Category Archive for: Monetary Policy [Return to Main]

Monday, May 23, 2011

Fed Watch: The War on Inflation

Tim Duy:

The War on Inflation, by Tim Duy: During World War II, advertisements warning against inflationary behavior were common. One example:

[click to enlarge]

This is a simple description of a wage-price spiral, something that was a real threat at the time as massive resources were being directed at the war effort. Some members of the Federal Reserve appear to believe this threat is as real today as it was then. Mark Thoma directs us to the Wall Street Journal, where Kathleen Madigan reads the FOMC minutes and concludes:

Windfall for commodity producers, no problem. Bigger paychecks for U.S. workers, now wait a minute…

That’s one reading of the minutes from the Federal Reserve‘s April 26-27 Federal Open Market Committee. The strategy makes sense from an economics’ standpoint; but it carries risks on both the political and growth fronts.

The extreme end of these fears can be found in Kansas City Federal Reserve President Thomas Hoenig’s recent Washington Post interview:

WP: One place where there’s not any inflation is in wages. Can you really have an inflation problem without wages rising?

TH: Not initially. But people are losing real purchasing power, and that changes how they’re going to negotiate. People want this lost purchasing power back in time. In negotiating, they’ll say, “Prices have been rising, we deserve more.” We’re already seeing it in some of the surveys that we run. Businesses are telling us, “Yes, we had a pay freeze a year and a half ago, but we’re doing some catch up now. We want to make sure we keep our good people.”

Any significant wage gains in the current environment appear to be sector specific – it certainly does not appear in the aggregate data. And note Hoenig’s distress that some firms are looking to play catch-up. I think you could interpret this as Hoenig desiring to see a downward level shift in trend wages. In other words, Hoenig expects the recession should result in a permanently lower level of standard of living than would have been the case otherwise.

For the moment, however, calmer minds prevail, pushing the Fed to delay tightening. From the minutes:

In their discussion of monetary policy, some participants expressed the view that in the context of increased inflation risks and roughly balanced risks to economic growth, the Committee would need to be prepared to begin taking steps toward less-accommodative policy. A few of these participants thought that economic conditions might warrant action to raise the federal funds rate target or to sell assets in the SOMA portfolio later this year, but noted that even with such steps, monetary policy would remain accommodative for some time to come. However, some participants indicated that underlying inflation remained subdued; that longer-term inflation expectations were likely to remain anchored, partly because modest changes in labor costs would constrain inflation trends; and that given the downside risks to economic growth, an early exit could unnecessarily damp the ongoing economic recovery.

If unit labor cost growth remains constrained, the Fed will tend to delay tightening, as the overriding economic reality is that simply described by New York Federal Reserve President William Dudley:

...the recovery remains moderate and we still have a considerable way to go to meet the Fed's dual mandate of full employment and price stability.

That said, it is worth considering that even the Fed doves probably have something of an itchy trigger finger when it comes to tightening. They are willing to stay the course given the lack of pass-through to wages, but one could imagine that changing quickly with the slightest whiff of rising unit labor costs. Which brings to mind an interesting topic. Way back in 2009, spencer at Angry Bear noted that labor payments as a share of output have been falling since the early 1980’s. Can this situation ever be reversed if the Fed steps on the brakes every time workers get a little too confident for their own good?

Mark concludes his review of the Madigan piece with:

We are much too worried about a wage-price inflation cycle breaking out and causing problems. If the Fed is too trigger happy, it could snuff out the recovery it is hoping to bring about.

The Fed is much, much better at slowing the economy down than it is at speeding it up. Thus, if the Feds is going to make an error, it should be biased toward the error it can fix the easiest. That is, in the face of uncertainty the Fed should be biased toward policy that is too loose rather than policy that is too tight -- a policy that is too loose is easier to correct if it's wrong. Unfortunately, I don't think the Fed sees it this way.

No, the Fed doesn’t see it this way. I think I know exactly how the Fed would respond to Mark: You think the 1980’s were easy? The expansion of the balance sheet has given rise to too many fears of the 1970’s within the Fed, and those fears will drive the Fed to try to stay far ahead of the inflation curve. That argues for a premature tightening. This year? Still seems difficult to imagine given the state of the economy. But next year seems reasonable, as further strengthening of the labor market will enhance fears that inflationary wage gains are just around the corner.

Finally, for those in Congress chastising the Fed for inflation, note point 4 in the advertisement above:

Support higher taxes…pay them willingly.

Thursday, May 19, 2011

Fed Fears Wage Increases

I think this is correct in terms of how the Fed is viewing inflation risks:

Fed Fears of Wage Increases Carry Risks, by Kathleen Madigan, RTE: Windfall for commodity producers, no problem. Bigger paychecks for U.S. workers, now wait a minute…
That’s one reading of the minutes from the Federal Reserve‘s April 26-27 Federal Open Market Committee. The strategy makes sense from an economics’ standpoint; but it carries risks on both the political and growth fronts.
According to the minutes, Fed officials continue to think the impact from higher commodity prices will be “transitory.” The bigger concern would be if wage increases took hold. After all, labor remains the biggest expense for most U.S. businesses. If wages were to increase rapidly, companies would be under more pressure to raise their selling prices — which would cause workers to ask for bigger raises to cover the higher prices.
So far, the Fed sees little evidence of that inflationary cycle — mostly because there is so much slack in the labor markets. ... And as long as the pressures on labor costs remain muted, “a large, persistent rise in inflation would be unusual,” the minutes added. In other words, higher prices concentrated in energy and raw materials won’t bring a response from the central bank. But if wages pick up, the Fed may step in.
In theory, the policy is sound, given the dominance of labor costs to pricing decisions. ... But don’t expect the public to welcome the idea that wage gains need to remain “subdued.” The Fed could face more threats of greater oversight from Washington politicians if central bankers are seen as turning a deaf ear to the wants of working voters. Congressional meddling would complicate the Fed’s job.
Second, the price increases being tolerated by the Fed are wreaking havoc on household budgets. ... Without faster real income growth, consumers won’t provide the demand needed to power the recovery. Keeping the recovery going is another ball the Fed needs to keep juggling.

We are much too worried about a wage-price inflation cycle breaking out and causing problems. If the Fed is too trigger happy, it could snuff out the recovery it is hoping to bring about.

The Fed is much, much better at slowing the economy down than it is at speeding it up. Thus, if the Feds is going to make an error, it should be biased toward the error it can fix the easiest. That is, in the face of uncertainty the Fed should be biased toward policy that is too loose rather than policy that is too tight -- a policy that is too loose is easier to correct if it's wrong. Unfortunately, I don't think the Fed sees it this way.

Wednesday, May 18, 2011

Fed Watch: Patting Themselves on the Back?

Tim Duy:

Patting Themselves on the Back?, by Tim Duy: The yield on 10-year Treasuries has slipped back to just a hair over 3% - despite the fact that the US has hit its legal "debt ceiling." The fresh reversal in yields appears to be further evidence against the ongoing hard-money fears that the combination of quantitative easing, deficit spending, and a falling dollar are sure to spell inflationary doom. As Paul Krugman likes to quip, the bond market vigilantes remain invisible.
From a monetary policy perspective, the behavior of the Treasury market would suggest that it may be too early to tap on the policy breaks. Here I offer an alternative perspective – one that I suspect will find some play among Fed officials. Recall that in his recent press conference, Federal Reserve Chairman Ben Bernanke focused on the need to maintain stable inflation expectations. Consider the behavior of an admittedly rudimentary measure of inflation expectations, the spread between Treasuries and inflation protected Treasuries:


By this measure, inflation expectations have come off their peaks in recent weeks. Further evidence that bond market vigilantes were getting ahead of themselves? Or evidence that the Fed did what “needed” to be done – throttle back on monetary policy to keep expectations under control?
In other words, I can see where some Fed officials could make the case that financial markets are simply responding positively to good, old-fashioned monetary austerity. The implications for policy are straightforward; officials could pat themselves on the back for a job well done, rather than worry that the move toward tighter money was once again premature.
From my perspective, recent market activity has followed a standard playbook – the advent of QE2 pushed market participants into the obvious trades. Long equities and commodities and short dollar. Trades that worked because they were balanced on a kernel of truth. Global economic activity did firm, and interest rate differentials should be dollar negative. At the same time, there was always a risk the trades would overextend and collapse, either under their own weight because the Fed took away part of the story. Perhaps it's been a little of both, with at least energy prices clearly sapping US growth and the Fed calling it quits on quantitative easing. What is left? An economy that is growing yet remains mired at a suboptimal level relative to potential output. Very similar to what we had before QE2 – an economic roundtrip to somewhere that is at least within sight of another lost decade for US job growth.

Thursday, May 12, 2011

Fed Watch: The Fed and Asset Prices

Is a Fed "put" official policy? I was just starting a post about this when I got an email from Tim saying he had just posted on the same topic. My post began with "If we're handing out money to rebuild balance sheets and spur the economy, I can think of more worthy recipients." Tim has a more thoughtful take:

The Fed and Asset Prices, by Tim Duy: Minneapolis Fed President Narayana Kocherlakota made some comments today explaining the role of equity markets in Fed policy. Michael Derby at the Wall Street Journal has the story:

In gauging the success of the Federal Reserve Treasury bond buying program commonly known as QE2, officials like Chairman Ben Bernanke have pointed to a rising stock market as a sign of policy making success.

Against the long course of Federal Reserve history, however, that’s a strange way to justify doing business. For many years, central bankers have declined to comment on the performance of stock markets, and have instead justified their actions in purely economic terms. ... Of course, stock market operators have always spoken of the a Fed “put,” in which the central bank will ease policy to arrest sustained stock market declines.

It isn’t clear whether Bernanke’s shift in focus represents a change in how the Fed does business, or whether his comments represent an effort to justify a policy that hasn’t worked as planned, leaving the chairman to support it in whatever way he can….

To start, I will agree that there is an effort on the part of Federal Reserve officials to not appear as if they are targeting the stock market directly. And I understand that Bernanke’s comment incited those who already believed the Fed targets stock prices. But officials certainly recognized long ago that the interest rate channel is not the only policy channel. Nor have they been afraid to acknowledge alternative channels. Refer to this 2003 speech by then-Governor Ben Bernanke:

Continue reading "Fed Watch: The Fed and Asset Prices" »



Tuesday, May 10, 2011

Is a 2% Inflation Target too Low?

I seem to be more hesitant about calling for a higher inflation target than people I generally agree with on economic policy:

A 2% Inflation Target Is too Low..., by Brad DeLong: Live at the Economist: Economist Debates: Inflation: Guest:
...should we be targeting a higher rate? I believe that the answer is yes.
To explain why, let me take a detour back to the early nineteenth century and to the first generations of economists--people like John Stuart Mill who were the very first to study in the industrial business cycle in the context of the 1825 crash of the British canal boom and the subsequent recession. John Stuart Mill noted the cause of slack capacity, excess inventories, and high unemployment: in the aftermath of the crash, households and businesses wished to materially increase their holdings of safe and liquid financial assets. The flip side of their plans to do so--their excess demand for safe and liquid financial assets--was a shortage of demand for currently-produced goods and services. And the consequence was high unemployment, excess capacity, and recession,.
Once the root problem is pointed out, the cure is easy. The market is short of safe and liquid financial assets? A lack of confidence and trust means that private sector entities cannot themselves create safe and liquid financial assets for businesses and households to hold? Then the government ought to stabilize the economy by supplying the financial assets the market wants and that the private sector cannot create. A properly-neutral monetary policy thus requires that the government buy bonds to inject safe and liquid financial assets--what we call "money"--into the economy.
All this is Monetarism 101. Or perhaps it is just Monetarism 1. We reach Advanced Macroeconomics when the short-term nominal interest rate hits zero. When it does, the government cannot inject extra safe and liquid money into the economy through standard open-market operations: a three-month Treasury bond and cash are both zero-yield government liabilities, and buying one for the other has no effect on the economy-wide stock of safety and liquidity. When the short-term nominal interest rate hits zero, the government has done all it can through conventional monetary policy to fix the cause of the recession. The economy is then in a "liquidity trap."
Now this is not to say that the government is powerless. It can buy risky and long-term loans for cash, it can guarantee private-sector liabilities. But doing so takes risk onto the government's books that does not properly belong there. Fiscal policy, too, has possibilities but also dangers.
My great uncle Phil from Marblehead Massachusetts used to talk about a question on a sailing safety examination he once took: "What should you do if you are caught on a lee shore in a hurricane?" The correct answer was: "You never get caught on a lee shore in a hurricane!" The answer to the question of what you should do when conventional monetary policy is tapped out and you are at the zero interest rate nominal bound is that you should never get in such a situation in the first place.
How can you minimize the chances that an economy gets caught at the zero nominal bound where short-term Treasury bonds and cash are perfect substitutes and conventional open-market operations have no effects? The obvious answer is to have a little bit of inflation in the system: not enough to derange the price mechanism, but enough to elevate nominal interest rates in normal times, so that monetary policy has plenty of elbow room to take the steps it needs to take to create macroeconomic stability when recession threatens. We want "creeping inflation."
How much creeping inflation do we want? We used to think that about 2% per year was enough. But in the past generation major economies have twice gotten themselves stranded on the rocks of the zero nominal bound while pursuing 2% per year inflation targets. First Japan in the 1990s, and now the United States today, have found themselves on the lee shore in the hurricane.
That strongly suggests to me that a 2% per year inflation target is too low. Two macroeconomic disasters in two decades is too many.

Monday, May 09, 2011

Fed Watch: Wild Week Leaves Fed Policy Intact

Tim Duy:

Wild Week Leaves Fed Policy Intact, by Tim Duy: Last week was quite the rollercoaster – one I suspect Fed policymakers will find consistent with their general outlook. The better than expected gains in nonfarm payrolls supports their claim that first quarter weakness will prove to be temporary, while the commodity price rout will give them the breathing room on inflation they felt they needed. This combination should keep the Fed locked on their current policy trajectory.

Consider last week’s data flow. It began with headline ISM manufacturing coming in 60.4, a tad below the previous month’s 61.2 but still respectable. The internals were arguable a bit weaker, although that should not be unexpected given such solid numbers in previous months – it is difficult to keep diffusion indexes moving upward at a certain point. All in all, another solid read on the manufacturing sector that showed no evidence of substantial slowing.

That optimistic view, however, was quickly upended by the ISM’s service sector report, which revealed a staggering 11.4 percentage point decline in the new orders index. This appears to be an artifact of commodity-price induced uncertainty. From the overall comments:

According to the NMI, 17 non-manufacturing industries reported growth in April. Respondents' comments are mixed about overall business conditions; however, they are mostly positive. Respondents' comments also indicate concern over rising fuel costs, commodity costs and the lingering uncertainty about the economy."

Interestingly, consider this note in the new orders category:

Comments from respondents include: "Customers are more optimistic" and "Improved market conditions."

I am not sure what to make of these comments, as they are not consistent with the new orders decline. Also note retail trade was the only sector reporting decreased business activity for the month, suggesting much strength otherwise. That does make sense given the likely impact of high gasoline prices on household budgets. Note the early read on retail sales was better than expected, but erratic. From the Wall Street Journal:

The 25 retailers tracked by Thomson Reuters showed an 8.9% sales gain for April at stores open more than a year, also known as same-store sales. The results beat analysts' expectations for an 8.4% rise and were the best showing in a year. The figures, however, were erratic, with a number of high profile retailers missing expectations.

Target Corp. (TGT) posted a 13.1% rise in April same-store sales, just beneath the 13.2% that analysts expected. The mass merchant said the results were somewhat below its own expectations as consumers were "very cautious" in their spending up until Easter. Chief Executive Gregg Steinhafel added that customers "face increasing pressure on their household budgets due to higher energy costs and increasing prices of food, apparel and home merchandise."

We get the official read on retail sales later this week.

Initial unemployment claims shot up, although the gains were attributed to noise in the data. Still, coming on the back of a general increase in claims in recent weeks, the report seemed to foreshadow a weak employment report. That was not exactly the case, as nonfarm payrolls posted a 244k gain, 268k in the private sector. The goods producing industries added 44k, with 29k in manufacturing alone, consistent with ongoing strength in that sector. Retail sales gained 57.1k, professional and business services 51k, and health care 41.8k. Possible red flag – temporary employment shed 2.3k workers

Notably, despite the employment gains and testifying to the overall low level of labor utilization, wage inflation remains non-existent, with average hourly earnings climbing just 3 pennies. Inflation hawks move along, nothing to see here.

The household survey was not quite as “bright.” Number of employed declined, number of unemployed and not in the labor force both rose. The net impact was to leave the unemployment rate slightly higher and the employment to population ratio slightly lower.

In short, the story remains the same – by the measure of nonfarm payrolls, labor markets are gaining momentum, but at a depressingly slow pace of improvement given the depth of the labor market hole. Yet, by in large, policymakers remain focused on the improvement, not the level. And that pushes policymakers into neutral gear, a point reiterated last week by New York Fed President William Dudley:

“The weakness of real GDP growth in the first quarter probably will prove temporary,” Federal Reserve Bank of New York President William Dudley said. “There are many reasons to believe conditions are in place for stronger growth in the coming months in the nation and the region,” he said.

While Dudley declined to comment on the monetary policy outlook, he noted “the recovery remains moderate and we still have a considerable way to go to meet the Fed’s dual mandate of full employment and price stability,” which suggests he sees no urgency to move to a more restrictive monetary policy stance.

Dudley declined to comment on the commodity price rout:

Dudley refused to comment on the recent activity in commodity markets. In response to a question, he said “I think I would never comment on short-term market price movements, and I don’t think today’s a good place to start.” He explained he’s more interested in medium to long-term trends, and he added “I would be hesitant to put much weight on very near-term development in terms of that changing the picture dramatically in terms of the broader issues. We’ll see how things go.”

He is not placing much weight on the drop because he placed little weight on the run-up in recent weeks. He is trying to look through the short-term gyrations to the underlying trend. Rational.

For the more hawkish policymakers, however, the short-term gyrations are important, and the decline in commodity prices in general, and oil prices in particular, should keep them at bay. A drop in headline inflation – Jim Hamilton estimates that gasoline prices could drop as much as 40 cents in the coming weeks – would leave them on shakier grounds when it comes to pushing for tighter policy sooner than later.

Bottom Line: The Fed believes Q1 weakness was temporary. I doubt this position changed much despite a wild week of data. Indeed, much of the weakness could be tied back to commodity prices, which look to be reversing course. Those declines will also silence the loudest screeches of the hawks. Most importantly, nonfarm payrolls surprised on the upside. Ultimately, that 244k gain is the life preserver they will cling to in an otherwise stormy sea.

Tuesday, May 03, 2011

"Frank Introduces Bill to Concentrate Fed Power in DC"

Taking a break from conference activities to note that this is a bad idea:

Frank Introduces Bill to Concentrate Fed Power in DC, by Luca Di Leo, WSJ: U.S. Rep. Barney Frank (D., Mass) Tuesday introduced a bill that would let interest rates be set only by Federal Reserve officials picked by the government, a new attempt to move power away from regional Fed officials chosen by the private sector.
The bill would remove from the 12-member policy-setting Federal Open Market Committee the five members who represent regional Fed banks. Only the seven-member board in Washington, which currently has two vacant seats, would get to vote onA interest rates. The congressman said this would make the Fed more democratic and increase “transparency and accountability on the FOMC” by eliminating those officials who are effectively picked by business executives.
Frank’s bill faces significant hurdles to clear Congress, where Republicans are likely to resist centralizing Fed powers in Washington. ...Analysts said Frank’s new proposal could hurt the Fed’s independence from Congress. ...

I can support - and have advocated -- reforming the way in which regional bank presidents are selected. But this proposal, which removes geographical representation even though recessions do not hit each area of the country equally, is a bad idea (the Board of Governors can already veto the appointment of a regional bank president, though I don't know of any instances where this power has been used). It takes us further away from the populist roots of the Fed's structure, a structure that tried hard to represent all interests in policy. It also furthers the concentration of power in Washington that has been occurring slowly but surely ever since the Bank Reform Acts in the wake of the recession established the Fed's current structure. In addition, it takes another step toward increasing the power of Congress over day to day monetary policy. When I look at how fiscal policy was conducted, the debate over the bank bailouts, the politicization of policy, and the general economic knowledge of those who want to have an increased hand in setting policy, I hate to even imagine how bad things would be if Congress had been in charge of monetary policy.

Anyway, there are more points to be made on this, most of which I've made in the past, but I think my view here is clear -- reform the selection process for regional bank presidents, but don't increase the concentration of power in Washington. (This was part of Dodd-Frank, it used to be that nine regional bank board members selected the regional bank president, three that represent bankers, three that represent business, and three that represent the public interest. Dodd-Franik removed the three votes representing banking interests, but left the three defending business interests. I would like to see, at a minimum, less representation of business so that the public interest generally can take center stage).

Monday, May 02, 2011

Fed Watch: Monetary Policy on Autopilot

Tim Duy:

Monetary Policy on Autopilot, by Tim Duy: The first quarter GDP number was profoundly disappointing. I always look back to the benchmark of the mid-80’s to measure the pace of the recovery, paying close attention to real final sales:


The pace of the current recovery pales by comparison. Indeed, even the meager 1.6% average final sales growth is inflated by the blowout 6.7% gain in the final quarter of last year. Excluding that quarter, the average is a miserable 0.9%. It was the that fourth quarter data that gave me hope the economy was actually turning a corner; that hope was so quickly dashed:

Headline GDP grew at an average of 2.45% over the past two quarters, at the lower end of estimates of potential growth. This is consistent with the numbers the labor market has been churning out in recent months, and hence it seems difficult to expect little change in the April employment report. Note the possibility for disappointment; as the economy has lost momentum, initial unemployment claims began to stagnate in April.

In the absence of dramatically faster growth, the output gap remains distressingly large:

Moreover, year-over-year core inflation remains well contained:

Near term core inflation, however, has edged up:


This is not surprising given pass-through from higher commodity prices, which, as noted by Calculated Risk, may already be easing. That near-term inflation rise, however, was enough to spook the Federal Reserve – the Bernanke word cloud reveals his emphasis on inflation as the inaugural press conference. St. Louis Federal Reserve President James Bullard was first out of the gate in the wake of last week's FOMC meeting to entrench expectations of tightening by the end of this year:

“We do have rising inflation and rising inflation expectations making me a little bit nervous,” Bullard said. “We’ve got to start taking some steps to start to tighten monetary policy as we continue on through 2011 to make sure we don’t allow inflation to get away from us.”

Bullard is a growth optimist:

The economy is likely to pick up speed following a slowdown at the start of the year, Bullard said, predicting gross domestic product will end rising 3.5% in 2011. Economic growth slowed to an annual 1.8% in the first quarter from 3.1% at the end of last year as higher prices, especially for gasoline and food, squeezed consumer spending in other areas.

I use the term optimist loosely. Note that if the economy grows 3.5%, the output gap closes by at best just one percentage point, so an the output gap of roughly 4.3% of GDP remains more than two years after the recession ended. This suggests the undercurrent is strongly disinflationary even if the commodity price jump places temporary upward pressure on inflation. It seems inconceivable in this environment, and with the Fed actually still easing, that policymakers are eager to reinforce expectations that tightening is imminent and thus work to nullify the easing before it actually occurs. Yet this is indeed the current state of policy.

Bottom Line: The die appears to be cast; the Fed is poised to complete QE2 by mid-year and then turn attention to tightening. We will be searching the data to see how much Q1 weakness is transitory. If it is more than transitory, and growth forecasts for the full year begin to trend down toward potential, the Fed will find itself again delaying a turn to tightening. But even if growth disappoints, until inflation begins to recede, any further easing looks off the table.

Saturday, April 30, 2011

David Andolfatto: Ron Paul's Comments on Bernanke's Press Conference

David Andolfatto continues his battle with Ron Paul and his supporters:

Ron Paul on Bernanke's Press Conference, Macromania: CNBC interview with Congressman Ron Paul yesterday (April 28, 2011); click here. The interviewer begins by quoting a statement Paul made after Bernanke's news conference:

Bernanke continues to ignore his culpability for the inflation all Americans suffer due to the Fed's relentless monetary expansion.

Let's take a look at U.S. inflation since 2008. Here it is.

The average annualized rate of inflation over this time period is a dizzying 1.6%. Note the significant deflation experienced during the economic crisis. Ah, good times. The rate of return on your money was really high back then! I can recall clearly how savers were rejoicing...praising the Fed for the deflation.

PCE inflation measures the nominal price of a basket of consumer goods. You know, the stuff people buy to maintain their material living standards. This price index was actually falling in 2010. For better or worse, the Fed interprets "price stability" as 2% inflation. This explains QE2.

PCE inflation has recently jumped up to near 5%. This jump is attributable primarily to food and energy prices. Despite what some people like to believe, the Fed does not control food and energy prices (at least, not separately from other prices). Most economists attribute these relative price changes to geopolitical events and other temporary global shocks affecting the world supply and demand for food and energy.

It seems that what Congressman Paul means by inflation (judging by this interview) is "commodity price inflation." I think he must have in mind the price of commodities like gold. ...

Recent money supply and gold price dynamics seem to support Congressman Paul's hypothesis, which he states as some sort of obvious universal truth. But if this is so, then what explains the following data?

The graph above plots the price of gold and the (base) money supply over the 20 year period September 1980 to March 2001. As you can see, the Fed created a lot of money "out of thin air" over this 20 year period. The base money supply increased by over 300%.

Imagine that you are 50 years old in September 1980. Imagine that a trusted friend of yours--oh, let's say your doctor--convinces you to put all your savings into gold. The reason he offers is that the Fed is pursuing a policy of "relentless money expansion." He warns you that the money supply is set to grow by 300% over the next 20 years. So you listen to him.

You buy gold at $673 per ounce. And then you wait. You wait until you turn 70. And then you go to withdraw your savings. You discover that the gold price in March 2001 is $263 per ounce. That's a whopping rate of return of...wait for it... -60% over 20 years. That's a minus sixty percent. ... Viva la gold standard! ...

Friday, April 29, 2011

Don't Let Fiscal Policymakers Off the Hook

The recent focus on Ben Bernanke and the Fed, in particular what more could be done to help the economy and the unemployed, takes the pressure off of fiscal policymakers. But Congress also bears as much responsibility, or more in my view, for the slow recovery and the sorry state of the employment picture.

Fiscal policy was far from aggressive enough -- at best it offset declines at the state and local level leaving the net effect near zero -- yet people express surprise it wasn't able to do more. It was also too small, way too late, and it was not persistent enough. Declines in stimulus spending as the program ends are holding back economic growth at a time when fiscal policy ought to be aiding, not stalling the recovery.

Our long-run budget problem is mostly a health care cost problem, and we do need to fix this. If we address the health care cost problem, the picture improves and any worry about bond vigalantes showing up in the future mostly goes away. If we don't adress health care costs, the long-run budget remains problematic no matter what else we do. Given that reality, there is plenty of time, plenty of room, and plenty of need for more help from fiscal policy. This was always a battle that needed to be fought on multiple policy fronts, neither monetary nor fiscal policy alone, or perhaps even in combination, was going to be enough. We needed both monetary and fiscal policy to respond aggressively, and to continue to respond as long as needed, but both have fallen short and there is no sign of monetary and fiscal policymakers moving to make up lost ground.

Monetary policymakers are feeling the heat right now, at least I hope they are, but don't forget about fiscal policymakers -- they too deserve to be on the hot seat. I understand that with all the talk of austerity, the chances of more help from fiscal policy without some huge change in the outlook is next to zero. But maybe, just maybe, we can stop Congress and the president from repeating the mistakes of the past (and present in Europe) by moving to balance the budget before the economy can handle it? I'm hoping we can avoid premature austerity -- that will hurt, not help employment -- but I'm not counting on it. </rant, for now anyway>

Update: From the CBPP:


Paul Krugman: The Intimidated Fed

Why won't the Fed do more to help the unemployed?:

The Intimidated Fed, by Paul Krugman, Commentary, NY Times: Last month more than 14 million Americans were unemployed by the official definition... Millions more were stuck in part-time work because they couldn’t find full-time jobs. And we’re not talking about temporary hardship. Long-term unemployment, once rare in this country, has become all too normal: More than four million Americans have been out of work for a year or more. ...
It all adds up to a clear case for more action. Yet Mr. Bernanke indicated that he has done all he’s likely to do. Why?
He could have argued that he lacks the ability to do more, that he and his colleagues no longer have much traction over the economy. But he didn’t. On the contrary, he argued that the Fed’s recent policy of buying long-term bonds, generally referred to as “quantitative easing,” has been effective. So why not do more?
Mr. Bernanke’s answer was deeply disheartening. He declared that further expansion might lead to higher inflation.
What you need to bear in mind here is that the Fed’s own forecasts say that inflation will be below target over the next few years, so that some rise in inflation would actually be a good thing, not a reason to avoid tackling unemployment. ...
The only way to make sense of Mr. Bernanke’s aversion to further action is to say that he’s deathly afraid of overshooting the inflation target, while being far less worried about undershooting — even though doing too little means condemning millions of Americans to the nightmare of long-term unemployment.
What’s going on here? My interpretation is that Mr. Bernanke is allowing himself to be bullied by the inflationistas: the people who keep seeing runaway inflation just around the corner and are undeterred by the fact that they keep on being wrong.
Lately the inflationistas have seized on rising oil prices as evidence in their favor, even though — as Mr. Bernanke himself pointed out — these prices have nothing to do with Fed policy. The way oil prices are coloring the discussion led the economist Tim Duy to suggest, sarcastically, that basic Fed policy is now to do nothing about unemployment “because some people in the Middle East are seeking democracy.”
But I’d put it differently. I’d say that the Fed’s policy is to do nothing about unemployment because Ron Paul is now the chairman of the House subcommittee on monetary policy.
So much for the Fed’s independence. And so much for the future of America’s increasingly desperate jobless.

Thursday, April 28, 2011

Joe Stiglitz and Joe Gagnon Debate QEII

This comes via Mike Konczal (who has additional comments):

Mike adds:

Side note: Gagnon earlier in his talk said that “one of the biggest goals of QEI was to push down the mortgage rate to spark a refinancing boom to encourage households and enable households to reduce their expenditures and repair their balance sheets and be able to spend again. That worked not quite as well as we hoped because the administration’s program for getting underwater borrowers to borrow didn’t work and I think that’s a true disaster that has no excuse. I have nothing but incredible, there’s just, the blame the administration on not doing this is just incredible. This could have been a huge success. We got the lowest 30-year mortgage rates in history and we couldn’t take advantage of them to the extent that we could. We got about a trillion dollars in refinancing when we should have gotten two or three trillion dollars in refinancing.” I haven’t heard this critique before and I thought it was really interesting.

Wednesday, April 27, 2011

"Decoding Ben Bernanke"

Here's the video I did on Bernanke's Press Conference that I mentioned in an earlier post: Decoding Ben Bernanke:

Green Shoots and the Fed

Here are some responses to Bernanke's Press conference from The Room for Debate:

Here's mine:

The Fed’s dual mandate requires it to pursue both full employment and price stability. Currently, however, the Fed is falling short on both of these goals.
Employment is far below its full employment level, and inflation is running below the Fed’s preferred range of 1.5 to 2.0 percent. Inflation is expected to rise a bit in the short-run due to rising commodity prices, but the Fed says it expects commodity price increases to be transitory.
Thus, none of the Fed’s forecasts show any long-run concern about inflation at all. The main question I wanted to hear Bernanke answer is, given that inflation is expected to remain low, why the Fed isn’t doing more to help with the employment problem? Why not a third round of quantitative easing?
Bernanke was asked this question, but his answer was unsatisfactory. The potential benefit of further policy moves by the Fed is higher growth and lower employment. The potential cost of more quantitative easing is inflation. So the decision on whether to provide more help to labor markets comes down to a comparison of the expected employment benefits to the expected inflation cost.
Even though there is no evidence of a problem in the Fed’s own projections, and the prices of long-term financial assets dependent upon future inflation show no evidence of inflation worries either, Bernanke nonetheless said that he believes the costs have risen relative to the benefits — that is, the Fed’s worry about inflation is standing in the way.
But I think there is something else behind the Fed’s reluctance to continue easing. The Fed first began seeing “green shoots” in April of 2009, a full two years ago. At every step since, the Fed has used the prospect of better times just around the corner as a reason to downplay the benefits of further easing.
But the growth of the green shoots has been stunted, or they have wilted away entirely. In retrospect, more aggressive action by the Fed was warranted in every instance. Perhaps this time is different — I sure hope so — but the recovery has been far too slow to be tolerable. Green shoots require more than hope, they require the nourishment, and with fiscal policy out of the picture it’s up to the Fed to provide it.

Bernanke's Press Conference

I am writing up my reaction to Bernanke's press conference, and it's basically the same as this. More later. I also did a video for CBS MoneyWatch discussing the conference and I'll post that as soon as it's available (Here's a link to the video).

Update: Here's Tim Duy's reaction:

Very High Bar for QE3, by Tim Duy: My first thoughts: The FOMC statement was consistent with my expectations, while Federal Reserve Ben Bernanke sounded slightly more hawkish than I anticipated.  The latter confirms the view I took two weeks ago – near term inflation gains were not sufficient to justify altering the current policy stance, but would derail any additional increases to the balance sheet beyond June.

The FOMC statement itself was largely straightforward.  Arguably a bit of a downgrade of the economy (as CR notes, the “firmer footing” language has disappeared) and a little more talk about inflation.  The new economic projections reflected these alterations, with growth forecasts brought down to pretty much the same range when the Fed initiated QE2, while near-term headline inflation forecasts are higher.

The initial phase of Bernanke’s press conference was also in line with my expectations.  He noted that the expectations for trend growth and the natural rate of unemployment were beyond the control of the Fed, while inflation was directly determined by monetary policy.  He explained the reasoning for a positive rate of inflation, explicitly pointing to the concern about deflation, defined as falling wages and prices.  This was, I believe, the last we heard about wages.

In response to the Q&A portion, he said the impending weak Q1 growth numbers are the result of transitory factors (defense spending, exports, weather), and “possibly less momentum.”  The latter phrase was a bit disconcerting and should suggest a predilection toward additional asset purchases beyond June, but apparently the FOMC intends to focus on the transitory nature of the numbers.  See again my earlier piece.  When questioned about the timing of any exit, Bernanke explained the relevant factors, including the sustainability of the recovery, the strength of the labor market, the direction of inflation, and resource slack.   Not surprisingly, he gave no timeline to tightening. 

Regarding the end of QE2, he reiterated the “stock” view of the balance sheet.  Essentially, the pace of accumulation is less important than the size of the balance sheet, and there were no plans to shrink assets.  Indeed, he suggested the first step toward tightening would be to stop reinvesting assets as they mature or are redeemed.  I thought he handled the Dollar questions well – throwing it back in the lap of Treasury Secretary Timothy Geithner and claiming, rightly in my opinion, that the best thing for the Dollar over time is that the Fed pursues policies that satisfy its dual mandate.

The most interesting comments came in response to questions about whether the Fed should do more to lower unemployment and if QE2 is effective, shouldn’t the program continue?  Here was a more hawkish Bernanke.  As I noted earlier, growth forecasts returned to the pre-QE2 range, which should be a red flag.  Unemployment remains high, with only moderate job creation.  Core-inflation remains low, while the impulse from commodity prices on headline inflation is expected to be temporary.  Finally, he claims that QE2 was in fact effective.  So why not do more?  Because the Fed needs “to pay attention to both sides of the mandate” and the “tradeoffs are less attractive.”  Much talk by Bernanke at this point about inflation expectations, and the importance of maintaining those expectations, and not much (none, I think), about the issue (or non-issue) of wage inflation. 

Apparently the threat of headline deflation off the table, Bernanke is not inclined to pursue sustained easing despite low core inflation and high unemployment.  Again, I am not entirely surprised, except that Bernanke appear to suggest we are much closer to an inflation tipping point than I would expect.  He could have tempered these comments with a more forceful discussion of labor costs, but did not.  It seems clear these comments were intended to calm the non-existent bond market vigilantes, but is it consistent with the outlook?  Arguably, no.  For what it’s worth, I think Bernanke appeared most uncomfortable during this portion of the conference. 

Bottom Line:  When I look at the revisions to the Fed’s outlook and listen to Bernanke, I get the sense that the basic Fed policy is summarized as follows:  “The economic situation continues to fall short of that consistent with the dual mandate, we have the tools to address that deviation, but will take no additional action because some people in the Middle East are seeking democracy.”

The FOMC Statement: No Change in Course

Here's the FOMC statement. A quick reading doesn't reveal any surprises. Rates will remain at "exceptionally low levels for the federal funds rate for an extended period," QE will continue as scheduled, and long-term expectations of inflation are stable even though prices have ticked up recently due to oil and commodity price increases. The Fed doesn't explain why, if both inflation and employment are below target levels, QE3 is out of the question. It merely states that "The Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings as needed to best foster maximum employment and price stability." If it's prepared to do so, why not take action?: Hopefully someone will ask something along those lines at Bernanke's press conference later today. It's likely fear of inflation in the future that is holding the Fed back, but I'd like to hear the basis for those fears:

Press Release, Release Date: April 27, 2011, For immediate release: Information received since the Federal Open Market Committee met in March indicates that the economic recovery is proceeding at a moderate pace and overall conditions in the labor market are improving gradually.  Household spending and business investment in equipment and software continue to expand.  However, investment in nonresidential structures is still weak, and the housing sector continues to be depressed.  Commodity prices have risen significantly since last summer, and concerns about global supplies of crude oil have contributed to a further increase in oil prices since the Committee met in March.  Inflation has picked up in recent months, but longer-term inflation expectations have remained stable and measures of underlying inflation are still subdued.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.  The unemployment rate remains elevated, and measures of underlying inflation continue to be somewhat low, relative to levels that the Committee judges to be consistent, over the longer run, with its dual mandate.  Increases in the prices of energy and other commodities have pushed up inflation in recent months.  The Committee expects these effects to be transitory, but it will pay close attention to the evolution of inflation and inflation expectations.  The Committee continues to anticipate a gradual return to higher levels of resource utilization in a context of price stability.
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 continue expanding its holdings of securities as announced in November.  In particular, the Committee is maintaining its existing policy of reinvesting principal payments from its securities holdings and will complete purchases of $600 billion of longer-term Treasury securities by the end of the current quarter.  The Committee will regularly review the size and composition of its securities holdings in light of incoming information and is prepared to adjust those holdings 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; Elizabeth A. Duke; Charles L. Evans; Richard W. Fisher; Narayana Kocherlakota; Charles I. Plosser; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen.

Fed Watch: Quick Note on Inflation Expectations

Tim Duy:

Quick Note on Inflation Expectations, by Tim Duy: The FOMC will render judgment on the economy today, followed by the inaugural post-meeting press conference by Federal Reserve Chairman Ben Bernanke. Policy is expected to remain essentially unchanged, with the large-scale asset program continuing through June. The FOMC statement will likely be similar to the last, maybe upgrading the state of the labor market but acknowledging weak first quarter data. I am curious to what extent they have adjusted their full year GDP forecast. Any downward adjustment would be further reason to maintain the current path of policy, and it is difficult to see reason for any upward revision.

The statement will likely maintain language on commodity prices, inflation, and inflation expectations – commodity prices are likely to have only a transitory impact on core-inflation, while expectations remain stable or anchored. Rates will be kept low for “an extended period.”

I am hopeful that the Chairman’s press conference will be illuminating but ultimately something of a nonevent – that the general consensus on the direction of monetary policy is consistent with that of the gravitational center of the FOMC, and thus Bernanke’s comments will be largely non-disruptive. Or at least it should be, as I anticipate we will learn that it was correct to heavily discount the more hawkish sounding regional bank presidents.

The Wall Street Journal focuses on the inflation expectations issue here and here. To be sure, I think the Fed is following this closely, but I think we should nuance the issue a little more carefully to account for a transmission mechanism from inflation expectations to actual inflation. I expect Bernanke would tie a discussion of inflation expectations to a discussion of labor costs. Vice Chair Janet Yellen did just that earlier this month:

In addition, the indirect effects of the commodity price surge could be amplified substantially if longer-run inflation expectations started drifting upward or if nominal wages began rising sharply as workers pressed employers to offset realized or prospective declines in their purchasing power…

…Consequently, longer-term inflation expectations became unmoored, and nominal wages and prices spiraled upward as workers sought compensation for past price increases and as firms responded to accelerating labor costs with further increases in prices….

…That said, in light of the experience of the 1970s, it is clear that we cannot be complacent about the stability of inflation expectations, and we must be prepared to take decisive action to keep these expectations stable. For example, if a continued run-up in commodity prices appeared to be sparking a wage-price spiral, then underlying inflation could begin trending upward at an unacceptable pace. Such circumstances would clearly call for policy firming to ensure that longer-term inflation expectations remain firmly anchored.

For a more immediate example of what this would look like, turn to recent stories from China like this:

China’s southern economic powerhouse Shenzhen said Thursday it would raise the minimum wage by 20 percent, following a similar move by Shanghai, as China continues to battle rising inflation and a labor shortage.

Sounds clearly like an economy in which inflation expectations have become unstable, to say the least. It is difficult to see a parallel to the current US situation – we don’t have a labor shortage, without which there is minimal upward pressure on wages, rendering senseless fears a wage-price spiral is imminent. I suspect Bernanke would agree with a similar line of argument, and it will be interesting if he explicitly cites unit labor costs.

Finally, the series of questions I would like asked: “What specific outcomes or goals did you expect when you initiated QE2? Have you reached those goals? If you haven’t reached those goals, are you preparing for QE3? Why or why not?”

Tuesday, April 26, 2011

The Fed Should Have Taken More Responsibility for the Housing Bubble

As I was searching for something else, I came across this post from July 2005 that I completely forgot I had written:

The Fed Should Take More Responsibility for the Housing Bubble: I didn’t find much in Greenspan’s testimony over and above what has already been noted here previously.  ...
The acknowledgment that incoming data have indicated some downside risk is fairly new. ...  The uncertainties he's referring to are rising input costs, particularly labor and oil, an increase in long-term interest rates, and the potential problems that could cause in the housing market.
It’s interesting to me that the Fed is not taking responsibility for the housing bubble even though monetary policy causing low interest rates had a hand in creating it.  If, in fact, low interest rates have caused a misallocation of resources towards the housing sector such that there are now risks, and there's a case to be made that it has, then the Fed should be more active and forceful in dealing with and forestalling the potential consequences.  That is, if Fed policy has enticed households to make decisions that put them at risk over the long-run, decisions they would not have made if the interest rate were at its natural level, then the Fed has a responsibility to do more than wash its hands of this sector of the economy and say its only role is to clean up after any crash that might occur. ...
Update #1:  Clarifying a bit, I am ready to believe those who say there is no significant deviation from fundamentals and hence less to worry about than if it were a true bubble (except for some areas such as coastal regions), though there are risks and it is the Fed's hand in creating those risks that I am addressing.  Nobody knows for sure how vulnerable this sector is so it is good policy to attenuate such risks to the extent possible.

My complaint is the way in which the Fed has disassociated itself from any responsibility for creating the environment that caused risks to emerge.  For example, the Fed could be more aggressive on the regulatory front in an attempt to ensure that low interest rates do not induce excessive risk taking by households, especially those living near the margin that will be most vulnerable to increases in interest rates.  It's really nice to get people into houses - I'm all for that, one hundred percent - but not if it causes financial distress and years of cleanup afterward (there's that bankruptcy bill thing as well) as households are induced to assume more risk than they can handle.

I suppose in the end we can say it's a free market and people should have known better, that they should have been more forward looking, but when prices are set below equilibrium in an attempt to stimulate the economy, market intervention to manipulate interest rates is present making the fundamentals themselves a result of policy intervention, and that has consequences. ...

Can't say I called the bubble, but I can say I called for caution and 'just in case' action.

Monday, April 18, 2011

Liberty Blog: What Is Driving the Recent Rise in Consumer Inflation Expectations?

Giorgio Topa, Wilbert van der Klaauw, Olivier Armantier, and Basit Zafar of the NY Fed's Liberty blog attempt to disentangle the forces behind recent increases in inflationary expectations. It appears to be oversensitivity to food and energy prices:

What Is Driving the Recent Rise in Consumer Inflation Expectations?, by Giorgio Topa, Wilbert van der Klaauw, Olivier Armantier, and Basit Zafar, NY Fed: The Thomson Reuters/University of Michigan Survey of Consumers (the “Michigan Survey” hereafter) is the main source of information regarding consumers’ expectations of future inflation in the United States. The most recent release of the Michigan Survey on March 25 drew considerable attention because it showed a large spike in year-ahead expectations for inflation: as shown in the chart below, the median rose from 3.4 to 4.6 percent and the other quartiles of responses showed similar increases. ... In this post, we draw upon the findings of an ongoing New York Fed research project to shed some light on the possible sources of the recent increase and to gauge its significance. While our research spans both short- and medium-term inflation expectations, this blog post discusses movements in short-term measures only...


Inflation expectations are a key consideration in the conduct of modern monetary policy. ... To this end, central banks not only look at market-based measures of inflation expectations and surveys of professional forecasters and businesses, but also track surveys of consumers’ inflation expectations, including the widely followed Michigan Survey. ...
Our research shows that ... the wording of the Michigan question induces mixed interpretations, with many people thinking about the specific prices they pay in their everyday purchases, and especially those prices that undergo large changes, such as food and gasoline prices. As a result, the Michigan measure appears to reflect expectations of food and gasoline price increases to a much larger extent than is suggested by their share in household expenditures and in measures of overall inflation such as the consumer price index. ...
With this background information, we now return to our initial question: What factors could explain the recent large spike in short-term inflation expectations observed in the Michigan Survey? One possible explanation is that the observed rise in inflation expectations is tied to an expected increase in nominal wages. ... As the chart below indicates, year-ahead median wage growth expectations have remained muted since February 2009. While this is a troubling sign for wage earners’ incomes, it suggests that concerns about wages exerting second-order effects on inflation are not founded at present.


Another possible explanation for the Michigan Survey reading is that short-term inflation expectations may be responding to concerns about accelerating growth in government debt. In our survey, we also ask respondents about their expectations for the year-ahead change in the level of government debt. We find that these expectations have actually declined in recent months, as shown in the chart below. Therefore, the recent rise in inflation expectations does not seem to be tied to an expected increase in the growth of government debt.


Finally, our experimental survey also asks respondents about expected price changes for specific items. The last chart reports year-ahead inflation expectations for gasoline, food, medical costs, and housing costs. The survey responses point to increases in inflation expectations for food and housing costs, as well as an especially large increase in expectations for gasoline inflation. ...


In sum, our research shows that expectations of higher nominal wage growth or concerns about increased growth of nominal government debt are unlikely to be behind the recent increase in short-term inflation expectations reported in the Michigan Survey. Instead, we suggest that this rise in inflation expectations reflects two factors: (1) sharp expected increases in food and especially gasoline prices and (2) the use of a survey question (“prices in general”) that results in reported expectations being more sensitive to these types of price change. An important open question concerns the extent to which households act on their expectations of overall inflation as well as on their expectations of specific price changes. As noted earlier, one significant area in which inflation expectations may influence consumer behavior is in the wage negotiation process, but thus far neither the “prices in general” nor the “rate of inflation” measure appears to be feeding into increases in expected future wage growth. We hope to return to this open question in a future post.
Chart data Excel 13 kb
The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author(s).

Friday, April 15, 2011

Fed Watch: On the Logic of Inflation Hawks

Tim Duy:

On the Logic of Inflation Hawks, by Tim Duy: Richmond Federal Reserve President Jeffrey Lacker:

Businesses thus far have absorbed input price increases, presumably believing that competitors would not follow suit, which suggests that they believe that overall inflation will remain low. The responsibility of the Federal Open Market Committee (FOMC) is to validate these expectations by conducting monetary policy in such a way that inflation does not accelerate. That's not always an easy task at this point in a recovery. In the last cycle, the economy began to grow more rapidly at the end of 2003. Although energy prices showed growth spurts, unemployment had not yet begun to fall and the core inflation measure that excludes energy and food prices was still just 1-½ percent. As a result, many forecasters expected inflation to diminish, and the FOMC kept the funds rate at a very low level well into 2004. Instead of falling, overall inflation soon rose to 3 percent, where it stayed, on average, through the end of the expansion in 2007. Core inflation averaged 2-¼ percent over that horizon. With hindsight, I think it is fair to say that policymakers overestimated the extent to which high unemployment would keep inflation from accelerating, and as a result, waited too long to withdraw monetary stimulus. Four years of 3 percent inflation may not have been the worst of all possible outcomes, but I do not consider it a success. I hope we do better this time. In particular, I believe we need to heed the lesson of the last recovery that inflation is capable of rising even if the level of economic activity has not returned to its pre-recession trend.

Note that Lacker changes the goalpost – rather than focus on core-inflation, he shifts the focus to headline inflation of 3%. Why? Because otherwise he needs to face the fact that core-inflation averaged a mere 25bp above trend over the 2004-2007 period:


Consider that in context of the entire decade to that point:


One could just as easily make the argument that the Fed was allowed core-prices to catch up after a period of inflation that fell 25bp below the upper bound. Lacker, however, does not see it that way. Instead, he would prefer to hold unemployment rates high in order to prevent prices from returning to trend. That’s dangerous thinking, especially if you believe that we should expect a period of higher inflation if output is to converge with potential. With friends like these….

Also note the path of commodity prices during this past decade:

Lacker professes disappointment with inflation results, and would prefer that more people were unemployed to “do better this time.” I would argue just the opposite: Given the upward trend in commodity prices – something the Fed had little if any control over – I think the Fed did a pretty good job maintaining inflation expectations in a period of falling unemployment. And I think it is odd that an insider doesn’t recognize this success.

Wednesday, April 13, 2011

Fed Watch: Q1 Growth Looking Weak – Will it Affect the Fed?

Tim Duy:

Q1 Growth Looking Weak – Will it Affect the Fed?, by Tim Duy: In my last post I argued the Fed will tend to look through an transitory inflation increase – especially any that can be traced back to commodity prices – as the economy marches toward potential output, and thus not rush into policy tightening. The string of downgrades to Q1 growth, however, is a reminder there is no guarantee that march will continue in a timely fashion. To what extent will the Fed tolerate growth that falls short of their forecasts? What is the tipping point for QE3?
Start with the most recent Fed economic projections from the January FOMC meeting. Although Q1 is looking weaker than anticipated, I doubt the projections will change much, as most policymakers will try to look through any one number to the underlying trend. The Fed is looking for Q4/Q4 growth in the 3.4-3.9 percent range this year. The longer run projection is 2.5-2.8 percent, a common estimate of potential growth, so the Fed projects closing the output gap by roughly a percentage point this year.
The downgrades to Q1 forecasts arguably place that forecast in jeopardy. Again, I don’t think the Fed will see it that way. I think they will see it as noise, especially if they are not picking up a lot of anecdotal information otherwise – I anticipate today’s Beige Book release to signal the recovery continues, with concern about energy prices eating into consumer spending. Moreover, notice this post from Calculate Risk with two interesting items. The first is from Goldman Sachs analysts, who argue that high frequency data suggest the pace of activity accelerated throughout the quarter, and thus the second quarter will be stronger. The second is a link to a WSJ article describing a shortage of rail cars. Both stories suggest a weak Q1 showing is more of a statistical aberration than anything else. Fed officials will be attracted to this line of reasoning.
I have argued that the pace of job creation suggests growth near or a little above trend, and thus myself have tended to discount a weak Q1 GDP report. Interestingly, the IMF delivered an updated assessment of the world economy, forecasting US growth of 2.8 percent (annual average), just about potential output. In contrast to the Fed, which expects growth to accelerate in 2012 and 2013, the IMF expects growth to be relatively unchanged for the next three years, which suggests little if any closure of the output gap and much higher unemployment than the Fed expects.
The Fed and IMF views are dramatically different. At this point I would add the words of wisdom once offered by a close friend: Always bet against the IMF. I think this stemmed from frequent IMF announcements that the “crisis is contained,” which rarely turned out to be accurate, but always an opportunity to short some emerging market currency. But, that aside, suppose the reality is looking more like the IMF view by the middle of this year, is there room for QE3? This quote (via the WSJ) from New York Federal Reserve President William Dudley suggests not, or at least not immediately:
I’d be very surprised if we didn’t complete QE2 [referring to the Fed’s second round of quantitative easing]. After that, though, the hurdle for QE3 is higher… One reason we embarked on QE2 was we really were worried about the risk of deflation in the U.S… Now the risks of deflation are greatly diminished. So one of the motivations behind QE2 is no longer in place.
The deflation threat was key reason the Fed stepped up the asset purchase program. Now no one is talking about deflation. And unless commodity prices just collapse, nor will they by midyear. Why? I suspect we will still be experiencing some of the pass through from the recent commodity price hikes for the next few months, which will be enough to keep Fed hawks riled up. Even if the economy is limping along near potential, jog growth should be steady if not exciting. I suspect that a touch of inflation coupled with growth, albeit lackluster, would make it difficult to clear the bar for QE3.
One could imagine that situation changing in early to mid-2012 as the transitory effects on inflation fade. And, of course, assuming the IMF is right and the Fed is wrong. If the Fed’s forecast is accurate, by early next year they will be looking to tighten.
Finally, a final interesting quote from Dudley:
It’s important to recognize that even with these commodity price pressures, other measures of inflation are very quiescent… There is no sign of any second round effect. Wages are rising very slowly and unit labor costs are running very very flat.
Watch wages it you are worried the Fed is getting behind the inflation curve, and notice Dudley points specifically to unit labor costs. The core of the Fed will resist panic unless unit labor costs start spiraling upward. Then they will panic.
Bottom line: Weak Q1 GDP is not likely to upset the Fed’s basic outlook. At best it is another nail in the coffin for any argument to pull the plug early on QE2. But even if growth comes in below the Fed’s forecast this year, the hurdle for QE3 is high. I think monetary policymakers would need to see clear evidence that the risks are turning back toward deflation. And unless growth is far weaker than expected, such evidence is unlikely to return until late this year or early next year.

Tuesday, April 12, 2011

Fed Watch: Back to Basics

Back to Basics, by Tim Duy: It is worthwhile to construct a simple framework to place into context the various Federal Reserve views on the state of the economy. Via that framework, we can at least keep clear whose bread is buttered on which side.
Begin with a basic AS-AD model:


I illustrated sort-run aggregate supply as kinked, with the horizontal portion reflecting sufficient excess capacity that prices hold constant across a range of output. This is not strictly necessary for a simple framework, but reflects the general impression that the threat of deflation was quickly replaced with inflation concerns. Also, I understand that a model in levels is not exactly ideal for considering inflation dynamics, but I also think we can see through to the general implications for inflation and policy. Consider an increase in aggregate demand:


Whatever you think of the nature of the recovery, there appears to be general agreement that some recovery is in place, what the Fed describes as “firmer footing.” The pace of job creation in the last six months appears consistent growth a little above trend. I think we can consider this improvement as a general increase in aggregate demand.
Note what occurs once demand rises sufficiently to pull output past the “kink” in the short run aggregate supply curve – there is suddenly room for upward pressure on prices. This appears consistnet with the general shift in risk away from deflation toward inflation. The situation could be somewhat more complicated if supply issues, particularly for oil, are putting upward pressure on the long run aggregate supply curve at the same time, but for the reasons given below this also does not need to impact our long run inflation story.
Importantly, we need to expect such pressure to continue as the price level rises until output reaches its potential. In short, the rising prices can coexist with large output gaps. How does this translate into likely the likely path of inflation? The way I think about it is that prices return to their prerecession trend:

Continue reading "Fed Watch: Back to Basics" »

Saturday, April 09, 2011

Fed Watch: Meltzer, Part II

Tim Duy follows up his post about Allan Meltzer:

Meltzer, Part II, by Tim Duy: David Altig gives Allan Meltzer a more charitable read than I did:

Generally speaking, the Meltzer strategy offers what I perceive to be two critical criteria for a viable exit plan. One is that the winding down of the mortgage-backed securities (MBS) and long-term Treasury securities on the Fed's balance sheet should be conducted in a way that avoids market disruption and distortion as much as possible. The second is, of course, that the excess reserves held in the banking system—the liability side of the Federal Reserve’s balance sheet—have to be removed or "locked up" as needed to avoid an inflationary expansion of broad money and credit.

I take Altig seriously, but believe he is giving Meltzer far too much credit.

First off, there is nothing in the Meltzer plan that keeps the excess reserves “locked up.” Instead, Meltzer claims that simply moving a portion of the assets and corresponding liabilities off the Fed’s balance sheet onto another bank’s balance sheet somehow magically changes the monetary situation. From the Wall Street Journal:

The Fed's current operating balance sheet would be back to a more manageable range of about $1 trillion. This proposal removes some of the risk of inflation by removing some of the bank reserves that threaten to fuel it.

This seems pretty clear – Meltzer suggests that bank reserves that are not “officially” part of the balance sheet are no longer available to fuel inflationary pressures. Why? If we split the Fed in half, call one part the “official” Fed, and the other part the “bad” Fed, does the aggregate size of the balance sheet change? Does the aggregate amount of excess reserves change? I don’t see how.

Altig, in the above quote, shows a preference for an orderly plan to wind down the balance sheet. I agree, but think there needs to be flexibility to wind down quickly should the need arise. Meltzer’s plan does not offer that flexibility:

The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature. Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery.

Again, Meltzer implies that if he simply changes the location of the assets, that if they are not “official Fed assets,” they magical change from inflationary to inert. Moreover, he ensures that the assets are not available for immediate sale should it become necessary, thereby depriving the Fed of one tool to rapidly drain reserves.

What I suspect is that Meltzer does not trust the Fed to reduce the balance sheet and thus seeks to create a mechanism that forces it to do so. He thinks this reduces the inflationary risk; I would say just the opposite.

Altig then nails down the fatal flaw of the Meltzer plan:

Which brings me to a point that I don't quite follow about the Meltzer plan: If reserve assets are removed from the banking system, what are the corresponding offsets on the balance sheets of private banks?

The potential problem is that the excess reserves held by private banks do not have to stay at the Federal Reserve – they are free to leave and becoming new lending. Something needs to occur to draw them into the Fed, or any quasi-Fed bad bank. If you want to take away one asset, cash, you need to give them another. It is not an issue of Altig not being able to “follow the Meltzer plan.” Again, he is giving Meltzer too much credit. Meltzer simply does not address this issue. In contrast, Altig does address this issue, and his post contains numerous example of mechanisms, either directly or indirectly through links, to draw excess reserves into the Fed. For example:

My guess is you end up with something like term deposits or their economic equivalent—nonnegotiable sterilization bonds, for instance. And if you match the maturities of those deposits with the maturities of the MBS and long-term security portfolio, it becomes pretty clear that the debate is really less about tactics and more about some pretty familiar, but difficult, issues: When is it time to stand pat on policy, and when is it time to reverse course?

Exactly. Meltzer offers nothing new, just another voice that saying the Fed needs to act sooner than later. Otherwise, he is empty of new ideas. The Federal Reserve staff have already devised a number of actual and potential tools to drain reserves, all of which can be done without creating a “bad” bank. Meltzer offers up an accounting slight of hand that fails to address the key issue of what will prevent private banks from lending out the excess reserves rather than parking them at the Fed. That hole – the crux of the issue – is filled by Altig.

Friday, April 08, 2011

Fed Watch: Misguided Meltzer

Tim Duy:

Misguided Meltzer, by Tim Duy: After scouring the Wall Street Journal for stories by competent journalists, I found myself in the op-ed section. Apparently I feel compelled to make the same mistakes over and over. In any event, I found Allan Meltzer’s latest inflation warning staring me in the face. Most of the piece is not new territory, but it has an interesting twist at the end.

Meltzer begins with the same, tired lament:

Federal Reserve Chairman Ben Bernanke sees little risk of inflation because he doesn't look in the right places. Inflation is a general increase in prices, but increases always occur at different rates. Right now, labor costs are not rising but other costs, such as the prices of raw materials, have been and are continuing to increase. Businesses will pass some of these costs to their customers. Health-care costs also are continuing to rise.

Inflation is not a general increase in prices. That is a one-time price increase, or a shift in relative prices. Inflation is a continuous increase in the price level, which, to be perpetuated, needs to be matched by increasing wages – something Meltzer admits is not happening. Without an increase in wages, the current gains in headline inflation will prove to be transitory. Meltzer then brings up the boogieman of the 1970s:

Mr. Bernanke tells us that inflation won't be a problem as long as unemployment remains at an unacceptable level. But considerable research shows that this reasoning is badly flawed. During the inflation of the 1970s, for example, the discredited "Phillips Curve"—which suggested that high unemployment and rising prices shouldn't go together—persistently underestimated inflation and misled the Fed into pursuing an ever more expansive policy. If the Fed looked, it would find many other countries that experienced high inflation and high unemployment together.

Yes, inflation can coexist with high unemployment, but only in the presence of accelerating wage growth. This combination existed in the 1970s, but not now. Look at the historical record. The path of unit labor cost growth prior to 1980 is very different from that experienced since 1980. Until unit labor costs start accelerating, fears of a return to the 1970s are misplaced. Next Meltzer tries to redefine the CPI:

Those who doubt that the United States is headed for inflation remind us that increases in the consumer price index (CPI), and the "core" CPI that omits food and energy prices, remain modest. But the CPI and the core CPI are currently misleading because 40% of the CPI and 25% of the core CPI represent housing prices and are heavily dependent on statistical estimates of what homeowners would pay to rent their homes. Most of us never see these prices and do not pay them the same way we pay for food, gasoline and health insurance.

First, Meltzer does not even understand when the data is actually poised to work in his favor. Apartment vacancy rates are falling, suggesting that rents, and thus housing component of CPI, are set to rise. Perhaps Meltzer would be happy to use the housing prices that people actually pay, but those are falling, which is not exactly consistent with his argument. Notice also that Meltzer wants to narrow the CPI down to only those items going up in price. Why not to those items going down in price? He continues:

Furthermore, the Fed treats gasoline and oil price increases as a transitory blip. That's almost certainly correct about the effect of Arab unrest or the Japanese tsunami. But much of the rise in oil prices came before these events and was in response to the strengthening world economy. Prices will likely continue to rise as the world economy grows. Meanwhile, world grain prices have been driven up by the foolish U.S. ethanol program. When ethanol raises corn prices, prices for substitutes like wheat and rice rise also. There is no sign that Congress will repeal the ethanol program.

Meltzer conveniently ignores that rising commodity prices have simply reversed the losses sustained during the recession. Apparently he would be happier if the Fed induced a recession to offset that terrible improvement in the global economy. On top of which he wants the Fed to “fix” the relative price changes induced by Congress. Good luck with that.

Then Meltzer finishes with a twist, his grand proposal to save us from inflation:

One of the Fed's recent errors was increasing the money supply by buying more than $1 trillion of mortgage-backed securities as part of its "quantitative easing" policy. Its hefty balance sheet now threatens to finance further inflationary increases in the money supply. How can it be unwound in an orderly way?

One idea is for the Fed to create its own version of a "bad bank." The Fed should promptly put the $180 billion of its long-term government debt and more than $1 trillion of its mortgage-backed securities into a separate entity. The long-term government debt and mortgage-backed securities would be the new bank's assets…

…The Fed would make a commitment not to sell any of the bad bank's mortgage-backed securities and Treasurys until they mature…

Yes, that’s right – Meltzer’s solution to the inflation threat is to tie the hands of the Federal Reserve so that they cannot liquidate the balance sheet if necessary. More:

…Almost half of the Fed's currently held assets, more than $1 trillion, have 10 or more years until maturity, so all of them would be off the table as far as financing inflation during the gradual economic recovery. As the mortgages mature and are paid off, the bad bank's assets decline. The reduction in the bad bank's assets means that its liabilities, the excess reserves, would also decline—though that would be years away.

No, if the Fed cannot sell the assets, then they are not “off the table,” they are the centerpiece of the table. If you are worried about inflation, you don’t want to entrench a system that ensures that excess reserves would decline “years away.” You want the exact opposite – to drain the reserves right now.

Rather than admitting that the Fed has not induced a monetary collapse, that the world has not ended, that Treasury rates are mired below 4%, that he is simply wrong, Meltzer offers a completely backwards policy proposal. A short step from there to complete irrelevance.

Wednesday, April 06, 2011

Fed Watch: More Hawkish Rhetoric

Tim Duy:

More Hawkish Rhetoric, by Tim Duy: And so it continues. Via Jon Hilsenrath at the Wall Street Journal:

James Bullard, president of the Federal Reserve Bank of St. Louis, said he would push at the Fed’s upcoming two-day policy meeting (April 26 and April 27) to reduce the central bank’s quantitative easing program by $100 billion, but held out little hope of being successful.

“I don’t always get my way on the committee,” he noted in an interview with the Wall Street Journal. Most Fed officials want to carry the program through to its end in June. “Any changes that we’re going to make we’re going to have to make at this meeting,” he added.

Bullard’s position is not news. At least he admits the Fed is not likely to follow his suggestion, so I give him credit for providing proper guidance. Still, his logic is interesting:

Mr. Bullard was elaborating on comments he made last week about the Fed’s $600 billion program of U.S. Treasury securities purchases. When the Fed launched the program last November it had lower forecasts for growth and inflation, he said.

“We got a stronger economy and we got higher inflation and higher inflation expectations than we expected at the time,” he said. “The logical thing to do is to pull back.”

Bullard seems to be saying that we need to end the program early because it is working. The majority of the majority will view it otherwise - don't mess with something that is working. Consider also the Fed’s projections last November and at the end of January:


The longer run projections were virtually unchanged. For 2011, the GDP forecast is about 0.4 percentage points higher than the November forecast – an improvement, to be sure, but nothing to write home about. The high end of the core-PCE range was pulled down – in other words, the Fed was less confident on the inflation outlook in the immediate wake of QE2. The unemployment rate is likely to come down sooner than anticipated – but this is arguably because of lack of re-entry to the labor force. Labor force participation remains stubbornly low.

In essence, we can argue that we are moving a little faster toward the long run projections than prior to QE2. Evidence that the program is working as intended, but not more so than intended. Bullard may be hinting that internal forecasts suggest dramatically better growth, but the Fed’s forecast was already better than private sector forecasts, and those will likely come down a tad with a weak first quarter. Indeed, at best I see the path of data has the potential to generate the Fed’s forecast. Still, I would add that the labor market is not yet signaling growth vastly above potential growth, which means the Fed’s forecast still imply more trend reversion than seems likely or than the private sector expects.

Regarding higher inflation, he could be referring to headline inflation, but that means he is confusing a relative price change with a general price change. Monetary policymakers should not be confused about this distinction.

Moreover, I am not sure there is room to be unhappy with inflation expectations. They seem to have moved back to exactly where they should be:


You could point to surveys that signal rising near term inflation expectations among consumers, but ask them if they can get higher wages to compensate. Wait, someone has. From the Reuters/University of Michigan survey March press release:

Just one-in-four consumers expected their financial position to improve during the year ahead, returning to near the lowest level ever recorded of 20%. Scarce income gains as well as rising food and gas inflation were responsible for these dismal financial expectations. Only 38% of all households expected income increases in the year ahead, the smallest proportion ever recorded. Just 11% of all households expected inflation-adjusted income gains during the year ahead, barely above the all-time low of 8% in 1980.

If I remember correctly, the early 1980s ushered in a period of disinflation, not inflation.

Bullard explains further:

“It is tumultuous times for monetary policy and that is why you’re hearing more from the Fed,” he said. “A tightening cycle is the hardest thing for a central bank to do. There is a lot of risk that you might fall behind the curve and wind up with a lot of inflation. On the other hand you hate to choke off a fledgling recovery. And so there is a lot of debate about it.”

He asserts there is a lot of risk of inflationary outcomes, but doesn’t explain why. Most importantly, I would like him to explain why we should expect significant risk of falling behind the curve in an environment where wages gains are minimal at best. Given that we need to get job growth up and unemployment down sufficiently to drive wage growth beyond what can be compensated by productivity, something of a lengthy process to say the least, it doesn’t seem likely the Fed will fall behind the curve anytime soon.

The interview concludes:

In the past, the Fed hasn’t explained itself well. “We’re trying to do a better job of communicating.”

I can’t resist: They need to try harder.

Tuesday, April 05, 2011

Fed Watch: The Good, The Bad, and the Fed

Tim Duy:

The Good, The Bad, and the Fed, by Tim Duy: The data flow can be characterized as generally good from a growth perspective and generally bad from a levels perspective. Fed policymakers who focus on the former will tend toward removing policy accommodation sooner than later. Those who focus on the latter tend toward the opposite. I think the key decision makers, notably Federal Reserve Chairman Ben Bernanke, will be in the second group, leading the Fed to finish up with the current asset purchase program as scheduled before moving to the sidelines.

Start with the good. The March employment report tells a story not unlike the February report, but without the ability to dismiss it as simply an artifact of weather related disruptions in January. Private sector job growth continues to compensate for weakness on the government side, sustaining net overall job growth at a monthly average of 159k during the first quarter. This was a tad better than the 139k average of the final quarter of last year and consistent with declining initial unemployment claims. Overall, nonfarm payrolls data suggest the economy fell into a more sustainable growth path at the end of last year, near trend growth, perhaps a little above as the first quarter came to a close.

If we focus on the underlying trends, rather than getting bogged down in volatile month-to-month or quarter-to-quarter numbers, it looks as though the cyclical tide has turned. The manufacturing surveys, including the most recent ISM report on manufacturing, remain well into solid territory. It can be argued that the March dip in auto sales forewarns of the negative impact of higher energy prices, but also should be taken in context of a solid gain in February. Also, note the rising confidence among CEO’s:

Optimism among U.S. chief executive officers surpassed the highest level reached before the recession as more business leaders projected increased sales, investment and hiring, a survey showed.

The Business Roundtable’s economic outlook index increased to 113 in the first quarter, the highest point since records began in 2002, from 101 in the previous three months, the Washington-based group said today. Readings greater than 50 coincide with an economic expansion. The previous peak was 104 in the first three months of 2005.

…Fifty-two percent of CEOs said they will add to payrolls, up from 45 percent in the fourth quarter and the largest share on record. Some 62 percent said they plan to spend more on equipment, up from 59 percent.

…The chief executives in the Business Roundtable survey forecast U.S. economic growth of 2.9 percent this year compared with the 2.5 percent projection in the previous survey.

All generally good news, and the growth forecast is consistent with trend growth. Hold onto the number, though – we will need it later.

Finally, keep an eye on inventories –which were depleted at the beginning of this year:


If firms were experiencing a sharp drop in demand, and thus an increase in unexpected inventories, I find it challenging to believe they would continue to add workers in February and March. Instead, firms are probably trying to make up lost inventory ground, which will support the sustainability of the recovery going forward.

In sum, the economy looks to be on, as the Fed describes, “firmer footing.” Definitely good. But definitely not without warts. Housing, for example – a market that just won’t heal in light of a very big structural change toward tighter underwriting conditions. Yet the biggest wart is simply that the pace of growth appears to ensure the economy operates far below potential for far too long. This is the “bad.” As a consequence, unemployment is retreating slowly. Arguably, we wouldn't mind if unemployment increased a bit if growth was sufficiently strong to draw a mass of persons back into the labor force. But labor force participation fell to 64.2 percent and held there for three months:


Likewise, the employment to population ratio shows no indication of rebounding to prerecession levels anytime soon. At this rate of recovery, I am generally worried that the next decade will prove to be once again “jobless,” that nonfarm payrolls will once again remain stagnant by the time we are near the trough of the next recession. Maybe this is what inevitably becomes of aging economies.

The palpable weakness of the labor market reveals itself in stagnant wage growth. Average hourly earnings gained just a penny in February, and nothing in March. Workers might be feeling the effect of headline inflation, but apparently have absolutely no power to respond with anything but belt tightening. The lack of wage growth is simply the biggest hole in the inflation story, as it suggests that underlying inflation inertia is practically nonexistent. That this is not obvious to all monetary policymakers is somewhat shocking. spencer at Angry Bear puts it succinctly:

Continue reading "Fed Watch: The Good, The Bad, and the Fed" »

Monday, April 04, 2011

Are Large-Scale Asset Purchases Fueling the Rise in Commodity Prices?

In this Economic Letter from the FRBSF, Reuven Glick and Sylvain Leduc argue that the Fed did not cause the run-up in commodity prices:

Prices of commodities including metals, energy, and food have been rising at double-digit rates in recent months. Some critics argue that Federal Reserve purchases of long-term assets are fueling this rise by maintaining an excessively expansionary monetary stance. However, daily data indicate that Federal Reserve announcements of large-scale asset purchases tended to lower commodity prices even as long-term interest rates and the value of the dollar declined.

More here.

Fed Watch: Retirement in the Liquidity Trap

Tim Duy:

Retirement in the Liquidity Trap, by Tim Duy: Reporter Mark Whitehouse, via the Wall Street Journal, has a piece on a negative side effect of the Federal Reserve’s zero interest rate policy:

Mr. Yeager is among the legion of retirees who find themselves on the wrong end of the Federal Reserve's epic attempt to rescue the economy with cheap money.

A long spell of low interest rates has created a windfall worth billions to banks, mortgage borrowers and others it was designed to benefit. But for many people who were counting on their nest eggs, those same low rates can spell trouble.

I was a bit surprised that Whitehouse did not compare the current situation with that of Japan, where the elderly have long suffered from the impact of ultra low interest rates. Perhaps that part was left in on the editing room floor.

As with many polices, there are winners and losers, and the losers now are with those dependent on the once steady returns from ultra-safe assets. Dallas Fed President Richard Fisher:

"Americans who have done everything right, have worked hard, saved their money and stayed out of debt are the ones being punished by low interest rates," says Richard Fisher, president of the Federal Reserve Bank of Dallas and a voting member of the Fed's policy-making open market committee. "That state of affairs is not sustainable for a long period of time."

Fisher obviously doesn’t realize that Japan has already proved that it is indeed sustainable for a long period of time.

At one point, I might have shared this concern, thinking that the Fed was recklessly snuffing out yield along the yield curve regardless of the damaged it caused to older savers. But there is problem with this analysis – the Fed’s policies are following the economy, not leading it. If economic activity was stronger, yields on safe assets would be rising, forcing the Fed to follow suit on the short end of the curve. We are stuck with the opposite. Despite all the warnings of the bond vigilantes, yields stubbornly remain low, as one would expect if the US economy was mired at or near a liquidity trap. As a consequence, those most dependent on safe assets suffer.

I think Fisher thinks he can help savers by lifting short-term rates. I suspect that is temporary help at best – it would undermine the recovery and force the Fed right back to a zero-rate stance. Instead, we need to lift the economy far from the liquidity trap, which would entail more fiscal and monetary stimulus. Now that the economy is on upswing, give it a final boost to reestablish past trends. Alas, we are likely to get neither. Fiscal policy is poised to be at least mildly contractionary, and the Fed will bring assets purchases to a halt within a few months – with a nontrivial contingent of policymakers eager to actually repeat the mistakes of 1937 and tighten soon.

Finally, if believe the Fed’s policy is creating an adversely affected group even as others are helped (the financial services sector), you could remedy the negative impact with transfer payments. Especially with such an easily identifiable group – just boost social security payments (funded perhaps by a financial services tax). Try selling that one in a Congress bent on fiscal discipline.

Thursday, March 31, 2011

Fed Watch: Something to Chew On

Tim Duy:

Something to Chew On, by Tim Duy: Something to chew over while you wait for the employment report. From the Wall Street Journal's bit on Cleveland Fed President Sandra Pianalto's speech:

With the economy on “a firmer footing,” she said, U.S. corporate leaders seem inclined to continue investing in equipment and software despite such worries as turmoil in the Middle East, the Japanese earthquake and the sovereign debt crisis in Europe. “On this firmer footing, these shocks are hitting us, but it seems like we’re more resilient and able to absorb these shocks,” she said.

I am not sure that we should find this resiliency surprising, despite the seemingly perpetual fears of market participants. I believe that all US recessions, at least post-WWII, are attributable directly to domestic disturbances - monetary policy and/or domestic financial crisis - or oil price shocks. Arguably, the Asian Financial Crisis was close via the Long Term Capital Management fiasco, but no cigar, as the US economy powered ahead until the tech bubble collapse (a domestic story).

Hence, I have been hesitant to put much economic concern on Japan and Europe - the transmission mechansims appear too weak to appreciably change the US outlook. One can suggest that financial crisis in Europe will filter back through to US institutions, but I think this would have been more likely two or three years ago than now. Back then, we could credibly believe that a US financial institution could fail. Now, however, I am pretty sure the financial sector has an explicit government guarantee. Financial exigency clauses will come into play sooner than later this time around.

I am concerned about the potential for a sharp rise in energy prices to knock the wind out of consumers this year, but also recognize that the increase refelcts improving growth prospects. See spencer's note at Angry Bear on this point.

None of this is meant to imply that the US economy is without warts; nothing could be further from the truth. Only that the primary risks are internal demand and energy shocks, not other external shocks.

Why Do Central Banks Have Discount Windows?

The names of the banks that borrowed from the Fed during the financial crisis will be released today by court order. It's probably just a coincidence that this post on the history of the discount window and the stigma of being identified as needing to use it appeared on the new blog from the NY Fed:

Why Do Central Banks Have Discount Windows?, by João Santos and Stavros Peristiani, Liberty Blog: Though not literally a window any longer, the “discount window” refers to the facilities that central banks, acting as lender of last resort, use to provide liquidity to commercial banks. While the need for a discount window and lender of last resort has been debated, the basic rationale for their existence is that circumstances can arise, such as bank runs and panics, when even fundamentally sound banks cannot raise liquidity on short notice. ... In this post, we discuss the classical rationale for the discount window, some debate surrounding it, and the challenges that the “stigma” associated with borrowing at the discount window poses for the effectiveness of the discount window. ...

While the discount window is an important tool for central banks dealing with liquidity problems that may threaten financial stability, its effectiveness depends critically on the willingness of banks to borrow from central banks. Banks are often reluctant to borrow from central banks not only because this source of liquidity tends to be expensive but also because of the “stigma” that is associated with discount window borrowing. ...
If a bank worries that borrowing from the discount window will lead other banks to doubt its fundamental solvency, it may avoid the discount window even if the discount window provides the cheapest funds available.  Instead, the bank may liquidate marketable assets or try to borrow in the interbank market at onerous terms, further straining these markets and making it even more difficult for other banks to obtain funding or sell assets.  Thus, central banks typically disclose only a limited amount of information about discount window activity to avoid branding healthy (but illiquid) banks as weak.  The Federal Reserve, for example, has historically published the total amount of borrowing from the discount window on a weekly basis, but not information on individual loans.[1]  By allowing banks to borrow confidentially, this policy aims to make healthy institutions more willing to use the discount window during periods of market stress. It should be emphasized that confidentiality is not meant to protect the identities of individual banks per se, but rather to make the discount window more effective in dealing with market disturbances.
Central banks have long recognized the challenges that stigma creates for the effective operation of the discount window during crisis. Donald Kohn, former Vice Chairman of the Fed, has discussed the stigma problem in past speeches. “The problem of discount window stigma is real and serious. The intense caution that banks displayed in managing their liquidity beginning in early August 2007 was partly a result of their extreme reluctance to rely on standard discount mechanisms,” Kohn noted in a 2010 speech.  In fact, the need to mitigate stigma influenced the design of some of the lending facilities, such as the Term Auction Facility, created by the Fed during the financial crises.[2]
In sum, the discount window is a vital tool to maintain the uninterrupted functioning of the banking system, but its effectiveness may be limited by the stigma associated with using it. This explains why policies that aim at dealing with the stigma of discount window borrowing are so important. Admittedly, the existence of the discount window may create some moral hazard, but of course, the Federal Reserve limits moral hazard by restricting discount window access to depository institutions that are closely regulated and supervised by federal banking authorities.

Wednesday, March 30, 2011

Fed Watch: Running the Fed Like an Economics Department

Tim Duy:

Running the Fed Like an Economics Department, by Tim Duy: My central complaint with Federal Reserve Chairman Ben Bernanke is his penchant for what is often described as running the Fed like a university economics department. Internally, I do not see this as a challenge, and for the Fed’s culture may be an effective management style. Externally, I see this a potential communications disaster always in the making. The recent uptick in inflation heightens my unease at this approach, and I think Ryan Avent hits the nail squarely on the head:

…An increase in inflation is only worrying to the extent that it undermines the Fed's efforts to satisfy those mandates, and the above clearly doesn't count. Yet the simple fact of increasing inflation sends writers running to speculate on and, in many cases, demand central bank action.

And central bankers often play along. You have a number of regional Fed presidents warning that they may be ready to end the latest round of asset purchases ahead of schedule. I don't know whether there's any communications strategy within the Fed—whether Ben Bernanke is tacitly approving of these comments or upset by them—but it's fairly certain that the comments themselves represent a tightening of monetary to the extent that they shape actual market expectations (and there does seem to have been some impact).

That's no way to make policy. It's a poor means of communication and a poor decision to tighten. And these poor choices are encouraged by writing that misrepresents the extent of current inflation and its consistency with Fed mandates.

It seems to me that the Fed lacks a coherent communication strategy – there is no willingness on the part of the leadership to enforce talking points. As a consequence, there is enormous pointless chatter from Fed officials that might be interesting in some sense, but provide misleading guidance about policy direction. Recent talk about scaling back the size of the large scale asset program, for instance. Almost certainly not going to happen – so why talk about it? Sadly, it appears to be an almost deliberate effort to create uncertainty among market participants at a time when the opposite is so important.

Of the frequent Fed speakers, I think Chicago Fed President Charles Evans and Atlanta Fed President Dennis Lockhart are particularly good. And not because they tend to say things that I agree with, but because they say things that I think reflects the majority view of the monetary policymakers. I suspect incoming San Francisco Fed President John Williams will fall into that same category. The so-called hawks Philadelphia Fed President Charles Plosser and Richmond Fed President Jeffrey Lockhart are interesting, but one needs to discount their tendency toward inflation/balance sheet concerns. And, I hate to say it about a Fed official, but I wouldn’t take much stock in the words of Dallas Federal Reserve President Richard Fisher. He may talk tough, but I believe he would always fall in line with the majority decision of the FOMC.

Hopefully, regular press conferences by Bernanke will foster a more consistent voice among Fed officials, or at least a guidepost by which market participants can more easily identify and dismiss the loose talk of policymakers and the fringes of policy.

Tuesday, March 29, 2011

Inflation vs. Jobs: Fed’s Move Can Seal Its Fate

Haven't had a chance to write much the last few days, but here's something you can yell at me about in comments (or not):

Inflation vs. Jobs: Fed’s Move Can Seal Its Fate

Update: I forgot to mention that CBS MoneyWatch asked me to write about a similar topic yesterday (I tried to say something different, but there's still a bit of repetition):

Bernanke’s New Quarterly Press Conferences

Fed Watch: Quick PCE Notes

Tim Duy:

Quick PCE Notes, by Tim Duy: The February Personal Income and Outlays report revealed the drag of higher food and energy costs as a 0.3 percent gain in nominal disposable personal income was knocked back to a 0.1 percent loss in real terms. Similarly, the 0.7 percent gain in nominal spending turned into a just 0.3 percent real gain. While better than the flat reading in January, the relatively weak performance of PCE this quarter will lead analysyst to knock down Q1 growth forecasts. I try not to read too much into any one quarter, and tend to view the consumer slowdown in light of the acceleration at the end of last year. Overall, the trend in PCE growth since the middle of last year is consistent with annual gains of around 3% a year. The footing is firming, and it is sustainable, but it is still far short of what is needed to rapidly return consumption to its pre-recession trend.
Since the recession ended, real PCE gained at a rate of 0.18 percent per month:

By a year into the recovery, household spending accelerated, and since July of 2010 has grown at 0.23 percent per month, just about the prerecession trend:

Continue reading "Fed Watch: Quick PCE Notes" »

Sunday, March 27, 2011

Ron Paul's Money Illusion: The Sequel

David Andolfatto continues his battle with Ron Paul supporters:

Ron Paul's Money Illusion (Sequel), by David Andolfatto: As I promised to do here, I am posting a sequel to my original column: Ron Paul's Money Illusion. ... I ... hope that the nature of my criticism will be more clearly understood.

The purpose of my original post was to critique a statement I've heard Fed critics repeat ad nauseam. The statement can be found in Paul's book End the Fed (p. 25):

One only needs to reflect on the dramatic decline in the value of the dollar that has taken place since the Fed was established in 1913. The goods and services you could buy for $1.00 in 1913 now cost nearly $21.00. Another way to look at this is from the perspective of the purchasing power of the dollar itself. It has fallen to less than $0.05 of its 1913 value. We might say that the government and its banking cartel have together stolen $0.95 of every dollar as they have pursued a relentlessly inflationary policy.

I think that the first part of this statement is true, so I do not wish to dispute this fact. ... As for the final sentence in the quote above, well, I think it is just plain false. Now let me explain why...

Let me begin with the picture most popular with end-the-fed types--a graph depicting the declining purchasing power of the USD. I use postwar data without loss of generality, since most of US inflation has happened since then.

This picture plots the inverse of the price-level (as measured by the consumer price index). I have normalized the price-level to $1.00 in 1948. It falls to roughly $0.11 in 2010. This corresponds to roughly a nine-fold increase in the price-level or about a 4.6% annual rate of inflation. (Note that the rate of inflation has slowed considerably since 1980).

The picture above is used by some end-the-fed types to great effect in generating anger and fear among some members of the population. Anger via the claim that the Fed has stolen 90% of (the purchasing power) of your money; and fear through the prospect of this purchasing power approaching zero in the not-too-distant future. ...

Let me draw you another picture. This one plots the inverse of the U.S. nominal wage rate (total nominal wage income divided by aggregate hours worked).
This graph plots the purchasing power of the USD, where purchasing power is now measured in terms of labor, rather than goods. This graph shows that you need a lot more money today than you did in 1948 to purchase 1 hour of labor. Another way of saying this is that the average nominal wage rate in the U.S. has increased by a factor of 25 since 1948. ...

Let me now combine the two graphs above into one picture, with both series inverted, and with both the price-level and nominal wage rate normalized to $1.00 in 1948 (the actual nominal wage rate was $1.43).

According to these (publicly available) data, the price-level (CPI) has increased by about a factor of 10 since 1948. But the average nominal wage rate has increased by a factor of 25. (There is, of course, considerable disparity in wage rates across members of the population. But I am aware of no study that attributes significant wage or income heterogeneity to monetary policy. Of course, if readers know of any such studies, I would be grateful to have them sent to me.)

The figure above implies that the real wage (the nominal wage divided by the price-level) has increased by a factor of 2.5 since 1948. This is undoubtedly a good thing because it implies that labor (the factor we are all endowed with) can produce/purchase more goods and services. More output means an increase in our material living standards (Though again, I emphasize that this additional output is not shared equally. ...)

Now, an interesting question to ask is how the picture above might have been altered if the price-level had instead remained more or less constant. ...

I suggested, in my original post, that there is reason to believe that under an hypothetical regime of price-level stability, the nominal wage rate in the graph above would instead have ended up increasing only by a factor of 2.5 (more or less)--the factor by which real wages actually rose. This is what I meant by my claim of long-run neutrality of the price-level increase; and it is also what I meant by Ron Paul's Money Illusion (which is subtly different than claiming the superneutrality of money expansion; more on this later).

Some evidence in favor of my "long-run neutrality view" is to be found in the time-path of labor's share of income (GDP):

I see no evidence in the data here that our higher price level today has whittled the share of income accruing to labor. Moreover, I see no evidence suggesting that episodes of high or low inflation are related in any systematic way to the resources accruing to labor. (In fact, I see some evidence of a rising labor share during the high inflation decade of the 1970s.) But perhaps other data tells a different story. If so, I'd like to see the data (i.e., instead of a short email claiming that I am wrong). ...
To conclude, I think that the ... assertion that "the Fed has stolen 95 cents of every dollar" I view as absurd. There are legitimate criticisms one could level at the monetary institutions of this country, but these are not some of them. ...

Monday, March 21, 2011

Fed Watch: Intervention Thoughts

Tim Duy:

Intervention Thoughts, by Tim Duy: It is worth pointing out some interesting reporting regarding last week’s G7 intervention. I think this summary via the Wall Street Journal is basically correct:

The Group of Seven’s coordinated efforts Friday to weaken the value of the Japanese yen are likely designed more to temper panicked markets than targeting a specific currency level, economists say….

“This is a short-term measure that has more the goal of stabilization and averting a short-run panic than taking a view about how global imbalances might evolve and what the right value of the yen is against other currencies,” said Ralph Bryant, a former director of the U.S. Federal Reserve‘s international finance division, now a fellow at the Brookings Institution.

I have a hard time reading anything more than the obvious into the G7 intervention. In response to the earthquake and subsequent tsunami the Yen was appreciating rapidly in what appeared to be a disruptive fashion. The Japanese authorities would have acted on their own sooner or later, but secured the backing of their G7 partners to provide evidence that efforts to stabilize the Yen should not be confused with attempts to direct the value of the Yen to achieve a trade advantage. It will work as a break on speculative activity, but will have limited impact, if any, on any long-run, fundamental forces driving the value of the currency. To fight the latter requires a committed, repeated effort on the part of the Ministry of Finance, something that at the moment does not appear to be on the table.

The Wall Street Journal also has a more curious piece relating the currency intervention to the Federal Reserve’s balance sheet that reads like it was rushed on a Friday afternoon. (which I can identify with, as most pieces I rush fall short of where they should be). The piece begins:

Continue reading "Fed Watch: Intervention Thoughts" »

Sunday, March 20, 2011

(Don't) Raise Rates to Boost the Economy

David Frum tweets:

If there were a prize for the most foolish op-ed of the week, we wouldn't have to wait till next Friday to award it.


Raise Rates to Boost the Economy, by Andy Kessler, Commentary, WSJ: The chairman of the Federal Reserve is stuck between a rock and a hard place—well, more like a house and a gas tank. How to escape? Mr. Bernanke, raise interest rates now. ...
It's all counterintuitive, but it will work. Ending quantitative easing and raising short-term rates will surely cause the stock market to crater. 1,000 points? 2,000? Who knows? But a selloff will ensue. Does that mean a negative wealth effect? I doubt it. Who really thought they were wealthier at Dow 12,000 versus Dow 10,000?
Some banks will sputter, and maybe even fail, even the big boys. ... Hopefully the FDIC is ready to dive in and remove the remaining toxic mortgage assets of any failing banks, along with their managements, and then refloat the institutions. ...
But along with a likely lower stock market and failing banks will be several positive effects that will finally kick-start the economy. Oil and wheat and commodities will see a 20%-30% drop in price as speculators run for the hills. This will be a de facto tax cut for consumers. Hiring should restart when businesses see normal short-term rates, most likely 2%. ...

The key to recovery begins with a Fed induced stock market crash, followed by failing banks -- perhaps even systemically important ones? This may win more than "the most foolish op-ed of the week".

Friday, March 18, 2011

DeLong's Law

Say's Law:

This says that there cannot be a general excess demand or excess supply of goods, i.e. that the sum of the excess demands (excess supply if negative) across all goods must equal zero. There can be no "general gluts."

Walras says, not so fast. We also have to consider money demand and money supply. If there is an excess demand for money, there can be an economy-wide excess supply of goods. Walras Law:


Thus, if there is an excess supply of goods, the imbalance can be cured by increasing the supply of money.

Brad DeLong says, not so fast, we also need to consider the supply and demand of "high-quality interest bearing assets." Delong's Law:

This says that there can be a general gluts of goods offset by either an excess demand for money or an excess demand for assets (or some combination of the two that nets out correctly, and sometimes -- like now -- the assets in A and M are perfect substitutes). What is the cure for an excess supply of goods in this case? In Brad's own words:

I would say that the right way to think about the current situation is to move from a two-commodity model--money and goods--to a three-commodity model: goods, money, and "high-quality interest bearing assets." When there is an excess demand for high-quality interest bearing assets the interest rate goes to zero, in which case money becomes a perfectly good high-quality interest bearing asset. Then money gets swapped out of the "transactions" balance account into the "speculative" (or "insurance") balance account, and all of a sudden you have an excess demand for transactions-balance account money and so by Walras's Law a deficient demand for currently-produced goods and services.

I'm happy to call that a "monetary phenomenon" if it will make Nick Rowe happy.

But might it not be more illuminating to call it a financial phenomenon? A Minkyite or Kindlebergian or Bagehotian phenomenon?

Elsewhere, Brad adds:

Hicks and Wicksell would say that you also have to include the supply and demand for bonds--for interest-yielding savings vehicles. And, of course, at the ZLB money becomes a perfectly good savings vehicle and a perfectly good safe asset: it is no longer dominated by the other assets for those wanting a savings vehicle or safety because interest rates are zero.

Thursday, March 17, 2011

Mankiw and Weinzierl: An Exploration of Optimal Stabilization Policy

I haven't had a chance to ready beyond the introduction and conclusion of this paper by Greg Mankiw and Matthew Weinzierl, "An Exploration of Optimal Stabilization Policy," but a couple of quick reactions. First, in the paper, in order for there to be a case for fiscal policy at all, the economy must be at the zero bound and the monetary authority must be "unable to commit itself to expansionary future policy." This point about commitment has been made in other papers (I believe Eggertsson, for example, notes this), and I think the credibility of future promises to create inflation is a problem. If so, if the Fed cannot credibly commit to future inflationary policy, then this paper provides a basis for, not against, fiscal policy when the economy is stuck at the zero bound.

Second, they note in the paper that tax policy can do a better job of replicating the flexible price equilibrium in terms of the allocation of resources, and hence tax policy should be used instead of government spending. However, since I think that there is a strong case that we are short on infrastructure, and that public goods problems prevent the private sector from providing optimal quantities of these goods on its own, I don't see the distributional issues as an important objection to government spending at present.

Here's the introduction to the paper:

An Exploration of Optimal Stabilization Policy, by N. Gregory Mankiw and Matthew Weinzierl March 8, 20111 Introduction What is the optimal response of monetary and fiscal policy to an economy-wide decline in wealth and aggregate demand? This question has been at the forefront of many economists' minds over the past several years. In the aftermath of the 2008-2009 housing bust, financial crisis, and stock market decline, people were feeling poorer than they did a few years earlier and, as a result, were less eager to spend. The decline in the aggregate demand for goods and services led to the most severe recession in a generation or more.
The textbook answer to such a situation is for policymakers to use the tools of monetary and fiscal policy to prop up aggregate demand. And, indeed, during this recent episode, the Federal Reserve reduced the federal funds rate -- its primary policy instrument -- almost all the way to zero. With monetary policy having used up its ammunition of interest rate cuts, economists and policymakers increasingly looked elsewhere for a solution. In particular, they focused on fiscal policy and unconventional instruments of monetary policy.
To traditional Keynesians, the solution is startlingly simple: The government should increase its spending to make up for the shortfall in private spending. Indeed, this was a main motivation for the $800 billion stimulus package proposed by President Obama and passed by Congress in early 2009. The logic behind this policy should be familiar to anyone who has taken a macroeconomics principles course anytime over the past half century.
Yet many Americans (including quite a few congressional Republicans) are skeptical that increased government spending is the right policy response. They are motivated by some basic economic and political questions: If we as individual citizens are feeling poorer and cutting back on our spending, why should our elected representatives in effect reverse these private decisions by increasing spending and going into debt on our behalf? If the goal of government is to express the collective will of the citizenry, shouldn't it follow the lead of those it represents by tightening its own belt?
Traditional Keynesians have a standard answer to this line of thinking. According to the paradox of thrift, increased saving may be individually rational but collectively irrational. As individuals try to save more, they depress aggregate demand and thus national income. In the end, saving might not increase at all. Increased thrift might lead only to depressed economic activity, a malady that can be remedied by an increase in government purchases of goods and services.
The goal of this paper is to address this set of issues in light of modern macroeconomic theory. Unlike traditional Keynesian analysis of fiscal policy, modern macro theory begins with the preferences and constraints facing households and …firms and builds from there. This feature of modern theory is not a mere fetish for microeconomic foundations. Instead, it allows policy prescriptions to be founded on the basic principles of welfare economics. This feature seems particularly important for the case at hand, because the Keynesian recommendation is to have the government undo the actions that private citizens are taking on their own behalf. Figuring out whether such a policy can improve the well-being of those citizens is the key issue, a task that seems impossible to address without some reliable measure of welfare.

Continue reading "Mankiw and Weinzierl: An Exploration of Optimal Stabilization Policy" »

Wednesday, March 16, 2011

Fed Watch: Policy Still on Autopilot, For Now

Tim Duy:

Policy Still on Autopilot, For Now, by Tim Duy: The Federal Reserve did as expected, leaving policy unchanged. But policymakers tweaked the statement ever to slightly to suggest that indicators are at a minimum not moving away from the objectives of the dual mandate – a critical first step on the road toward normalizing monetary policy.

First, apparently there was some surprise that the Federal Reserve failed to mention the unfolding crisis in Japan. From the Wall Street Journal:

Federal Reserve policy statements are supposed to outline the forces that will drive monetary policy over coming months, so while it wasn’t unexpected, it’s nevertheless puzzling central bankers omitted the biggest risk of all: Japan.

I suspect they did not mention Japan because little information is known about the economic risk or they don’t perceive it to be the primary risk in the US outlook. Indeed, we have been down this road before with Hurricane Katrina - even very large disasters in advanced economies appear to have limited overall economic impact, although the regional impacts could be quite severe. I often wonder if economists have a tendency to initially overestimate the potential impact of such events as they believe the economic impacts must somehow reflect the human impact, or that if they don’t play up the economic impacts they will be seen as downplaying the human impact. I tend to be less concerned about the economic impact (particularly over the longer term; market economies have proven to be remarkably resilient) and instead am much, much more concerned about the very devastating and long-lasting human impact of this tragedy. I recommend the guest post at Econbrowser on this topic. To be sure, policymakers will be watching this and other situations closely, but I suspect they would turn to this kind of research as a guide and conclude for now that the global economic impact will be largely transitory.

Indeed, instead of focusing on the downside risk, policymakers turned their attention largely to on the moderately positive news. First, as has been widely noted, the Fed upgraded the economic assessment – the recovery is not only on “firmer footing,” but labor markets “appear to be gradually improving.” The last bit is important. The lack of any meaningful improvement in labor markets has been a central feature of this recovery, and a major impediment to any change in policy. Signs of improving labor conditions are a welcome relief for policymakers.

Note also that the language regarding commodity prices is focused on the inflationary, not deflationary, implications. I tend to believe the Fed would ultimately be forced to ease policy further in the event of a significant oil price surge, but there is no indication here that this is the concern.

Furthermore, notice the slight change in the language regarding the inflation trend. The Wall Street Journal missed it:

The language on its closely watched measures — core inflation and expectations — is unchanged. The bottom line here is that policy makers aren’t overly concerned about inflation right now.

True, they are not overly worried about inflation. But Calculated Risk spots the small but important change:

Inflation "subdued" instead of "trending downward"

If you are looking for QE3, you need some combination of ongoing labor market stagnation and threat of deflation (the two go hand in hand). Instead, what the Fed sees is improving labor markets and inflation that appears to have hit a floor:


Of course, despite indications data is actually heading in the direction of the dual mandate, the size of the output gap, high unemployment, and weak wage growth all argue against tightening policy in any way, shape, or form. Hence the current large scale asset program continues unabated. I still believe the calendar argues against any deviation from this plan. Even if incoming data strongly surprised on the upside, by the time the Fed was able to assess such data and act, the policy would be nearly at an end. Changes would be essentially pointless.

Bottom Line: Monetary policy continues on autopilot – they still plan that QE2 will end as expected at which time policymakers will turn their attention to policy normalization, setting the stage for a rate hike in 2012. Watch for signs that the downside risks (oil, Japan, Europe, etc.) are evolving in such a way that they are impacting actual data, with the weak reading on consumer confidence being a cautionary tale. But if the data holds up, with steadily improving labor markets and improving inflation measures, the next test for monetary policy will be the end of QE2. Will markets falter in the absence of a steady drip of monetary policy?

Tuesday, March 15, 2011

The FOMC Leaves Fed Policy Unchanged

At MoneyWatch, I have a brief reaction to the Fed's decision to leave policy unchanged:

The FOMC Leaves Fed Policy Unchanged

Why Politics, Ideology and the Fed Don’t Mix

We are, as they say, live. Senator Shelby blocking Peter Diamond's appointment to the Federal Reserve Board of Governors, and this talks about whether there is any justification for doing so, and how the appointment process might be improved:

Why Politics, Ideology and the Fed Don’t Mix

I'm not sure you'll agree with this one.

Update: One thing that doesn't come through very well in the column is that a president's first few appointments to the Board of Governors should be given due deference (and a lot is due). After that scrutiny, even blocking, is justified since a president's ability to stack the Board should be limited -- that's the Senate's role. Scrutiny over Krosner was appropriate since Bush had ample opportunity (and then some) to shape the ideological makeup of the Board. Blocking Diamond as payback for blocking Kroszner is not appropriate since Diamond is clearly qualified and among the first few nominations.

Thursday, March 10, 2011

Should the Fed Respond to Commodity Price Increases?

To answer the question in the title of this post, it's useful to think of an island with only two goods. One of the goods is non-renewable, but highly desirable. The other good is less preferred, but it is renewable (thinking of renewable and non-renewable energy resources, for example). The key is to distinguish between changes in prices that reflect changes in the relative scarcity of the two goods, and changes driven by increases in the money supply.

Over time, as the stock of the more desired good falls due to consumption, the price of this good will rise relative to the renewable good. Consumers will be hit by increases in the cost of living -- the same basket of the two goods purchased last year now costs more.

But is this the kind of increase in prices the Fed should respond to? No, the price increase -- and the increase in the cost of living -- reflects increasing scarcity of the desired good. The price of the two goods are changing to balance the relative supplies of the two goods. Unless the price of the non-renewable resource does not properly take account of the preferences of future generations -- and it may not -- or there is some other market failure, there is no reason for government to intervene to change the prices. If the prices are correct, they will allocate the resources optimally.

Now consider a different case. Suppose the central bank in charge of money -- sea shells of a particular type identified with the central bank's special mark -- and the money supply is being increased at a rapid rate. This will drive the prices of both goods up, but so long as the price of each good rises in proportion to the change in the money supply so that the relative price of the two goods is undisturbed, no problem. The price level will adjust to the number of sea shells in circulation, but since relative values remain intact, nothing will change.

However, suppose one of the two prices is sticky. It does not change very fast when the number of sea shells in circulation increases. In this case relative prices will be distorted as the number of sea shells increases, one price will rise faster than the other, and resources will be misallocated. In this case the Fed would want to do something about the inflation since it is having negative effects on the efficient allocation of the two resources. This is, essentially, the Fed's justification for activist policy.

A couple of notes. First, it's interesting to think about how technological change that improves the quality or lowers the price of the renewable good plays into this. Such a change could offset the increase in the cost of living that households face. Thus improving technology, not Fed policy, is the key to helping people on the island struggling with high prices.

Second, this is about the long-run and growth in demand. The central bank may still want to try to offset temporary price spikes, for example when sticky prices can cause problems that persist beyond the spike in the price of one of the two goods (e.g. a spike in the price of oil that leads to long-lived price distortions). But long-run growth that causes the price of one of the goods to rise by more than the other, i.e. relative price changes, is not something the Fed should try to neutralize.

"The Free-Banking vs. Central-Banking Debate"

David Andolfatto has been "the recipient of hundreds of rather nasty emails lately":

The Ron Paul Thing: I've taken down my post entitled "Ron Paul's Money Illusion" because it seems to have provoked mindless rage rather than thoughtful debate.

A part of this is my fault for saying that, while I respected many of the Congressman's libertarian ideals, I thought that he could be more circumspect at times. Well, I didn't exactly use this language, if you know what I mean. And for that, I want to apologize to the Congressman and all of his ardent supporters.

Having said this, I stand by the substantive point that I was trying to make. That column, however, was written too hastily. So I think I'll rewrite it, this time a little more carefully, and with a little less colorful language...

Here's his next post:

The free-banking vs. central-banking debate: ...As many of you can imagine, I've been the recipient of hundreds of rather nasty emails lately. I don't know any other way to describe it except as "awesome." Oh, I don't especially like being called names and being insulted, but it's no big deal (academics need pretty thick skins to survive). The awesome part is how people are so eager to express their views. ...
Now for a little story--some background, I guess. Long ago, a remarkable debate took place about the optimal way to organize an economy's money and banking system. The proponents of free-banking eventually lost out to those who favored some form of central bank regime. The nature of these debates are nicely summarized by Vera Smith in her book, The Rationale of Central Banking. ...
As an academic who has devoted a considerable amount of time on the subject, I cannot say that I presently fall strongly on either side of the debate. I can see merits (and defects) in both points of view. ...
To make a solid case one way or the other, it is important to keep the facts straight..., not to present data in a misleading light. Now, I do not think everything Ron Paul says is wrong. In fact, as I said in my original post, I appreciate the libertarian philosophy. But if one wants to promote libertarianism based on sound intellectual foundations, it does the cause no good to make and promote misguided statements about money, prices, and the role of central banks. History is replete with examples of  bad government policies in place well before the existence of central banks. In my view, it is wrong to convey the impression that something close to economic nirvana will dawn in the absence of a central bank. ...
It is my belief that Ron Paul promotes a misleading argument concerning the fact that our price-level today is much higher today than it was 100 years ago. His argument implicitly suggests that nominal wages today would be roughly where they are at even in the absence of currency debasement. This is, in my view, just plain wrong.
But for people who believe it (and evidently there are many out there that do), it provokes rage against the Fed. It is as if the Fed has stolen virtually all of their wages and that real material living standards today would be much higher if only the price-level had remained at its 1913 level. This proposition is grossly at odds with the evidence, which shows roughly 2% annual real growth in per capita income and roughly stable income and expenditure shares. There is, of course, considerable discussion about growing income inequality. But almost every paper I read about this phenomenon seems to point either to skill-biased technological change or competition from emerging economies. I'm not sure what Fed policy has to do to with those forces.
I am no defender of inflation. But the US inflation rate has been low and stable for decades now. ... Now, there may be other reasons for abolishing the institution, but if so, then why not emphasize those? As I said in my original post,... it does no service to the libertarian cause to attack the Fed with misleading arguments ... because opponents to the libertarian cause can latch on to the lame arguments and use them to discredit the more worthy ones.
The Fed was established by an act of Congress in 1913. The Fed is operating under the rules established by Congress. If you have a problem with these rules, then I encourage you to lobby your Congressional representatives to change them. Blaming the Fed for following the law as established by Congress  (and other guidelines, such as the dual mandate) seems like a rather strange way to go. But hey--power to the people.

I'm more of a central banking type.

Monday, March 07, 2011

Fed Watch: Ignore Hawkish Rhetoric

Tim Duy:

Ignore Hawkish Rhetoric, by Tim Duy: The Wall Street Journal suggests the Fed is facing a policy conundrum. I would suggest that "conundrum" is an overstatement. Push comes to shove, there will be little debate - if the current oil price shock turns nasty, Fed officials will embrace another round of quantitative easing.

Dallas Federal Reserve President Richard Fisher offers the hawkish view, and remains colorful as always. Today he ranted against QE2:

To be sure, there are some, including me, who worry that the Fed ultimately may have taken out too much insurance against a double-dip recession and slippage into a deflationary spiral. There are some, including me, who argued against the last tranche of insurance we took out in committing to buy $600 billion in U.S. Treasuries between last November and the end of this coming June as we were simultaneously purchasing additional Treasuries to make up for the roll off in our mortgage-backed securities portfolio. There was a strong feeling among those of my policy persuasion that we had already sufficiently refilled the tanks holding the financial fuel businesses needed to drive their job-creating machines. They felt that by being too accommodative, we might run the risk of planting the seeds that could germinate into renewed volatility, speculation and inflation, or give comfort to a government that for far too many congressional cycles has fallen down on the job by spending and borrowing and committing to unfunded programs with reckless abandon.

Am I the only one who sees Fisher as a remarkably irresponsible policymaker? I get the sense that at best he is trying to undermine the effectiveness of monetary policy by repeatedly emphasizing that it doesn’t work. At worst, he is deliberately trying to feed inflation expectations, for what purpose I know not. I think the responsible policy approach would be to exude confidence in the Federal Reserve, particularly during period of turmoil. The policy is in play; no good comes from public derision at this junction. Simply reiterate that the Fed has the tools to remove the accommodation should it become necessary.

Goodness, if anyone took him seriously, he could do some real damage. Luckily, I think by now we have been trained to largely dismiss Fisher. For a more nuanced and thoughtful policy approach, I suggest the competing speech by Atlanta Fed President Dennis Lockhart, with what I think is a key insight:

Where my views might depart from the mainstream to some extent is on the question of the range of plausible economic scenarios from this juncture. In thinking about an appropriate and balanced policy for at least the near term, it seems to me a critical question is whether the range of plausible scenarios is narrowing (that is, is certainty growing) or widening (that is, is uncertainty growing). My view is the range has widened—not dramatically, but somewhat. For some time, my list of headwinds and risks has encompassed European sovereign debt, our own federal, state and municipal fiscal challenges, house prices, and commercial real estate. My sense of the balance of risks has shifted with the addition of unrest in the Middle East and North Africa.

That growing uncertainty has weighed on me in recent weeks. Rather than digging in his heels like Fisher, Lockhart allows policy flexibility in the months ahead:

With the information I have today, my first inclination is to be very cautious about extending asset purchases after June. Given the emergence of new risks, however, I prefer a posture of flexibility as regards policy options. As we have seen, conditions can change rapidly, so I will continue to evaluate the incoming information as much as possible with fresh eyes as I approach each meeting and each decision.

Lockhart’s position will become the dominant view at the Fed. A month ago, the likelihood of additional easing was nearly zero. QE2 would end as scheduled, and the Fed would turn its attention to the timing of policy reversal. The evolving commodity price shock, however, clouds that outlook. To be sure, Lockhart recognizes the potential inflationary impact of recent events:

To recap, one can't help but notice rising inflation anxiety among the business community as well as consumers based on recent experience with highly visible and highly publicized commodity prices. So far, this anxiety has not translated to a loosening of the moorings of inflation expectations….But my concern is that broad inflation worries—even if in reaction to what are probably temporary relative price movements—could shift and cut loose inflation expectations. It goes without saying that we policymakers must watch indications of expectations very carefully and be on guard for an approaching inflection point.

But he recognizes that this should not be the baseline expectation. Instead:

In my opinion, central to the question of the potential for price action becoming broad inflation is the behavior of wages. I remember the early eighties well. I was in a management role in a bank then, and in my organization we were moving salaries around 10 percent a year to retain our people. Wage accommodation of rising prices has the effect of institutionalizing and embedding inflation. However, I do not see widespread wage pressures developing any time soon in the current circumstances of upwards of 20 million people either out of work or working part-time for economic reasons.

The February employment report would appear to support Lockhart’s position – average hourly wages climbed by a mere penny. Indeed, it is hard to see the basis of a wage-price inflation spiral evolving:


Spencer at Angry Bear adds succinctly:

With income growth this weak fears of significantly higher inflation appear to be misplaced. Although headline inflation may be ticking up because of food and energy, the weak income growth implies that the impact of higher food and oil prices will be felt much more in weak consumer spending rather than higher inflation expectations.

Bottom Line: The ongoing commodity price shock argues for further monetary accommodation, not less. In the current environment, efforts to pass through higher prices to consumers will only erode spending power, not provide the basis for additional wage gains. This is not Europe or Asia; dismiss policymakers who suggest otherwise.

Politics Matters

One thing I've learned from the crisis is that the politics of economic intervention to stabilize the economy is far more important than I realized. When you teach stabilization policy out of textbooks, it's easy, you just say that the government cuts taxes or increases spending, that the Fed takes this or that action, and then calculate the result (or, more likely, show it graphically). The politics, e.g. the distributional consequences of the policies, are rarely if ever mentioned.

The importance of the politics started to dawn on me as I began to observe the reaction to the bank bailout and the stimulus package on this blog and elsewhere. For example, I was traveling from Seattle to Victoria by ferry and I overheard a conversation from the group sitting behind me. There were two couples, I'd place pretty good odds they showed up in either a Volvo or a Prius, and the conversation turned to the economic stimulus. They said how worried they were about the debt -- all that spending Congress was going to do -- and how we would pay it off? They were very emphatic, and clearly very worried about this. They said many things that seemed to come out of the anti-stimulus playbook, and at several points it was all I could do not to turn around and try to straighten them out. But I decided there was more value in listening to how they felt about the bank bailout and stimulus packages, and it was an eye opener. They were very much opposed to the actions that had been taken. I heard a similar conversation across the aisle from me on a plane trip not too long after that, with the health care plan at the forefront of worries, and at other times as well, but it really hit home when I was watching a Duck game with some friends who are very liberal, very populist, and very much working class. They hated the bank bailout in particular -- it was seen as a bailout for the wealthy -- and I was quite surprised at the degree to which they opposed this policy. The anger in their voices was evident, and they had no interest at all in listening to my explanations of why the bailout policy was done this way, and how it would help everyone. Where's my bailout I heard again and again. The attitude was that the rich got bailed out -- as always -- but the people who could have actually used the money got nothing but the bills. There was no sense whatsoever that they believed bailing out the banks had saved Main Street from an even worse fate -- this was nothing more than a scam to funnel money to the rich. As far as I could tell, they simply did not believe that the bank bailout would help them in any way. But they would be asked to pay the bills.

The result of this -- and it's something I've written about several times -- was to wonder about this "trickle down" approach to policy. Why not help people pay their bills directly instead of letting them go under and then bailing out the bank when households cannot repay loans? Economically it isn't that much different from the banks' perspective -- they get the money they need to survive either way, it's simply a matter of who gets the money first.

The point I'm making is a simple one. We have a responsibility to make sure that both monetary and fiscal policy are still there for future generations. If we do things now that are economically justified, but political disasters, then the next time policy is needed it won't be there -- the policies won't have the public support that is needed for politicians to get behind them. As we calculate the value of enacting a policy, politics matters. We have to take account of the costs to future generations of potentially not having these policies available due to the political opposition that might come about as a result of our actions to try to stabilize the economy. For that reason, we need to think a bit harder about the distributional consequences of policies that are put in place during a crisis. If, when the next crisis hits, we try to repeat the actions taken this time, the political opposition will likely stand in the way -- there is little support for a repeat of current policy (and I do not believe that resolution authority is enough by itself to prevent the need to bail out banks in a severe crisis). There are alternatives to helping the well off and hoping it trickles down -- there are trickle up alternatives that help middle and lower class households directly -- but we haven't put enough effort into developing these policies. That needs to change.

Sunday, March 06, 2011

How Long Until We Reach Full Employment?: Using the Last Two Recessions as Guides

Comments to this post have pointed out what I tried to acknowledge in the write-up, the forecasts of how quickly unemployment will recover present a relatively optimistic case. Though it didn't come through very well, that was part of the point. Even with an optimistic outlook, the return to full employment will take a long, long time. (See also Brad DeLong's comments.)

However, a more pessimistic outlook is likely warranted. Suppose that instead of looking over the entire sample to make the forecasts, as in the last post, we restrict our attention to just the last two recoveries.

Again, taking a quick, back of the envelope approach, the rate of recovery from the peak unemployment rate of 7.8% in June of 1992 through the trough of 3.8% in April of 2000 was, on average, a -0.04255 change per month. From the peak of 6.3% in June of 2003 through the trough in 4.4% in October of 2006, the average rate of change per month was -0.04750.

Averaged over both periods, the rate of decline was -0.04403 per month. This is the rate used to construct the forecasts shown by the dotted red lines in the figure. (Both the in-sample and out-of-sample forecasts are shown. The out-of sample forecast begins at the peak of 10.1% in November of 2009 to be consistent with the way the rates of change are constructed. In the previous post the forecast began the period after the end of the sample.):


The resulting forecast is truly scary. Here are updated versions of the benchmarks in the previous post:

7% unemployment in August of 2015
6% unemployment in June of 2017
5% unemployment in May of 2019
4% unemployment in April of 2021

Thus, if we recover at the same pace as in the last two recessions, something we certainly can't rule out, it will take more than six years to get to 6% unemployment rate, and until June of 2018 to get to 5.5%, the figure I cited in the last post as my best guess of the long-run natural rate.

So why are we sitting on our hands?

Saturday, March 05, 2011

Greenspan: The Costs of Government Activism

When Alan Greenspan was nearing the end of his time as Chairman of the Federal Reserve System, there was a celebration of his career at the Fed meeting held annually at Jackson Hole, Wyoming. At this meeting he was ordained, for all intents and purposes, as the greatest central bank ever. He must have been on top of the world.

However, since the housing market crash and subsequent deep recession, an event that can be linked to regulatory failures under his watch and to other policies he supported, his reputation has taken a big hit. In response, Greenspan has been doing everything he can to restore his reputation, including writing a book, writing op-eds, and giving interviews laying out his case.

Greenspan would not agree with the charge above that failure to regulate banks adequately caused the crisis. In fact, he argues just the opposite -- that government activism was responsible for the crisis. His latest defense of his anti-regulatory stance continues this argument, and in a new article he blames the severity of the economic recession on "regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism." This activism, in his view, is "crippling our chances of a full long-term recovery":

The costs of government activism, EurekAlert: In an article to be published in the forthcoming issue of International Finance, Dr. Alan Greenspan, former chairman of the Federal Reserve, issues a major analysis of the U.S. government's economic recovery and reform efforts since the collapse of Lehman Brothers in September 2008. ...
Applying a range of analytical and historical lenses, and data-sifting techniques, Greenspan concludes that the primary cause of the malaise is the exceptional level of government activism during the past two years. "Although the actions the government took in the immediate aftermath of the Lehman Brothers shutdown were necessary and appropriate responses to the crisis," he writes, "these actions are not necessary any longer, and could in fact be crippling our chances of a full long-term recovery."
Greenspan argues that the real problems with government activism began with the stimulus package of early 2009 and the failure to phase out the "temporary" actions taken during the last quarter of 2008. He argues that this fostered a degree of risk aversion to investment in illiquid fixed capital, on the part of both corporations and individuals, that was most evident in our longest-lived assets – real estate, both nonresidential and residential. "Without the abnormal weakness in long-lived assets," he writes, "the current unemployment rate would be well below 9%."

Here's the abstract from his article:

The US recovery from the 2008 financial and economic crisis has been disappointingly tepid. What is most notable in sifting through the variables that might conceivably account for the lacklustre rebound in GDP growth and the persistence of high unemployment is the unusually low level of corporate illiquid long-term fixed asset investment. As a share of corporate liquid cash flow, it is at its lowest level since 1940. This contrasts starkly with the robust recovery in the markets for liquid corporate securities. What, then, accounts for this exceptionally elevated level of illiquidity aversion? I break down the broad potential sources, and analyse them with standard regression techniques. I infer that a minimum of half and possibly as much as three-fourths of the effect can be explained by the shock of vastly greater uncertainties embedded in the competitive, regulatory and financial environments faced by businesses since the collapse of Lehman Brothers, deriving from the surge in government activism. This explanation is buttressed by comparison with similar conundrums experienced during the 1930s. I conclude that the current government activism is hampering what should be a broad-based robust economic recovery, driven in significant part by the positive wealth effect of a buoyant U.S. and global stock market.

He also warns that new regulation will destabilize financial markets:

The degree of complexity and interconnectedness of the global 21st century financial system, even in its current partially disabled form, is doubtless far greater than the implied model of financial cause and effect suggested by the current wave of re-regulation. There will, as a consequence, be many unforeseen market disruptions engendered by the new rules.

I hope it's clear by now that I do not support Greenspan's view of regulation. I think the failure to bring the shadow banking system under the regulatory umbrella that covered traditional banks -- something Greenspan opposed vigorously -- was a big mistake. Thus, the non-activism he supported was a big part of the problem. And, contrary to Greenspan who thinks recent regulation has gone too far, in my view it does not go far enough.

Thursday, March 03, 2011

Fed Watch : Game Changers

Tim Duy:

Game Changers?, by Tim Duy: The strong data flow continues. Following up on its manufacturing counterpart, the ISM’s service sector report extended January’s improvement. Retail sales appeared to bounce higher in February, supporting the contention that January’s weakness in retail sales was weather related. When the roads cleared, consumers realized they had a few extra dollars burning a hole in their pockets. And, most importantly, initial unemployment claims sank, bringing the 4-week average below the 400k mark. We are at levels that typically foreshadow solid labor market improvement, which is undeniably good news.

All in all, incoming data reinforce my sense that the upside and downside risks to the forecast are intensifying, which could make for a very interesting few months. I sense there is a tendency to downplay the upside risk because of the depth of the US employment and output holes. To be sure, there remains significant slack in the economy, enough so that a steady stream of good data should not induce monetary or fiscal authorities to withdraw stimulus anytime soon. This, of course, is the mistake the ECB looks likely to make:

European Central Bank President Jean-Claude Trichet said the ECB may raise interest rates next month for the first time in almost three years to fight mounting inflation pressures.

An “increase of interest rates in the next meeting is possible,” Trichet told reporters in Frankfurt today after the central bank set its benchmark rate at a record low of 1 percent for a 23rd month. “Strong vigilance is warranted,” he said, adding that any move would not necessarily be the start of a “series.”

Overeager ECB policymakers aside, one can see the foundation of a shockingly sustainable recovery forming. I know, it has been so long since we saw good data that the natural inclination is to be dismissive. But at this point, all we really need is to light a little fire under the labor market to entrench a positive feedback loop. And the sharp improvement in initial claims suggests that fire has been lit. It is just a matter of time before it shows up in nonfarm payrolls.

But lighting the fire is not enough to prompt the Fed to make a rapid policy reversal. Some policymakers will focus on what they see as brewing inflation. From the Beige Book:

Manufacturing and retail contacts across Districts reported rising input costs. Manufacturers in many Districts conveyed that they were passing through higher input costs to customers or planned to do so in the near future. Homebuilders in the Cleveland and Atlanta Districts noted rising material costs, but acknowledged little ability to pass through the costs to buyers. Retailers in some Districts mentioned they had implemented price increases or were anticipating such action in the next few months.

Efforts to pass along higher prices, however, should not be enough to unsettle the Fed as a whole. Eyes should be drawn to the next sentence:

There is little evidence of wage pressures across Districts. Wages remained steady in the Boston, Philadelphia, Cleveland, Kansas City, and Dallas Districts, while moderate wage pressures were reported in the Chicago, Minneapolis and San Francisco Districts. Philadelphia, Dallas, and San Francisco noted that most wage increases were for workers with specialized skills.

Until we see enough labor demand, and reduced slack, that we see some widespread upward momentum in wages, it is tough to see how higher input cost do anything but temper demand growth.

Simply put, the baseline scenario should be that labor markets are not going to improve sufficiently quickly to unsettle the Fed’s plans. Still, there is a risk that we are underestimating the degree of slack in labor markets. I think one needs to pay more attention to that risk should we see a string of solid employment reports.

At the same time the economy is showing signs of sustained momentum, thus raising the specter of upside risks, we are faced with the downside risks from the commodity side. Undoubtedly, higher commodity prices are a drag on activity. But the last shock came in the context of waning US economic activity and rock bottom saving rates. This time, the US economy is on the upswing, with positive saving rates to provide cushion, suggesting that for now the commodity shock can be managed. Still, I can outline a scenario where low interest induces a flood of money into commodities to chase a supply induced price shock. And I am more inclined to believe that this would trigger a recessionary rather than inflationary environment.

Bottom Line: We await yet another employment report, facing intensifying risks on both sides of the forecast. The possibility of some real game changing developments is at hand. At this moment, I think the balance of risks are now on the upside, but am very, very conscious of how quickly that balance can change in the wake of a commodity price shock. I would be wary about letting the depth of this recession interfere with your read of the data, just as wary as you should be about letting the data tempt you from thinking it is time to push stimulative policies into reverse.

Long and Variable Lags in Monetary Policy

I am between classes and in a rush, so I don't have time to say much about Scott Sumner's latest misrepresentation of what I've said (I tried to clear it up here, e.g. for just one example, he turns the statement "it would be very unusual for monetary policy to work that fast" into my saying it couldn't possible have happened -- that's not what I said). However, on one point -- the lags in monetary policy -- since Scott claims (based upon his own work on the Great Depression) that "I don’t see any long and variable lags there," and uses this to try to refute my claim about policy lags, and since he makes it sound like I am relying solely on "modern macro" to draw this conclusion, let me quote Milton Friedman as an authority on monetary policy in the Great Depression (and outside of it for that matter). Here's what Friedman said to me on policy lags in a letter on one of my papers:

...Turning to your mathematization of the idea, I am struck that it is extremely ingenious and I have no comments to make on that. In re the conclusions, I am not greatly disturbed that positive money growth shocks do not have a large impact on inflation when the economy is operating at maximum level. We have consistently found that changes in money lead changes in inflation by about two years, and there is no reason why that lag should not be just as operative at upper turning points as elsewhere. You include, as I understand it, a lag of at most six months. True, the impulse response functions implicitly extend the lag, but I suspect that is not the same as allowing for a very much longer lag. Changes in money tend to affect output after something like about six to nine months, and inflation only after another 18 months, by which time the effect on output is negative rather than positive. Hence, it is not surprising that the short-term reaction is on interest rates rather than on inflation. In a frictionless world in which money was completely neutral, the impact of monetary growth would always be solely on inflation. In the real world, given the lags that I have described and taking for granted that positive money growth is not reflected in inflation for a considerable period, it must be reflected somewhere. The obvious candidates are output, interest rates, and buffer money stocks. When the economy is operating below capacity, it is easy for part of the impact to be taken up by real output and a lesser part by interest rates or by buffer stocks. But when the economy is operating at full capacity, it cannot be taken up by output. It will therefore have to have a stronger influence on the two other components. ...

The claim that there are lags before policy takes effect is not at all controversial. I can understand the inclination to argue otherwise when you need short lags -- no lags essentially in this case -- to justify the story you've been telling about policy. But saying it, and acting quite assured in doing so, does not make it true. So, once again, to restate the claim I made, there are long and variable lags in policy. Finding significant employment effects so soon after the QEII policy was announced -- essentially within a quarter, four months at the most -- is difficult to believe given that employment is even slower to respond than output. As I said initially, we don't have the data to sort this out yet, it's too soon to know for sure, but a lag that short would be "unusual."

[Update: I probably should have also clarified what it was that I responded to in the initial post long ago. Scott claimed in a post, without any qualification I can recall, that fiscal policy had failed. Period. No question about it. My point was a simple one -- we don't have the evidence to come to that conclusion yet (and the evidence that does exist points in both directions -- you can support whatever you want by choosing the right study), and due to the timing of various policies, it will be difficult even when we do have all the data we need to do the tests properly. When monetary and fiscal policies are implemented at nearly the same time, as they were, and when they come at or near the trough of cycles, as both QEII and the recent tax cuts did, it is hard to identify them separately. And it will also be hard to separate the effects of policy from the natural recovery. The part about QEII working so soon, or not, drew the most reaction, but it was not the main point being made.]