Japan?
Part of the answer is internal dissension..., with three inflation hawks on the committee... The larger answer, however, is outside political pressure. Last year, the Fed actually did institute a policy of buying long-term debt, generally known as “quantitative easing”... But it faced a political backlash out of all proportion...
Now just imagine the reaction if the Fed were to act on the other and arguably more important parts of that Bernanke 2000 agenda, targeting a higher rate of inflation and welcoming a weaker dollar. With prominent Republicans like Representative Paul Ryan already denouncing policies that allegedly “debase the dollar,” a political firestorm would be guaranteed.
So now you see why I don’t expect any substantive policy announcements at Jackson Hole. ... In effect, it has been politically intimidated into standing by while the economy stagnates. And that’s a very, very bad thing.
Political opposition has already crippled fiscal policy; instead of helping to create jobs, the federal government is pulling back, acting as a drag on output and employment.
With the Fed also intimidated into inaction, it’s hard to see any end to the ongoing economic disaster.

Thursday, August 25, 2011

Why is the Fed Hesitant to Do More for the Economy?

I try to explain why the Fed is unlikely to do more to help the economy:

Why is the Fed Hesitant to Do More for the Economy?

"Rules-based Keynesian Policy?"

Is John Taylor anti-Keynesian?:

Rules-based Keynesian Policy?, Twenty Cent Paradigms: John Taylor, who is one of the most prominent academic critics of administration and Fed policy over the past several years, grapples with the label "anti-Keynesian" that was pinned on him by The Economist. He writes:

In a follow-up to the Economist article, David Altig, with basic agreement from Paul Krugman, argued that it was a misnomer because I developed and used macro models (now commonly called New Keynesian) with price and wage rigidities in which the government purchases multiplier is positive (though usually less than one), or because the Taylor rule includes real variables in addition to the inflation rate. In my view, rigidities exist in the real world and to describe accurately how the world works you need to incorporate such rigidities in your models, which of course Keynes emphasized. But you also need to include forward-looking expectations, incentives, and growth effects—which Keynes usually ignored.

In my view the essence of the Keynesian approach to macro policy is the use by government officials of discretionary countercyclical actions and interventions to prevent or mitigate recessions or to speed up recoveries. Since I have long been critical of the use of discretionary policy in this way, I think the Economist is correct so say that I am anti-Keynesian in this sense of the word. Indeed, the models that I have built support the use of policy rules, such as the Taylor rule for monetary policy or the automatic stabilizers for fiscal policy, which are the polar opposite of Keynesian discretion. As a practical prescription for improving the economy, the empirical evidence is clear in my view that discretionary Keynesian policy does not work and the experience of the past three years confirms this view.

"Keynesian" means different things to different people - at its broadest, it means accepting that there are frictions in the economy which mean that aggregate demand matters and policy can have real effects. This is in contrast to the pure classical view, in which Say's law holds, demand is irrelevant, and output depends on technology and preferences. In the version of Keynesian economics in our undergraduate textbooks - the IS-LM/AS-AD framework - the frictions are nominal rigidities and the Keynesian model deals with "short run" fluctuations around a "long run" equilibrium determined by the classical model. In this setting, both monetary and fiscal policy matter (by shifting the LM and IS curves, respectively), though early Keynesians emphasized fiscal policy and "monetarists" (most prominently Milton Friedman), gave primacy to monetary policy. The version of Keynesian economics in our graduate textbooks and academic journals - "New Keynesian" - combines dynamic optimization with sticky prices, and explicitly addresses the lack of "forward looking expectations" in the traditional textbook version. Furthermore, some argue that both the IS-LM and New Keynesian incarnations really miss the point and gloss over more fundamental irrationality and instability Keynes saw in the capitalist system.

As Taylor describes his views of the economy (and from what I know of his academic work), it seems consistent with mainstream New Keynesian economics (though his version has been less favorable to fiscal policy than some others). His criticism of recent fiscal and monetary policy grows out of another longstanding conundrum in macroeconomics, "rules versus discretion." He is not claiming that countercyclical fiscal and monetary policy are fundamentally impossible, which is what I would say is the true "anti-Keynesian" view. Rather, he is arguing that discretionary policy may do more harm than good, and policy should be based on stable, predictable rules.

A primary argument for rules is that discretionary "fine tuning" is impractical based on "long and variable" lags associated with (i) recognizing the state of the state of the economy, (ii) designing and implementing a policy and the (iii) the policy's impact reaching the economy. Often lurking behind this argument is a political philosophy that is skeptical of government (no coincidence that Milton Friedman was the most famous proponent of rules - Brad DeLong recently argued this is how he resolved the contradiction between an economics that said monetary policy can be effective with a libertarian political philosophy).

Taylor is careful to say that he opposes "discretionary Keynesian policy" - I think "anti-discretion" might be a better characterization of his critique than "anti-Keynesian." Of course, that only matters if it is possible to be "anti-discretion" without being "anti-Keynesian." I think it is.

I don't share the political philosophy, but the experience of the last several years has underscored the practical difficulties of discretionary policy. The early-2009 Obama administration with large congressional majority is about as close to government by center-left mainstream Keynesian technocrats as the American political system is likely to ever give us. In retrospect, it is clear they misjudged the scope and duration of the downturn and were not able make adjustments as that became apparent.

Monday morning quarterbacking in April, I suggested that the stimulus should have been designed in a "state-contingent" fashion to remain in place until the recovery reached certain benchmarks. It is a small step from there to a "rules based" countercyclical fiscal policy - policies like aid to state governments, extended unemployment benefits, payroll tax cuts and even increased infrastructure spending could be designed to kick in and ramp down automatically based on the state of the economy (e.g., with triggers based on the unemployment rate). To me, that's very "Keynesian", but also "rules-based", and its easy to imagine that might have worked better than the actual policies that were put in place.

Monday, August 22, 2011

Krugman: Stop Worrying and Learn to Love Inflation

Paul Krugman is taking a break from his column today (Arrrr!), so here's a summer rerun. Can you guess when he wrote this?:

Stop worrying and learn to love inflation, by Paul Krugman: ...depression economics - the kinds of problems that characterized much of the world economy in the 1930s but have not been seen since - has staged a stunning comeback.
Five years ago hardly anybody thought that modern nations would be forced to endure bone-crushing recessions for fear of currency speculators; that a major advanced country could be persistently unable to generate enough spending to keep its workers employed; that even the Federal Reserve would worry about its ability to counter a financial market panic. The world economy has turned out to be a much more dangerous place than we imagined. For the first time in two generations, failures on the demand side of the economy - insufficient private spending to make use of the available productive capacity - have become the clear and present limitation on prosperity for much of the world.
Economists and policymakers weren't ready for this. The specific set of silly ideas known as 'supply-side economics' is a crank doctrine, which would have little influence if it did not appeal to the prejudices of wealthy men; but over the past few decades there has been a steady drift in thinking away from the demand side to the supply side of the economy. The truth is that good old -fashioned demand-side macroeconomics has a lot to offer in our current predicament - but its defenders lack all conviction.
Paradoxically, if the theoretical weaknesses of demand-side economics are one reason we were unready for the return of depression-type issues, its practical successes are another. Central banks have repeatedly managed demand - cutting rates to keep spending high - so effectively that a prolonged slump due to insufficient demand became inconceivable. Except in the very short run, then, the only limitation on economic performance was an economy's ability to produce - that is, the supply-side. ...
The question of how to keep demand adequate to make use of the capacity has become crucial. Depression economics is back. ... The free-market faithful tend to think of Keynesian policies - deliberate efforts by governments to stimulate demand - as the enemy of what they stand for. But they are wrong. For in a world where there is often not enough demand to go around, the case for free markets is a hard case to make. ...
The right perspective is to realize how very much good free markets and globalization have done; the point is to preserve those gains. One cannot defend globalization merely by repeating free-market mantras as economy after economy crashes. If we want to see more nations making the transition from abject poverty to the hope of a decent life, we had better find answers to the problems of depression economics. ...
I don't like the idea that countries will need to interfere in markets - to limit the free market in order to save it. But it is hard to see how anyone who has been paying attention can still insist that nothing of the kind needs to be done, that financial markets will always reward virtue and punish only vice.
One of the most important obstacles to sensible action, however, is prejudice -by which I mean the adherence of too many influential people to orthodox views that are no longer relevant to our changed world. ...
This brings us to the deepest sense in which depression economics has returned. The quintessential economic sentence is supposed to be 'There is no free lunch'; it says that there are limited resources; to have more of one thing you must accept less of another. Depression economics, however, is the study of situations where there is a free lunch, if we can figure out how to get our hands on it, because there are unemployed resources that could be put to work.
In 1930, John Maynard Keynes wrote that 'we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand'. The true scarcity in his world - and ours - was therefore not of resources, or even virtue, but understanding.
Originally published, 6.20.99

Then, as now, he points to inflation as the answer to a liquidity trap:

So what should we be doing differently? ... Japan, having fallen in its liquidity trap - unable to recover by means of conventional monetary policy, because even a zero interest rate is not low enough - and having exhausted its ability to spend its way out with budget deficits, must now radically expand its money supply. It must convince savers and investors that its current deflation will turn into sustained, though modest, inflation. Once the Japanese make up their mind to do this, the results will startle them. ... There is no economic evidence suggesting that inflation at the ... 4 per cent rate I believe Japan should target, does any noticeable harm; and the things advanced countries need to do to counter depression economics do not involve any compromise of the commitment to free markets. ...

Thursday, August 18, 2011

"Defending the Dollar"

David Glasner:

Defending the Dollar, Uneasy Money: After administering a pro-forma slap on the wrist to Texas Governor Rick Perry for saying that it would be treasonous for Fed Chairman Bernanke to “print more money between now and the election,” The Wall Street Journal in today’s lead editorial heaps praise on the governor for taking a stand in favor of “sound money.” First there was Governor Palin, and now comes Governor Perry to defend the cause of sound money against a Fed Chairman who, in the view of the Journal editorial page, is conducting a massive money-printing operation that is debasing the dollar.

Well, let’s take a look at Mr. Bernanke’s record of currency debasement. The Bureau of Labor Statistics announced the latest reading (for July 2011) of the consumer price index (CPI); it stood at 225.922. Thirty-six months ago, in July 2008, the index stood at 219.133. So over that entire three-year period, the CPI rose by a whopping 3.1%. That is not an annual rate, that it the total increase over three years, so the average annual inflation rate over the whole period was less than 1%. The last time that the CPI rose by as little as 3% over any 36-month period was 1958-61. It is noteworthy that during the administration of Ronald Reagan — a kind of golden age, in the Journal‘s view, of free-market capitalism, low taxes, and sound money — there was no 36-month period in which the CPI increased by less than 8.97%, or about 3 times as fast as the CPI has risen during the quantitative-easing, money-printing, dollar-debasing orgy just presided over by Chairman Bernanke. Here is a graph showing the moving 36-month change in the CPI from 1950 to 2011. If you can identify which planet the editorial writers for The Wall Street Journal are living on, you deserve a prize. ...

“Mr. Perry,” the Journal continues, “seems to appreciate that the Federal Reserve can’t conjure prosperity from the monetary printing presses.” A huge insight to be sure. But the Journal is oblivious to the possibility that there are circumstances in which monetary stimulus in the form of rising prices and the expectation of rising prices could be necessary to overcome persistent and debilitating entrepreneurial pessimism about future demand. How else can one explain the steady decline in real (inflation-adjusted) interest rates over the past six months? On February 10 the yield on the 10-year TIPS bond was 1.39%; today the yield has dropped below zero. For the Journal to attribute the growing pessimism to the regulatory burden and high taxes, as it reflexively does, is simply laughable now that Congressional Republicans have succeeded in preserving the Bush tax cuts, preventing any new revenue-raising measures, and blocking any new regulations that were not already in place 6 months ago. ...

Wednesday, August 17, 2011

Richard Green: I am a Big Fan of Stein's work

Richard Green says I should support Jeremy Stein's appointment to the FOMC (this also gives me a chance to note that Richard Clarida has removed himself from consideration):

Jeremy Stein for Fed Governor, by Richard Green: Mark Thoma writes that the administration is considering nominating Richard Clarida and Jeremy Stein for the Federal Reserver Board. He cites an encouraging Clarida speech, but writes, "I know less about Stein, so I'll withhold judgment for the moment."

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

  • Herd Behavior and Investment
  • A Unified Theory of Underreaction, Momentum Trading and Overreaction in Asset Markets
  • Rick Management: Coordinating Investment and Financing Policies
  • Bad News Travels Slowly: Size, Analyst Coverage and the Profitability of Momentum Strategies
  • Internal Capital Markets and the Competition for Corporate Resources.
Stein has spent his career trying to figure out how capital markets really work instead of pledging fealty to models that don't work very well. I can't think of a better intellectual qualification for a Federal Reserve Board member.

I have done a bit of reading since, and I agree.

Thinking of the Fed's recent commitment to keep interest rates low though mid-2013, the membership rotates among the regional Feds every January. Will changes in the composition of the committee make any difference? If you look at the composition of the FOMC next year (it changes every January), not much will change. Presently the regional bank representation is (ignoring New York since it doesn't change, the D, N, SH, and H designations stand for dove, neutral, soft-hawk, and hawk, and are taken from here):

Chicago - Evans (D)
Philadelphia - Plosser (H)
Dallas - Fisher (H)
Minneapolis - Kocherlakota (SH)

Come January it will change to:

Cleveland - Pianalto (N)
Richmond - Lacker (H)
Atlanta - Lockhart (SH)
San Francisco - Williams (D)

Most of these are a wash:

Williams for Evans (D for D)
Lacker for Fisher (H for H)
Lockhart for Kocherlakota (SH for SH)
Pianalto for Plosser (N for H)

Pianalto for Plosser should tilt the Committee a bit toward easing, but for the most part the hawkishness/dovishness of the FOMC won't change all that much. Thus, if the committee is going to change noticeably any time soon, it will have to come from new appointments rather than the rotation of the regional Fed presidents. But with new appointments all but blocked, especially those that would lean toward dovishness, that's unlikely.

Tuesday, August 16, 2011

The Not Ready for Prime-Time Players

Steve Benen:

Republican presidential candidate Rick Perry raised a few eyebrows yesterday with borderline-violent rhetoric about the Federal Reserve and Ben Bernanke. “If this guy prints more money between now and the election, I don’t know what y’all would do to him in Iowa, but we would treat him pretty ugly down in Texas,” the Texas governor said. “Printing more money to play politics at this particular time in American history is almost treacherous, or treasonous, in my opinion.”

The comments have drawn bipartisan criticism, but as of this morning, the Perry campaign isn’t backing down.

A spokesman for Mr. Perry said Tuesday the governor “got passionate” in his remarks about the Federal Reserve, but he did not disavow the comments.

“He is passionate about getting federal finances under control,” the spokesman, Ray Sullivan, said in an interview here. “They shouldn’t print more money, they should cut spending and move much more rapidly to a balanced budget.”

Apparently he thinks the Fed has the ability to cut spending and balance the budget. What a clown.

Friday, August 12, 2011

Clarida on Monetary and Fiscal Policy

This is from an old post (March 2009, Clarida and DeLong on Fiscal Policy). It should give you a bit of perspective on potential Fed Governor Richard Clarida's views on monetary and fiscal policy:

A lot of bucks, but how much bang?, by Richard Clarida, Vox EU: “We have involved ourselves in a colossal muddle, having blundered in control of a delicate machine, the workings of which we do not understand” - John Maynard Keynes, “The Great Slump of 1930”, published December 1930.

I recently had the privilege of participating on a panel that was part of the Russia Forum, an annual conference held in Moscow that brings together market makers, policymakers, and academic experts... The topic assigned to our panel, not surprisingly, was the global financial crisis – causes, consequences, and policy responses. Although each speaker had his own, unique perspective, a cohesive, urgent theme did emerge, or so it seemed to me...

That theme suggests the title I’ve chosen for this column; there are, at last, a ‘lot of bucks’ now committed by policymakers to address the global recession and the global financial crisis, but there is real doubt about how much ‘bang’ we can expect from these bucks.

In the US, President Obama has just signed a nearly 800 billion dollar stimulus package and the Fed has cut the Federal Funds rate to zero. Monetary policy in the rest of the G7, while lagging behind the US, will follow the US lead and soon come close to zero. (In the case of the ECB, the policy rate may end up at 1%, but the effective interbank rate has been trading well below the official policy rate in recent weeks so a policy rate of 1% could translate into an effective interbank rate of nearly zero). Likewise for fiscal deficits – they are rising globally and headed higher, propelled by a combination of discretionary actions and automatic stabilisers.

To date, however, these traditional policies have been insufficient for the scale and scope of the task. Recall that the Obama stimulus package is actually the second such US effort in the last 12 months. The 2008 edition was deemed to be a failure because a big chunk of the rebate checks were saved or used to pay down debt and not spent. The Obama package includes tax cuts and credits that will provide a boost to disposable income, but how much of these will be spent rather than saved or used to pay down debt? The package also includes a substantial increase in infrastructure spending, as well as transfers to the states, but the infrastructure spending is back-loaded to 2010 and later, and the transfers to states will most likely just enable states to maintain public employment, not expand it appreciably.

Bucks without bang

What is the source of this concern that the US fiscal package will not deliver a lot of ‘bang’ for the ‘bucks’ committed? Because of the severe damage to the system of credit intermediation through banks and securitisation, policy multipliers are likely to be disappointingly small compared with historical estimates of their importance. Recall the Econ 101 idea of the Keynesian multiplier – the impact traditional macro policies are ‘multiplied’ by boosting private consumption by households and capital investment by firms as they receive income from the initial round of stimulus. It important to remember why and how policy multipliers actually come about. Policy multipliers are greater than 1 to the extent the direct impact of the policy on GDP is multiplied as households and companies increase their spending from the increased income flow they earn from the debt-financed purchase of goods and services sold to meet the demand from the initial round of stimulus.

Historically, multipliers on government spending are estimated to be in the range of 1.5 to 2, while multipliers for tax cuts can be much smaller, say 0.5 to 1. But these estimates are from periods when households could – and did – use tax cuts as a down payment on a car or to cover the closing costs on a mortgage refinance. For example, in 2001, the economy was in recession, but households took advantage of zero-rate financing promotions – as well as ready access to home equity withdrawal from mortgage refinancings – to lever up their tax cut checks to buy cars and boost overall consumption. With the credit markets impaired, tax cuts and income earned from government spending on goods and services will not be leveraged by the financial system to nearly such an extent, resulting in (much) smaller multipliers.

There is a second reason while the bang of the fiscal package will likely lag behind the bucks. Even if the global financial system soon restores some semblance of order and function, the collapse in global equity and housing market values has so impaired household wealth that private consumption (which represents 60% to 70% of GDP in G7 countries) is likely to lag – not lead – economic growth for some time, as households rebuild their balance sheets the old-fashioned way – by boosting their saving rates. Just in 2008 alone, I estimate that the net worth of US households fell by some 10 trillion dollars, with much of this concentrated in older demographic groups who, in our defined contribution world, must now be focused on building back up their wealth to finance retirement, which is not that far away. This means more saving, less consumption, and smaller multipliers. ...

Will the Fed pull it off?

So where does this leave us? A LOT is riding on the efforts of the Fed and other central banks to stabilise the financial system and restore the flow of credit.

Officials recognising these challenges are now seriously considering “non-traditional” policies that combine monetary and fiscal elements. Cutting rates to (near) zero has not been a mistake, but it has been ineffective – really the most striking example of ‘pushing on a string’ I have witnessed in my lifetime. The reason, again, is the impaired credit intermediation system. The private securitisation channel, which at its peak was intermediating nearly 50% of household credit in the US, has been destroyed. Banks are hunkering down in the bunker, hoarding capital as a cushion against massive losses yet to be recognised on the trillions of dollars of ‘legacy’ assets that they have been unable or unwilling to sell at the deep discount required to attract private investors. For this reason, the Fed and Bank of England – with many other central banks likely to follow suit in some form or fashion – are filling the vacuum by directly lending to the private sector. The Fed aims to purchase 600 billion dollars worth of mortgage-backed and agency securities this year and, via the soon to be launched Term Asset-Backed Securities Loan Facility (TALF), to finance without recourse up to one trillion dollars worth of private purchases of credit cards, auto loans, and student loans. Since last fall, the Fed has also been supporting the commercial paper market via the Commercial Paper Funding Facility (CPFF).

Altogether, between the MBS, CPFF, and TALF programs, the Fed is committing nearly 2 trillion dollars of financing to the private sector. While these sums may be necessary to prevent an outright economic collapse that extends and deepens into 2011 and beyond, it is not clear to me that they are sufficient to turn the economy around so that it returns to robust growth. Moreover, based on the Fed’s just released economic forecast and Chairman Bernanke’s recent testimony to the Senate Banking committee, the Fed is also not convinced that these policies are sufficient to turn the economy around. On 24 February, knowing that an 800 billion stimulus had passed, that the Fed has committed nearly 2 trillion dollars of lending to the private sector, and that the Treasury’s Public Private Investment Fund will aim to support up to one trillion dollars of private purchases of bank legacy assets, Chairman Ben Bernanke said,

If actions taken by the administration, the Congress, and the Federal Reserve are successful in restoring some measure of financial stability – and only if that is the case, in my view – there is a reasonable prospect that the current recession will end in 2009 and that 2010 will be a year of recovery,

As I said in my remarks at the conference, I think of myself as an optimist, and that outlook on life has served me well. However, the last nine months have severely tested that mindset, at least as it pertains to my professional endeavours. But old habits are hard to break, so I am casting aside the contrary evidence and putting my ‘bucks’ on the Fed. But it is a close call.

Jeremy Stein and Richard Clarida Identified as Potential Nominees to Fed

Some news:

The Obama administration has identified two economists, one Democrat and one Republican, for two empty seats on the seven-member Federal Reserve Board, according to several people familiar with administration deliberations.
The two are Jeremy Stein, a Harvard University specialist in finance, and Richard Clarida, an executive vice president at money manager Pimco and professor of economics and international affairs at Columbia University.
Mr. Stein did a stint in the White House at the beginning of Barack Obama's presidency. Mr. Clarida was a Treasury official in the early years of the George W. Bush administration.
The administration coalesced around the two names a few months ago, hoping that pairing a Republican with a Democrat would smooth the way for Senate confirmation. But the White House has yet to nominate either formally and could change course depending on the political environment and the individuals' circumstances.
Although the two men have different political views, both are well-credentialed economists who have done scholarly work on central banking and would bolster the economic expertise on the Fed board. Only two of the five current Fed governors are Ph.D. economists, Mr. Bernanke and Vice Chairwoman Janet Yellen.

More here and here. Clarida is a good choice. I know less about Stein, so I'll withhold judgment for the moment.

What Was Kocherlakota Thinking When He Dissented on Monetary Policy?

Narayana Kocherlakota makes it clear that the rate at which the recovery is proceeding is just fine with him. No more accommodation from the Fed is necessary given that "Since November, inflation has risen and unemployment has fallen."

But he doesn't acknowledge that the November date is cherry-picked to some extent. Since January -- just two months from when he starts his measurement -- unemployment has actually risen. He's happy with that? As for inflation -- the worry that is stopping him from endorsing a more aggressive policy -- using his preferred time period from last November until now, core PCE has risen from 1.0% to 1.3%. And it didn't move at all between May and June, it was 1.3% in both months. Uh oh, hyperinflation! Assuming a target of 2.0%, at this rate the Fed will reach it's inflation target in about a year and a half. Sounds kind of like the guidance they issued (and there is a good argument that the Fed should overshoot its target in the short-run). Perhaps lag effects can explain his response, if we tighten now we may not feel it until a year later, but that doesn't seem to be his argument:

In its August 9 meeting, the Committee changed this “extended period” language to say instead that it “currently anticipates economic conditions … are likely to warrant extraordinarily low levels of the federal funds rate through mid-2013.” This statement is designed to let the public know that the fed funds rate is likely to stay between 0 and 25 basis points over the next two years, not just over the next three to six months. Hence, the new language is intended to provide more monetary accommodation than before.
I dissented from this change in language because the evolution of macroeconomic data did not reflect a need to make monetary policy more accommodative than in November 2010. In particular, personal consumption expenditure (PCE) inflation rose notably in the first half of 2011, whether or not one includes food and energy. At the same time, while unemployment does remain disturbingly high, it has fallen since November. I can summarize my reasoning as follows. I believe that in November, the Committee judiciously chose a level of accommodation that was well calibrated for the prevailing economic conditions. Since November, inflation has risen and unemployment has fallen. I do not believe that providing more accommodation—easing monetary policy—is the appropriate response to these changes in the economy.

Again, "well-calibrated" should include both the direction and pace of change. Even if the direction is correct, is he satisfied with the pace of change for employment? I realize he thinks we will have to tighten in 3-6 months, but it's hard to see how a data-based projection takes you to this outcome (even more so if you believe, as I do, that the risks are asymmetric, i.e. that unemployment is more costly than inflation).

Finally, this is not a rock solid commitment from the Fed. This is their view of the most likely path for the federal funds rate, they have not said this is what they will do independent of how the data evolve. All they have said is that economic conditions are likely to warrant this outcome. The dissenters seem to believe that another outcome is more likely, the view is that economic conditions will force the Fed into a different posture -- you know, that high inflation and rapid recovery we've been seeing to date -- in as soon as 3-6 months. Anything is possible, but again, it's hard to see how recent data point to this outcome.

Update: See Matt Rognlie: Macroeconomics in Action (I've made this point several times in the past, and should have mentioned it here as well).

Update: Here's the view from the right.

Wednesday, August 10, 2011

Fed Watch: Weak Medicine

Tim Duy:

Weak Medicine, by Tim Duy: The Federal Reserve pronounced on the state of the economy, and the assessment wasn't pretty. I think this was pretty much the only good news:

However, business investment in equipment and software continues to expand.

We'll see if that holds up given the downdraft in the economy. Speaking of that downdraft, the growth outlook pushes back the return to full employment:

The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, downside risks to the economic outlook have increased.

And that hawkish inflation story is falling apart:

The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further.

In response to these clear and present dangers to the economy, policymakers offered this:

The Committee currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.

Not exactly shock and awe. And this takes some of the fun out of Fed watching. What will become of us if the Fed starts telling everyone the policy path for the next two years? I imagine we will preoccupy ourselves with this:

The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ these tools as appropriate.

We can do more, but we won't. And why not? I think the answer was back up in the first paragraph:

Longer-term inflation expectations have remained stable.

The story from the Treasury rally is more of a low growth than a deflation story. In what world would anyone foresee that real 5 year yields would be negative, real 10 year yields would be zero, and the real 30 year yield just 1.06 percent? If this really represents annual potential growth over the long run, the next few decades are going to be no fun at all.

Now, I think it is perfectly reasonable to argue that low growth will eventually work its way into substantially lower inflation expectations, and it would be better to get ahead of that curve. The Fed doesn't see it that way. They will need to see inflation expectation numbers turn more solidly south to bring out another round of QE3. I think that takes some additional weakness on top of what we are currently experiencing.

As far as the expectation of near zero rates for two years, is this weak or strong medicine? My initial reaction was similar Paul Krugman's:

The Fed didn’t announce a new policy. And despite what some press reports said, it didn’t even commit to keeping rates low; all it did was say that if the economy stays weak, rates will stay low — well, duh...

The Fed did not actually promise to keep rates low (whether market participants caught that nuance is another matter). They only said that based on what they see now, they would anticipate zero rates for another two years. And so what? We were going to figure that out sooner than later. The expected date of the first rate hike of the cycle has been repeatedly pushed back "another six months." And, sure, with mere words the Fed can flatten the near term portion of the yield curve to nearly zero, but there wasn't a lot of room to play around there to begin with.

Still, upon reflection, I see some additional upside from this psuedo-commitment. In effect, the FOMC publicly marginalized the hawks. You know who I am taking about:

Voting against the action were: Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who would have preferred to continue to describe economic conditions as likely to warrant exceptionally low levels for the federal funds rate for an extended period.

Awfully convenient to have a block of three dissenters - the names "Larry, Moe, and Curly" come to mind. But I digress. One complaint over the past two years is that Fedspeak turns prematurely hawkish. The instant one good month of data rolls through the door, the more hawkish policymakers rush to let market participants know the end of easy money is near, talk that induces a tightening as agents hedge their dovish bets. Now we know not to be distracted by such talk, that while the bar to QE3 might be high, so too is the bar to actually raising rates. In other words, while not a promise, the Fed's outlook works to entrench expectations against any misunderstandings caused by Fed hawks.

Bottom Line: All in all, this is pretty weak medicine given the condition of the patient. I would have preferred to see an open-ended commitment to asset purchases - buying up anything not nailed to the floor at a rate of $10 or $15 billion a week until achieving the dual mandate is in clear sight. But policymakers, on average tend to think they have relatively weak ammunition to stimulate growth. Their tools are more effective against deflation. And until the former turns into the latter, expect the Fed to do little more than modifications of the basic zero interest rate / hold balance sheet constant policy combination.

Tuesday, August 09, 2011

The Fed Says Rates Likely to Remain Low Through Mid-2013

Here's my reaction to today's the FOMC meeting:

The Fed Says Rates Likely to Remain Low Through Mid-2013

"For once, I'd like to see the Fed get out in front of the problem, and with the recent emergent signs of weakness on so many fronts, now would have been a great time for the Fed to show it can do more than look in the rear view mirror."

Monday, August 08, 2011

Fed Watch: The Unpleasantness Continues

Tim Duy:

The Unpleasantness Continues, by Tim Duy: Lots of moving pieces tonight as financial centers around the world prepare for the impact of the S&P downgrade of US debt and the ongoing Eurozone debt crisis. The list:

ECB Finally Ready to Come to the Table. The ECB is signaling they are prepared to buy up massive quantities of Italian and Spanish debt, hoping to put a firewall around the European debt crisis. Of course, this isn’t the first firewall European leaders have set, to no avail. Perhaps this time will be different. Paul Krugman argues, I think correctly, that at least for Italy the issue is seemingly a liquidity crisis, not an insolvency crisis. The ECB could effectively act as a lender of last resort in such a case, and bring about stability with only minor fiscal adjustment. My concern is that if this was just a liquidity crisis, then why did the ECB posture that significant fiscal adjustments were necessary? Just to look tough? As to whether or not the ECB is actually prepared to follow through with big bond purchases, I refer you to Yves Smith:

My readers of European press tell me that the signals this weekend was that the ECB wants to nibble only and is trying to prevent panic sales. If this reading is correct, this is a variant on the Paulson “bazooka” strategy of July 2008 with Fannie and Freddie, that if the markets knew he had a bazooka in his pocket, he would not have to use it. We know how that one turned out.

The G7 Communiqué. The G7 finances ministers and central bankers met over the weekend and more or less confirmed their commitment to fiscal austerity:

We are committed to addressing the tensions stemming from the current challenges on our fiscal deficits, debt and growth, and welcome the decisive actions taken in the US and Europe. The US has adopted reforms that will deliver substantial deficit reduction over the medium term. In Europe, the Euro area Summit decided on July 21 a comprehensive package to tackle the situation in Greece and other countries facing financial tensions, notably through the flexibilisation of the EFSF. We are now focused on the quick and full implementation of the agreements achieved. We welcome the statement of France and Germany to that effect. We also welcome the statement of the Governing Council of the ECB.

Whether the US has adopted a credible medium term plan for fiscal reform is debatable, even more so given ongoing economic weakness likely to be exacerbated by near-term fiscal austerity. What the US needs is near-term stimulus and long-term consolidation, or at least a political system capable of producing this.

Regarding the rapid implementation of the EFSF, I think this means the someone in Europe is going to have to cut their vacation short and actually get on this before the end of the month. A key paragraph:

We are committed to taking coordinated action where needed, to ensuring liquidity, and to supporting financial market functioning, financial stability and economic growth.

I think this gives the Fed cover to move this morning; more later. I like this part:

These actions, together with continuing fiscal discipline efforts will enable long-term fiscal sustainability. No change in fundamentals warrants the recent financial tensions faced by Spain and Italy. We welcome the additional policy measures announced by Italy and Spain to strengthen fiscal discipline and underpin the recovery in economic activity and job creation.

On one hand, nothing warrants the pressure on Spain and Italy – just a liquidity crisis. On the other hand, they welcome additional policy measures. Less reassuring, has the feel of a solvency problem. Honestly, I think I would be more confident if the ECB had just stepped up to the plate and not demanded a quid pro quo. Finally:

The Euro Area Leaders have stated clearly that the involvement of the private sector in Greece is an extraordinary measure due to unique circumstances that will not be applied to any other member states of the euro area.

This is a clear line in the sand. Expect more fiscal austerity.

The Federal Reserve. As I argued last week, the usual guides to monetary policy, a combination of Fedspeak and data flow, are not conducive to a near-term policy shift. An overriding factor, however, would be financial crisis, and the G7 statement seems to raise the current circumstances to crisis level. This should give the Fed a green light to act. I still think the best option is to come in before the market opens and announce they are buying $100 billion of Treasuries. Just get ahead of this. The problem is that so many Fed policymakers have come out seemingly dead set against any additional bond purchases that action just a day before the next FOMC meeting seems like a big leap. Still, a financial crisis is a good time for a big leap.

The S&P Downgrade. Lot’s of speculation on the competence of S&P. They obviously messed up on the math. And let’s not forget the role they played during the financial crisis – aren’t any mortgage backed assets investment grade? They are if you want to keep earning your fees. But Ezra Klein and Felix Salmon argue that the circus of US politics warrants a debt downgrade. After all, a small but apparently vocal contingent thinks the debt-ceiling is no big deal, and is actually willing to press the button to prove their point.

Should the downgrade have significant economic consequences? I fear the answer is yes. First, if you believe confidence is important, that confidence has surely been shaken, as evidenced by wild ride of financial markets. Second, the political response could be a full-court press for more fiscal austerity. Finally, we don’t completely know the knock-off effects on the rest of the financial system. From the Wall Street Journal:

The downgrade late Friday had implications for a range of entities with links to the U.S. government or holdings of its debt, running the gamut from mortgage giants Fannie Mae and Freddie Mac to large insurers to securities clearinghouses—not to mention rates on consumer loans such as mortgages that are linked to Treasury yields.

The risk for all these borrowers is that the downgrade to double-A-plus, even though by just one of the three major rating firms, could result in slightly higher interest rates. Those costs might be small for each borrower, but in total could essentially mean a tightening of credit in the country at a time when a weak economy can ill afford higher rates.

The world needs more safe assets. The safest asset just became a little bit less safe. That can’t be good. The sad part is that there really shouldn’t be any doubt the US can and will repay its debt in full. Any way you cut it, this is a self-inflicted wound.

Good luck today.

Saturday, August 06, 2011

Fed Watch: Jobs Report and the Fed

Tim Duy:

Jobs Report and the Fed, by Tim Duy: The jobs report was somewhat better than expectations. Admittedly, this isn't saying much. But it was "good" enough to give the Fed pause before rushing into a fresh round of easing.

The headline NFP gain of 117k jobs was a combination of a not-terrible 154k gain in the private sector and a 37k loss on the public side of the ledger. Overall, simply a sideways movement. From the perspective of policymakers, however, the numbers will suggest that recession fears are overblown. And the 10 cent gain in hourly wages will suggest to some FOMC members that a renewal of deflation fears are also equally overblown.

It is true that, as Calculated Risk notes, the survey period was before agents turned cautious as the debt farce deepened. But, then again, the Fed would simply argue they need to see how much of that caution is quickly reversed.

Now, they could turn their attention the the household survey, and note that both labor force participation rates and the employment to population ratio continue to decline. But they could attribute these effects to largely structural causes, and as such beyond their purview. This too would also argue against any significant change in policy.

The implied inflation expectations from the TIPS market is 193bp and 225bp at the 5 and 10 year horizons, respectively. Still well above last summer's lows. The Fed has repeatedly argued they can't do anything about growth, but can fight deflation. But this doesn't appear to be a strong deflationary signal. This too argues against significantly policy shifts.

Financial market chaos argues for a shift in policy, but traditionally the Fed has resisted until the impact on actual economic activity becomes more evident. Again, an argument against looser policy.

On net, and with the benefit of the labor report in our back pocket, I think Neil Irwin at the Washington Post is most likely correct:

The Fed is holding its regular meeting on monetary policy next week, and leaders of the central bank will surely discuss the weakening outlook, whether they should do anything in response and what such a response might consist of. Their public statement following the meeting will likely reflect the worsening outlook for the economy, but they appear inclined not to make any policy changes until more evidence has become available and there has been more time to weigh it.

They will offer the possibility of further action, but none will be forthcoming next week. Now, all that said, I think the Fed should get ahead of this one - failure to do so has not yielded positive results in the past. But what the Fed should do and will do are two different things.

Friday, August 05, 2011

Fed Watch: That. Was. Unpleasant.

Tim Duy:

That. Was. Unpleasant., by Tim Duy: The rapidity with which confidence can shift is nothing short of a wonder of nature. I am not sure there was any terribly new news today. The evidence the US economy is weakening has been mounting for weeks. That equities had not sold off yet was something of a testament to the underlying profit situation.

But now fear grips financial market participants as the rush to cash or cash equivalents accelerated. A rush to judgment on the US economy? Felix Salmon tries to paint a positive picture:

Firstly, this is not necessarily a Bad Thing. If you’re saving for retirement, stocks are cheaper now, and your 401(k) contribution goes further than it did a few weeks or months ago. That’s good.

Secondly, if there ever were serious doubts about the USA’s creditworthiness, they’re gone now. The 10-year bond is yielding less than 2.5%: there are no worries in evidence there.

Put those two things together, and you can even be quite happy about today’s sell-off. If you’re a debtor rather than a saver, then falling interest rates are good for you. If you want to buy a house, then falling mortgage rates — not to mention falling home prices — are also good news. And if you want to invest in some wonderful future income stream, then money’s cheap right now to do so.

This seems to me to be a point in the recovery where you do not want the 10-year Treasury plunging to 2.41 percent. Felix offers a bit more pessimism:

Still, the future of the global economy is very uncertain, and southern Europe in particular is still far from any kind of sustainable resolution. The US economy has no particular exposure to Greece — but Italy is another matter entirely. This is a global sell-off, with European markets down just as much as those in the US; Asia’s sure to follow suit when it opens. Now that the Fed has stopped dropping dollar bills on the US economy, it’s hard to see where confidence and optimism are going to come from in the coming months.

Yes, will the Fed come to the rescue? Ryan Avent:

The good news is this: the Fed can't help but act. On Tuesday, I worried that the Fed would stand pat at its meeting next week, leaving the economy to dip into recession before it finally reacted in late August or following its September meeting. That no longer seems like the most likely outcome to me; events are moving too fast. Ben Bernanke may not announce a new policy next week, but I believe he will hint at new Fed easing—potentially at new purchases, but perhaps also at other available tools. The drop in inflation expectations should force the Fed's hand.

Inflation expectations are coming down, with the 5 year TIPS measure less than 2 percent but the 10 year TIPS measure is still 2.23 percent (down just 4bp from yesterday). Looking at the past week, I think Avent is on the right track – the Fed should be ready to get ahead of this mess, and next week is an opportune time. That said, the Fed has tended to be late in the game throughout the past few years. You have a lot of policymakers that need to fundamentally shift their intellectual framework to come to terms with a rapid shift in policy. And they could easily point to the 10 year implied inflation expectation and say it need to fall further before we will act. Same with the 5 year implied inflation expectation – it was bouncing along near 1.2 percent by late August last year.

In other words, it took considerably greater worries on the deflation front to prod the Fed into action last year.

In my view, Avent’s policy prescription is correct. For goodness sake, get ahead of this thing. Does another $200 billion on the balance sheet really matter that much? But the history of the last few years it this: They get to the right solution, but it takes some time. Now, one would think they learned some lessons in the last few years, and would tighten up the timeline. At the same time, though, one would have thought they learned their lesson from last years ill-timed turn toward hawkishness. Yet, they once again eagerly walked into that track this year as well.

The slow learning curve on Constitution Ave. argues against action next week. The reality of the world argued for action last month. Go figure.

Of course, the slowest learning curves are in Europe. Via the Wall Street Journal:

The euro zone’s inflation outlook has remained largely unchanged since the European Central Bank‘s July policy meeting, ECB President Jean Claude Trichet said Thursday, noting that he would not rule out further rate increases despite the ECB broadening its efforts to support fragile financial markets.

Speaking in a television interview with Dow Jones Newswires, Trichet said “our judgment is very much the same as in the previous meeting a month ago. We consider that we’re still in a situation where the risks are more on the upside… and that we will have to monitor the situation very closely.”

It speaks for itself. With policymakers across the Atlantic seemingly oblivious to their own dire situation, the fear gripping financial markets is completely understandable.

Bottom Line: The market nosedive does not yet guarantee Fed action in the near future. History has shown the Fed tends to react with a lag. They should have learned better by now, but if they had learned anything, they would not have pushed forward with hawkish rhetoric earlier this year. Arguably, they will hold firm, let the markets think they are out of the game and further bid down implied inflation expectations, and then, once the damage is done, up the level of stimulus. Terrible way to run an economy, I know. Still, it would be remiss to declare anything is certain before the employment report is released. A downside surprise could promt the Fed into more rapid action. I am now entirely speechless on the European situation – with Trichet's ongoing hawkish stance, it has truly devolved into one of those slow-motion train wrecks that one only sees in the movies.