Category Archive for: Monetary Policy [Return to Main]

Tuesday, January 25, 2011

Fed Watch: The “Recalculating” Debate

Tim Duy:

The “Recalculating” Debate, by Tim Duy: The fundamental nature of the recession continues to be debated – a debate with important policy consequences. Is the recession the consequence of a general aggregate demand deficiency, or is it a structural consequence of the housing bubble? If the former, the policy approach should be to support aggregate demand via a combination of fiscal and monetary policy. If the latter, only time will resolve the challenge, and aggressive policy will only lead to inflation.

David Beckworth and Ryan Avent provide nice summaries of the nature of the debate. Paul Krugman argues that the answer is obviously a demand shortfall, and bemoans:

Now, however, we’re seeing a much more widespread attack on demand-side economics. More than that, it’s becoming clear that many people don’t so much disagree with the idea that demand matters as find it abhorrent, incomprehensible, or both.

Nick Rowe offers an alternative explanation:

For decades my job has been to teach students that, despite the evidence of their senses, and contrary to their hearsay of the heretical teachings of the Keynesian Cross, aggregate output is basically supply-determined. Which it is. Basically. Though short-run fluctuations in demand can and will cause short run fluctuations in aggregate output around an average level that is determined by the supply-side.

And, for once, the memories of their parents are actually supporting me in my job. Look what happened in the 1970's, when demand increased. Printing too much money and increasing demand really did cause inflation. It really didn't make us all richer. It didn't reduce unemployment.

Now, just for once, we have to switch gears. These times are not normal. Just for once, the demand side really is the problem. Just for once, the overly obvious truth your senses are telling you really is the truth. Just for once, your parents' experience of the 1970's doesn't apply. Just for once, it really is OK to have a drink, even though you are a recovering alcoholic.

In some sense, economists diluted the reasoning of demand side macroeconomics with a focus on supply side factors. The Great Moderation only served to entrench the supply side view – after all, by the late-90’s I recall articles suggesting that we had conquered the business cycle. Demand side fluctuations had become a thing of the past.

I would offer another observation. I agree that the issue is a shortfall in demand. And not just for this recession, but arguably the entire last decade. That said, I think it is easy to lose sight of this demand shortfall in light of another feature of the past two business cycles. Both appear to have been inexorably connected to asset price bubbles, first in information technology and then in housing:


Supporting sufficient aggregate demand to maintain full employment looks to have required supporting relative levels of net worth well above a decades-long baseline. And pushing net worth to those levels was a consequence of asset price bubbles. Hence, it appears that the demand generated by that wealth was “fake.” Moreover, that “fake” demand arguably induced a supply side effect by pushing capital first into information technology and then into housing. To be sure, ultimately the impacts of such capital misallocations will fade away. Information technology depreciated rapidly, and the excess housing stock will eventually be absorbed by a growing population. It is not quite obvious, however, why this adjustment needs to extend to such a large portion of the workforce. The answer, I think, is not the housing adjustment itself, but the loss of general demand precipitated by the housing decline and subsequent balance sheet malaise.

The wealth-supported demand surely was not “fake,” as real goods and services were indeed purchased. But it was ephemeral, evaporating with the popping of bubbles. So it should be of little surprise the Federal Reserve is viewed by some as doing nothing more than supporting another round of “fake” demand. Fed officials probably compound this problem by citing the stock market increase as evidence that QE2 is working. Via the Wall Street Journal:

In recent weeks, the Federal Reserve has been turning to an unusual metric to prove the potency of its bond-buying program: the stock market.

Comments from Fed Chairman Ben Bernanke and other officials, as well as research by the central bank, cite rising stock prices as a sign that the central bank’s $600 billion bond-buying program is working to bolster the economy.

Of course, it is perfectly reasonable for officials to note that high equity prices signal improving economic prospects, the latter a consequence of their policy stance. Some, however, may interpret this as further evidence that the Fed is simply trying to create another asset price bubble, which will, if history is any guide, will also prove to be fleeting. The resulting aggregate demand will then be viewed as “fake.” In this light, the Federal Reserve is not really fixing anything, just papering over the underlying problem.

In short, I appreciate hesitation to embrace “more money” as a solution when it appears that “more money” was part of the problem. Indeed, I used to be more sympathetic to that notion than I am now.

But what exactly is the underlying problem? Or is there an underlying problem? I don’t know that we have agreement on that. Why was the US economy dependent on asset bubbles to spur demand over the past decade, and will the same be true for the next decade? Is the Fed’s current policy stance destined to fuel another bubble? I don’t think that is a excuse to forego monetary and fiscal support – the alternative of ongoing high unemployment is not particularly enticing – but I think we would all feel a bit more comfortable if the next decade sees robust growth without an asset price bubble.

Are Low Rates A Subsidy to Banks?

Paul Krugman responds to (and disagrees with) Axel Leijonhufvud:

Are Low Rates A Subsidy to Banks?, by Paul Krugman: Mark Thoma sends us to Axel Leijonhfvud, who declares that

The Fed is supplying the banks with reserves at a near-zero rate. Not much results in bank lending to business, but banks can buy Treasuries that pay 3% to 4%.

This hefty subsidy to the banking system is ultimately borne by taxpayers. Neither the subsidy, nor the tax liability has been voted for by Congress.

This is a common view. But it misses the key point, which is maturity: short-term rates are near zero, while those 3-4 percent Treasuries are long-term.

Here’s a stylized picture:


Short rates will (and should) remain low until the economy recovers substantially; thereafter, they’ll rise as we get closer to full employment. Long-term rates are, to a first approximation, the average future expected short-term rate — because investors choose whether to park their funds short-term or buy long bonds based on which they think will yield more over the next 10 years.

So what can we say about a bank that gets short-term deposits or loans and puts the money into long-term Treasuries? Yes, it’s earning more interest now than it’s paying. But it’s also tying up funds in long-term assets; if and when short rates rise, it will either find itself paying more interest than it receives, or have to sell those long-term bonds at a capital loss. There’s no subsidy here.

Now, there is a question about reported earnings: do rosy numbers on bank earnings take into account the likely future losses on those long-term bonds? I suspect not, or at least not sufficiently — which means that reports of the revival of the financial sector are exaggerated, as are bonuses. But that misreporting is the issue — not the alleged subsidy to the banks.

"Zero-Interest Policies as Hidden Subsidies to Banks"

Axel Leijonhufvud argues that political independence of central banks is "impossible to defend in a democratic society":

Shell game: Zero-interest policies as hidden subsidies to banks, by Axel Leijonhufvud, Vox EU: The two pioneers of modern monetary economics – Irving Fisher and Knut Wicksell – were passionately concerned to find monetary arrangements that would insure against arbitrary redistributions of income and wealth. They saw such distributive effects as offenses against social justice and consequently as a threat to social and political stability. 

Fisher and Wicksell thought that price level stability was a sufficient condition for avoiding distributive effects. In this they were in error. A hundred years later, the motivating concern for their work has long since disappeared from monetary economics.

But the error survives. For example:

  • The Fed is supplying the banks with reserves at a near-zero rate. Not much results in bank lending to business, but banks can buy Treasuries that pay 3% to 4%.
  • This hefty subsidy to the banking system is ultimately borne by taxpayers. Neither the subsidy, nor the tax liability has been voted for by Congress.

The Fed policy drives down the interest rates paid to savers to some small fraction of 1%. At the same time, banks leverage their capital by a factor of 15 or so, thus earning a truly outstanding return from buying Treasuries with costless Fed money or very nearly costless deposits.

Wall Street bankers are then able once again to claim the bonuses they became used to in the good old days and to which they feel entitled because of the genius required to perform this operation. These bonuses are in effect transfers from tax-payers as well as from the mostly aged savers who cannot find alternative safe placements for their funds in retirement.

The shell game: “Now you see it, now you don’t.”

The Fed’s low-interest-rate policy has turned into a shell game for the general public who are unable to follow how the money flows from losers to gainers.

  • The bailouts of the banks during the crisis were clear for all to see and caused widespread outrage; now the public is being told that they are being repaid at no cost to the taxpayer.
  • What the public is not told is that the repayments come to a substantial extent out of revenues paid by taxpayers for the banks to hold Treasuries.
  • Both parties supported the bailouts so neither party seems ready to protest the claim that they are being repaid at no cost to taxpayers.

The goals of monetary policy

Present monetary policy achieves two aims.

  • One is to recapitalize the banks and to do so without the government taking an equity stake.

The authorities do not want to be charged with “nationalization” or “socialism.” So the banks have to be given the funds outright. Economists have agonized a lot lately about the zero lower bound to the interest rate as an obstacle to effective policy in the present circumstances. The agony seems misplaced. As long as the big banks are to be subsidized, why not just pay them to accept reserves from the friendly central bank?

  • The second aim, of course, is to prevent the housing bubble from deflating all the way.

In this respect, the policy has had some effect. Homeowners whose houses are not “under water” can often refinance at long-term rates around 5% and sometimes even lower. 

Miscalculation of economic values: Who pays?

Any financial crash reveals a large, collective miscalculation of economic values. The incidence of the losses resulting from such miscalculations has to be worked out before the economy can begin to function normally again. Because the process of a crash is unstable, it cannot be left for the markets and bankruptcy courts to work out the eventual incidence. In the present case, doing so would simply have led into another Great Depression.

This means political choices have to be made to determine who bears the losses from this collective miscalculation. Obviously such choices are terribly difficult. Yet, temporizing can prolong the period of subnormal economic performance indefinitely – as the history of Japan over the last 20 years illustrates. The shell game, as presently played, is in effect an attempt to settle a large part of the incidence problem “under the radar” of public opinion.

The risks of this quiet bank subsidy

Quite apart from its distributional effects, the policy is not without risk.

  • To the extent that it succeeds in inducing the banks to load up on long-term, low-yield assets, a return to more normal rates will spell another round of banking troubles.

If the US were to suffer years of slow deflation, a return to higher rates will be long postponed. At present, strong deflationary pressures are kept at bay by equally strong inflationary policies. If the US escapes the Japanese syndrome, the Fed will sooner or later have to raise rates to stem inflation or to defend the dollar.

Central Bank independence?

For the last 20 or 30 years, political independence of central banks has been a popular idea among academic economists and, of course, heartily endorsed by central bankers. Such independence has not been much in evidence in the recent crisis. But central banks would very much like to restore their independence.

The independence doctrine, however, is predicated on the distributional neutrality of their policies. Once it is realized that monetary policy can have all sorts of distributional effects, the independence doctrine becomes impossible to defend in a democratic society.

Monday, January 24, 2011

Fed Watch: Inevitable Inflation Fears

Tim Duy notes rising concern about inflation from hawkish central bankers in Europe and elsewhere, and the tension that is building "as emerging markets fight the Fed":

Inevitable Inflation Fears, by Tim Duy: The Wall Street Journal is reporting that ECB head Jean-Claude Trichet is turning increasingly hawkish:

Inflation fears—fueled by spiraling food, oil and raw material prices—are mounting around the globe, prompting the head of the European Central Bank to signal that it could raise interest rates in the future even though some countries have been weakened by the Continent's debt crisis.

In an interview with The Wall Street Journal ahead of this week's annual meeting of the World Economic Forum in Davos, Switzerland, Jean-Claude Trichet warned that inflation pressures in the euro zone must be watched closely, and urged central bankers everywhere to ensure that higher energy and food prices don't gain a foothold in the global economy…

An interesting development in light of the ongoing (or is it never ending?) European Debt Crisis. Rate hikes will just be adding insult to injury for the peripheral nations already struggling with a debt-deflation spiral. The price for being part of the Euro just keeps getting higher.

Inflation fears have yet to grip the Federal Reserve, for good reason. Back to the Wall Street Journal:

While high unemployment and spare capacity are restraining underlying inflation pressures in the U.S. and elsewhere in the developed world, annual inflation in China is almost 5%—and a sizzling 9.8% economic growth rate in the fourth quarter triggered fears of more price pressures ahead. Inflation in Brazil is even higher.

The next inflation crisis is not occurring in the US, as opponents of QE2 thought likely, but in the developing markets instead. To be sure, my sympathy for developing nations wore thin long ago. They will identify the Federal Reserve as the proximate cause of their problems, whereas they have only themselves to blame. Higher inflation abroad was the only outcome if the protocols of Bretton Woods II did not submit to the onslaught of QE2. And the Federal Reserve has very good reason to keep the pedal to the medal. A review of recent inflation behavior:

If inflation abroad is a problem, it is not because the Federal Reserve has set rates too low, but because emerging markets been unwilling to allow their currencies to appreciate sufficiently against the Dollar. See, for example, recent Dollar buying on the part of Brazil. See also Paul Krugman, who illustrates the clear difference in emerging and developed nation industrial production trends. Again, if inflation abroad is a problem, it is one that emerging markets need to tackle themselves.

Expect global tensions to continue building as emerging markets fight the Fed. While the Fed may identify higher commodity prices as a potential concern, policymakers are not likely to reverse course and tighten policy unless higher commodity prices push through to core inflation. Such an outcome appears unlikely given persistently high unemployment. Consider too that the likely outcome of rising commodity prices is to slow US growth, thereby decreasing the odds of pass-through to core.

I have said this before – I do not see how this ends well. Given that the Fed is not likely to back down from this fight, emerging markets need to put the brakes on their internal inflation issues, the sooner the better. Otherwise they will be facing pain of a real inflation crisis, one that requires stepping on the brakes even harder. How this story unfolds this year will determine of the global economy can transition to a sustainable, balanced growth trajectory, or plunges into yet another of the seemingly all-too-frequent crises.

Sunday, January 16, 2011

Fed Watch: Housing and the Fed in 2005

Tim Duy:

Housing and the Fed in 2005, by Tim Duy: The Federal Reserve released the 2005 FOMC transcripts this week. Attention quickly turned to the Fed's view of the growing housing bubble. Calculated Risk finds some very prescient warnings from then Atlanta Fed President Jack Guynn, who describes housing as an "accident waiting to happen." Bloomberg continues with the obvious path of criticism:

Federal Reserve staff and policy makers identified a housing bubble in 2005 and failed to alter a predictable path of interest-rate increases to slow down the expansion of mortgage credit, transcripts from Open Market Committee meetings that year show.

Led by then-Chairman Alan Greenspan, the FOMC raised the benchmark lending rate in quarter-point increments to 4.25 percent from 2.25 percent at the end of December 2004. The committee also removed uncertainty about the pace of rate increases by telegraphing that future moves would be “measured” in every statement.

The “measured” pace language helped fuel the housing boom by keeping longer-term interest rates low and was inappropriate at the time given the uncertainties about both inflation and asset prices, said Marvin Goodfriend, a professor at Carnegie Mellon University in Pittsburgh.

“It was a major mistake of the Fed,” said Goodfriend, who attended some of the 2005 meetings as a policy adviser to the Richmond Fed. “It gave markets a sense that the Fed was on top of everything to a degree that wasn’t the case. It gave the impression that this was a mechanical adjustment to normality. The market was overconfident.”

David Beckworth follows up:

With the release of the 2005 FOMC transcripts we learn that the Fed was aware of the housing boom but failed to alter monetary policy. Among other damning evidence, we find this gem in the December 2005 FOMC meeting. It shows the real federal funds rate compared to the Fed's estimate of the equilrium or neutral real federal funds. There is a striking gap that emerges during the early-to-mid 2000s. This indicates the Fed was highly accommodative and aware of it.

The problem with this criticism is that it fails to capture the implications of the low interest rate environment for the economy at large. Andy Harless, in a response to Beckworth, beats me to the punch:

I just don't get how this Fed-too-easy story is consistent with the data on NGDP growth. From 2001 to 2006, NGDP grew at an annual rate of 5.3%. That's actually slightly slower than the prior 5 year period (5.4%) or the 5 years before that (also 5.4%). If the Fed was too easy in 2002-2003, then that period should have been followed by a huge boom in NGDP. It wasn't. All that happened was that NGDP grew (almost) fast enough (about 6% annually) to make up for the slow growth during the recession and the year of weak recovery that followed. As far as I can tell, the data vindicate the judgment of Fed officials who ignored the model-based estimates.

Looking back at the path of nominal GDP over the last decade:


Considering the path of employment, output, and prices, I have difficulty arguing that the level of rates was significantly wrong. I tend to think that regulatory failure was the primary Fed error - if the Fed realized the housing market was evolving into a bubble, shouldn't they have been more focused on the kind of mortgage lending that was taking place? Shouldn't, in their jobs as banking regulators, made more aggressively us of stress tests before housing prices began to melt? More directly, from a regulatory perspective, the Fed simply lost view of its societal function. Via Rajiv Sethi:

But even in our very imperfect world, might we not have been able to stabilize output and employment by returning quickly and forcefully to the original mandate of the Federal Reserve, to channel credit preferentially to productive uses?

The Fed was probably too captured by a free markets ideology to seriously question the wisdom of channeling so much capital into housing, which was really less about capital investment and more about consumption. And, in their defense, attempting to direct capital flows is indeed tricky business fraught with peril. But allowing everybody and their cousin to get a half million dollar mortgage with no income documentation? Addressing that issue seems like it should have been doable.

Still, rather than lay all the blame at the feet of monetary policymakers, I think the real question we still need to resolve is more fundamental. Turning the question around, why did the US economy struggle so dramatically this decade that the Fed was pushed into a very low interest rate environment? The jobs record is simply unprecedented - a decade with no job growth. To what extent are domestic policymakers to blame? And was it domestic policy at all? I don't recall the 1970's as a policy paradise, but at least jobs were created over that decade. Answers will vary; mine is that US policymakers across the ideological spectrum allowed and even supported the pursuit of foreign nations' mercantilist policies on a unprecedented scale, thereby distorting global patterns of production and consumption in a way that fundamentally hobbled the US economy. If this is true, how can we chart a path back?

In short, I think we need to understand why the last decade was jobless - it is tempting to blame the Fed, but the story is likely deeper. Until we do, I don't think I can definitively say the next decade will be any different.

Friday, January 14, 2011

Fed Watch: A Mixed Bag of Data

Tim Duy:

A Mixed Bag of Data, by Tim Duy: Today's data flow suggests ongoing expansion, but should also send a note of caution. Industrial activity continues to respond to firming demand, but capacity has yet to show solid gains. Firms are still not sufficiently confident, or lack sufficient demand, to justify widespread investment. Similarly, consumer spending continues along its upward trend, although the increase in energy costs are likely constraining the pace of that growth and keeping a lid on consumer confidence. Something of a mixed bag largely consistent with the general consensus view.

Start with the better than expected industrial production report, via Bloomberg:

Industrial production in the U.S. rose in December more than forecast, boosted by gains in business equipment and home electronics that indicate factories remain at the forefront of the recovery as the new year begins.

Output at factories, mines and utilities climbed 0.8 percent, the most in five months, after a revised 0.3 percent increase in November, figures from the Federal Reserve showed today in Washington. Economists forecast a 0.5 percent gain, according to the median of 82 projections in a Bloomberg News survey. Manufacturing climbed 0.4 percent, and utility output increased 4.3 percent as snowstorms swept parts of the nation.

I have taken to looking at the capacity data for signs of a solid, self-sustaining recovery. Here we see the most tentative signs of improvement, or at least stabilization:


Looking back at the decade, capacity gains really took hold in late-2004 as the economy finally shook off the post tech-bubble doldrums on the back of the building housing bubble:


Before one gets too excited at the possibility, we can take a look back at the pace of progress during the 1990s.


We should be hoping for a recovery more like the 1990s than the 2000s, but it is challenging to find a story that allows for that kind of growth. I am not even sure how we get the recovery of the 2000s without an asset price bubble.

Moving on to retail sales, the numbers fell short of the outsized expectations that developed in the run up to the Christmas season. Still, the overall trend looks intact:


That said, I think you get a cleaner picture of underlying consumer trends by stripping out auto related sales:


Here the rebound looks less impressive, but the trend remains in the right direction. That said, there was a noticeable decline in the rate of monthly growth during the final quarter, 0.77%, 0.59%, and 0.36% for October, November, and December, respectively. I think it is safe to say that the consumer has some momentum, especially with rising nonfarm payrolls, but higher energy prices are likely to constrain the pace of growth going forward.

Similarly, rising energy costs were a culprit behind the decline in consumer confidence. And those higher costs clearly showed up in the consumer price index. Bloomberg has a curious introduction:

The cost of living in the U.S. climbed more than forecast in December, led by higher fuel and food prices, while other goods and services showed the smallest annual increase on record.

Looking at the the CPI release, one gets something of a different story:

The energy index increased in December. The gasoline index rose sharply and accounted for about 80 percent of the all items seasonally adjusted increase. The household energy index, which declined in November, increased as well. The food index increased slightly in December, with the fruits and vegetables index rising notably.

The headline increase was driven by energy, not food as Bloomberg reports. Core prices increased just 0.1% for the month and 0.8% compared to last year. So far, higher energy/commodity prices have yet to work their way through to final prices, not surprising given persistently weak labor markets and consistent with the Beige Book story.

Finally, Richmond Fed President Jeffrey Lacker offered up the possibility of reviewing the large scale asset purchases:

“While the outlook may not have improved enough yet to warrant adjusting our purchase plans in the near-term, I anticipate earnest re-evaluation as economic developments unfold in the months ahead,” Lacker said today in prepared remarks of a speech in Richmond, Virginia.

I am not surprised that some policymakers would point to better data as a reason to reevaluate the program. But I would think about the timeline on this. Lacker says describes the process in the months ahead. But how many months do we have left? The current program is expected to end by the second quarter of this year, just about 5 months. Unless growth explodes, by the time FOMC members would feel comfortable disrupting the plan, it will be almost complete anyway. Even other traditionally hawkish policymakers expect the plan to concluded as planned.

Bottom Line: Data generally in line with a sustainable growth, but expectations that the economy is about to take off remain premature. Inflation fears still appear overblown given that inability to pass higher commodity prices through to consumers. Energy prices, however, do appear to be constraining consumer spending. Overall better data will continue to be reflected in Fedspeak, but time is running short to change the current asset purchase program.

Fed Watch: Shifting to Autopilot

Tim Duy:

Shifting to Autopilot, by Tim Duy: Incoming data this week suggest the US economy continues to meander on its upward path, albeit at a rate that is decisively lackluster, at least relative to the magnitude of the output gap. That path of growth guarantees the Fed completes the current large scale asset purchase program. But soon we will have to turn our attention to what comes next. The baseline scenario is that the Fed holds pat - holding the balance sheet steady for the remainder of 2011, a scenario endorsed by at least two policymakers this week. Still, we should continue to challenge this assumption. Considering the expected slow improvement in labor markets and tame inflation, will the Fed consider extending asset purchases beyond the most recent $600 billion? Probably not.

Thursday we saw some reminders that the path to recovery is not a straight line. First, initial unemployment claims retraced some of the recent declines. Mark Thoma has the story here. To be sure, given the noise in this series, one week of data contains limited information. In general, the downward trend remains intact. Still, it argues against expectations the job market is set to rocket forward.

Housing news continues to tell the same old story. The record level of foreclosures in 2010 is not expected to be a record for long, while more evidence collects that housing prices are still falling. That said, housing is an old story. Nothing to see here folks, please move along.

More importantly, the trade data also was not as supportive as one could hope. While the nominal deficit improved in November, the real deficit deteriorated slightly in contrast to October's significant improvement. Still, barring a surprise deterioration in December, the external accounts should contribute positively to 4Q10 growth. To be sure, this adds to the positive momentum heading into 2011, but one quarter is not enough to break the general downward trend of 2010. The combination of high unemployment and a lack of clear direction on rebalancing of global activity promises to keep the threat of global trade wars alive. US Treasury Secretary Timothy Geithner rattled the sabers this week to keep pressure on his Chinese counterparts. From the Wall Street Journal:

"We are willing to make progress" on issues of interest to China, Mr. Geithner said at Johns Hopkins University's School for Advanced International Studies, "but our ability to move on these issues will depend on how much progress we see from China," including a faster appreciation of the Chinese currency.

To be sure, I question whether Geithner is truly committed to global rebalancing. A reminder from Bloomberg:

U.S. Treasury Secretary Timothy F. Geithner said he has continued to support the strong dollar policy he helped craft in the Clinton administration when he worked for his predecessor Robert Rubin.

“That particular phrase and commitment of policy was first written in my office at the Treasury Department in 1995,” Geithner said today, when asked about the currency during a Senate Finance Committee hearing.

Sorry, don't mean to be skeptical, but I am sensing mixed messages. The resolution, of course, is that the appropriate policy direction is one of managed exchange rate depreciation - no sudden stops of capital, please. On this point, Geithner talks a good game:

Geithner said he agreed that the U.S. needs to show commitment to lowering its deficits over time, to avoid losing the confidence of investors around the world. That could hurt the economy, raise interest rates and reduce investment, the Treasury chief said.

“If we do not make people believe that we are going to fix those deficits, bring them down over time, then we will risk losing confidence in our financial future,” Geithner said.

Something of a Catch-22, I fear. Sustaining confidence in US markets means resolving long term US fiscal issues, but there is no pressing reason to address those issues in the absence of a loss of confidence.

Ultimately, I fear that should the Dollar fall enough to provide a significant boost to the US economy, it will also be enough to rattle Wall Street. I hate to say it, but I suspect should that point be reached, Washington will choose Wall Street over Main Street. Pessimist or realist? Of course, the ongoing European crisis suggests this is not a problem anything soon, as the uncertainty helps prop up the Dollar. I imagine US policymakers are in an uncomfortable place (or at least should be) on that topic. They probably want to see the Euro remain intact, rather than risk the impact of a rapidly appreciating Dollar. Of course, that means forcing a debt-deflation spiral on the periphery nations. Doesn't seem quite right.

Warts aside, forecasters continue to upgrade their expectations for US growth. From the Wall Street Journal:

Economists have steadily grown more upbeat about growth in recent months and boosted their estimates for the fourth quarter of 2010 in this survey. On average, respondents now estimate the U.S. grew 3.3% at a seasonally adjusted annual rate in the fourth quarter—up from an estimate last month of 2.6% growth. The economy grew 2.6% in the third quarter.

Amid the stronger growth forecasts, economists now expect the U.S. to generate nearly 180,000 jobs a month on average this year, significantly more than last year's average of 94,000. But with continued population growth, that isn't nearly enough to quickly bring down the unemployment rate, now at 9.4%. By the end of 2011, the economists, on average, expect the jobless rate to be 8.8%.

Federal Reserve Chairman Ben Bernanke shares a similar view:

“We see the economy strengthening,” Bernanke said as part of a panel discussion on boosting lending to small businesses. “It looks better in the last few months. We think that a 3 to 4 percent-type of growth number for 2011 seems reasonable.”

“Now you’re not going to reduce unemployment at the pace that we’d like it to,” Bernanke said. “But certainly it would be good to see the economy growing. That means more sales, more business for companies of all sizes.”

So, let's establish 3 to 4% as the Bernanke Baseline, which would be above trend growth, but, as Bernanke reiterates, still imply painfully slow improvements in the unemployment rate. Still, above trend it is, and that suggests to me that extending the current asset purchase program would meet a great deal of internal resistance. True to form, Dallas Federal Reserve President Richard Fischer, now a voting member of the FOMC, appears opposed to additional action:

The entire FOMC knows the history and the ruinous fate that is meted out to countries whose central banks take to regularly monetizing government debt. Barring some unexpected shock to the economy or financial system, I think we have reached our limit. I would be wary of further expanding our balance sheet. But here is the essential fact I want to emphasize today: The Fed could not monetize the debt if the debt were not being created by Congress in the first place...

...the key to correcting the underperformance of the American economy and American job creation does not rest with the Federal Reserve. It is in the hands of those who make fiscal and regulatory policy.

The Fed has reduced the cost of business borrowing to the lowest levels in decades. It has seen to it that liquidity is widely available to banks and businesses. It has kept the economy from deflating and it has kept inflation under control. This has helped raise the economic tide. Recent data make clear that the risks of a double-dip recession and deflation have ebbed and that economic growth and job creation are beginning to flow…

I don’t believe this has much to do with the Fed. None of my business contacts, large or small, publicly held or private, are complaining about the cost of borrowing, the lack of liquidity or the availability of capital. All express concern about taxes, regulatory burdens and the lack of understanding in Washington of what incentivizes private-sector job creation. All are stymied by a Congress and an executive branch that have appeared to them to be unaware of, if not outright opposed to, what fires the entrepreneurial spirit. Many have begun to feel that opportunities for earning a better and more secure return on investment are larger elsewhere than here at home.

Colorful, as always. I have to admit enjoying Fischer's speeches, at least for their entertainment value. Still, he is not immediately worried about inflation:

The policy maker said he saw some evidence that firms are trying to push through price increases, and added commodity prices are on the rise mostly on strong global demand factors. But he also allowed that the Fed’s easy money policy may be contributing to some of the gains. That said, Fisher is not worried about inflation, saying “I don’t see inflation presently” or in the “immediately foreseeable future.” Instead, policy makers’ problem “is getting the economy moving again.”

No time to halt current policy. This repeats the story of the Beige Book:

Most District reports mentioned increasing prevalence of cost pressures but only modest pass-through into final prices because of competitive pressures.

Pushing through hirer prices remains a challenge. Another FOMC member who spoke up on the asset purchase program was now voting member Philadelphia Fed President Charles Plosser:

Charles Plosser, president of the Federal Reserve Bank of Philadelphia, was the latest to signal a desire for continuity from the Fed, even though he is highly skeptical of the program's effectiveness. "I wish we hadn't done it, but that doesn't mean I want to stop it right now," Mr. Plosser said in an interview with The Wall Street Journal...

...In a separate interview with The Wall Street Journal, Mr. Fisher said, "I would not have voted for QE2 had I been a voting member" last year.

Neither Fischer nor Plosser would be willing to call an end to the current program, but with growth above trend, both would likely dig in their heals against additional action. I don't think they would be alone. Remember, the Fed was hesitant to act further last summer, clinging to forecasts of solid growth. It was only the mid-year slowdown and its threat of a double-dip that pushed them into action. If Bernanke's current forecast is realized, it is difficult to see where the support would come from to prompt another round of easing.

Bottom Line: The data still is not perfectly clean. That said, forecasts for 2011 are firming, both within and outside the Fed, and pointing toward above trend growth. Nothing spectacular, to be sure, which will keep up the pressure on the Administration to address high unemployment. That promises continued verbal support of external rebalancing from Treasury. On the monetary front, Bernanke will have plenty of support to continue the current policy, but the FOMC will be wary about further easing. At the same time, the current constellation of growth, inflation, and unemployment rates argues against any tightening in the near term. Policy is thus likely to shift to autopilot.

Monday, January 10, 2011

Arizona Shooter's Obsession with Returning to the Gold Standard

The editors at CBS MoneyWatch asked my to discuss Jared Lee Lougher's views on the gold standard, and whether his call to return to the gold standard is entirely crazy. They thought that there might be "value in giving some context on his views and noting that he's not alone in holding them":

Arizona Shooter's Obsession with Returning to the Gold Standard

Fed Watch: Are Oil Prices About to Undermine the Recovery?

Tim Duy:

Calculated Risk directs us to an LA Times story identifying the possibility that rising gasoline prices will undermine the recovery. He also reminds us that James Hamilton recently wrote on the subject as well, concluding:

I could certainly imagine that an abrupt move up in gasoline prices from here could hurt the struggling recovery of the domestic auto sector and dampen overall consumer spending. I do not think it would be enough to give us a second economic downturn, but it could easily be a factor reducing the growth rate.

I would add that the current price appears inline with the general upward trend since the beginning of last decade. Here I extrapolated on the 2000-2006 trend:

New Picture
The sudden rise in oil in 2007, a clear deviation from the trend in the first half of the decade, led to substantial demand destruction, a severe blow to the US economy which at the time was struggling under the weight of the housing meltdown and the financial crisis (and arguably still is). The recent rise in oil appears different, more a reestablishment of the previous trend.

From this point on, I tend to think the issue is less of will oil continue to rise, but at what speed will it rise. The trend over the last decade appears to make a lie of recent claims that we have entered into a period of plentiful energy (see also James Hamilton), and while higher oil prices will tend to crimp growth, a gradual price increase should allow for non-disruptive adaptation on the part of economic agents.

What I more concerned with is the possibility of another sharp spike in prices, such as occurred in 2007-08. A repeat of that incident would once again cripple households, who, after 18 months of recovery, are just barely starting to see the light. The most obvious channel to trigger such a spike is monetary, that the Federal Reserve's large scale asset purchases trigger a disruptive decline in the Dollar. Federal Reserve Chairman Ben Bernanke was not buying that story last week. From the Wall Street Journal:

Mr. Bernanke says his quantitative easing policy is not to blame for the sharp increase in the price of oil. Instead, oil’s rise is the result of strong demand from emerging markets. The dollar, he notes, has been “quite stable” in the past few months. One worry in the run up to the Fed’s $600 billion bond-buying announcement in November was that it was going to cause the dollar to fall sharply, which would in turn put upward pressure on commodities like oil priced in dollars. The stable dollar, which has risen since the program’s announcement, implies the Fed isn’t the problem in commodities markets, Mr. Bernanke notes.

Movements in commodity prices have not been sufficiently disruptive to suggest a Fed-induced cause is at hand, and have tended to be more consistent with indications of general economic improvement.

In short: Energy prices are yet another thing to keep an eye on. Still, recognize the increase to date appears to be more of a return to the recent trends than a disruptive price spike. Not that rising prices won't have consequences, but the trend of the past decade may simply be something we need to learn to live with. Rather than watching the trend itself, be watching for upward spikes from that trend - those would almost certainly translate into something nasty for the still struggling US economy.

Saturday, January 08, 2011

"What is the Treasury Up To?"

Stephen Williamson:

What is the Treasury Up To?, New Monetarist Economics: As I pointed out here, the QE2 Treasury security purchases by the Fed have actually had little effect on the stock of outside money, principally because there have been large inflows into the Treasury's General Account at the Fed. That continues to be the case. The ... Fed's stock of securities has increased about $122 billion since the QE2 program began in November 2010. However,... we see modest increases in currency and reserves.  Since early November, the increase in currency is about $18 billion, and in reserves only about $10 billion. The ... Treasury accumulated $81 billion in its General Account over the same period.

In its General Account and Supplementary Financing Account with the Fed, the Treasury now holds a total of about $315 billion. ...[I]f you thought that some of the effects of QE2 might come through effects on the stock of outside money (e.g. increases in the currency stock as banks dump the extra reserves), there is not that much of that happening.

"Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?"

An interesting new paper from Hess Chung, Jean-Philippe Laforte, and David Reifschneider of the Board of Governors, and John Williams of the SF Fed:

Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?, by Hess Chung, Jean-Philippe Laforte, David Reifschneider, and John C. Williams, January 7, 2011: Abstract Before the recent recession, the consensus among researchers was that the zero lower bound (ZLB) probably would not pose a significant problem for monetary policy as long as a central bank aimed for an inflation rate of about 2 percent; some have even argued that an appreciably lower target inflation rate would pose no problems. This paper reexamines this consensus in the wake of the financial crisis, which has seen policy rates at their effective lower bound for more than two years in the United States and Japan and near zero in many other countries. We conduct our analysis using a set of structural and time series statistical models. We find that the decline in economic activity and interest rates in the United States has generally been well outside forecast confidence bands of many empirical macroeconomic models. In contrast, the decline in inflation has been less surprising. We identify a number of factors that help to account for the degree to which models were surprised by recent events. First, uncertainty about model parameters and latent variables, which were typically ignored in past research, significantly increases the probability of hitting the ZLB. Second, models that are based primarily on the Great Moderation period severely understate the incidence and severity of ZLB events. Third, the propagation mechanisms and shocks embedded in standard DSGE models appear to be insufficient to generate sustained periods of policy being stuck at the ZLB, such as we now observe. We conclude that past estimates of the incidence and effects of the ZLB were too low and suggest a need for a general reexamination of the empirical adequacy of standard models. In addition to this statistical analysis, we show that the ZLB probably had a first-order impact on macroeconomic outcomes in the United States. Finally, we analyze the use of asset purchases as an alternative monetary policy tool when short-term interest rates are constrained by the ZLB, and find that the Federal Reserve’s asset purchases have been effective at mitigating the economic costs of the ZLB. In particular, model simulations indicate that the past and projected expansion of the Federal Reserve's securities holdings since late 2008 will lower the unemployment rate, relative to what it would have been absent the purchases, by 1½ percentage points by 2012. In addition, we find that the asset purchases have probably prevented the U.S. economy from falling into deflation.

And, from the conclusions:

Continue reading ""Have We Underestimated the Likelihood and Severity of Zero Lower Bound Events?"" »

Friday, January 07, 2011

Fed Watch: More of the Same

Tim Duy:

More of the Same, by Tim Duy: The jobs report was a clear disappointment relative to both expectations at the beginning of the week and certainly after the blowout ADP report.  After adjusting expectations to the upside, ADP once again scores a major miss (how we came to care about this data series still remains a mystery to me).  That said, the overall tenor of fourth quarter employment reports suggest an economy growing around trend growth.  Better, but not good enough to prompt a policy response from the Fed.

The headline NFP gain was 103k overall, 113k private.  Consensus had been looking for something around 140k at the beginning of the week.  On the upside, the BLS revised up the October and November numbers, so that the average monthly NFP gain during the fourth quarter was 128k, pretty much right in the middle of the 100k to 150k estimates of growth required to keep a lid on unemployment.  And the unemployment rate did more than hold steady - it retreated, falling from 9.8% to 9.4%.  The improvement, however, is less positive than at first blush.  Persistently high unemployment continues to drive workers out of the labor force, illustrated by a fresh decline in the labor force participation rate:

New Picture 
The report internals were not particularly reassuring if one is still looking for the fabled V-shaped recovery.  Gains in wholesale and retail trade as well as transportation and warehousing   were consistent with the generally solid consumer spending news during the quarter.  But the biggest gainer was the ever consistent health care sector, which added 37.1k.  Something of a disappointment was the deteriorating trend in the rate of temporary help gains - the sector added just 15.9k jobs, down from 31.1k in November and  28.6 in October.  Weekly hours, both average and aggregate were unchanged, while hourly wage gains were a minimal 3 cents.

In short, nothing to change the direction of monetary policy, a point reinforced by Federal Reserve Chairman Ben Bernanke's Senate testimony today.  Although Bernanke begins with a nod to the recent data:

More recently, however, we have seen increased evidence that a self-sustaining recovery in consumer and business spending may be taking hold. In particular, real consumer spending rose at an annual rate of 2-1/2 percent in the third quarter of 2010, and the available indicators suggest that it likely expanded at a somewhat faster pace in the fourth quarter. Business investment in new equipment and software has grown robustly in recent quarters, albeit from a fairly low level, as firms replaced aging equipment and made investments that had been delayed during the downturn.

his ultimate conclusion remains unchanged:

Although it is likely that economic growth will pick up this year and that the unemployment rate will decline somewhat, progress toward the Federal Reserve's statutory objectives of maximum employment and stable prices is expected to remain slow. The projections submitted by Federal Open Market Committee (FOMC) participants in November showed that, notwithstanding forecasts of increased growth in 2011 and 2012, most participants expected the unemployment rate to be close to 8 percent two years from now. At this rate of improvement, it could take four to five more years for the job market to normalize fully.

Bernanke continued his defense of large scale asset purchases, explaining the importance of ongoing monetary easing given the persistent deviation of unemployment and inflation from the Fed's mandate.  He also emphasizes that this policy is ultimately temporary and not equivalent to unbounded government spending:

As I am appearing before the Budget Committee, it is worth emphasizing that the Fed's purchases of longer-term securities are not comparable to ordinary government spending. In executing these transactions, the Federal Reserve acquires financial assets, not goods and services. Ultimately, at the appropriate time, the Federal Reserve will normalize its balance sheet by selling these assets back into the market or by allowing them to mature.

Bernanke then places himself, again, in the middle of the fiscal policy debate.  Should this be the purview of the Fed Chair?  Does it invite Congress to meddle with monetary policy?  Is this a reflection of Bernanke's political affiliation, his desire to take sides with fellow deficit hawk Republican's?  Interesting that Bernanke continues the tradition of blaming retirees for the nation's fiscal challenges:

In subsequent years, the budget outlook is projected to deteriorate even more rapidly, as the aging of the population and continued growth in health spending boost federal outlays on entitlement programs. Under this scenario, federal debt held by the public is projected to reach 185 percent of the GDP by 2035, up from about 60 percent at the end of fiscal year 2010. 

By linking the aging population and health care costs in the same sentence, he sends the message that the old are sick and consequently the cause of the impending crisis.  I would have preferred that he explicitly separated rising health care prices we all face from the issue of the aging population. 

Bottom Line:   The employment report was lackluster, consistent with expectations the US economy is operating - sustainably - around trend growth.  The report was also consistent with the view that this just isn't good enough to rapidly alleviate the hardships imposed by the recession.  The lack of more dramatic improvement in labor markets keeps the idea of policy tightening off the FOMC's table, and while I can envision the Fed bringing a halt to large scale asset purchases when the current program is complete, given the employment and inflation data, I can't wrap my mind around a rate increase this year.

Wednesday, January 05, 2011

Fed Watch: Generally Positive

Tim Duy is "generally positive" about the economy, but still sees reasons to worry:

Generally Positive, by Tim Duy: Today's ISM nonmanufaturing headline figure provided further evidence the US economy left 2010 on firmer footing. Generally solid internals as well, with both production and new orders posting solid gains. Like its manufacturing cousin, the weak spot was employment, a critical determinant for the evolution of Fed policy this year.

In contrast, the ADP numbers were released with great fanfare, suggesting a 297k gain in private nonfarm payrolls. A potential blowout in the making given that expectations for Friday's employment report was 140k overall. However, a word of caution regarding the ADP figure via the Wall Street Journal:

But there is a seasonal quirk in the ADP number that may have inflated the December number. ADP and Macroeconomic Advisers do a seasonal adjustment that takes into account a typical December purge, where employers who have fired workers over the course of the year but don’t remove them from officials payrolls right away clear the rolls.
Ben Herzon of Macroeconomic Advisers explains: "If companies were laying off fewer employees throughout 2010 than had been the case in recent years, the amount by which the seasonal adjustment process subtracted from [ADP National Employment Report] growth last year through November was too great. Following the same logic, fewer layoffs through November implies fewer December purges than in recent years, so the boost to December employment growth to offset the normal December purge may have been too large."

On the inflation outlook, today's ISM release revealed a higher percentage of firms reporting higher prices. Firming demand may allow firms to pass on some of these cost increases to consumers, but as the Wall Street Journal notes, this isn't a bad outcome:

If higher commodities prices do trigger a small but manageable pickup in U.S. inflation, it will count as a success for the Fed’s extraordinary efforts to avoid the ravages of deflation that have beset Japan these past two decades.

Three additional factors likely to weigh on the Fed: Housing, state and local budgets, and Europe. From the FOMC minutes:

Others pointed to downside risks to growth. One common concern was that the housing sector could weaken further in light of the considerable supply of houses either on the market or likely to come to market. Another concern was the ongoing deterioration in the fiscal position of U.S. states and localities, which could lead to sharp cuts in spending and increases in taxes. In addition, participants expressed concerns about a possible worsening of the banking and financial strains in Europe, which could spill over to U.S. financial markets and institutions, and so to the broader U.S. economy.

Despite an improving revenue picture, state and local budgets are expected to fall short of what is necessary to maintain current service levels, especially given escalating wage and benefit costs. This is likely to remain a drag on growth - and jobs - until the governments realign spending and revenue growth trends. Nothing really new here, just an ongoing concern.

And, finally, Europe. Via CR, Europe looks to be heading to renewed crisis. It would appear that despite all the EU interventions, investors believe a day of reckoning is still at hand, that at most sovereign defaults have simply been pushed out three years. I find it difficult to see how the situation is resolved without an enhanced fiscal authority in Europe with the power to make transfers, not loans, from solvent to insolvent regions, the exit of some nations from the Euro, or some combination of these two. I wish that European leaders would see the light sooner than later rather than dragging us through two or three more crises.

Bottom Line: Data continues to be supportive, with at least one more hint of solid job growth to add to the improving trend evidence in initial claims. Still, the hole we are in is deep, not every piece of data has fallen into line, the positive trends are relatively recent, and at least three swords are still holding over the heads of FOMC members. The combination should keep policymakers clinging to the current stance of monetary policy, although even the more dovish will need to publicly recognize the more solid pattern of data sooner than later.

Tuesday, January 04, 2011

Fed Watch: A Solid Start To 2011

One more from Tim Duy:

A Solid Start To 2011, by Tim Duy: The ISM manufacturing number was not a blowout by any means. Indeed, the rise to 57.0 headline number was slightly below expectations. Still, it is a solid number and the internals were generally supportive. New orders gained while inventory measures declined, suggesting solid sales that will sustain future production. Not surprisingly, the pricing component remains high, consistent with rising commodity prices - indeed, according to the report, no industries reported falling prices.

The disappointment in the report was the employment measure, which fell from 57.5 to 55.7. I am not sure this tells us much about the impending employment report for the final month of 2010 - I don't think anyone had high hopes that the manufacturing sector would lead a jobs recovery; the minimal gains in durable goods manufacturing stalled out in the second half of 2010 while employment in nondurable goods generally continued the free fall initiated in the mid-90s.

Overall, the ISM report was generally consistent with the relatively upbeat flow of data seen in recent weeks suggesting that growth accelerated to something above trend at the end of 2010. This, coupled with decreasing initial unemployment claims, supports the consensus expectation for 140k nonfarm payroll gain in Friday's report. While well above the dismal October report, it would promise persistent high unemployment, as 140k would be at the top end of estimates of natural labor force growth.

Paul Krugman worries that policymakers will ignore the depth of the recession and instead grab onto the positive data flow to press for fiscal and/or monetary consolidation. On the latter:

I’m also worried about monetary policy. Two months ago, the Federal Reserve announced a new plan to promote job growth by buying long-term bonds; at the time, many observers believed that the initial $600 billion purchase was only the beginning of the story. But now it looks like the end, partly because Republicans are trying to bully the Fed into pulling back, but also because a run of slightly better economic news provides an excuse to do nothing.

There’s even a significant chance that the Fed will raise interest rates later this year — or at least that’s what the futures market seems to think. Doing so in the face of high unemployment and minimal inflation would be crazy, but that doesn’t mean it won’t happen.

I was not optimistic the Fed would opt to continue running the printing press once the current $600 billion of asset purchases is on the balance sheet, and even less so as the data continued to suggest above trend growth. It was only the mid-year slowdown that forced the Fed's hand in the first place. Without that slowdown, the Fed would probably have sat on their hands despite high unemployment.

Will Bernanke & Co. move in reverse this year and actually raise rates? I find that hard to believe given the likelihood growth will fall well short of that required to drive the unemployment rate significantly lower. But I am also not surprised that future markets are pointing in that direction. Indeed, that should be expected given that rates are effectively set near zero - traders have nothing to bet on but a rate increase! That is simply the direction the risk lies.

I am looking for more upbeat data to influence upcoming Fedspeak, confirming expectations that the Fed is preparing to move to the sidelines. On the other hand, I am not hopeful such talk will make its way into Federal Reserve Chairman Ben Bernanke's upcoming Senate testimony. He has displayed a willingness to play his cards close to the chest, not eager to stake out a policy shift in advance of other FOMC members. I don't expect much deviation from the message of December's FOMC statement, with the risk being obvious - that he follows the upbeat flow of data.

Bottom Line: More confirmation that the economy accelerated as we exited 2010, enough to justify winding down the large scale asset purchases and to push more FOMC members to once again think about the exit strategy, but not enough to justify an imminent tightening of monetary policy.

Monday, December 27, 2010

Paul Krugman: The Finite World

It's not always about us:

The Finite World, by Paul Krugman. Commentary, NY Times: Oil is back above $90 a barrel. Copper and cotton have hit record highs. Wheat and corn prices are way up. Over all, world commodity prices have risen by a quarter in the past six months. So what’s the meaning of this surge?
Is it speculation run amok? Is it the result of excessive money creation, a harbinger of runaway inflation just around the corner? No and no.
What the commodity markets are telling us is that we’re living in a finite world,... the rapid growth of emerging economies is placing pressure on limited supplies of raw materials, pushing up their prices. And America is, for the most part, just a bystander in this story. ...
This doesn’t necessarily ... reject the notion that speculation is playing some role... But the fact that world economic recovery has also brought a recovery in commodity prices strongly suggests that recent price fluctuations mainly reflect fundamental factors.
What about commodity prices as a harbinger of inflation? Many commentators on the right have been predicting for years that the Federal Reserve ... is setting us up for severe inflation. ... Yet inflation has remained low. What’s an inflation worrier to do?
One response has been a proliferation of conspiracy theories, of claims that the government is suppressing the truth about rising prices. But lately many on the right have seized on rising commodity prices as proof that they were right all along, as a sign of high overall inflation just around the corner.
You do have to wonder what these people were thinking two years ago, when raw material prices were plunging. If the commodity-price rise of the past six months heralds runaway inflation, why didn’t the 50 percent decline in the second half of 2008 herald runaway deflation?
Inconsistency aside, however, the big problem with those blaming the Fed ... is that ... commodity prices are set globally, and what America does just isn’t that important a factor.
In particular,... the primary driving force behind rising commodity prices isn’t demand from the United States. It’s demand from China and other emerging economies. As more and more people in formerly poor nations are entering the global middle class, they’re beginning to drive cars and eat meat, placing growing pressure on world oil and food supplies.
And those supplies aren’t keeping pace. Conventional oil production has been flat for four years; in that sense, at least, peak oil has arrived. ... Also, over the past year, extreme weather ... played an important role in driving up food prices. And, yes, there’s every reason to believe that climate change is making such weather episodes more common.
So what are the implications of the recent rise in commodity prices? It is, as I said, a sign that we’re living in a finite world, one in which resource constraints are becoming increasingly binding. This won’t bring an end to economic growth, let alone a descent into Mad Max-style collapse. It will require that we gradually change the way we live, adapting our economy and our lifestyles to the reality of more expensive resources.
But that’s for the future. Right now, rising commodity prices are basically the result of global recovery. They have no bearing, one way or another, on U.S. monetary policy. For this is a global story; at a fundamental level, it’s not about us.

Thursday, December 23, 2010

The Case for Nominal GDP Targeting

David Beckworth:

The Case for Nominal GDP Targeting, Macro and Other Macro Musings: I am late getting to this, but Mark Thoma wants to hear the case for nominal GDP targeting. This approach to monetary policy requires the Fed stabilize the growth path for total current dollar spending. As an advocate of nominal GDP level targeting, I am more than happy to respond to Mark's request. I will focus my response on what I see as its three most appealing aspects: (1) it provides a simple and intuitive approach to monetary policy, (2) it focuses monetary policy on that over which it has meaningful influence, and (3) its simplicity makes it easier to implement than other popular alternatives. Let's consider each point in turn.
(1) It provides a simple and intuitive approach to monetary policy. This first point can be illustrated by considering the following scenario. Imagine the U.S. economy is humming along at its full potential. Suddenly a large negative shock, say a housing bust, hits the economy. This development leads to a decline in expectations of current and future economic activity. As a result, asset prices decline, financial conditions deteriorate, and there is a rush for liquidity. The rise in demand for liquidity means less spending by households and firms and thus, less total current dollar spending in the U.S. economy. Because prices do not adjust instantly, this drop in nominal spending causes a decline in real economic activity too. Thus, even though the primal cause of the decline in the real economy was the housing bust, the proximate cause was the drop in total current dollar spending. The Fed cannot undo the housing bust, but it can prevent the drop in total current dollar spending by providing enough liquidity to offset the spike in liquidity demand. If nominal spending has not been stabilized then the Fed has failed to do this. A nominal GDP target, then, is simply a mandate for the Fed to stabilize total current dollar spending.
Though a simple objective, stabilizing nominal spending is key to macroeconomic stability. The figure below shows that changes in the growth rate of total current dollar spending (i.e. nominal GDP) got transmitted mostly to changes in the growth rate of real economic activity (i.e. real GDP) rather than inflation (i.e. GDP Deflator). This implies that had monetary policy done a better job stabilizing nominal spending then there would have been fewer recessions during this time. (Click on figure to enlarge.)

(2) It focuses monetary policy on that over which it has meaningful influence. There are two types of shocks that buffet the economy: aggregate supply (AS) shocks and aggregate demand (AD) shocks. A nominal GDP targeting rule only responds to AD shocks. It ignores AS shocks while keeping total current dollar spending growing at a stable rate. This is the way it should be. For if monetary policy attempts to offset AS shocks it will tend to increase macroeconomic volatility rather than reduce it. For example, let's say Y2K actually turned out to be hugely disruptive for a prolonged period. This negative AS shock would reduce output and increase prices. A true inflation targeting central bank would have to respond to this negative AS shock by tightening monetary policy, further constricting the economy. A nominal GDP targeting central bank would not face this dilemma. It would simply keep nominal spending stable.
In general, any kind of price stability objective for a central bank is bound to be problematic because price level changes can come from either AD or AS shocks and are hard to discern. For example, was the low U.S. inflation in 2003 the result of a weakened economy (a negative AD shock) or robust productivity gains (a positive AS shock)? It makes much more sense to focus on the underlying economic shocks themselves rather than a symptom of them (i.e. price level changes). Nominal GDP targeting does that by focusing just on AD shocks. This point is graphically illustrated here using the AD-AS model. More discussion on this point can be found here.
(3) Its simplicity makes it easier to implement than other popular alternatives. This is true on many front. First, a nominal GDP target requires only a measure of the current dollar value of the economy. It does not require knowledge of the proper inflation measure, inflation target, output gap measure, the neutral federal fund rate, coefficient weights, and other elusive information that are required for inflation targeting and the Taylor Rule. There will always be debate on which form of the above measures is appropriate. For example, should the Fed go with the CPI or PCE, the headline inflation measure or the core, the CBO's output gap or their own internal estimate, the original Taylor Rule or the Glenn Rudebush version, etc.? A nominal GDP target avoids all of these debates.
Second, nominal GDP targeting would also be easier to implement because it is easy to understand. The public can comprehend the notion of stabilizing total current dollar spending. It is less clear they understand output gaps, core inflation, the neutral federal funds rate, and other esoteric elements now used in monetary policy. The Fed would have a far easier time explaining itself to congress and the public if it followed a nominal GDP target. On the flip side, this increased understanding by the public would make the Fed more accountable for its failures.
Third, a nominal GDP target would take the focus off of inflation and what its appropriate value should be. Thus, if there needed to be some catch-up inflation and nominal spending to get nominal GDP back to its targeted growth path the Fed could do it with less political pressure.
Some folks argue that the nominal GDP targeting is nothing more than just a special case of a Taylor Rule. Maybe so, but the point they miss the bigger point that nominal GDP targeting is a far easier approach to implement for the reasons laid out above. Moreover, in practice the Fed has deviated from the Taylor Rule and during these times it appears to be more of a pure inflation targeter. Thus, adopting an explicit nominal GDP target would force the Fed to stick to stabilizing nominal spending at all times.
Ultimately, I would like to see the Fed adopt not only a nominal GDP level target, but a forward-looking one that targeted nominal GDP futures market. This is an idea that Scott Sumner and Bill Woolsey have been promoting for some time. See here and here for more on this proposal.

Monday, December 20, 2010

Sumner's Reply on Nominal GDP Targeting

Here's a response to my request for more discussion of the merits of nominal GDP targeting (in both levels and growth rates) relative to a Taylor rule:

Reply to Thoma on NGDP targeting, by Scott Sumner: Mark Thoma recently asked the following question:

So, for those of you who are advocates of nominal GDP targeting and have studied nominal GDP targeting in depth, (a) what important results concerning nominal GDP targeting have I left out or gotten wrong? (b) Why should I prefer one rule over the other? In particular, for proponents of nominal GDP targeting, what are the main arguments for this approach? Why is targeting nominal GDP better than a Taylor rule?

...Thoma raises issues that I don’t feel qualified to discuss, such as learnability.  My intuition says that’s not a big problem, but no one should take my intuition seriously.  What people should take seriously is Bennett McCallum’s intuition (in my view the best in the business), and he also thinks it’s an overrated problem.  I think the main advantage of NGDP targeting over the Taylor rule is simplicity, which makes it more politically appealing.  I’m not sure Congress would go along with a complicated formula for monetary policy that looks like it was dreamed up by academics (i.e. the Taylor Rule.)  In practice, the two targets would be close, as Thoma suggested elsewhere in the post.

Instead I’d like to focus on a passage that Thoma links to, which was written by Bernanke and Mishkin in 1997 ...[continue reading]...

Just one quick note. I'm not sure I agree that McCallum thinks learnability is an "overrated problem." For example, he cites it as an important factor in arguing against using determinacy as a "selection criterion for rational expectations models":

Another Weakness of “Determinacy” as a Selection Criterion for Rational Expectations Models, by Seonghoon Cho and Bennett T. McCallum: ...It is well-known that dynamic linear rational expectations (RE) models often have multiple solutions... It is also well-known that much of the literature, especially in monetary economics, approaches issues concerning such multiplicities by establishing whether a solution is, or is not, “determinate” in the sense of being the only solution that is dynamically stable. Often, cases featuring “indeterminacy,” defined as the existence of more than one stable solution, are regarded as problematic and to be avoided (by means of policy) if possible.[1] On the other hand, several authors, including Bullard (2006), Cho and Moreno (2008), Evans and Honkapohja (2001), and McCallum (2003, 2007) have— implicitly, in some cases—questioned this practice on various grounds. For example, determinate solutions may not be learnable (Bullard (2006), Bullard and Mitra (2002)) whereas cases with indeterminacy may possess only one “plausible” solution (McCallum (2003, 2007)). In the present paper we present another argument against the use of determinacy as a guide ... to interpretation of outcomes implied by a RE model.

Or, probably better, see his rejoinder to Cochrane's "Can Learnability save New-Keynesian models?," one of many papers he has written on this topic, and see if you conclude that McCallum thinks learnability is an unimportant issue.

Saturday, December 18, 2010

Nominal GDP Growth Targeting

In 1997, Ben Bernanke and Frederic Mishkin explained why they do not think that targeting nominal GDP growth is better than targeting inflation:

Is Inflation the Right Goal Variable for Monetary Policy? The consensus that monetary policy is neutral in the long run restricts the set of feasible long-run goal variables for monetary policy, but inflation is not the only possibility. Notably, a number of economists have proposed that central banks should target the growth rate of nominal GDP rather than inflation (Taylor (1985); Hall and Mankiw (1994)). Nominal GDP growth, which can be thought of as "velocity-corrected" money growth (that is, if velocity were constant, nominal GDP growth and money growth would be equal, by definition), has the advantage that it does put some weight on output as well as prices. Under a nominal GDP target, a decline in projected real output growth would automatically imply an increase in the central bank's inflation target, which would tend to be stabilizing.[14] Also, Cecchetti (1995) has presented simulations that suggest that policies directed to stabilizing nominal GDP growth may be more likely to produce good economic outcomes, given the difficulty of predicting and controlling inflation:
Nominal GDP targeting is a reasonable alternative to inflation targeting, and one that is generally consistent with the overall strategy for monetary policy discussed in this article. However, we have three reasons for mildly preferring inflation targets to nominal GDP targets. First, information on prices is more timely and frequently received than data on nominal GDP (and could be made even more so), a practical consideration which offsets some of the theoretical appeal of the nominal GDP target. Although 20 collection of data on nominal GDP could also be improved, measurement of nominal GDP involves data on current quantities as well as current prices and thus is probably intrinsically more difficult to accomplish in a timely fashion. Second, given the various escape clauses and provisions for short-run flexibility built into the inflation-targeting approach, we doubt that there is much practical difference in the degree to which inflation targeting and nominal GDP targeting would allow accommodation of short-run stabilization objectives. Finally, and perhaps most important, it seems likely that the concept of inflation is better understood by the public than the concept of nominal GDP, which could easily be confused with real GDP. If this is so, the objectives of communication and transparency would be better served by the use of an inflation target. As a matter of revealed preference, all central banks which have thus far adopted this general framework have chosen to target inflation rather than nominal GDP.

Here's the question I have, and a shot at the answer. If we link the growth of nominal GDP to the federal funds rate (as opposed to the money supply), then it shares many characteristics of a Taylor rule. That is, the growth rate of nominal GDP is equal to the growth rate of output plus the growth rate of prices, i.e. output growth plus inflation. Thus, an interest rate rule connected to the growth rate of nominal GDP would be of form i = f(output growth, inflation) which is very close to a standard Taylor rule formulation.

My intuition was that nominal GDP targeting based upon a rule of this type would exhibit indeterminacy. However, surprisingly to me, this is not the case. In 2003, Kaushik Mitra showed that a rule where the interest rate is adjusted so as to keep nominal GDP growth as close as possible to a constant value does not suffer from this problem. The rational expectations equilibrium is locally unique under nominal GDP growth targeting (essentially, the rule satisfies the Taylor principle of moving the nominal interest rate more than one-to-one with expected inflation). Furthermore, the equilibrium is stable under learning. This is important because, as Mitra notes:

[Howitt] explicitly warned that, in general, any RE analysis of monetary policy should be supplemented with an investigation of its stability under learning. He emphasized that the assumption of RE can be quite misleading in the context of a fixed monetary regime; if the regime is not conducive to learnability, then the consequences can be quite different from those predicted under RE

Note, however, an important exception to the encouraging results for nominal GDP growth targeting using interest rate rules. Some people define nominal GDP targeting as setting expected nominal GDP growth one period ahead equal to a fixed value. This version of nominal interest rate targeting does not satisfy the Taylor principle (i.e. indeterminacy is a problem) and it is not stable under learning. Thus, this shows that the form of the nominal GDP targeting rule matters, and some rules can perform very badly.

I have not said much about the Taylor rule versus nominal GDP growth targeting debate, in part because if GDP growth is linked to money, i.e. if we use a money rule rather than an interest rate rule, then, while that is fine theoretically, there are big problems with defining and measuring the appropriate monetary aggregate to target (such an aggregate may very well be dynamic as well as difficult to measure, i.e. it changes over time, further complicating this approach). As I've discussed here in the past, and others have discussed recently as well, the relationship between money and nominal GDP appears to break down in the early 1990s (you can see this in a graph of M2 velocity). Thus, a rule linked to money runs into the problem of how to define money, and it's not a problem we have solved. So there didn't seem to be much reason to think hard about these kinds of rules.

The other reason I have not embraced nominal GDP targeting is the one discussed above. If an interest rate rule is used instead of a money rule, it seemed like a version of a Taylor rule with different coefficients (and a different measure of output -- the Taylor rule uses percentage deviation from full employment, while under nominal GDP targeting the variable is output growth), so it wasn't clear that it could resolve the known problems with these kinds of rules. In fact, I thought it would make problems such as indeterminacy even worse. But that turns out not to be the case, nominal GDP targeting seems to do better in terms of determinacy and stability under learning. (The results are, of course, model dependent so it's as much a debate about the proper model of the macroeconomy as it is a debate about monetary policy rules. Some rules seem to be robust across a wide variety of models, and due to our uncertainty over the correct macro model to use, my evaluation of alternative policy rules gives large weight to the robustness feature).

My bias has been toward Taylor rules rather than nominal GDP targeting, mostly because I think of GDP targeting as linked to the money supply rather than the interest rate. But given results such as Mitra's on interest rate rules, I think we need to keep an open mind on the optimal form of the monetary policy rule.

So, for those of you who are advocates of nominal GDP targeting and have studied nominal GDP targeting in depth, (a) what important results concerning nominal GDP targeting have I left out or gotten wrong? (b) Why should I prefer one rule over the other? In particular, for proponents of nominal GDP targeting, what are the main arguments for this approach? Why is targeting nominal GDP better than a Taylor rule? I don't think I've seen a simple, bullet-point type summary of the pros and cons of nominal GDP targeting versus a Taylor rule (while you're at it, setting aside issues of measurement, under what conditions is nominal GDP a better nominal anchor than money?). Also, I didn't talk about targeting the level of nominal GDP at all, just the growth rate, but some of you advocate level targeting rather than growth targeting. This comes up with Taylor rules as well, and whether to target growth rates or levels, or both, depends upon how persistence is modeled and the type of rigidity that is imposed on the model. Is the same true for nominal GDP targeting? When is level targeting better than growth targeting, or vice-versa?  The main question here is the relative merits of nominal GDP targeting versus a Taylor rule, but how the results vary with level versus growth targeting (and other factors such as the presence of forward or backward looking elements in the rule) is also of interest.

[I'm very interested in this question, so I'll post (or link to) all reasonable responses that discuss of the merits of alternative policy rules.]

Update: Andy Harless in comments:

I like NGDP level (or "path") targeting largely because it separates the Fed from the politically contentious issue of what the inflation rate should be. If the inflation rate turns out to be too high or too low for someone's taste, the Fed can say, "Hey, we did our job. Complain to the real economy about that." Of course, it's no accident that I've come to this position recently, at a time when the Fed could really use some political cover for aggressive unconventional policies designed to stimulate recovery from a particularly deep recession. All this nonsense about how QE2 (and more importantly QE3 and QE4 -- since QE2 is not aggressive enough) is potentially inflationary: the answer should be, "Yeah, so what. It's not our job to set the inflation rate. If the real economy responds, then great. If inflation responds instead, then the real economy is behaving badly. Somebody else needs to fix that, maybe. Not us." I believe, however, that NGDP growth rate targeting is a very bad idea. While some shocks are indeed persistent, this persistence (a) is not always present and (b) often ought to be resisted when it is. A big increase in the unemployment rate may result in a permanently lower real output path as workers lose their skills, but monetary policy ought to lean against this tendency, even at the expense of temporarily raising the inflation rate. With NGDP growth rate targeting, you basically try to avoid recovering from a recession unless the inflation rate goes down. That's clearly bad policy. Right now we have some people arguing that QE2 was unnecessary because NGDP already appears to be rising at a normal rate. That's clearly a silly way to think. NGDP needs to rise at a higher than normal rate now, or the unemployment rate will remain unnecessarily high. I don't see how anyone can advocate NGDP growth rate targeting after looking at the situation we're in today.

...To clarify..., my preference over 4 possible policy regimes would be: best: NGDP level targeting second best: Price level targeting second worst: Inflation rate targeting worst: NGDP growth rate targeting Let me say, also, that NGDP level targeting has an advantage over a Taylor rule in that it never breaks. When the Taylor rule implies an interest rate below zero, the appropriate course of action is unclear, and there is a lot of room for dispute. With NGDP targeting, there is less room for dispute: just look at your forecast; if it says NGDP will be below target, then you need a more aggressive policy.

Update: Scott Sumner's reply, and my response.

Wednesday, December 15, 2010

Fed Watch: Turning Tide

It wasn't quite as Tim describes, but glad he could do this:

[Note: I apologize for being missing in action. I have been deep in the weeds at work for the last month. I hadn't even really realized how long it had been since I last wrote until Mark cornered me Monday afternoon, and none-too-subtlety suggested that I was supposed to be busy writing a post, what with the impending FOMC meeting and all. So, with acknowledgement of Mark's wisdom….]

For the past three years, it has paid to bet on the pessimistic side of the outlook. For the past few months, I have privately fretted that this bet would soon wear thin. And it sure looks like it has. The flow of data in recent weeks has been, on net, very positive, offering a vision of a sustainable recovery.

The Fed, however, has not yet gotten that memo. From today's FOMC statement:

Information received since the Federal Open Market Committee met in November confirms that the economic recovery is continuing, though at a rate that has been insufficient to bring down unemployment. Household spending is increasing at a moderate pace, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. The housing sector continues to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have continued to trend downward.

The Fed remains locked into a forecast that anticipates output growth hovering near potential. Contrast this with rising expectations for, at a minimum, solid near term growth:

In the most recent Wall Street Journal forecasting survey, conducted last week, the 55 economists on average expected GDP to grow 2.6% at a seasonally adjusted annual rate in the fourth quarter from the third. But on the back of today’s retail report and a strong increase in October exports reported Friday, many are revising their estimates to more than 3%. Of seven revised forecasts, the average expected fourth-quarter growth forecast is now 3.3%, compared to 2.6% before the retail release.

Despite all the weights on the consumer - the FOMC statement reiterates that list - consumer spending is accelerating, pulling the post-recession trend rate close to that pre-recession:

Over the last four months, the rate for nonauto retail sales less gas has accelerated to an monthly average gain of 0.8%. That is nothing to sneeze at, and easily explains rising forecasts.

Still, the gap between the old trend and the new remains. Moreover, earlier this year, I would have tended to dismiss higher consumer spending on the grounds that it would simply be offshored in the form of higher import spending, a reemergence of the global imbalance that plagued output growth in the second and third quarters of this year. The most recent trade report indicates the opposite - that maybe, just maybe, the external sector will behave as it should in the wake of a financial crisis and provide a sustained boost to growth. To be sure, we would prefer not to see imports collapse, as this would signal a rather nasty demand shock. Instead, we are looking for import growth to stall as import competing firms become more competitive while export growth continues unabated. That has been the general trend of the last few months, giving rise to a more supportive trend in the trade balance:

This year, the external drag was an important factor in limiting the US recovery. Ending that drag would provide a significant boost - note that trade contributed a negative 2.63 percentage points to GDP growth, on average, in the second and third quarters. Thus, just going flat means a large gain to output. It's simply a big deal - it's enough to put output growth solidly in the sustainable region, not to mention solidly above trend.

And if an improving consumer and external outlook themselves would have been sufficient to generate above trend growth, the tax cut deal is icing on the cake. On net, it is more than anti-contractionary. It offers some real stimulus - for example, the payroll tax holiday will be less easily saved than a lump-sum check in the mail. To be sure, we can debate the political wisdom of the move from the Democrat's perspective, not to mention the long-term consequences of no real baseline for the US tax code, but in the short run, it is another shot in the arm.

And a shot in the arm is desperately needed. I do not intend to dismiss the real challenges the economy still faces. The plight of the 99er's in an economy of near double-digit unemployment rates is an obvious reminder. And, for that matter, so is the most recent employment report. Of course monthly changes in nonfarm payrolls are notoriously volatile, and the average of the last two months revealed that payrolls are growing just above 100k a month. The right direction, but not fast enough. More demand is clearly needed - and a solid consumer sector bolstered by external support and fresh stimulus would clearly help in that regard.

In this environment, it is not really much of a surprise that long term interest rates are headed higher. I tend to agree with those analysts echoed by Jim Hamilton and Brad DeLong - rising rates are a signal that the economy is strengthening. And strengthening enough that, despite the pessimistic tone of today's FOMC statement, it seems likely that the Fed will not feel compelled to extend large scale asset purchases beyond the existing plans. Without the Fed to serve as an excuse to keep buying Treasuries, traders are sending rates exactly where they should be going.

But won't rising rates slow the housing recovery, thereby putting the recovery in jeopardy? Seriously, what housing recovery is there left to protect? Should we really care at this point? Housing is SOOO 2005. The consumer is getting over it - the retail sales numbers tell that tale. Consumer spending is growing solidly in the absence of easy credit. I think we are finally in the acceptance phase when it comes to the housing market. Just like we eventually got to the acceptance phase in the wake of the tech collapse. We use even more technology, but that still doesn't justify the valuations we saw in the late 1990s. Same for housing - it is reverting back to an asset that provides primarily a service for the household rather than an investment. And that reversion will leave the economy healthier in the long run.

Will the Fed shift course, even in a rosier environment? Doubtful, at least near term. They will likely see the current plan through to its fruition, while holding rates at rock bottom levels until it is quite evident that the output gap is closing, which will take a few years even if growth accelerates sustainably to 4%. Will more be forthcoming? Also doubtful, especially as the composition of the FOMC turns more hawkish. Moreover, enough risks remain to keep Fed officials from sleeping too soundly at night. The European debt crisis runs hot and cold. The trade story could turn against us. Again. And uncertainty over the economic direction of China will be an ongoing challenge. I suspect the Fed will adopt the widely accepted view that a China slowdown would be a net negative to the global economy. Michael Pettis makes a convincing argument to the contrary.

In short: In general, the data flow of the last eight weeks is clearly encouraging. To be sure, not every release, like the employment report, is perfect. But enough are perfect that forecasters are quickly reversing the downgrades made just a few months ago during the mid-year slowdown. Will the data suddenly turn on us again? Always possible, always something to watch for, but I don't think that should be the expected path. Right now, the data suggest the US economy might start firing on more than just a few of its eight cylinders. A little optimism is justified. Don't expect the Fed to reverse course soon - they have yet to embrace the possibility that the economy is set to grow at something above trend. But a data flow like this cannot be ignored forever. Look for more glimmers of hope creeping into Fedspeak in the weeks ahead.

Tuesday, December 14, 2010

The Fed Leaves the Target Rate and QEII Unchanged

At MoneyWatch, I have a reaction to today's decision by the FOMC to leave policy unchanged, and a forecast for how long it will be until the Fed changes course:

The Fed Leaves the Target Rate and QEII Unchanged

Sunday, December 05, 2010

Bernanke on CBS’s '60 Minutes'

[Excerpts from the interview, Transcript and unaired excerpts.]

Narayana Kocherlakota: Monetary Policy Actions and Fiscal Policy Substitutes

On many occasions when the Fed was dragging its feet in terms of implementing a second round of quantitative easing, I made the claim that fiscal policy authorities don't have to wait for the Fed to take action, they can use tax changes to duplicate the incentives that are created when the Fed lowers the interest rate. Furthermore, while the Fed may have difficulty cutting interest rates as much as needed when the interest rate is near the zero bound, fiscal policy authorities have much more room to maneuver.

I missed this speech by Narayana Kocherlakota when it was given a couple of weeks ago, but it makes this point explicitly:

Monetary Policy Actions and Fiscal Policy Substitutes, by Narayana Kocherlakota, President, Federal Reserve Bank of Minneapolis: ...I’ll begin by discussing current macroeconomic conditions and the Federal Open Market Committee’s recent actions...
This is the economic situation that confronted the FOMC in its November meeting. Inflation and employment are both too low, and the pace of recovery is too slow. Economic growth is low and softening further. I think it is safe to say that, given this situation, the FOMC would have liked to have been able to cut its target interest rate. But this option is not available. ...
But the FOMC does have another policy instrument available: its balance sheet. ... At its November 3 meeting, the FOMC announced that it plans to buy $600 billion of long-term Treasuries in the open market by mid-2011. ... This kind of action is known as quantitative easing, or QE. ...
I believe that QE is a move in the right direction. However,... I also think there are good reasons to suspect that the ultimate effects of any amount of QE are likely to be relatively modest. That’s why I would have greatly preferred for the committee to have been able to cut its target rate rather than using QE. The problem is that its target rate is already essentially at zero, and so it was not possible...
Given this constraint on monetary policy, I believe it is important to ask if it is possible to synthesize the effects of a one-year interest rate cut of, say, 100 basis points using fiscal policy tools. In his current and past work, Minneapolis Fed staff researcher Juan Pablo Nicolini and his co-authors have answered this question in the affirmative.2 Their key insight is that there is a broad equivalence between monetary and fiscal policy. ...
In the remainder of my remarks, I’ll illustrate this insight by describing one particular fiscal policy plan that is equivalent to a 100-basis-point cut by the Fed. The proposal has three parts. The first part is a permanent consumption tax of 100 basis points, instituted with a one-year delay.3 The second part is a permanent decrease in labor income taxes of 100 basis points, also instituted with a one-year delay. The third part is an investment tax credit undertaken in 2011. The Nicolini et al. results demonstrate that, in a wide class of economic models, the effects of this three-part plan would be equivalent to the effects of a 100-basis-point interest rate cut. ...
The 1 percent permanent consumption tax that begins in 2012 stimulates consumption demand in 2011. The permanent reduction in labor income taxes ensures that this new consumption tax does not deter labor supply. Finally, the investment tax credit makes sure that the new consumption tax does not deter investment in 2011.
I’ll make two additional comments about this plan. First, how much would this three-pronged change in taxes cost the American taxpayer? The exact answer to this question would depend on a host of details... But let me offer a very rough calculation..., the first two parts of the plan would add about $20 billion per year to government revenue beginning in 2012. The plan also involves an appropriately sized investment tax credit..., a one-time cost in 2012 of $20 billion. These calculations, while obviously very rough, do indicate that the plan has the potential to be fiscally responsible.4
Second, I’ve not discussed distributional considerations. Raising consumption taxes by 1 percentage point and lowering labor income taxes by 1 percentage point for all Americans would tend to redistribute the burden of taxes toward lower-income citizens. For this reason, I believe that it would be desirable to redesign the labor income tax reduction to make it more progressive.
Overall, I believe that this analysis has both policy and intellectual aspects. From a policy point of view,... I find the resultant policy to be attractive because may be able to generate macroeconomic stimulus without increasing the deficit. From an intellectual point of view, the analysis demonstrates the remarkable power of public finance in addressing important macroeconomic questions. ...

The point is that the effects of QE are likely to be modest, and with unemployment remaining persistently high, we need to do more than monetary policy has to offer. Thus, fiscal policy has a key role to play, either through direct spending on infrastructure and other projects -- my first choice -- or through tax schemes designed to create incentives for increased economic activity.

Monetary policy has done all it can do, pretty much. I would like to see the Fed be even more aggressive, but even if it did implement a larger QE program, it can't do enough to solve the economic growth and unemployment problems by itself. Fiscal policy authorities need to step up and do more -- statements like the one above and those made recently by Ben Bernanke are pleas for help from fiscal authorities. But, unfortunately, Congress has fallen down on the job, there is no leadership from the White House promoting such action, and there is very little hope, none really, that more help will be forthcoming.

Monday, November 29, 2010

"Milton Friedman Would Have Supported QE2"

David Beckworth:

Case Closed: Milton Friedman Would Have Supported QE2, by David Beckworth: The debate over what Milton Friedman would say about QE2 can now be closed. Below is a Q&A with Milton Friedman following a speech he delivered in 2000. In this excerpted exchange with David Laidler, we learn that Friedman's prescription for Japan at that time is almost identical to what the Fed is doing now with QE2:...

David Laidler: Many commentators are claiming that, in Japan, with short interest rates essentially at zero, monetary policy is as expansionary as it can get, but has had no stimulative effect on the economy. Do you have a view on this issue?
Milton Friedman: Yes, indeed. As far as Japan is concerned, the situation is very clear. And it’s a good example. I’m glad you brought it up, because it shows how unreliable interest rates can be as an indicator of appropriate monetary policy.
During the 1970s, you had the bubble period. Monetary growth was very high. There was a so-called speculative bubble in the stock market. In 1989, the Bank of Japan stepped on the brakes very hard and brought money supply down to negative rates for a while. The stock market broke. The economy went into a recession, and it’s been in a state of quasi recession ever since. Monetary growth has been too low. Now, the Bank of Japan’s argument is, “Oh well, we’ve got the interest rate down to zero; what more can we do?”
It’s very simple. They can buy long-term government securities, and they can keep buying them and providing high-powered money until the high powered money starts getting the economy in an expansion. What Japan needs is a more expansive domestic monetary policy.
The Japanese bank has supposedly had, until very recently, a zero interest rate policy. Yet that zero interest rate policy was evidence of an extremely tight monetary policy. Essentially, you had deflation. The real interest rate was positive; it was not negative. What you needed in Japan was more liquidity.

...Thanks to Doug Irwin for locating this gem.

Tuesday, November 23, 2010

Why Republicans are Wrong to Oppose Quantitative Easing

I have a new column on QEII: 

Faith in the Fed: QE2 Will Not Spur Inflation

Friday, November 19, 2010

Paul Krugman: Axis of Depression

What's behind recent attacks on the Federal Reserve?:

Axis of Depression, by Paul Krugman, Commentary, NY Times: What do the government of China, the government of Germany and the Republican Party have in common? They’re all trying to bully the Federal Reserve into calling off its efforts to create jobs. And the motives of all three are highly suspect. ...
It’s no mystery why China and Germany are on the warpath against the Fed. Both nations are accustomed to running huge trade surpluses. But for some countries to run trade surpluses, others must run trade deficits — and, for years, that has meant us. The Fed’s expansionary policies, however, have the side effect of somewhat weakening the dollar, making U.S. goods more competitive, and paving the way for a smaller U.S. deficit. And the Chinese and Germans don’t want to see that happen.
For the Chinese government, by the way, attacking the Fed has the additional benefit of shifting attention away from its own currency manipulation, which keeps China’s currency artificially weak — precisely the sin China falsely accuses America of committing.
But why are Republicans joining in this attack?
Mr. Bernanke and his colleagues seem stunned to find themselves in the cross hairs. They thought they were acting in the spirit of none other than Milton Friedman, who blamed the Fed for not acting more forcefully during the Great Depression — and who, in 1998, called on the Bank of Japan to “buy government bonds on the open market,” exactly what the Fed is now doing.
Republicans, however, will have none of it, raising objections that range from the odd to the incoherent.
The odd: on Monday, a somewhat strange group of Republican figures — who knew that William Kristol was an expert on monetary policy? — released an open letter to the Fed warning that its policies “risk currency debasement and inflation.” These concerns were echoed in a letter the top four Republicans in Congress sent Mr. Bernanke on Wednesday. Neither letter explained why we should fear inflation when the reality is that inflation keeps hitting record lows.
And about dollar debasement: leaving aside the fact that a weaker dollar actually helps U.S. manufacturing, where were these people during the previous administration? The dollar slid steadily through most of the Bush years, a decline that dwarfs the recent downtick. Why weren’t there similar letters demanding that Alan Greenspan, the Fed chairman at the time, tighten policy?
Meanwhile, the incoherent: Two Republicans, Mike Pence in the House and Bob Corker in the Senate, have called on the Fed to abandon all efforts to achieve full employment and focus solely on price stability. Why? Because unemployment remains so high. No, I don’t understand the logic either.
So what’s really motivating the G.O.P. attack on the Fed? Mr. Bernanke and his colleagues were clearly caught by surprise, but the budget expert Stan Collender predicted it all. Back in August, he warned Mr. Bernanke that “with Republican policy makers seeing economic hardship as the path to election glory,” they would be “opposed to any actions taken by the Federal Reserve that would make the economy better.” In short, their real fear is not that Fed actions will be harmful, it is that they might succeed.
Hence the axis of depression. No doubt some of Mr. Bernanke’s critics are motivated by sincere intellectual conviction, but the core reason for the attack on the Fed is self-interest, pure and simple. China and Germany want America to stay uncompetitive; Republicans want the economy to stay weak as long as there’s a Democrat in the White House.
And if Mr. Bernanke gives in to their bullying, they may all get their wish.

Bernanke: Rebalancing the Global Recovery

Ben Bernanke defends the Fed (text of speech):

Bernanke Faults China for ‘Persistent Imbalances’, by Sewell Chan, NY Times: Ben S. Bernanke ... plans to argue Friday that currency undervaluation by China and other emerging markets is at the root of “persistent imbalances” in trade that “represent a growing financial and economic risk.” ...
For the last two weeks, the Fed has been criticized for its Nov. 3 decision to inject $600 billion into the banking system through next June, resuming an effort to lower long-term interest rates. ...
Mr. Bernanke’s speech argues that unemployment in the United States is at “unacceptable” levels, and gingerly wades into the fiscal policy debate roiling Washington.
“In general terms, a fiscal program that combines near-term measures to enhance growth and strong, confidence-inducing steps to reduce longer-term structural deficits would be an important complement to the policies of the Federal Reserve,” Mr. Bernanke will say. ...
Mr. Bernanke’s remarks amount to an endorsement of crucial elements of President Obama’s economic approach. But that endorsement ... could further stoke criticism by Congressional Republicans, who say the Fed is defying voters’ skepticism about large-scale government intervention in the economy and setting the stage for inflation later, and by foreign officials, who fear the Fed is trying to weaken the dollar to make American exports more competitive.
Mr. Bernanke ... will reiterate his argument that the Fed felt compelled to act because inflation is so low ... and unemployment so high... “In sum, on its current economic trajectory the United States runs the risk of seeing millions of workers unemployed or underemployed for many years,” he will say. “As a society, we should find that outcome unacceptable.” ...
The text includes indirect responses to domestic and overseas critics. He intends to argue that the Fed “remains unwaveringly committed to price stability” and that buttressing growth is “the best way to continue to deliver the strong economic fundamentals that underpin the value of the dollar.”
The speech addresses the anxieties of Brazil, Thailand and other emerging economies, which fear that a surge of foreign capital will drive up prices and interest rates.
If exchange rates were allowed to move freely, Mr. Bernanke will argue, emerging markets would raise interest rates — and allow their currencies to appreciate — even as advanced economies like the United States maintained expansionary monetary policies. That would curb the emerging markets’ trade surpluses and shift demand toward domestic consumption and away from export-led growth.
Instead, Mr. Bernanke plans to say, currency undervaluation in big surplus economies has led to unbalanced growth and “uneven burdens of adjustment.” ...

Antonio Fatás wonders why the Fed seems "so obsessed with ensuring that inflation always stays at or below 2%." Allowing inflation to rise above 2% temporarily could help the Fed with its goal of spurring the economy and increasing employment:

How negative should real interest rates be?, by Antonio Fatás: Standard monetary policy is about setting short-term nominal interest rates. Most macroeconomic models assume that inflation is sticky (constant) in the short run and by moving nominal interest rate the central bank is actually setting the real interest rate and by doing so influencing spending (consumption and investment) decisions. Of course, these spending decisions might depend on long-term interest rates and therefore we also need to understand how short-term interest rates affect both nominal long-term rates and inflation over a longer horizon (where we cannot assume that inflation is constant).
We can use this logic to think about the most recent quantitative easing policies announced by the Fed. That's what Mark Thoma does very well ... in his blog. One issue that I am missing in his analysis is how we think about real interest rates (not just nominal) in the current context. This is very much related to the defense that some Fed officials have done over the last hours of their policies. For example, in his interview with the WSJ, Janet Yellen argues that QEII (the next round of quantitative easing) is not intended to raise inflation. That the Fed is happy with an inflation rate below but close to 2%.
I understand the importance of having a "low and stable" inflation target but we need to keep in mind that these targets should be interpreted in a medium-term framework, we are not asking the central bank to deliver a constant 2% inflation every month, quarter or year. And given that the Fed has refused to adopt a formal inflation target to keep its flexibility to set inflation on a short-term basis, why do they seem so obsessed with ensuring that inflation always stays at or below 2%? Even the ECB that is some times seen as putting too much emphasis on inflation has let the Euro inflation rate go above 2% during many of the months it has been in existence, so a little flexibility above 2% in the communications of the Fed might not hurt.
We can also think about what all this implies for real interest rates, by asking: what should the level for real interest rates be given current economic conditions? We know that with short-term rates at zero (and they cannot go lower) sending a strong message about inflation being below 2% sets a floor for how low real interest rates can go (the floor is -2%). Estimates of what the appropriate real interest rate is in the current situation (which tend to be made within the context of a Taylor rule) vary but some suggest that real interest rates might need to be even lower than that [By the way, I find this related post by Krugman very useful to understand the logic behind negative real interest rates].
In addition, we have the issue of the dynamics of expectations and actual inflation. It might be that Fed officials by sending a very strong message about not wanting to increase the inflation rate above 2% will keep inflation expectations low and actual inflation remains significantly lower than the 2% "target". My guess is that their conservatism when it comes to inflation is the result of the strong criticism that they have received (both at home and abroad), which has sent them into a defensive position where they need to reassure everyone that their current policies are not about raising inflation. But this might not be optimal, while anchoring long-term expectations of inflation around a low target is reasonable, there is nothing wrong in admitting that one of the goals of the current policy is to ensure that inflation stops falling and that we go back towards 2% or even higher in the short-term.

Wednesday, November 17, 2010

Mankiw on QE2

Greg Mankiw:

QE2: ...I judge QE2 to be a small but risky step in the right direction.

Update: In his post, Mankiw says:

I do see some potential downsides.  In particular, the Fed is making its portfolio riskier.  By borrowing short and investing long, the Fed is in some ways becoming the hedge fund of last resort.  If future events require higher interest rates, the Fed will end up making losses on its portfolio.  And even if doesn't recognize these losses (by not marking to market), it could end up paying more interest on newly expanded reserves than it is earning on its newly acquired portfolio of long bonds.  Such a cash-flow deficit could potentially undermine the Fed's political independence (which is already not very popular in some circles).  Yet if the Fed tries to avoid these losses by failing to raise rates when needed, inflation could indeed become a problem down the road.  I trust the team at the Fed enough to think they will avoid that mistake.

Economics of Contempt emails:

Pretty absurd post on QE2 from Mankiw, don't you think? Calling the Fed the "hedge fund of last resort" is about as disingenuous as it gets. If the Fed is becoming a hedge fund, it's a hedge fund that only invests in *Treasuries*! Is Mankiw seriously worried about the risks of the Fed owning 10YR and 30YR Treasuries? I *highly* doubt it.

Interest on Reserves and Inflation

[I originally had this as part of the post below this one on the most recent inflation data, but decided to make it a separate post.]

There's been a lot of talk lately about the Fed's policy of paying interest on reserves with many claiming that this has caused banks to retain reserves that might have otherwise been turned into loans, and thus the policy has depressed aggregate activity. However, paying interest on reserves is a safety net for the Fed that allowed them to do QEI and QEII. If the Fed wasn't paying interest on reserves, QEI would have likely been smaller, and QEII may not have happened at all.

First, on whether paying interest on reserves is a constraint on loan activity, the supply of loans is not the constraining factor, it's the demand. Increasing the supply of loans won't have much of an impact if firms aren't interested in making new investments. Businesses are already sitting on mountains of cash they could use for this purpose, but they aren't using the accumulated funds to make new investments and it's not clear how making more cash available will change that.

Second, I doubt very much that a quarter of a percentage interest -- the amount the Fed pays on reserves -- is much of a disincentive to lending (market rates have fluctuated by more than a quarter of a percent without a having much of an impact on investment and consumption).

Third, this a safety net for the Fed with respect to inflation. Paying interest on reserves gives the Fed control over reserves they wouldn't have otherwise, and control of reserves is essential in keeping inflation under control. If, as the economy begins to recover, the Fed loses control of reserves and they begin to leave the banks and turn into investment and consumption at too fast a rate, then inflation could become a problem. 

But by changing the interest rate on reserves, the Fed can control the rate at which reserves exit banks. The incentive to loan money is the difference between what the bank can earn by loaning the money or purchasing a financial asset and what it can make by holding the money as reserves. Suppose, for example, that the Fed raises the interest rate on reserves to the market rate of interest. In that case, banks would have no incentive at all to make loans and would instead just hold the reserves.

The tool the Fed has for removing reserves from the system is open market operations (QEI and QEII are essentially traditional open market operations, but the Fed buys long-term rather than the more traditional short-term financial assets). So why do they need another tool -- interest on reserves -- to control reserves? Removing reserves too fast through open market operations could disrupt financial markets. Paying interest on reserves gives the Fed a way to remove reserves in a more leisurely fashion while still maintaining control over inflation. They can raise the interest rate on reserves freezing them within the banking system, and then remove the reserves over time through open market operations as desired.

To say this another way, traditionally the only way the Fed could raise the federal funds rate is through open market operations that remove reserves from the system. However, since interest on reserves is a floor for the federal funds rate (it's a floor because nobody would lend reserves at a rate less than they can earn by holding them), an increase in the rate the Fed pays on reserves will increase the federal funds rate even though the reserves are still in the system. The economy can be slowed through increases in the federal funds rate without having to remove substantial quantities of reserves all at once as would be the case if open market operations were the only tool available.

Thus, though I don't think paying interest on reserves has much of an effect on loan activity right now, even if you believe it has, this is the price that must be paid for the ability to do QEI and QEII. If the Fed did not have this tool available, it would be much more fearful about its ability to control inflation, and much less likely to try to use unconventional policy to spur the economy.

Update: In comments, Andy Harless correctly points out that the Fed could cut the rate it pays on reserves to zero now, but still have the authority to raise rates later as necessary to help to fight inflation.  As I noted in a reply to Andy, I agree, but the Fed does not -- I meant to, but forgot to include Bernanke's worries that cutting the rate to zero would cause problems in the federal funds market. Bernanke's argument is:

“The rationale for not going all the way to zero has been that we want the short-term money markets, like the federal funds market, to continue to function in a reasonable way,” he said.

“Because if rates go to zero, there will be no incentive for buying and selling federal funds — overnight money in the banking system — and if that market shuts down … it’ll be more difficult to manage short-term interest rates when the Federal Reserve begins to tighten policy at some point in the future.”

The argument itself is a bit hard to swallow and I don't buy it, prior to the recession the rate was zero and the markets functioned fine. But from the Fed's perspective that doesn't matter -- they seem to believe that it is necessary to pay something on reserves to prevent problems in the overnight market for reserves. Thus, in the Fed's view, paying a quarter of a percent right now is a necessary part of this policy, a policy that gives them the comfort they need to employ quantitative easing. The Fed may or may not be correct about the impact on the overnight federal funds market, but it holds all the cards and as a practical matter, if you want QEII, then this is part of the bargain.

"Pretty Good for Government Work"

Warren Buffett thanks the government for saving the day:

Pretty Good for Government Work, by Warren Buffett, Commentary, NY Times: Dear Uncle Sam,
...Just over two years ago, in September 2008, our country faced an economic meltdown. ... A destructive economic force unlike any seen for generations had been unleashed.
Only one counterforce was available, and that was you, Uncle Sam. Yes, you are often clumsy, even inept. But when businesses and people worldwide race to get liquid, you are the only party with the resources to take the other side of the transaction. And when our citizens are losing trust by the hour in institutions they once revered, only you can restore calm. ...
 The challenge was huge, and many people thought you were not up to it. Well, Uncle Sam, you delivered. People will second-guess your specific decisions; you can always count on that. But just as there is a fog of war, there is a fog of panic — and, overall, your actions were remarkably effective.
I don’t know precisely how you orchestrated these. But I did have a pretty good seat as events unfolded, and I would like to commend a few of your troops. In the darkest of days, Ben Bernanke, Hank Paulson, Tim Geithner and Sheila Bair grasped the gravity of the situation and acted with courage and dispatch. And though I never voted for George W. Bush, I give him great credit for leading, even as Congress postured and squabbled. ...
Delusions, whether about tulips or Internet stocks, produce bubbles. And when bubbles pop, they can generate waves of trouble... This bubble was a doozy and its pop was felt around the world.
So,... Uncle Sam, thanks to you and your aides. Often you are wasteful, and sometimes you are bullying. On occasion, you are downright maddening. But in this extraordinary emergency, you came through — and the world would look far different now if you had not.
Your grateful nephew,

Tuesday, November 16, 2010

QEII and the Yield Curve

Posted at MoneyWatch:

What is QEII?

QEII is explained through its effects on the yield curve.

"How to Restore Confidence in the US Economy"

I'm guessing you won't like this idea very much. Roger Farmer argues that the Fed should stabilize the stock market in order to restore confidence in the economy:

How to restore confidence in the US economy without inflating a new asset market bubble, by Roger Farmer, Commentary, Financial Times: ...I have argued ... that more QE can create jobs and prevent a second Great Depression. But it matters how the policy is implemented. ...
Currently, investors hold more than a trillion dollars in excess reserves at the Fed... The problem is that investors are fleeing from risk and are demanding safe assets. The Fed is uniquely positioned to provide a safe haven for investors by buying risky securities from the public and replacing them with interest bearing deposits at the Fed.
What kind of risky assets should the Fed buy? Mr Bernanke plans to purchase treasury bonds..., a better plan would be to ... buy and sell stocks with the goal of reducing private sector risk. How might this be achieved? ...
QE is a new, unconventional monetary policy and ... there are two ways that it can be implemented. One is to buy securities in fixed amounts each month. That is what Mr Bernanke plans to do, although he proposes to buy bonds rather than stocks. The other is to buy and sell shares to stabilize fluctuations in the stock market. I propose this second strategy.
If the Fed were to announce that the Dow would not be allowed to drop below 11,000 over the next three months, for example, it would provide the confidence to private investors to move back into the market and spend some of the $1,000bn in excess reserves that are sitting in the banking system. But guaranteeing no downside to stocks is not, on its own, a good idea. The Fed must also limit swings on the upside. If QE simply fuels another unsustainable asset market bubble it will have made the problem worse, not better. Just as conventional monetary policy stabilizes swings in interest rates, so unconventional monetary policy must stabilize swings in asset prices.

Monday, November 15, 2010

GOP's Pence: The Fed Should Drop Its Dual Mandate

This says a lot about how much Republicans care about the unemployed:

GOP’s Pence Calls for Fed to Drop Focus on Employment, by Sudeep Reddy: Rep. Mike Pence of Indiana, a top House Republican, said he plans to introduce legislation Tuesday to end the Federal Reserve’s dual mandate, which requires the central bank to balance both employment and inflation concerns in its monetary policy. ... On Monday, he called for striking the dual mandate to force the Fed to focus only on price stability. The Fed today, under a 1977 law, also must pursue maximum sustainable employment... “The Fed’s dual mandate policy has failed,” Pence said in a statement. “For a record 18th straight month the nation’s unemployment rate is at or above 9.4 percent. It’s time for the Fed to be solely focused on price stability and not the recently announced QE2 which will monetize our debt and trigger inflation.”

The unemployment rate would be even higher if the Fed had not acted but, in any case, a single mandate wouldn't alter the Fed's current course of action. If the Fed is worried about disinflation/deflation, as it should be, then QEII is what is required for price stability. Dropping the dual mandate won't change that (and the debt will be "unmonetized" when conditions return to normal and the Fed begins to remove reserves from the system to avoid inflation, so the debt monetization argument doesn't hold unless you believe the Fed will abandon its long-run inflation target -- something it has made very clear it has no intention of doing).

Republicans oppose fiscal policy -- including things such as extending unemployment compensation and job creation initiatives to help to overcome severe conditions (though tax cuts for the wealthy are okay) -- and they oppose monetary policy that tries to lower the unemployment rate. So, in essence, they oppose doing anything to help the unemployed during a recession.

Welcome to the "you're on your ownership society."

"Republicans, Democrats, the Fed and QE2"

Jeff Frankel says conservative economists should learn "some insufficiently understood history" before expressing worries about Democrats and monetary policy:

The Pot Again Calls the Kettle Red: Republicans, Democrats, the Fed and QE2, by Jeff Frankel : Some conservatives are attacking current monetary policy as being too expansionary, as likely to lead to excessive inflation and debauchment of the currency. The Weekly Standard is promoting a critical letter to Fed Chairman Ben Bernanke signed by a list of conservatives, most of whom are well-known Republican economists. Apparently they are taking out newspaper ads tomorrow. If the National Journal and Wall Street Journal are right that the Republicans are trying to stake out a position that Democrats are pursuing inflationary monetary policy, they are on very shaky ground.

I will leave it to others to make the most important point, how low is the risk of excessive inflation now compared to the risk of alarming Japan-style deflation, with the economy having only begun to recover from its nadir of early 2009. Or to acknowledge that QE2 — the Fed’s new round of monetary easing — is only a second best policy response to high unemployment. (Fiscal policy would be much more likely to succeed at this task, if it were not for the constraints in Congress.)

I will, rather, respond to the partisan content of the National Journal’s question by pointing out some insufficiently understood history:

  1. Republican President Nixon successfully pushed Fed Chairman Arthur Burns into an excessively easy monetary policy in the early 1970s — leading to high inflation which the White House tried to address with wage-price controls. Nixon, of course, also devalued the dollar, and took it off gold, thereby ending the Bretton Woods system.
  2. Republican Presidents Ronald Reagan and George H.W. Bush repeatedly tried to push Fed Chairmen Paul Volcker and Alan Greenspan into easier monetary policy. This is documented in Bob Woodward’s 2000 book Maestro. The White House succeeded in making life unpleasant enough for inflation-slayer Volcker that he eventually asked not to be reappointed, prompting James Baker to exult “We got the son of a bitch!” (p.24).
  3. Democratic Presidents Jimmy Carter and Bill Clinton are the two presidents who have refrained from pushing their Fed Chairmen (Volcker and Greenspan, respectively) into easier monetary policy.
  4. Under Republican President G.W.Bush, monetary policy once again became excessively easy, during 2003-06, contributing substantially to the housing bubble and subsequent crash.

...Perhaps such accusations will strike some who don’t pay close attention as superficially plausible, even after all these years. But they nonetheless fly in the face of history. Another case of the pot calling the kettle “red.” Yes, I know, the usual saying is about the color black. But red is the color of deficits, overheating, … and Republicans.

I document this history in “Responding to Crises,” Cato Journal 27, 2007.

Friday, November 12, 2010

Fed Watch: Will the Fed Scale Up QE2?

Tim Duy:

Will the Fed Scale Up QE2?, by Tim Duy: I often feel caught between two complementary yet seemingly contradictory narratives regarding the US economy, one that sounds very optimistic while the other, in my opinion, pessimistic. Nevertheless, I think both narratives can be embraced, at least to a certain extent. And which narrative the Federal Reserve embraces will determine the dominate monetary policy question: Will the Fed scale up quantitative easing, or scale down?

It is reasonable to conclude that the US economy possess the basis for sustained growth in the quarters ahead. Indeed, the signs of a cyclical upturn are all over the data - manufacturing, investment, retail sales, inventories, take your pick, they are generally moving in the right direction. And my take on the recent spate of data is that economic conditions firmed somewhat as we entered the fourth quarter. The ISM reports, both manufacturing and service sectors, were looking much more solid than the previous months. Initial unemployment claims have drifted downward, possibly even poised to make a sustained break below the 450k mark. And the all important employment report did surprise on the upside.

Overall, the four quarter average of GDP growth is 3.1% - perhaps a bit higher than potential (or perhaps not, given earlier productivity gains), consistent with the relatively steady path of the unemployment rate since the beginning of the year. And note private sector payrolls are rising at a monthly rate of about 112k this year, at the low end of estimates necessary to absorb the growing labor force (albeit acknowledging the potential for additional drag from the public sector). To be sure, during the past two quarters, average GDP growth slowed to an average of 1.9%, threatening to undo these patterns and prompting the Fed to step up large scale asset purchases. But the pick up in activity suggested by the ISM reports signals that growth will edge back up in the final quarter of this year.

Like others, I could find quibbles with the data. For instance, the household side of the October employment report was not exactly inspiring, suggesting that high unemployment continues to drive persons out of the labor force. And the gains on the employment side were concentrated in a handful of sectors - retail and wholesale trade, temporary employment, and health and education services accounted for 123.1k of the 159k total. I would prefer broader based increases, but will hold out hope that the temp employment gains foreshadow a more durable recovery in the months ahead.

Moreover, I believe households are setting the groundwork for sustained spending growth in the quarters ahead. Not only are savings rates well off their lows, meaning that some or even much of that adjustment is already behind us. And financial obligations have collapsed back to levels last seen prior to the 2001 recession:

Goodness, consumer credit even rose a touch in September! Moreover, steady gains in the labor market would go a long way in supporting the handoff from spending sustained on transfer payments to spending sustained on wages. The net impact might not cause a surge in consumer spending, but it would at least keep it on its recent steady upward trend.

And yes, of course, households are still fundamentally challenged relative to five years ago. Housing markets remain a mess, net worth has been shredded, etc. And these events appear to have made something of a permanent mark on consumer psychology. Witness as retailers rush to get the jump on the holiday shopping season, ratcheting up discounts amid worries that consumers remain frugal and more discerning about their spending. From the Wall Street Journal:

Retailers and manufacturers are slashing flat-screen television prices more aggressively than usual this holiday season in hopes of avoiding a pileup of inventory.
Wal-Mart Stores Inc., Best Buy Co. and Inc. are touting deals ahead of Black Friday to clear out older and cheaper sets before an anticipated flood of deeper price cuts in coming weeks...
...The frenzy is being fueled by such top makers as Sony Corp. and Samsung Electronics Co., which are reducing suggested retail prices and sweetening their promotions with such extras as free Blu-ray movie players and 3-D glasses after initially overestimating the American consumer's appetite for pricey features….
...Television makers had expected bullish sales for 2010 on the theory that Americans were slowly loosening their purse strings and becoming receptive to new, pricier technologies such as ultrathin LED screens, Internet-connected sets and 3-D TV.
But slow 3-D TV sales and a buildup of U.S. television inventories in August and September showed that Americans were still behaving frugally amid continuing high unemployment...

That said, I think it is important to recognize that the relative challenges still facing households - namely a loss of asset values and the access to credit those values provided - is more a story of why spending did not quickly revert to trend, not a reason to believe that spending cannot be maintained along its current anemic trend:


Overall, I believe it is reasonable to embrace a story that the economy settles into a trend near potential growth - by some measures, an optimistic outlook. Indeed, I believe this was a story the Federal Reserve was willing to embrace, and would have had it not been for the slowing evident over the past two quarters.

That said, the recent flow of data does little to convince me that the US economy is set to grow much faster than potential. For the sake of argument, supposed that QE2 does in fact support the economy, pushing growth back up to the 3% range in 2011 and 2012. Sales increases, profits increase, jobs increase, everyone's happy, correct? Probably not. Consider the trajectory of the output gap under such circumstances:


I included the path of the output gap through the 1981 recession cycle, centering both on the begining of the respective recessions. At 3% growth, the output gap will narrow to 4.5% by the end of 2012, 14 quarters after the "end" of the recession. In contrast, in the mid-1980s, it took just 7 quarters to collapse the output gap to just 1%. Perhaps more dramatic is a look back at the employment to population ratio:

Continue reading "Fed Watch: Will the Fed Scale Up QE2?" »

Thursday, November 11, 2010

Hall: Inability to Cut Rates Fuels Joblessness

Robert Hall says we need to institute monetary policies that make current purchases cheap relative to future purchases (as with inflation):

Inability to Cut Rates Fuels Joblessness, by Timothy Aeppel: American consumers borrowed and spent their way into today’s slow recovery, and the jobless rate is being held near 10% because the Federal Reserve is unable to cut interest rates below zero, says Stanford University economist Robert E. Hall.
In a paper presented Thursday at a Federal Reserve Bank of Atlanta conference, Mr. Hall calculates that loose credit earlier in this decade resulted in consumers buying 14% more long-lasting items — from cars and dishwashers to houses — than they would have if credit conditions had remained as they were in the previous decade.
The recession was marked by those overextended households cutting spending and saving more in the face of hard times. The problem now is that the normal tool used to revive consumer spending and hiring — cutting interest rates well below the inflation rate — isn’t available because rates are nearly at zero. So unemployment has remained stuck at a high level, currently 9.6%.
Mr. Hall ... concludes that the only way to get the job market growing is to institute monetary policies “that emulate the effect of low real rates — making current purchasing cheaper than future.” That should be music to the ears of many at the Fed...

That is not the only way to get the job market growing, there's also fiscal policy. It's not politically viable right now, but it is an alternative tool. Fiscal policy can mimic the incentive effect of changes in real interest rates and expected inflation through changes in taxes, and it can stimulate the economy directly by purchasing goods and services from the private sector.

Too Much Concern about the Upside Risk to Inflation

 Japan also has inflation hawks on its monetary policy committee:

Maybe economists should only have one hand, by Antonio Fatas: ...[T]he debate about whether inflation or deflation is more likely, and about whether the aggressive response of central banks is appropriate today is at the heart of some of the most basic issues in macroeconomics. ...
One example that I always find interesting is the debate that one finds in the minutes of the monetary policy meetings at the Bank of Japan. When discussing the inflation outlook in Japan in recent years, you can always find views on both sides, those who are concerned with deflation and those who are concerned with inflation picking up. Here is a paragraph from the meeting back in April 2010.
Regarding risks to prices, some members said that attention should continue to be paid to a possible decline in medium- to long-term inflation expectations. One member expressed the view that attention should also be paid to the upside risk that a surge in commodity prices due to an overheating of emerging and commodity-exporting economies could lead to a higher-than-expected rate of change in Japan's CPI.
Of course, given the last 10 years of data in Japan, it seems awkward that some are concerned with the upside risk to inflation. While one cannot completely rule out this possibility maybe erring on the other side, making the mistake of letting inflation be "too high", for a few years would be good for the Japanese economy.
Clearly the US or Europe are not in the same situation as Japan but given some of the recent commentary about inflation I wonder whether we are getting close to a debate with too many hands and too many scenarios that leads to a lack of strong actions in the right direction. One can make mistakes in both directions (too much or too little inflation) and only time will tell in which direction our mistakes go, but given what we know about inflation, inflation expectations and long-term interest rates (all of them are low, stable or falling), it seems that we are worrying too much about the potential mistake of being too aggressive when it comes to monetary policy.

Tuesday, November 09, 2010

The GOP Victory and Macroeconomic Policy

I have a new column:

GOP Victory May End Government Economic Intervention: One of the oldest, most controversial issues in economics is how active government should be in managing the economy. Views on this have varied greatly through the ages, and we are in the middle of yet another large change in attitudes about the proper role of government. ...

I hope I'm wrong about this, and I think there's a decent chance that I am.

Monday, November 08, 2010

Paul Krugman: Doing It Again

The "inflationistas" are standing in the way of policy that might help the unemployed:

Doing It Again, by Paul Krugman, Commentary, NY Times: Eight years ago Ben Bernanke ... spoke at a conference honoring Milton Friedman. He closed his talk by addressing Friedman’s famous claim that the Fed was responsible for the Great Depression, because it failed to do what was necessary to save the economy.
“You’re right,” said Mr. Bernanke, “we did it. We’re very sorry. But thanks to you, we won’t do it again.” Famous last words. For we are, in fact, doing it again. ...
We’ve already seen this happen with fiscal policy: fearing opposition in Congress, the Obama administration offered an inadequate plan, only to see the plan weakened further in the Senate. In the end, the small rise in federal spending was effectively offset by cuts at the state and local level, so that there was no real stimulus to the economy.
Now the same thing is happening to monetary policy. The case for a more expansionary policy ... is overwhelming. Unemployment is disastrously high, while U.S. inflation data ... almost perfectly match the early stages of Japan’s relentless slide into corrosive deflation. ...
Yet the Pain Caucus —... those who have opposed every effort to break out of our economic trap — is going wild.
This time, much of the noise is coming from foreign governments ... complaining vociferously that the Fed’s actions have weakened the dollar. All I can say ... is that the hypocrisy is so thick you could cut it with a knife.
After all, you have China, which is engaged in currency manipulation ... unprecedented in world history — and hurting the rest of the world by doing so — attacking America for trying to put its own house in order. You have Germany, whose economy is kept afloat by a huge trade surplus, criticizing America for running trade deficits — then lashing out at a policy that might, by weakening the dollar, actually do something to reduce those deficits.
As a practical matter, however, this foreign criticism doesn’t matter much. The real damage is being done by our domestic inflationistas — the people who have spent every step of our march toward Japan-style deflation warning about runaway inflation just around the corner... — and they may already have succeeded in emasculating the Fed’s new policy.
For the big concern about quantitative easing isn’t that it will do too much; it is that it will accomplish too little. Reasonable estimates suggest that the Fed’s new policy is unlikely to reduce interest rates enough to make more than a modest dent in unemployment. The only way the Fed might accomplish more is by ... leading people to believe that we will have somewhat above-normal inflation over the next few years, which would reduce the incentive to sit on cash. ...
But in the same remarks in which he defended his new policy, Mr. Bernanke — clearly trying to appease the inflationistas — vowed not to change the Fed’s price target: “I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy.”
And there goes the best hope that the Fed’s plan might actually work.
Think of it this way: Mr. Bernanke is getting the Obama treatment, and making the Obama response. He’s facing intense, knee-jerk opposition to his efforts to rescue the economy. In an effort to mute that criticism, he’s scaling back his plans in such a way as to guarantee that they’ll fail.
And the almost 15 million unemployed American workers, half of whom have been jobless for 21 weeks or more, will pay the price, as the slump goes on and on.

Sunday, November 07, 2010

Williamson Yet Again

Steven Williamson replies again. He says things like:

I don't know what "aggregate demand" is.

I'll let him figure that out on his own, so let me deal with another part of his reply. He says this graph shows why we should fear inflation:

Presumably Mark would characterize the current state of the economy as "depressed." And, the fact is that reserves are leaving banks in the form of currency as we can see in this chart.


Note in particular that reserves have recently been leaving banks at a more rapid rate. It's possible that we would get more inflation even without QE2.

Ah, I see, the surge in 2008 is why we are having such a problem with inflation today! Oh wait.

It would be nice if he would take logs so that the "surge" is not misrepresented visually. And it would also be nice if he presented the entire series so we can see if there is, in fact, a surge relative to the historical average:

I'll let you decide if there has been a sudden surge in the growth rate of currency. It does appear to be a bit higher relative to the bubble years, but not relative to the entire history.

But what does an increase in currency holdings tell us anyway? People sitting on cash is no different than banks sitting on excess reserves. Are they spending the money right away or holding it for long periods of time? It matters.

In any case, the charts above show currency in circulation. But Wiliamson says that "Inflation is everywhere and always a monetary phenomenon." So what has been happening to (the log of) M2 (the monetarists' favorite measure of money -- he does call himself a New Monetarist after all)? Not much:


There was a little bit of a surge (remember all that inflation when it happened?), but M2 appears to be mostly back to trend. Maybe a second round of QE can change that?

And what do we know from other evidence on this question? Let me turn it over to Williamson's bestest buddy in the whole world, Paul Krugman (the monetary base is the sum of currency in circulation plus bank reserves):

Here’s a chart of growth rates of the monetary base and of M2, Friedman’s preferred monetary aggregate:
Bank of Japan
So, after 2000 the Bank of Japan engineered a huge increase in the monetary base; this was the original quantitative easing. And it didn’t even translate into a surge in the money supply!

And we are all aware of the severe problems Japan has faced with inflation as a result of its quantitative easing policy.

Just for completeness, here is the same graph with the growth in currency in circulation shown just underneath it for comparison (taken from the Bank of Japan web site):

Currency in Circulation - Bank of Japan

Japan had surges in currency too, but they did not translate into an outbreak of inflation.

Finally, I found this to be an interesting argument that the presence of excess reserves has nothing to do with the lack of demand for bank loans:

If the opportunities are there, the banks will lend.

Well, yes, but that begs the question of whether the opportunities are, in fact, there. I also like the contention that calling Bernanke a "wuss" is not "disparaging Bernanke's character." Yes, saying Bernanke is lying to himself or the rest of us when he claims, as he has repeatedly over the last week, that he will not let inflation get out of control is not a comment of his character, but whatever.

Despite Williamson's wishes to the contrary, there's no evidence here that inflation is just around the corner, or even down the street.

Update: Williamson replies yet again. I have interspersed my own comments [in brackets to keep them separate]:

Thoma - Last Comment: Thoma is back again with this. Replies as follows:
Ah, I see, the surge in 2008 is why we are having such a problem with inflation today!

He's talking about the surge in currency in circulation in 2008. Yes, exactly. This is why I'm not an old-fashioned quantity theorist. What has to be going on here is a large increase in the world demand for US currency during the financial crisis. All the more reason to be worried about inflation, as the crisis-driven demand goes away.

[The Fed has no way to remove currency or bank reserves from the system once the crisis is over and the economy starts recovering? This relies on the idea that the Fed won't be aggressive in fighting inflation, which in turn relies upon Williamson's contention about Bernanke's character. More on this below.]

what has been happening to (the log of) M2 (the monetarists' favorite measure of money -- he does call himself a New Monetarist after all)?

No, New Monetarists don't care about broader monetary aggregates. Neil Wallace taught us that.

[So his preferred monetary aggregate for predicting inflation is currency in circulation? I find that a bit strange. If it's not his preferred monetary aggregate, then what is it and why didn't he present that as evidence instead of the graph on currency in circulation? Perhaps because it doesn't make the case he wanted to make?]

I also like the contention that calling Bernanke a "wuss" is not "disparaging Bernanke's character."

This seems a bit strange. I'm not sure how Mark comes by all this respect for authority. In this context, I think it's healthy to be skeptical about what these central bankers are telling us. They have a penchant for secrecy, and I don't think we should take everything they say at face value, or necessarily trust them. We've given them an important job, and I think they are taking some big risks. If they screw up, we'll all suffer for it.

[It's possible to question authority without using the word "wuss" or turning it into a character issue, so his reply misses the mark. But this has nothing to do with questioning authority -- I have no problem with that -- and it's not about the particular words that are used. He's trying to turn this into a complaint about language when the underlying issue is that Williamson used a supposed character defect to justify his claim that we should be worried about inflation. He chose to hang his hat largely on Bernanke's character rather than try to make the case with economics, but seems unwilling to own up to this (even above, his main argument is that Bernanke and other Fed officials could be intentionally lying to us so we shouldn't trust them). I am not a big fan of Bernanke for reasons that precede his tenure at the Fed, and we should be skeptical and ask questions, but I think I would at least admit it when I attacked his character as a means of buttressing relatively weak economic arguments and to justify my arguments about inflation. Maybe he's right about Bernanke's character, maybe not, but as I said before nobody should mistake what Williamson is doing for economics. It's just as easy to use the character issue to argue that Bernanke will tighten too soon rather than too late, and debating Bernanke's inner soul gets us nowhere.]

[I'll end by simply noting that while I was pleased to see his first post today acknowledge the inconsistency in his original argument that I pointed out, he still hasn't answered one of the questions I asked, how inflation occurs in a recession when the unemployment rate is 10%. This was something he said we should be very worried about but how, exactly, does this occur? He said this was his last comment, so I guess we'll never know.]

Just for completeness, here is the same graph with the growth in currency (taken from the Bank of Japan web site) just underneath for comparison:

The Resetting of Clocks and Monetary Neutrality

This is mostly for Nick Rowe who says:

...Why does money have real effects? It's just bits of paper. It's not real. We are still stuck on David Hume's puzzle. If we double the number of bits of paper each one should be worth half as much. It should be a purely nominal change. Nothing real should change. If we switch from meauring turkeys in pounds to measuring them in kilograms, the price per unit weight should be divided by 2.2, but the same turkey should cost exactly the same in pounds or kilograms, and we should buy exactly the same number of turkeys as before.

Metrification was a nominal change that had negiligible real effects, as far as I know. Daylight Savings Time is a nominal change that has real effects. Some monetary changes, like currency reforms where we knock a couple of zeroes off the old currency and call it the new currency, are like metrification, where nothing real changes. And maybe all monetary changes are like metrification in the long run. But some monetary changes are like Daylight savings Time, and have real effects, at least in the short run.

If we understood Daylight Savings Time better, and how it works, we might understand monetary policy better. ...

This is a bit on the wonkish side, but here's an example along these lines from David Romer's graduate macro text (pgs. 295-296):

An analogy may help to make clear how the combination of menu costs with either real rigidity or insensitivity of the profit function (or both) can lead to considerable nominal stickiness: monetary disturbances may have real effects for the same reasons that the switch to daylight saving time does.[16] The resetting of clocks is a purely nominal change -- it simply alters the labels assigned to different times of day. But the change is associated with changes in real schedules -- that is, the times of various activities relative to the sun. And there is no doubt that the switch to daylight saving time is the cause of the changes in real schedules.
If there were literally no cost to changing nominal schedules and communicating this information to others, daylight saving time would just cause everyone to do this and would have no effect on real schedules. Thus for daylight saving time to change real schedules, there must be some cost to changing nominal schedules. These costs are analogous to the menu costs of changing prices; and like the menu costs, they do not appear to be large. The reason that these small costs cause the switch to have real effects is that individuals and businesses are generally much more concerned about their schedules relative to one another's than about their schedules relative to the sun. Thus, given that others do not change their scheduled hours, each individual does not wish to incur the cost of changing his or hers. This is analogous to the effects of real rigidity in the price-setting case. Finally, the less concerned that individuals are about precisely what their schedules are. the less willing they are to incur the cost of changing them; this is analogous to the insensitivity of the profit function in the price-setting case.

The question Romer is trying to answer is how it is possible for small menu costs (i.e. small costs of changing prices) to have large effects on the real economy.

I used to get mad at losing an hour of daylight and having it get dark before 5:00 pm, and for many, many years I refused to change my clock (I also hate changing it back in spring and losing an hours sleep). I still had to adjust my schedule to everyone else's so it didn't do much good, but somehow leaving my clocks an hour off made it a tiny bit better. I was surprised at how fast I was able to adjust each fall to the clock being wrong by an hour, though there were several instances when people in my office would get quite confused and panic after looking at the clock and thinking it was an hour later than it actually was. I found that amusing, they found it weird, and I did eventually turn the office clock so that visitors couldn't see it. These days, most of my clocks adjust automatically and I don't bother to change them back, but last year there were a couple of non-self adjusting clocks that I never got around to changing. I doubt I'll bother to change them this year either.

Williamson Responds to "Grumpy Thoma"

I was kind of grumpy. Here's Steven Williamson's response to my post:

Grumpy Thoma, by Steven Williamson: Apparently Mark Thoma didn't like my last piece on QE2. I've had a fairly peaceful time here for a while. Thankfully my fellow bloggers have not been paying much attention to me, and my readers are typically thoughtful and helpful in the comment box.

Now, as my mother (rest her soul) would have said, "Mark, did you get out of the wrong side of the bed this morning?" Hopefully my mother is not reading Thoma's blog, wherever she is, or she would think I had turned into a nasty piece of work.

Thoma was right about a couple of things, though. First, I did not lay out all the details of my arguments. Most of those are in previous posts, and obviously I can't assume everyone is reading all these things. Second, there is an inconsistency in there.

First, the details. What causes inflation? I'm with Milton Friedman on this one. Inflation is everywhere and always a monetary phenomenon. I'm not with Milton Friedman in the sense that I don't think the demand for an asset is anything like the demand for potatoes. Trying to find stable demand functions for monetary quantities is a waste of time. Think of the price level as being the terms on which the private sector is willing to hold the stock of outside money - currency and reserves. The Fed determines the total stock of outside money, and the private sector determines how that total gets split up between currency and reserves. What makes the price level go up? That would be anything that increases the supply of outside money relative to the demand.

Now, what is QE2 about? Under the current circumstances, with a large stock of excess reserves held in the financial system, it seems clear that a conventional exchange of reserves for T-bills cannot matter at all in the present. The Fed swaps one interest-bearing short-term asset for another, and nothing much should happen, short of some minor effects due to the somewhat different roles played by T-bills and reserves in the financial system. On the other hand, swapping reserves for long-maturity Treasuries, as in the QE2 plan, is a different story. We're now swapping a short-term interest-bearing asset for a long-term one. But what will the effects be? Unfortunately there is no good theory to tell us. To the extent that this matters in the present, for example by moving asset prices in the way that Bernanke seems to expect, this depends on some kind of financial market segmentation. Private financial intermediaries cannot be capable of undoing what the Fed is about to do.

Now, what I discussed in the previous paragraph is just about the current effects of the QE2 open market operations. What about the medium-term effects? There are two important points to note here about QE2. The first is that, while interest-bearing reserves, when they are held by banks, look essentially like T-bills, they have one feature that is very different from T-bills. This is that they can be converted one-for-one into currency. For a bank, a reserve account is a transactions account, and currency can be withdrawn from that account in the same way that you withdraw cash from the ATM. Thus, in contrast to T-bills, interest-bearing reserves can be converted into an asset that can be used in retail transactions.

Therefore, the more reserves that the Fed floods the financial system with, the more potential there is for inflation. As the economy recovers, other assets will become more attractive to banks relative to reserves, the demand for outside money will fall, and the price level must rise. Further, there could simply be a net increase in the supply of outside money relative to the demand at the outset of the QE2 operation. What I have in mind here is that, in spite of the fact that a QE2 open market operation simply swaps one consolidated-government liability for another, there may be some friction that implies that, on net, banks will not want to hold the extra reserves at market prices. Surely this is part of what the Fed has in mind. They think that long bond yields will fall. However, part of the adjustment should be an increase in the price level as well.

Now, if the inflation rate starts to rise, what happens then? There are three forces here that are going to make inflation control difficult. First, QE2 will have lengthened the maturity of the Fed's asset portfolio, so that the Fed has a lot more to lose from an increase in short-term interest rates. To tighten, the Fed will have to increase the interest rate on reserves (thus increasing all short rates), which results in a capital loss on its portfolio that will be larger the longer the average maturity of the Fed's assets. If the Fed continues to hold those assets, its income will fall, and if it sells the assets it will be selling them at a loss. If the Fed does not tighten, then inflation rises. None of these outcomes is very appealing. The second force at play is that Bernanke in particular thinks that monetary policy matters for real activity in a big way, and he will be very reluctant to tighten as he will think that he risks another recession. Third, and I may be wrong about this, but I think Bernanke is probably a wuss. He does not want to bear the short term pain associated with people screaming at him if tightening occurs.

Finally, on the inconsistency, I said here, by implication, that I did not think that QE2 would have much in the way of real effects. But I also said that it is costly to bring inflation down. Seems a little goofy, right? Some people think they understand nonneutralities of money well, but I don't feel like I do. Keynesians (new and old) have not convinced me that sticky wages and prices imply that a monetary expansion gives aggregate output a big kick in a positive direction. Some people, including me, made a case that market segmentation could imply a substantial redistributive effect of monetary policy, but this seemed to matter more for asset prices and allocation than for aggregate activity. New Monetarist ideas may give us short-run nonneutralities of money associated with asset trading and liquidity, and with credit market activity, but we haven't worked all of that out. Given what we know, my forecast is that the net real effects of QE2 will be insignificant. Now, what if inflation takes off, Bernanke is not a wuss, and substantial monetary tightening occurs? Do we have to suffer a lot to bring inflation down, or not? The "Volcker recession" was severe, but in the early 1980s inflation came down over a relatively short period from about 15% to 5%. There were plenty of people at the time who thought that the consequences of tightening would be much more severe. Possibly with the benefit of our 1970s and 1980s experience we can manage this inflation better. Who knows?

I'm happy to see that he acknowledges the inconsistency I pointed out, but I don't think this fully answers one of my questions. Saying that inflation is always and everywhere a monetary phenomena, and that prices depend upon the amount of outside money in the system, doesn't answer the question about how we get inflation before aggregate demand kicks up. That is, how do we get inflation in the scenario in his previous post where inflation begins increasing to worrisome levels even if there is an unemployment rate of 10% and aggregate demand remains depressed? As Williamson acknowledges, money that piles up in the banks as excess reserves does not increase inflation, it's only "potential" inflation. Exactly how the excess reserves leave banks in a depressed economy is not explained other than through reference to some vague friction that says banks won't want to hold reserves. But who will buy the reserves they no longer want to hold? The story above assumes that banks can loan money if they want, that there is plenty of demand if banks are willing to meet it, but is that really the case right now? Is the supply of credit the main constraining factor or is it the demand? And how much will that demand change if long-term rates fall by a small amount through quantitative easing? I understand the statement that "the more reserves that the Fed floods the financial system with, the more potential there is for inflation. As the economy recovers, other assets will become more attractive to banks relative to reserves, the demand for outside money will fall, and the price level must rise." This statement is conditional upon the economy recovering. But I still don't see how excess reserves are converted into real investments in plants and equipment on a significant scale, or converted into other components of aggregate demand, in a stagnating economy. Perhaps this can be clarified (I'm not saying this can't happen, there are historical instances of high inflation in stagnating economies, but the the mechanism Williamson has in mind and why the mechanism should be operable in this case is not yet clear.)

Finally, if claiming someone is a "wuss" is a key component of your argument, I suppose that's fine, but we shouldn't pretend that an opinion about someone's character is based upon any sort economic reasoning. It's a convenient opinion/assumption that helps Williamson's story about why we should worry about inflation hold together, but it runs contrary to what Bernanke has said he will do. It's just as easy to assert that Bernanke is very, very concerned about Fed credibility at this point, that he will therefore keep his word, and that he may even begin tightening too soon (and I don't think worries about losses on its portfolio will affect the Fed's decision much if at all). He may be too much of a "wuss" to risk inflation and the Fed's credibility, and his statement that "We're not in the business of trying to create inflation" lends credence to this view. Thus, making assertions about Bernanke's personality to support an argument doesn't get us anywhere useful, one can assert whatever is convenient for the argument at hand. In any case, an inflation problem from a booming economy would be welcome right now -- it's a problem I wish we had -- and if and when that occurs, I remain convinced the Fed has the tools and the will to keep the problem under control.

Saturday, November 06, 2010

"Federal Reserve Reflects on its History"

Bernanke says he's not trying to create inflation as a means of stimulating the economy:

After its big move to boost economy, Federal Reserve reflects on its history, by Neil Irwin, Washington Post: ...Fed Chairman Ben S. Bernanke and a long list of past and present Fed officials gathered this weekend for a conference on the history of the central bank...
That conversation, particularly a Saturday panel discussion featuring Bernanke, his predecessor, Alan Greenspan, and former New York Fed president Gerald Corrigan... Speaking at the "Return to Jekyll Island" conference sponsored by the Atlanta Fed, Bernanke argued that the steps are not as revolutionary as many observers in the financial markets and the news media have suggested.
"There's a sense out there that, quote, quantitative easing or asset purchases are some completely foreign, new, strange kind of thing and we have no idea what . . . is going to happen," Bernanke said, sitting on stage in a conference space that was once J.P. Morgan's indoor tennis court. "Quite the contrary - this is just monetary policy. . . . It will work or not work in much the same way that ordinary, more conventional, familiar monetary policy works."
Corrigan, who was a key lieutenant of Fed Chairman Paul A. Volcker and now a Goldman Sachs managing director, acknowledged some "uneasiness" with that approach.
"If you seek to nudge up the inflation rate," he said, "even with very, very low rates of capacity utilization in the labor market . . . is there a risk that getting inflation to 2 percent may turn out to be easier than capping it at 2 percent?" "That's the source of uneasiness that I wanted to register," Corrigan added.
Bernanke defended the action. "I have rejected any notion that we are going to try to raise inflation to a super-normal level in order to have effects on the economy," he said. "We're not in the business of trying to create inflation," Bernanke said. Rather, he said, the Fed is trying to avoid a further drop in inflation. ...

Since an increase in inflationary expectations is one potential way to stimulate the economy, Bernanke is "blocking one of the main channels through which his policy might actually work."

The "Greenspan Put" also came up:

To many Fed critics, a central failure over the past three decades has been the perceived willingness of the central bank to take action to prop up financial markets whenever they are faltering, a phenomenon known as the "Greenspan Put," which uses the term for an option that protects against an asset losing value.
The criticism is that by standing in to prevent precipitous declines in financial markets, the Fed made it appear that one could invest without risk...
Given that his own policies have helped prop up stock prices in the past year, Bernanke echoed the phraseology of some of his critics and referred to the phenomenon, almost sheepishly, as the "Greenspan/Bernanke Put."
Greenspan was unrepentant.
"If in effect the Greenspan Put is the notion which says you're stabilizing the system, then I hope so - that's what we're here for," the former Fed chairman said. "I don't really have an understanding of why that has become a pejorative term. . . . If I understand it, what we're doing is what we should be doing." ...

In looking through past comments on the Greenspan put, I found this from 2005:

...the broader question of whether the perception that the Fed will protect asset markets is causing overconfidence and excessive risk taking among investors is an interesting issue.  For some reason, I’ve been reminded lately of the overconfidence among policymakers in the early 1960s.  After the discovery of the Phillip’s curve and the belief that it represented a permanent inflation-unemployment tradeoff, policymakers were very confident in their ability to pick a particular point on the Phillip’s curve and it was widely believed that the stabilization problem was largely solved.  History teaches us that such overconfidence in any discipline is generally a bad idea, and the 1970s showed economists that humility is always a valuable trait.  Has a run of good luck caused a misperception of the risk of losses so that such overconfidence has emerged again?

I think it's safe to say now that it had. As for the Greenspan put, I had always argued there was no such thing, based partly on quotes like this:

Neither Mr. Bernanke nor his closest colleagues, some of whom served under Mr. Greenspan, believe there ever was a "Greenspan put," a reference to a contract that protects an investor from loss. Yet officials acknowledge the perception that the Fed has bailed out investors in the past. When the stock market crashed in 1987, Mr. Greenspan, then on the job for just two months, used aggressive open-market operations -- buying and selling government securities -- to pump banks full of cash...

What's best for the stock market isn't always what's best for the economy, and when there is a tension between the two, the economy should come first. While this is what I *think* Greenspan is saying above by redefining the Greenspan put to mean "stabilizing the system," it's disappointing to see him embrace the term without cautioning that the Fed shouldn't always try to prevent a fall in the stock market, and that it sometimes has to temper a stock market boom, e.g. by raising interest rates to prevent the economy from overheating, or by popping asset bubbles.

"Bernanke And The Shibboleths"

Paul Krugman:

Bernanke And The Shibboleths, by Paul Krugman: Everyone hates quantitative easing. The inflationistas believe that it’s the end of Western civilization (but as a correspondent points out, we want them to believe that; similar beliefs about the end of the gold standard helped recovery in the 1930s); meanwhile, the rest of the world is furious at the Fed’s actions.
Clearly, Bernanke must be doing something right. As Greg Ip says, all the objections currently being offered to QE would apply equally well to conventional monetary policy — and given high US unemployment and sagging inflation, how can you argue that monetary expansion is unjustified?
But what we’re seeing worldwide right now is an inability to think clearly about economics. In particular, the unconventional nature of our situation is making it clear how many people rely not on any model of how the economy works but rather on what the late Paul Samuelson called shibboleths — by which he meant slogans that take the place of hard thinking.
The basic situation of the world economy is simple: we have an excess of desired saving over desired investment, even at a zero interest rate. ...
How did this happen? The answer, mainly, is that over-borrowing in the past has left large parts of the world credit-constrained, forced to deleverage by cutting spending; and even a zero interest rate isn’t enough to persuade the unconstrained players to increase spending by enough to offset these cuts.
Yet interest rates can’t go below zero; which poses a problem. For the world as a whole, savings must equal investment, or, equivalently, spending must equal income. So this incipient excess of savings leads to a depressed world economy, in which income falls to match the amount people are able/willing to spend.
So what can policy do?
1. It can try to achieve negative real interest rates by creating expectations of inflation. ...
2. Alternatively, governments can step in and spend while the private sector won’t.
3. Finally, central banks can try to circumvent the zero lower bound by buying long-term debt. The point here is that we only have zero rates at the short end, and it’s possible, though not certain, that you can get at least some traction by buying those longer-term bonds.
But now that we’re in this situation, VSPs around the world are objecting to all of these possible actions. Inflation targets are horrible because we must have price stability. Fiscal policy is unacceptable because we must have balanced budgets. QE is outrageous because that’s not what central banks are supposed to do.
Notice that in each case the objection is based on a shibboleth. Price stability is treated as an absolute virtue, without any model to explain why. The same with budget balance. And those who are horrified at the idea of expansionary monetary policy have been inventing concepts on the fly to justify their position.
The simple fact is that we have a global excess supply of savings, which is doing terrible things to workers. The reasonable thing is to do something about it; it’s deeply unreasonable, and deeply irresponsible, to invent reasons not to act because you’re clinging to simplistic slogans.

Here's an example of someone worried that QEII will result in uncontrollable inflation. Steven Williamson has trouble being civil -- I suspect it's the frustration from thinking he's built a better theoretical mousetrap yet the world keeps beating a path to someone else's door -- so I'm sure this will bring some response about how stupid I am for not understanding this or that, and how stupid anyone who might disagree with him is. But his objections are hard to understand or, as Krugman predicted, left unexplained.

His first fear is that:

One possibility is that economic growth picks up, of its own accord, reserves become less attractive for the banks, and inflation builds up a head of steam. The Fed may find this difficult to control, or may be unwilling to do so.

If  the economy begins growing so robustly that inflation breaks out, and as posited by Williamson, QEII has nothing to do with that growth ("growth picks up, of its own accord"), why, exactly, would the Fed be reluctant to remove reserves from the system? If the system is overheating due to high rates of growth, what harm will the Fed fear? If adding the reserves didn't stimulate the economy, how will removing them harm it? QEII didn't help, but ending it will harm the economy? I suspect Williamson has an asymmetric loss function of some sort -- creating inflation, or the expectation of it in the future, doesn't stimulate the economy but lowering it does harm -- but we aren't told what that story is. We're simply told the Fed "may find this difficult" or "may be unwilling." There are certainly stories one can tell about the harmful effects of reducing inflation, e.g. a standard Phillips curve model, but what story does he have in mind? I doubt very much that it's the New Keynesian Phillips curve story, but can't really say -- it's hard to evaluate an objection when you aren't told what it is.

(The reason I am saying that Williamson is assuming QEII will do no good at all is that he only identifies costs and objects on that basis. If there are benefits, then they ought to be weighed against the costs if you are doing an economic analysis. But he doesn't do that. That means he either thinks there are no benefits, as I've assumed, or that he is presenting a one-sided, misleading argument based only on costs to make his case.).

His second objection is that:

Even worse is the case where growth remains sluggish, but inflation well in excess of 2% starts to rear its ugly head anyway. Bernanke is telling us that he "has the tools to unwind these policies," but if the inflation rate is at 6% and the unemployment rate is still close to 10%, he will not have the stomach to fight the inflation.

But how does inflation pick up if aggregate demand remains stagnant? If the reserves are simply piling up in banks, how, exactly does the inflation occur? (Does he mean asset price inflation perhaps? Worried about a bubble maybe?). Waving your hands and saying the economy is sluggish, but there's inflation without explaining how that inflation happens is simply assuming the bad results you want. Maybe Williamson has a story in mind about how prices get driven upward without an increase in aggregate demand, and I expect a (less than civil) response detailing this, but we aren't told what that story is.

Williamson's final paragraph says:

My concern here is that, given the specifics of the QE2 policy that was announced, the FOMC will be reluctant to cut back or stop the asset purchases, even if things start looking bad on the inflation front. Once inflation gets going, we know it is painful to stop it...

This completely ignores Bernanke's clear statement that the Fed will reevaluate the program in light of changing economic circumstances. The Press Release announcing the QEII program was very clear about that, and Bernanke made sure to repeat it in his Washington Post editorial the next day. Williamson clearly does not believe the Fed will actually do what it says it will do since he thinks the costs of ending the QEII program prematurely or reversing it would be so large. But, again, what are those costs? To summarize my questions, why is it painful to stop inflation when the economy is overheating due to excessive demand? We're told the Fed may be "reluctant," but why would they be reluctant to temper inflation in an overheating economy? Why would reducing inflation be so harmful in the Fed's eyes in this case? And if the economy is not overheating, if demand remains stagnant, how exactly does the inflation occur to begin with?

Let me add one more thing. This statement made me chuckle:

Predictably, Krugman and this two buddies DeLong and Thoma think the asset purchase program should have been larger.

First, anytime anyone wants to put me in the same group with DeLong and Krugman, that's fine with me, even if it is to claim we're all idiots. I don't mind being told I'm as dumb as those two. If the phrase "Krugman, DeLong, and Thoma" catches on, as opposed to, say, just "Krugman and DeLong," no problem here. But the funny part to me is that in his desire to put the three of us into the same group so he can summarily dismiss two of us as nothing more than Krugman echoes, he seems to have missed that the three of us don't agree on how well QE will work. I guess pointing out that "predictably" we disagree on some aspects of quantitative easing sort of ruins his effort to undermine us, but at least it would be accurate.

Update: Please see my follow-up post on this: Williamson Responds to "Grumpy Thoma".

Friday, November 05, 2010

"An Open Letter to the President"

Michael Perelman:

An Open Letter to the President, by Michael Perelman: This letter was sent to the President, who failed to heed the warning, which turned out to be correct.

You have made yourself the Trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office.

I wish I had the foresight to have written this letter, but it was sent to the new president in 1933. The author was John Maynard Keynes. Although the letter is old, it is absolutely on target in predicting, “If you fail, rational change will be gravely prejudiced throughout the world.”
Wake up Obama before you do more damage by imagining that cooperation with the Right rather than leadership is the way forward.
By the way, in 1938 Keynes also warned the president that because of the 1937 austerity, “the present slump could have been predicted with absolute certainty.” Brad DeLong reprinted that letter.

Here's a shortened version of the letter from the first link above. The letter is organized by numbered points. I found point 18 interesting in light of recent calls to use quantitative easing to bring down the long end of the yield curve. Keynes is talking about changing the average maturity of the Fed's bond holdings by trading short-term for long-term bonds rather than purchasing long-term bonds through an expansion of the Fed's balance sheet, so he isn't calling for quantitative easing. But he does "attach great importance" to movement at the long end of the yield curve. I also found point 8 interesting since World War II -- which came after this letter -- is generally credited with validating Keynes' ideas:

An Open Letter to President Roosevelt
By John Maynard Keynes

Dear Mr President,
1. You have made yourself the Trustee for those in every country who seek to mend the evils of our condition by reasoned experiment within the framework of the existing social system. If you fail, rational change will be gravely prejudiced throughout the world, leaving orthodoxy and revolution to fight it out. But if you succeed, new and bolder methods will be tried everywhere, and we may date the first chapter of a new economic era from your accession to office. This is a sufficient reason why I should venture to lay my reflections before you, though under the disadvantages of distance and partial knowledge.
2. At the moment your sympathisers in England are nervous and sometimes despondent. We wonder whether the order of different urgencies is rightly understood...
3. You are engaged on a double task, Recovery and Reform;--recovery from the slump and the passage of those business and social reforms which are long overdue. For the first, speed and quick results are essential. The second may be urgent too; but haste will be injurious, and wisdom of long-range purpose is more necessary than immediate achievement. It will be through raising high the prestige of your administration by success in short-range Recovery, that you will have the driving force to accomplish long-range Reform. On the other hand, even wise and necessary Reform may, in some respects, impede and complicate Recovery. For it will upset the confidence of the business world and weaken their existing motives to action, before you have had time to put other motives in their place. It may over-task your bureaucratic machine, which the traditional individualism of the United States and the old "spoils system" have left none too strong. And it will confuse the thought and aim of yourself and your administration by giving you too much to think about all at once.
4. Now I am not clear, looking back over the last nine months, that the order of urgency between measures of Recovery and measures of Reform has been duly observed, or that the latter has not sometimes been mistaken for the former. ...
5. My second reflection relates to the technique of Recovery itself. The object of recovery is to increase the national output and put more men to work. In the economic system of the modern world, output is primarily produced for sale; and the volume of output depends on the amount of purchasing power... Broadly speaking, therefore, an increase of output cannot occur unless by the operation of one or other of three factors. Individuals must be induced to spend more out o their existing incomes; or the business world must be induced, either by increased confidence in the prospects or by a lower rate of interest, to create additional current incomes in the hands of their employees, which is what happens when either the working or the fixed capital of the country is being increased; or public authority must be called in aid to create additional current incomes through the expenditure of borrowed or printed money. In bad times the first factor cannot be expected to work on a sufficient scale. The second factor will come in as the second wave of attack on the slump after the tide has been turned by the expenditures of public authority. It is, therefore, only from the third factor that we can expect the initial major impulse. ...
8. Thus as the prime mover in the first stage of the technique of recovery I lay overwhelming emphasis on the increase of national purchasing power resulting from governmental expenditure which is financed by Loans and not by taxing present incomes. Nothing else counts in comparison with this. In a ... slump governmental Loan expenditure is the only sure means of securing quickly a rising output at rising prices. That is why a war has always caused intense industrial activity. In the past orthodox finance has regarded a war as the only legitimate excuse for creating employment by governmental expenditure. You, Mr President, having cast off such fetters, are free to engage in the interests of peace and prosperity the technique which hitherto has only been allowed to serve the purposes of war and destruction. ...
10. I am not surprised that so little has been spent up-to-date. Our own experience has shown how difficult it is to improvise useful Loan-expenditures at short notice. There are many obstacle to be patiently overcome, if waste, inefficiency and corruption are to be avoided. There are many factors, which I need not stop to enumerate, which render especially difficult in the United States the rapid improvisation of a vast programme of public works. I do not blame Mr Ickes for being cautious and careful. But the risks of less speed must be weighed against those of more haste. He must get across the crevasses before it is dark.
11. The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the Quantity Theory of Money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor. ...
15. If you were to ask me what I would suggest in concrete terms for the immediate future, I would reply thus.
16. In the field of gold-devaluation and exchange policy the time has come when uncertainty should be ended. ...
17. In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months. ... You can at least feel sure that the country will be better enriched by such projects than by the involuntary idleness of millions.
18. I put in the second place the maintenance of cheap and abundant credit and in particular the reduction of the long-term rates of interest. The turn of the tide in great Britain is largely attributable to the reduction in the long-term rate of interest which ensued on the success of the conversion of the War Loan. This was deliberately engineered by means of the open-market policy of the Bank of England. I see no reason why you should not reduce the rate of interest on your long-term Government Bonds to 2½ per cent or less with favourable repercussions on the whole bond market, if only the Federal Reserve System would replace its present holdings of short-dated Treasury issues by purchasing long-dated issues in exchange. Such a policy might become effective in the course of a few months, and I attach great importance to it.
19. With these adaptations or enlargements of your existing policies, I should expect a successful outcome with great confidence. How much that would mean, not only to the material prosperity of the United States and the whole World, but in comfort to men's minds through a restoration of their faith in the wisdom and the power of Government!

With great respect,

Your obedient servant
J M Keynes

Thursday, November 04, 2010

Bernanke: What the Fed Did and Why

In the discussion earlier today of the Fed's announcement that it intends to purchase $600 billion in government bonds, I used the term "communications strategy" to describe some of the language in the Press Release. The language in the Press Release does attempt to communicate a commitment from the Fed to meet its inflation and employment targets, but the term "communications strategy" implies something beyond what the Fed announced it is doing (see here for a discussion). Using the term implies the Fed is taking bolder steps than it is actually taking.

The purchase should be much larger, and it should involve longer term Treasury securities (the plan is for 5 to 6 year bonds). The language in the Press Release about maintaining stable expectations is also disappointing to those who have been advocating a higher inflation target. This is not, by any means, a bold plan.

That's unlikely to change. Even if the economy continues to struggle, it's hard to imagine the Fed doing anything more than moving at a "measured pace," a pace too slow to do much except chip away at the margins.

With fiscal policy out the window and a timid, tip-toeing Fed, we're likely headed for an agonizingly slow recovery.

Here's Ben Bernanke's explanation of the Fed's policy and the reasoning behind it:

What the Fed did and why: supporting the recovery and sustaining price stability, by Ben S. Bernanke, Commentary, Washington Post: ...The Federal Reserve's objectives - its dual mandate, set by Congress - are to promote a high level of employment and low, stable inflation. Unfortunately, the job market remains quite weak; the national unemployment rate is nearly 10 percent, a large number of people can find only part-time work, and a substantial fraction of the unemployed have been out of work six months or longer. The heavy costs of unemployment include intense strains on family finances, more foreclosures and the loss of job skills.
Today, most measures of underlying inflation are running somewhat below 2 percent, or a bit lower than the rate most Fed policymakers see as being most consistent with healthy economic growth in the long run. ...
The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.
This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. ...
While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.
Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.
Our earlier use of this policy approach had little effect on ... broad measures of the money supply... Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.
The Federal Reserve cannot solve all the economy's problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.

Wednesday, November 03, 2010

The Fed Will Purchase $600 Billion in Treasury Securities

The Federal Reserve has decided to purchase $600 billion in Treasury securities through the end of the second quarter of 2011. As they note, this is around $75 billion per month. That is not enough to do much by itself (update: see here on this point), but this is an important addition to the policy:

The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed

The intent is to communicate a commitment to do whatever is necessary to hit inflation and employment targets, and the commitment is intended to impact expectations and hence impact expected inflation and real interest rates. The statement that we should expect "exceptionally low levels for the federal funds rate for an extended period" is part of this communications strategy.

As I've said many times, I'm skeptical about this doing much, but it could help some -- though a higher level of purchases each month would have been much better (update: and the bonds should be of longer duration than the 5-6 years bonds the Fed is planning to purchase). But with fiscal policy all but off the table, with tax cuts being the possible exception, it's the best we can hope for right now.

Here's the entire statement:

Press Release, November 3, 2010, For immediate release: Information received since the Federal Open Market Committee met in September confirms that the pace of recovery in output and employment continues to be slow. Household spending is increasing gradually, but remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending on equipment and software is rising, though less rapidly than earlier in the year, while investment in nonresidential structures continues to be weak. Employers remain reluctant to add to payrolls. Housing starts continue to be depressed. Longer-term inflation expectations have remained stable, but measures of underlying inflation have trended lower in recent quarters.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. Currently, the unemployment rate is elevated, and measures of underlying inflation are somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate. Although the Committee anticipates a gradual return to higher levels of resource utilization in a context of price stability, progress toward its objectives has been disappointingly slow.
To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month. The Committee will regularly review the pace of its securities purchases and the overall size of the asset-purchase program in light of incoming information and will adjust the program as needed to best foster maximum employment and price stability.
The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.
The Committee will continue to monitor the economic outlook and financial developments and will employ its policy tools as necessary to support the economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate. 
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; James Bullard; Elizabeth A. Duke; Sandra Pianalto; Sarah Bloom Raskin; Eric S. Rosengren; Daniel K. Tarullo; Kevin M. Warsh; and Janet L. Yellen.
Voting against the policy was Thomas M. Hoenig. Mr. Hoenig believed the risks of additional securities purchases outweighed the benefits. Mr. Hoenig also was concerned that this continued high level of monetary accommodation increased the risks of future financial imbalances and, over time, would cause an increase in long-term inflation expectations that could destabilize the economy. [Statement from Federal Reserve Bank of New York]

Also posted at MoneyWatch.

Update: I may not have been clear enough -- I agree with this assessment.

Monday, November 01, 2010

Will QEII Work?

As a follow up to the post below this one on whether QEII will work, here's Paul Krugman:

If I Were King Bernanke, by Paul Krugman: I’ve been asked by various people what I would do if I were Bernanke, and/or if I were in charge of the Fed. Those aren’t the same thing: Ben Bernanke isn’t a dictator, and the evidence suggests that he’d be substantially more aggressive in both his actions and his rhetoric if he weren’t constrained by the need to bring his colleagues with him.
So I don’t know what I’d do in his place. What I’d do if I were really in charge of the Fed, however, is the same thing I advocated for Japan way back when: announce a fairly high inflation target over an extended period, and commit to meeting that target.
What am I talking about? Something like a commitment to achieve 5 percent annual inflation over the next 5 years — or, perhaps better, to hit a price level 28 percent higher at the end of 2015 than the level today. (Compounding) Crucially, this target would have to be non-contingent — not something you’ll call off if the economy recovers. Why? Because the point is to move expectations, and that means locking in the price rise whatever happens.
It’s also crucial to understand that a half-hearted version of this policy won’t work. If you say, well, 5 percent sounds like a lot, maybe let’s just shoot for 2.5, you wouldn’t reduce real rates enough to get to full employment even if people believed you — and because you wouldn’t hit full employment, you wouldn’t manage to deliver the inflation, so people won’t believe you. Similarly, targeting nominal GDP growth at some normal rate won’t work — you have to get people to believe in a period of way above normal price and GDP growth, or the whole thing falls flat.
As I wrote way back, the Fed needs to credibly promise to be irresponsible — at least from the point of view of the VSPs.
The sad truth, of course, is that the chance of actually getting anything like this are no better than those of getting an adequate fiscal stimulus — at least for now. QE as currently contemplated is mild mitigation at best. What one has to hope is that as the reality that we’re in a liquidity trap sinks in (amazing how long that’s taking), as the fact that we’re doing worse than Japan starts to finally penetrate our arrogance, we’ll eventually get there. But it’s not going to happen this month.

Donald Kohn, who knows more than a little about the inside workings of the Fed, has something to say about whether the Fed is willing to promise to be irresponsible. He says the Fed is not about to let inflation get out of control, or even rise much:

The DNA of the FOMC [Federal Open Market Committee] is very focused on preventing a rise in inflation and inflation expectations that would be bad for the economy. I’m not worried about inflation getting out of control. Even if [the Fed] waits too long [to raise interest rates] when the time comes, they’ll be very alert and if necessary they’ll tighten up faster than they would have.

How is this policy going to generate an increase in expected inflation to the degree that is needed?

QEII: Even if Real Rates Fall and Expected Inflation Increases, Will Firms and Households be Induced to Increase Consumption and Investment?

It seems to me that everyone fighting today over whether QEII will work are worried about whether the Fed can affect real rates, but are forgetting about the second step in the process. Once real rates rates fall, firms and households then have to be induced to borrow more, then consume or invest (I'm including the response to expected inflation in this). Even if we manage to change real rates, and I have never quarreled with the Fed's ability to do this (though the extent depends upon their ability to affect expectations), why do people think it will bring about a strong consumption and investment response in the current environment? As Paul Krugman notes today, firms are already sitting on mountains of low opportunity cash and they aren't investing, and loans to consumers are already pretty cheap and they aren't increasing their consumption [Update: Or maybe you are hoping for a boom in exports as other countries allow the dollar to depreciate against their currency?]. Can the Fed create a enough expected of inflation (which it would have to validate later, or it will lose credibility and this will never work again) to change the behavior of firms and consumers enough to really matter?

The Stagnation Regime of the New Keynesian Model and Current US Policy

My colleague George Evans has an interesting new paper. He shows that when there is downward wage rigidity, the "asymmetric adjustment costs" referenced below, the economy can get stuck in a zone of stagnation. Escaping from the stagnation trap requires a change in government spending or some other shock of sufficient size. If the change in government spending is large enough, the economy will return to full employment. But if the shock to government spending is below the required threshold (as the stimulus package may very well have been), the economy will remain trapped in the stagnation regime.

(I also highly recommend section 4 on policy implications, which I have included on the continuation page. It discusses fiscal policy options, quantitiative easing, how to help to state and local governments, and other policies that could help to get us out of the stagnation regime):

The Stagnation Regime of the New Keynesian Model and Current US Policy, by George Evans: 1 Introduction The economic experiences of 2008-10 have highlighted the issue of appropriate macroeconomic policy in deep recessions. A particular concern is what macroeconomic policies should be used when slow growth and high unemployment persist even after the monetary policy interest rate instrument has been at or close to the zero net interest rate lower bound for a sustained period of time. In Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010), using a New Keynesian model with learning, we argued that if the economy is subject to a large negative expectational shock, such as plausibly arose in response to the financial crisis of 2008-9, then it may be necessary, in order to return the economy to the targeted steady state, to supplement monetary policy with fiscal policy, in particular with temporary increases in government spending.
The importance of expectations in generating a “liquidity trap” at the zero-lower bound is now widely understood. For example, Benhabib, Schmitt-Grohe, and Uribe (2001b), Benhabib, Schmitt-Grohe, and Uribe (2001a) show the possibility of multiple equilibria under perfect foresight, with a continuum of paths to an unintended low or negative inflation steady state.[1] Recently, Bullard (2010) has argued that data from Japan and the US over 2002-2010 suggest that we should take seriously the possibility that “the US economy may become enmeshed in a Japanese-style deflationary outcome within the next several years.”
The learning approach provides a perspective on this issue that is quite different from the rational expectations results.[2] As shown in Evans, Guse, and Honkapohja (2008) and Evans and Honkapohja (2010), when expectations are formed using adaptive learning, the targeted steady state is locally stable under standard policy, but it is not globally stable. However, the potential problem is not convergence to the deflation steady state, but instead unstable trajectories. The danger is that sufficiently pessimistic expectations of future inflation, output and consumption can become self-reinforcing, leading to a deflationary process accompanied by declining inflation and output. These unstable paths arise when expectations are pessimistic enough to fall into what we call the “deflation trap.” Thus, while in Bullard (2010) the local stability results of the learning approach to expectations is characterized as one of the forms of denial of “the peril,” the learning perspective is actually more alarmist in that it takes seriously these divergent paths.
As we showed in Evans, Guse, and Honkapohja (2008), in this deflation trap region aggressive monetary policy, i.e. immediate reductions on interest rates to close to zero, will in some cases avoid the deflationary spiral and return the economy to the intended steady state. However, if the pessimistic expectation shock is too large then temporary increases in government spending may be needed. The policy response in the US, UK and Europe has to some extent followed the policies advocated in Evans, Guse, and Honkapohja (2008). Monetary policy has been quick, decisive and aggressive, with, for example, the US federal funds rate reduced to near zero levels by the end of 2008. In the US, in addition to a variety of less conventional interventions in the financial markets by the Treasury and the Federal Reserve, including the TARP measures in late 2008 and a large scale expansion of the Fed balance sheet designed to stabilize the banking system, there was the $727 billion ARRA stimulus package passed in February 2009.
While the US economy has stabilized, the recovery has to date been weak and the unemployment rate has been both very high and roughly constant for about one year. At the same time, although inflation is low, and hovering on the brink of deflation, we have not seen the economy recording large and increasing deflation rates.[3] From the viewpoint of Evans, Guse, and Honkapohja (2008), various interpretations of the data are possible, depending on one’s view of the severity of the initial negative expectations shock and the strength of the monetary and fiscal policy impacts. However, since recent US (and Japanese) data may also consistent with convergence to a deflation steady state, it is worth revisiting the issue of whether this outcome can in some circumstances arise under learning.
In this paper I develop a modification of the model of Evans, Guse, and Honkapohja (2008) that generates a new outcome under adaptive learning. Introducing asymmetric adjustment costs into the Rotemberg model of price setting leads to the possibility of convergence to a stagnation regime following a large pessimistic shock. In the stagnation regime, inflation is trapped at a low steady deflation level, consistent with zero net interest rates, and there is a continuum of consumption and output levels that may emerge. Thus, once again, the learning approach raises the alarm concerning the evolution of the economy when faced with a large shock, since the outcome may be persistently inefficiently low levels of output. This is in contrast to the rational expectations approach of Benhabib, Schmitt-Grohe, and Uribe (2001b), in which the deflation steady state has output levels that are not greatly different from the targeted steady state.
In the stagnation regime, fiscal policy, taking the form of temporary increases in government spending, is important as a policy tool. Increased government spending raises output, but leaves the economy within the stagnation regime until raised to the point at which a critical level of output is reached. Once output exceeds the critical level, the usual stabilizing mechanisms of the economy resume, pushing consumption, output and inflation back to the targeted steady state, and permitting a scaling back of government expenditure.

Here is the section on policy options recommended above (it is relatively non-technical):

Continue reading "The Stagnation Regime of the New Keynesian Model and Current US Policy" »

Friday, October 29, 2010

"Friedman was All Wrong about Japan ... and the Great Depression"

As I've noted before, one thing I've learned from this recession is that it's not as easy to increase the money supply as I thought. It's easy to create additional bank reserves and increase the monetary base, but if the new reserves simply pile up in the banking system, then they don't have much of an effect on the supply of money:

More On Friedman/Japan, by Paul Krugman: ...So: David Wessel quoted what Milton Friedman said about Japan in 1998, and interpreted it as meaning that Friedman would favor quantitative easing now. I think that’s right. And just to be clear, I also favor QE — largely because it might help some, and seems to be just about the only policy lever still available in the face of political reality.

But I think it’s also important to note that Friedman was all wrong about Japan — and that you can argue that he was also wrong about the Great Depression, for the same reason.

For what Friedman argued, both for Japan in the 1990s and America in the 1930s, was that all the central bank needed to do was more — push out those reserves into the banking system. This would raise the money supply, and a higher money supply would have the usual effects.

But the Bank of Japan tried that — and found that pushing more reserves into the banks didn’t even lead to rapid growth in the money supply, let alone end the problem of deflation. Here’s a chart of growth rates of the monetary base and of M2, Friedman’s preferred monetary aggregate:

Bank of Japan

So, after 2000 the Bank of Japan engineered a huge increase in the monetary base; this was the original quantitative easing. And it didn’t even translate into a surge in the money supply! This is why I’m so skeptical of people who say that all the Fed has to do is target higher nominal GDP growth — in liquidity trap conditions, the Fed doesn’t even control money, so how can you blithely assume that it controls GDP?

And this also calls very much into question Friedman’s famous claim that the Fed could easily have prevented the Depression, which gradually got transmuted into the claim that the Fed caused the Depression. Yes, M2 fell — but why should we believe that the Fed had any more control over M2 in the 30s than the BOJ had over M2 more recently?

Again, that doesn’t mean that I oppose having the Fed engage in unconventional asset purchases. I’m just trying to be realistic about the likely results. We really, really need expansionary fiscal policy along with Fed policy; and we’re not going to get it.