A few comments on today's FOMC decision:
Tuesday, December 13, 2011
Friday, December 09, 2011
A Mixed Bag From Europe, by Tim Duy: I find it somewhat hard to judge the merits of this week's developments in Europe. Some positives, some negatives. On net, though, I remain a Europessimist. In my opinion, the issues of internal rebalancing remain completely ignored, and this will eventually doom the Euro if not addressed.
The European Central Bank moved forward with additional easing specifically intended to alleviate pressures in the banking system. The breakdown in the interbank lending market threatened to create a Lehman-type event sooner than later, and that threat was receded with the ECB's extension of liquidity facilities and cutting in half reserve requirements for commercial banks. The ECB also cut interest rates to 1%, with more cuts expected.
That said, the European financial system remains under pressure with continuing deleveraging and eventually more bank recapitalizations efforts needed. The result will be a worsening of the European recession, an event that is only in its infancy. And, as has been widely reported, ECB President Mario Draghi did not offer unlimited support for Eurozone sovereign debt, which was greeted with disappointment yesterday. I think it is premature to expect such a commitment; they will only play that card as a very last measure.
Overall, somewhat more aggressive than than I expected, and a clear indication that the ECB now realizes the depth of the Eurozone's financial problems. So far, so good. Yes, I would be happier with a clear statement that the ECB is the lender of last resort for European sovereign debt, but I just don't expect to hear this yet anyway.
In contrast, the Eurozone summit predictably failed to meet expectations. The UK bowed out of the agreement, guaranteeing a lack of EU wide commitment. At best you get the 17 Eurozone nations plus a few others to sign up. This opens up the possibility of more EU ruptures in the future. The seal has been broken. Second, as Felix Salmon points out, we have an agreement in principle, but ratification battles lie ahead:
It seems that German chancellor Angela Merkel is insisting on a fully-fledged treaty change — something there simply isn’t time for, and which the electorates of nearly all European countries would dismiss out of hand. Europe, whatever its other faults, is still a democracy, and it’s clear that any deal is going to be hugely unpopular among most of Europe’s population. There’s simply no chance that a new treaty will get the unanimous ratification it needs, and in the mean time the EU’s crisis-management tools are just not up to dealing with the magnitude of the current crisis.
Many opportunities for national politics to blow this agreement apart in the weeks ahead.
As far as Eurozone crisis-management tools are concerned, we are simply still where we have always been - the wealthier nations of the Eurozone - largely Germany - continue to resist putting in the necessary capital to create effective crisis funds. Moreover, the ECB appears to remain unwilling to lend the necessary money to rescue funds. In the absence of internal support, Europe continues to look toward international support. I still think this is ludicrous. How much help should Europe really expect knowing that Germany is not willing to go all-in financially to save the Euro, and now that we know the UK is making a calculated bet that the Euro is already a doomed experiment?
Let's put aside the above concerns for a minute. When all is said and done, I am still amazed that the outcome of this summit is being described as a move toward fiscal union. It is not that - it is commitment to unified fiscal austerity, nothing more. Consider just a strict enforcement of the 3% deficit ceiling in light of actual deficits in the EU. Via NPR:
Just on the surface, it is tough to see any commitment to fiscal austerity as credible. Germany itself exceeded the targets in 7 out of the past 11 years. Talk about the pot calling the kettle black. France missed 6 in the past 11 years. And Italy 8 times. Thus, in addition to the periphery nations, the biggest economies in the Eurozone will all need to increase government saving to meet these targets.
Such saving will be attempted in the context of a recession in which the private sector also will be increasing savings as well. In other words, the public sector will be engaging in massive pro-cyclical fiscal policy as the recession intensifies. You have to imagine the end result is a substantial deflationary environment.
In short, I think Europe is rushing full speed to a Japanese outcome, with slow growth coupled with an appreciating currency. And it is that promise of slow growth and a strong currency will be what eventually tears the Eurozone apart. And this is truly sad given that deficits are not really the problem to begin with.
Why will the Eurozone fail? Because we still see nothing that addresses the internal imbalances between the core (largely Germany), and the periphery. That is the result of failing to commit to a real fiscal union. Such a union would include automatic internal fiscal transfers that are essential to maintaining regional economic stability. For example, economic distress in a US state results in an automatic relative transfer of resources via decreased tax revenue from and increased transfer payments to that state. Lacking such a mechanism, a slow growth, hard money regime will increasingly ratchet up the levels of economic distress in the periphery. And eventually the costs of staying in the Euro will exceed the costs of exit.
If Europe was serious about saving the Euro, they would commit to issuing more safe assets (more sovereign debt), using the ECB backstop to create such assets, and engage in direct fiscal transfers to reduce economic pain in the periphery while encouraging continuing structural and budget reforms in recipient economies. I don't think we are anywhere near such a plan - and are arguably moving in the opposite direction.
Bottom Line: I remain a Europessimist. The ECB is moving aggressively to preventing an imminent financial collapse. That should be seen as good news. But there remain unresolved deeper issues. At the core of those issues is the inability to see Europe as one large, fiscal unified economy rather than a combination of separate, fiscally austere economies. And in that remains the long-term vulnerability of the Euro experiment.
Tuesday, December 06, 2011
The Fed fires back:
Fed Shoots Back at Media Portrayal of Crisis Lending, by Luca Di Leo, Real Time Economics: Federal Reserve Chairman Ben Bernanke shot back in unusually strong terms at news reports it blamed for making “egregious errors” about the size and impact on Americans of the Fed’s emergency lending during the 2008 financial crisis.
In a letter to the Senate banking committee, Bernanke released a staff memo that rebuts the portrayals in recent Bloomberg and other news articles that the Fed was aiming to help big banks’ profits at the expense of taxpayers. (Read the letter)
A Bloomberg Markets Magazine article released Nov. 27 said that big banks reaped an estimated $13 billion of income after the Fed committed $7.7 trillion in funds as of March 2009 to rescuing the financial system. ...
Calling the lending numbers in the media “wildly inaccurate,” the Fed said total credit outstanding under its liquidity programs was never more than the $1.5 trillion peak reached in December 2008. ...
The Fed said that nearly all of the emergency assistance has been fully repaid or is on track to be, something it said wasn’t stressed in news articles. The central bank claimed that the loans benefited American taxpayers by generating an estimated $20 billion in interest income for the U.S. Treasury. ...
I don't think this addresses Brad DeLong's criticism of how the program was structured:
When you contribute equity capital, and when things turn out well, you deserve an equity return. When you don't take equity--when you accept the risks but give the return to somebody else--you aren't acting as a good agent for your principals, the taxpayers.
Thus I do not understand why officials from the Fed and the Treasury keep telling me that the U.S. couldn't or shouldn't have profited immensely from its TARP and other loans to banks. Somebody owns that equity value right now. It's not the government. But when the chips were down it was the government that bore the risk. That's what a lender of last resort does.
That's why Bagehot's rule is to lend freely but at a penalty rate. The bankers should not profit from the fact that they were over leveraged, and compelled the government to act as a lender of last resort.
Update: I should add that I am not questioning the Fed's role as a lender of last resort, only how the gains from fulfilling that function are divvied up.
Monday, December 05, 2011
Possible Fed Communication Strategy, by Tim Duy: As is widely known, the Federal Reserve is working on improving its communication strategy to provide better guidance about monetary policy and thus hopefully induce better outcomes. From today's Wall Street Journal:
The Fed has taken ad hoc steps in this direction. During the financial crisis, it said rates would stay low for an "extended period." In August, it said they would stay low "at least through mid-2013." Quarterly projections would formalize this guidance and make it more specific. If the Fed signals that rates will stay lower even longer than investors expect, it could push long-term interest rates down now, spurring investment, spending and growth.p>
"The scope remains to provide additional accommodation through enhanced guidance on the path of the federal funds rate," Fed vice chairwoman Janet Yellen said in a speech last week. She is chairing the Fed subcommittee designing the communications overhaul.
The "mid-2013" formulation is especially problematic. At some point it will need to be updated. With unemployment high and not falling quickly, it is possible the Fed won't raise interest rates until much later. Of course, if inflation surprisingly picks up, it might need to move rates up sooner.
What form might "enhanced" guidance take? It seems unlikely that the Fed would limit itself to point estimates on the future course of interest rates. Reality is much more probabilistic, and I would expect additional Fed guidance to reflect forecast uncertainty via confidence intervals. One such example would be the Monetary Report of the Swedens' central bank. Forecasts for inflation:
Essentially, this formalizes what we already expect - if inflation exceeds forecasts, then it is likely interest rates will rise at a greater rate than currently expected. It also provides information on the magnitude of any deviation from the interest rate forecast given differing inflation forecasts. Of course, we would expect the Fed to include a similar forecast for unemployment. And, given the current range of policy tools, it would be nice to have guidance on the balance sheet as well, although I sense it to be unlikely.
Expect some push back from some Federal Reserve policymakers:
Some Fed officials still aren't convinced this is the right approach. Giving interest rate guidance "might be an interesting exercise," Richard Fisher, president of the Dallas Fed, said in an interview last week. "Its utility I wonder about."
Some officials, like Mr. Fisher, doubt it will accomplish much. One risk is the Fed's signals about the expected path of rates might even confuse the public, rather than clarify the central bank's intentions.
I tend to think this is misguided - that a probabilistic assessment of the Feds' forecast will make it easier to interpret the implications of incoming data for the evolution of Fed policy, thus making the public less reliant on the often discordant views of Fed officials. Importantly, in the current environment I think additional guidance would make clear that the more hawkish policymakers are outliers, thus minimizing the likelihood of raising premature expectations of policy tightening as we experienced earlier this year. Which would explain Fisher's resistance to chance - he would prefer not to be further marginalized in the policymaking process.
Note: Sorry to be short on posts recently. I have been running around the last few days trying to tie up loose ends at the end of the term.
Friday, December 02, 2011
I just posted this at CBS News:
The Department of Labor released the employment report on Friday, and it shows 120,000 jobs created in the month of November, and the unemployment rate falling from 9.0 percent to 8.6 percent.
At first glance the fall in the unemployment rate seems like good news, but a closer look at the numbers reveals some weakness in the report.
First, note that depending upon which estimates you look at, it takes from 90,000-125,000 jobs just to keep up with the growth in the population. Thus, the 120,000 jobs that were created in November is enough to keep the unemployment rate from going up, but it is not enough by itself to absorb all the new workers entering the labor force and at the same time reduce the fraction of people that are currently unemployed. So the fall in the unemployment rate cannot be attributed to robust job growth.
Second, the report shows a decline in the labor force of 315,000 for November, and about half of the decline is attributed to discouraged workers giving up the search for a job. This exit of workers rather than job creation is the main source of the fall in the unemployment rate, and since so much of it is from discouraged workers this is not an encouraging development. Note, however, that there is a lot of month to month variability in the labor force participation numbers, and some of this may simply be month to month noise in the measurement.
Third, many of the unemployment duration numbers continue to increase. Average search duration reached a new peak for this downturn of 40.9 weeks, and hence long-term unemployment is getting worse, not better.
Fourth, many of the jobs that were created are in the retail sector. Thus, while some workers are finding new jobs, the new employment does not, in general, pay as well as previous employment. In addition, if the seasonal factors are different this year, e.g. if some of this is hiring for the holidays that seasonal adjustment procedures miss, then the picture is even weaker than the numbers suggest.
There are positive trends in this report as well. For example the number of people working part-time involuntarily fell by 374,000, employment in construction increased, and employment in manufacturing held its own, but there is a reason to point out the weak points in the report. Congress is considering two initiatives, maintaining or even increasing the payroll tax cut enacted to fight the recession, and an extension of unemployment benefits. If this report is interpreted as unambiguous good news and a sign that things are getting better at a relatively rapid pace -- at .4 percent decline per month the unemployment rate would fall at a fairly rapid pace over a year -- then Congress may not feel as much pressure to extend the tax cuts and unemployment benefits. It's something they'd rather not do, and they are looking for excuses that avoid the need to make tough decisions. But the problems for the labor market are far from over and we could use some insurance against the risks from Europe, so now is not the time to conclude that our troubles are over and we can turn our attention to other things. It's been nearly three years since Ben Bernanke first talked about green shoots, and that was used as a reason to pursue less aggressive monetary and fiscal policy than we needed, and we should avoid making the same mistake again. Maybe the green shoots are real this time -- I certainly hope that they are -- but it's too early to be certain, and it would be a mistake for policymakers to conclude that the labor market is on its way to a healthy recovery and no longer needs their help.
Wednesday, November 30, 2011
More comments at the NY Times Room for Debate on today's announcement that monetary authorities are taking steps to increase the availability of dollar loans to foreign banks in the hopes of avoiding a Lehman-like crisis. The question we were asked is:
Should the Fed be more aggressive in dealing with Europe’s financial crisis? What are the risks of its involvement?
Here are our responses:
- Mark Thoma: Reducing Risk for the U.S.
- Dean Baker: It Needs to Do More
- Arnold Kling: What About the 99 Percent?
- Edward Harrison: Risky Business for All
[Additional comments here.]
Tuesday, November 29, 2011
Dean Baker says the Fed should step in if the ECB refuses to act as a lender of last resort (Antonio Fatas is also frustrated with the ECB's failure to act):
Time for the Fed to Take Over the European Central Bank’s Job, by Dean Baker, Al Jazeera English: The European Central Bank (ECB) has been working hard to convince the world that it is not competent to act as central bank. One of the main responsibilities of a central bank is to act as the lender of last resort in a crisis. The ECB is insisting that it will not fill this role. It ... would sooner see the eurozone collapse than risk inflation exceeding its 2.0 percent target.
It would be bad enough if the ECB’s incompetence just put Europe’s economy at risk. ... However, it is also likely that the financial panic following the collapse of the euro will lead to the same sort of financial freeze-up that we saw following the collapse of Lehman. In this case,... we will be seeing unemployment possibly rising into a 14-15 percent range. This would be a really serious disaster.
Fortunately, the Fed has the tools needed to prevent this sort of meltdown. It can simply take the steps that the ECB has failed to do. First and most importantly it has to guarantee the sovereign debt of eurozone countries. ... This doesn’t mean giving the eurozone countries a blank check. The Fed can adjust the interest rate at which it guarantees debt depending on the extent to which countries reform their fiscal systems. ... The difference between a 2.0 percent interest rate and 7.0 percent interest would be a powerful incentive to eliminate corruption and waste. ...
Of course this sort of intervention will look horrible from the standpoint of the eurozone countries. It will appear as though they cannot be trusted to manage their own central bank and deal with their own economic affairs.
Unfortunately, this is the case. They have entrusted the continent’s most important economic institution to a group of ideological zealots who are infatuated by the sight of low inflation rates...
Perhaps the Europeans will respond... But if they can’t rise to the task, we should not allow the ECB ideologues to wreak havoc on the lives of tens of millions of innocent people in Europe, the developing world, and here in the United States.
While the Fed is solving the world's problems, it might also think about the high rates of unemployment that already exist in the US, and how easing policy at home could help.
Saturday, November 26, 2011
Brad DeLong explains how the "Federal Reserve might be able to spark a real economic recovery": What Could Bernanke Do?.
Wednesday, November 23, 2011
And the Global Economic Saga Continues, by Tim Duy: The last week has been a non-stop flood of news. And, quite honestly, none of it is encouraging. I imagine the sole exception to that rule is the relatively sanguine nature of the US data. That said, I remain unconvinced that the US can for much longer resist the downward pull of the rest of the globe.
What more can we say about Europe that has not already been said? There has been no forward progress in the past week. To be sure, ECB bond buying has helped keep a lid on Italian bond yields. Yet, while ECB monetary policymakers focus on Italy, Spain and Belgium are slipping away. And France is clearly the next domino to fall. The "accidental" downgrade last week simply reveals that S&P has already prepared the report, clearly anticipating a deterioration in France's budget position as the Eurozone recession deepens. And to make matters worse, Zero Hedge points us to signs the Dexia bank rescue is faltering, and the Belgians realize they need to shift more of that burden of that rescue onto France. Meanwhile, the situation in Eastern Europe is rapidly deteriorating - Yves Smith directs us to the Telegraph for that story. And in Greece, the opposition party still insists they will not sign any pledge to commit to the October deal. Was any deal really reached last month?
Conventional wisdom is that the European Central Bank eventually acts as a lender of last resort to alleviate the sovereign debt crisis. This was clearly not on the mind of ECB President Mario Draghi in his recent speech. I certainly hope something was lost in translation, as the speech has some memorable moments. Notably:
Activity is expected to weaken in most of the advanced economies. This is the result of a weakening of various components of aggregate demand, both domestic and foreign.
Economic activity is weakening because the underlying components of economic demand are weakening. I am not sure this is particularly insightful. Is this the best analysis he can muster from the intellectual firepower of ECB economists? If so, we are in very big trouble. But it continues. The first two of Draghi's three pillars of monetary policy:
Continuity first and foremost refers to our primary objective of maintaining price stability over the medium term.
Consistency means to act in line with our primary objective and with our strategy both in time and over time.
I am having a hard time distinguishing between "continuity" and "consistency" here. The third (second?) pillar is predictable:
Credibility implies that our monetary policy is successful in anchoring inflation expectations over the medium and longer term. This is the major contribution we can make in support of sustainable growth, employment creation and financial stability. And we are making this contribution in full independence.
Gaining credibility is a long and laborious process. Maintaining it is a permanent challenge. But losing credibility can happen quickly – and history shows that regaining it has huge economic and social costs.
Translation: "We can only save the Euro, but only at the cost of German hyperinflation of the 1920's." He then pulls a Ben Bernanke and tosses the ball back to fiscal policymakers"
National economic policies are equally responsible for restoring and maintaining financial stability. Solid public finances and structural reforms – which lay the basis for competitiveness, sustainable growth and job creation – are two of the essential elements.
But in the euro area there is a third essential element for financial stability and that must be rooted in a much more robust economic governance of the union going forward. In the first place now, it implies the urgent implementation of the European Council and Summit decisions. We are more than one and a half years after the summit that launched the EFSF as part of a financial support package amounting to 750 billion euros or one trillion dollars; we are four months after the summit that decided to make the full EFSF guarantee volume available; and we are four weeks after the summit that agreed on leveraging of the resources by a factor of up to four or five and that declared the EFSF would be fully operational and that all its tools will be used in an effective way to ensure financial stability in the euro area. Where is the implementation of these long-standing decisions?
Here I think that Draghi is simply delusional. Does he not realize that plans to expand the ESFS are essentially dead at this point? That France and Germany are not willing or able to contribute more capital? That the plans to leverage the ESFS are floundering as the reality sets in that financial engineering will not work here? That the Chinese scoffed at efforts to get them to buy into such a plan? That the EU political system is capable at moving even a fraction of the speed of financial markets?
I understand the ECB does not want to take on the role of fiscal authority, but what other choice do they have? Little else than to oversee the collapse of the currency they are charged to protect.
Meanwhile, word is the Greek debt haircut deal is in jeopardy. Not a surprise, as not real was really reached at the summit, just a desperate attempt to buy time. Market participants should by now realize the outcome of any European summit is little more than smoke and mirrors.
Speaking of smoke and mirrors, the news from this side of the pond is not exactly encouraging. The Supercommitte hit a brick wall, to no one's surprise but Wall Street's. The stage is set for a nontrivial fiscal tightening in short order - 5 weeks or so. Greg Ip at the Economist puts some numbers on what is at stake, and comes up with contractionary policy on the order of 2.4% of GDP. Note that the Federal Reserve forecast for 2012 is 2.5% to 2.9%, and I bet not much fiscal contraction is built into those numbers. So, make no mistake, the failure of the Supercommittee to come up with a plan for "smart" austerity - austerity focused on the medium and long-runs, with stimulus in the short run, is very meaningful. The conventional wisdom is that Congress will not go home for the holidays without at a minimum extending the payroll tax credit. I will follow that lead, but remain worried that the weight of Washington gridlock argues for more disappointment in the weeks ahead.
Across the Pacific, another storm is brewing - the Chinese economy continues to slow. Via Bloomberg:
China’s manufacturing may contract this month by the most since March 2009 as home sales slide, adding to evidence the world’s second-biggest economy is slowing, a preliminary purchasing managers’ index shows.
The reading of 48 reported by HSBC Holdings Plc and Markit Economics today compares with a final number of 51 last month. A number below 50 indicates a contraction.
Conventional wisdom is that the downside is limited, as at its heart China is a command and control economy. That said, even a minor slowdown is disconcerting, as the US economy does not need another trade shock to add to the trade and, more importantly, financial shock about to flow from Europe.
Bottom Line: The world economy remains in a precarious place as we head into the final month of 2011.
Tuesday, November 22, 2011
Our not so robust recovery is weaker than first reported:
Real gross domestic product ... increased at an annual rate of 2.0 percent in the third quarter of 2011 ... according to the "second" estimate released by the Bureau of Economic Analysis. ... The GDP estimates released today are based on more complete source data than were available for the "advance" estimate issued last month. In the advance estimate, the increase in real GDP was 2.5 percent...
So once again the advance estimate captured headlines and allowed policymakers to say hurray, things are improving, we don't have to act. I disagreed at the time -- even 2.5 percent is a sputtering recovery compared to what we need to reemploy the millions of jobless and policymakers have waited far too long already -- but the headline figure was enough to allow policymakers to "wait and see." Now, with growth even lower than we thought, will policymakers change course? Though I see no reason to let them off the hook, I gave up on fiscal policy authorities long ago. I just hope they won't make things worse. But monetary authorities ought to be acting now to bolster the economy further, especially given the substantial risks from Europe and elsewhere, and it's disappointing that they haven't done more already.
Update: More comments at CBS News.
Thursday, November 17, 2011
I've been wondering why the Fed hasn't lowered the interest it pays on bank reserves from its current value of .25 percent to zero. It probably wouldn't do much, but it would slightly lower the incentive for banks to hold cash rather than loaning it out, and more loans would help to spur the economy, so why not give it a try? In addition, unlike some other policies the Fed might pursue, this would be easily reversible, and it would help to convince critics that the Fed is trying everything it can think of.
Though it's buried deep within the post, the NY Fed explains the FOMC's reluctance to pursue this option. The argument is that it's possible for some interest rates to go slightly negative, and if they do it will cause various problems the Fed would rather avoid (see below). Since banks can borrow from anyone charging less than the rate they earn on reserves and arbitrage the difference away, paying interest on reserves puts a floor on interest rates. Here's the full argument:
Why Is There a “Zero Lower Bound” on Interest Rates?, by Todd Keister, Liberty Street: Economists often talk about nominal interest rates having a “zero lower bound,” meaning they should not be expected to fall below zero. While there have been episodes—both historical and recent—in which some market interest rates became negative, these episodes have been fairly isolated. In this post, I explain why negative interest rates are possible in principle, but rare in practice. Financial markets are generally designed to operate under positive interest rates, and might experience significant disruptions if rates became negative. To avoid such disruptions, policymakers tend to keep short-term interest rates above zero even when trying to loosen monetary policy in other dimensions. These policy choices are the source of the zero lower bound.
The standard description of the zero lower bound begins with the observation that the nominal interest rate offered by currency is always zero: If I hold on to a dollar bill, I’ll still have one dollar tomorrow, next week, or next year. If I invest money at an interest rate of -2 percent, in contrast, one dollar of saving today would become only ninety-eight cents a year from now. Because everyone has the option to hold currency, the argument goes, no one would be willing to hold some other asset or investment that offers a negative interest rate.
This argument is only part of the story, however. Safeguarding and transacting with large quantities of currency is costly. One only needs to imagine the risk and hassle of making all transactions in cash—paying the rent or mortgage, utility bills, etc.—to appreciate the safety and convenience of a checking account. Many individuals would likely be willing to keep funds in deposit accounts even if these accounts pay a negative interest rate or charge maintenance fees that make their effective interest rate negative.
Large institutional investors are in a similar situation. They use a variety of short-term investments, such as lending funds in the “repo” (repurchase agreement) market and holding short-term Treasury bills, in much the same way individuals use checking accounts. These investments will remain attractive to large investors even at negative interest rates because of the security and convenience they offer relative to dealing in currency. Some repo rates did in fact become negative in 2003 (see this New York Fed study) and again more recently (see Bloomberg). Interest rates in the secondary market for Treasury bills have also been slightly negative recently (see Businessweek).
In other words, market interest rates can move somewhat below zero without triggering a massive switch into currency. Nevertheless, central banks typically maintain positive short-term interest rates even while using less conventional tools (such as large-scale asset purchases) to provide additional monetary stimulus.
The Federal Reserve, for example, currently pays an interest rate of 0.25 percent on the reserve balances that banks hold on deposit at the Fed. The ability to earn this interest gives banks an incentive to borrow funds in a range of markets (including the interbank market and the repo market) and thus has the effect of keeping market interest rates positive most of the time. The Federal Open Market Committee (FOMC) discussed the idea of reducing the interest on reserves (IOR) rate at its September meeting, but no action was taken. Reducing this rate would tend to lower short-term market interest rates and might push some rates below zero. The minutes from the meeting report that “many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict.”
Similarly, the Monetary Policy Committee (MPC) of the Bank of England discussed the possibility of lowering the official Bank Rate below 0.5 percent at its September meeting, but decided against doing so. The MPC had previously expressed concern that “a sustained period of very low interest rates would impair the functioning of money markets.”
Some examples of areas where disruptions could potentially arise in U.S. financial markets are:
- Money market mutual funds: Money market funds operate under rules that make it difficult for them to pay negative interest rates to their investors, either directly or by assessing fees. Many of these funds would likely close down if the interest rates they earn on their assets were to fall to zero or below, possibly disrupting the flow of credit to some borrowers.
- Treasury auctions: The auction process for new U.S. Treasury securities does not currently permit participants to submit bids associated with negative interest rates. If market interest rates become negative, new Treasury securities would be issued with a zero interest rate—effectively a below-market price—and bids would be rationed if demand exceeds supply. Such rationing, which has occurred in recent auctions, would generate an incentive for auction participants to bid for more than their true demand, leading to even more rationing. This situation could generate market volatility, as unexpected changes in the amount of rationing in each auction could leave some investors holding either many more or many fewer securities than they desire.
- Federal funds: A decrease in the IOR rate would also likely affect the federal funds market, where banks and certain other institutions lend funds to each other overnight. A lower IOR rate would give banks less incentive to borrow in this market, which would likely decrease the amount of activity. When less activity takes place, the market interest rate will be influenced more by idiosyncratic factors, making it a less reliable indicator of current conditions. This decoupling of the federal funds rate from financial conditions could complicate communications for the FOMC, which operates monetary policy in part by setting a target for this rate.
These examples demonstrate that many current institutional arrangements were not designed with near-zero or negative interest rates in mind. In principle, these arrangements—such as the rules governing mutual funds and Treasury auctions—could be changed. The implementation of a “fails charge” in 2009 for the settlement of Treasury securities (see this New York Fed study) is one example of an institutional adaptation that allows markets to function better at very low interest rates. (A similar charge is scheduled to take effect in some mortgage-related markets in February 2012.) In practice, however, such changes may take significant time to implement and could simply move disruptions to other markets.
Given the markets’ limited experience with very low interest rates, it is difficult to predict with any degree of certainty how they will react to them. If the types of disruptions described above turn out to be significant, taking steps to lower short-term interest rates could actually make financial conditions tighter rather than looser and thus hinder the economic recovery. To avoid this outcome, policymakers tend to choose policies that keep market interest rates positive. In other words, the potential for negative interest rates to disrupt financial markets limits the extent to which policymakers can stimulate economic activity by lowering interest rates. This limit is known as the zero lower bound.
Wednesday, November 16, 2011
So, with inflation fears falling, the Fed is more likely to act, right? Don't set your hopes too high:
But not all members of the FOMC share this sentiment. From the WSJ story:
John Williams, who leads the San Francisco Fed, Tuesday joined a rising chorus of central bank officials calling for continued action to bolster the economy.
But it also says:
Other officials remain staunchly opposed to taking further unconventional steps to spur growth, such as buying more mortgage bonds–and Lacker is among them.
And there's this from Boston:
While the Fed is taking it's time trying to figure out what to do, it should remember how many people are hoping that somebody does something to spur job creation, that most of the forces driving the recent spurt of headline inflation appear to be temporary (as today's data attests), and that the economic outlook is very risky -- we could use some insurance against future problems (especially with evidence that the potential cost of that insurance, i.e. the potential for inflation, is falling).
Thursday, November 10, 2011
Nick Rowe says the ECB needs to step in and save the Euro (I've called for fiscal federalism as a stabilization tool, but Nick is making a different point -- how the ECB can accomplish this on its own by using its powers to act as a central fiscal authority):
Could the ECB become the central fiscal authority?, by Nick Rowe: There is only one way to save the Euro now. The ECB acts as lender of last resort to the 17 Eurozone governments. But nobody would want to act as lender of last resort to a deadbeat, and the ECB wouldn't want to act as lender of last resort to a fiscal deadbeat. With the guarantee of unlimited loans from the ECB, the fiscal deadbeat would have every incentive to keep on borrowing and spending unlimited amounts. It's a mix of: the free-rider problem (because they are only one in 17, and even less than that for a small country); and the Samaritan's dilemma (if they know you are going to help them get out of trouble, they are not going to stay out of trouble).
The Eurozone lacks a central fiscal authority to match the central monetary authority. And it seems to lack the ability to create a central fiscal authority in the normal way. Nobody seems to have the power to exert that central fiscal authority, and force the 17 governments to do what they are told.
But the ECB does have that power. It can say to each of the 17 governments: "We will act as your lender of last resort if and only if you do what we say. If you don't do what we say, we will loudly announce that we will no longer act as your lender of last resort, and the bond markets will make mincemeat of your bonds, and there will be runs on all your banks."
In fact, the ECB is the only body that does have that power. I'm not talking about legal power. It's long past that stage of the game. Good central banks ignore all the rules in an emergency (as Brad DeLong tells us the Bank of England did for a century). The ECB has the de facto power to save any or all of the 17 countries. But it won't use that power unconditionally. It has to make the 17 governments do what it tells them to do. It has the power to do that. "Do what we say, or your country is toast".
The normal question in political macroeconomy is whether the monetary authority should have independence from the fiscal authority. It's time, in the Eurozone, to reverse that question. Should the 17 fiscal authorities have independence from the one monetary authority?
Is this democratic? Of course not. Might it happen? I don't know.
Thursday, November 03, 2011
David Andolfatto notes that the real interest rate is near zero, even negative in some cases, and says "Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow":
Negative real interest rates, Macromania: ...In macroeconomic theory, the nominal interest rate plays second-fiddle to the so-called real interest rate. The real rate of interest is ... a relative price. It is the price of output today measured in units of future output... So, if the risk-free annual interest rate on an inflation-indexed U.S. treasury is 2%, then one unit of output today is valued at 1.02 units of output in the future....
Economists typically focus on the real interest rate because people presumably care about output and not money (they care about money only to the extent that it may be used to purchase output). ... The higher the real interest rate, the more output is valued today vis-a-vis future output. A high real interest rate reflects the market's strong desire to have you part with your output today (in exchange for a promise of future output). Unlike the nominal interest rate, however, there is nothing that naturally prevents the real interest rate from becoming negative; see Nick Rowe. And indeed, this appears to have happened recently in the U.S. The following diagram plots the real interest rate as measured by the n-year treasury inflation-indexed security (constant maturity) for n = 5, 10, 20; see FRED.
Prior to the Great Recession, real interest rates are hovering around 2% p.a. and the yield curve is upward sloping (long rates higher than short rates), at least until early 2006 (when it flattens). Following the violent spike up in real interest rates (associated with the Lehman event), real interest rates have for the most part declined steadily since then. The 20 year rate is below 1%, the 10 year rate is basically zero, and the 5 year rate is significantly negative. What does this mean?
The decline in real rates that has taken place, especially since the beginning of 2011, is a troubling sign. ... This premium may be signaling an expected scarcity of future output. If so, then this is a bearish signal.
The decline in market real interest rates is consistent with a collapse (and anemic recovery) of investment spending (broadly defined to include investments in job recruiting). For whatever reason, the future does not look as bright as it normally does at the end of a recession. To some observers, this looks like a "deficient aggregate demand" phenomenon. To others, it is the outcome of a rational pessimism reflecting a flow of new regulatory burdens and a potentially punitive tax regime. Both hypotheses are consistent with the observed "flight to safety" phenomenon and the consequent decline in real treasury yields.
Unfortunately, the two hypotheses yield very different policy implications. The former calls for increased government purchases to "stimulate demand," while the latter calls for removing whatever barriers are inhibiting private investment expenditure. There seems to be room for compromise though. Surely there are public infrastructure projects that can be expected to yield a real return higher than zero? This is a great time for the U.S. treasury to borrow (assuming that borrowed funds are not squandered, of course).
In the event of an impasse, can the Fed save the day? It is hard to see how. The Fed's influence on real economic activity is usually thought to flow through the influence it has (or is supposed to have) on the real interest rate. One could make the case that real interest rates are presently low in part owing to the Fed's easing policies. But this would be ignoring the fact that the Fed's easing policies were/are largely driven by the collapse in investment spending. (I am suggesting that in a world without the Fed, these real interest rates would be behaving in more or less the same way.)
In any case, real interest rates are already unusually low. How much lower should they go? Is it really the case that our economic ills, even some of them, might be solved in any significant manner by driving these real rates any lower? My own view is probably not. If there is something the Fed can do, it is likely to operate through some other mechanism. ...
David also looks at inflation expectations and concludes:
there is no evidence to suggest that inflation expectations are whirling out of control, one way or the other. I'm not sure to what extent this constitutes success. At the very least it is not utter failure.
I am more confident that David is that the Fed can still help the economy, but it can't do it on its own and too much focus on the Fed takes the pressure off of Congress to do its part to help to overcome the unemployment crisis. Members of Congress need to be worried that their own jobs are at risk if they don't do something to help the unemployed (and they shouldn't be allowed to get away with claiming that cutting the deficit by cutting social insurance programs is a means to this end). That's one of the reasons I keep calling for fiscal policy as well -- both sets of policymakers need to feel as much pressure to act as possible.
Wednesday, November 02, 2011
A few comments on the FOMC meeting:
It's disappoinnting that the fed didn't do more to help th eeconomy, but not unexpected.
Update: Here is a response to Bernanke's Press Conference. "I don't think Bernanke explained adequately why the Fed is reluctant to do more to help the economy."
One more from Tim Duy:
Meanwhile, Back on This Side of the Pond..., by Tim Duy: The break down in the relationship between consumer confidence and actual spending is something that has been nagging at me for awhile. This picture:
While confidence is at recession levels, real personal consumption expenditures continue to grow at a reasonable clip. Should confidence numbers be totally dismissed, or do they signal an underlying fragility among households that should not be ignored? Some hints at an answer may be found in the September income and spending report. Notably, real personal disposable income looks to have rolled over:
So where is the spending power coming from? A plunge in the saving rate:
It looks like households are struggling to hold onto the even meager spending gains achieved since the recession ended, and that struggle may be what is reflected in the consumer confidence numbers. Overall, this suggests to me that consumer spending is much more fragile than commonly believed.
Manufacturing activity also looks shaky. To be sure, it is reasonable to expect some momentum from the surge in equipment spending in the third quarter. But it is also reasonable to believe that some of this demand was pulled forward as firms try to get ahead of the expiration of the accelerated depreciation benefit. And even with that surge, note the ISM report surprised on the downside Tuesday morning. On the positive side, the new orders measure climbed back above 50, while on the negative, both the export and import components fell. The latter point is a troubling indication of spillover from slowing manufacturing activity in China and Europe. A contraction in global activity isn't exactly what we need at this juncture, especially as it will first bleed through to what has been one of the bright spots in the US recovery.
Bottom Line: With all attention focused on the Greek drama, plus the well-received Q3 GDP report, it has been easy to overlook the underlying fragility in the US economy. This was especially the case when US equities looked to be on a nonstop trip to the moon. Perhaps the US economy can squeak through the next few quarters, and perhaps, in contrast to my expectations, Europe is able to bring an end to the crisis with limited collateral damage to the economy. But I can't shake the feeling that the US economy closer to running on fumes than is commonly believed, and will run out of gas in a very hostile global environment.
Tuesday, November 01, 2011
David Glasner is displeased with John Taylor (for good reason, as he documents in the full post):
A Walk Down Memory Lane with John Taylor, Uneasy Money: John Taylor has had a long and distinguished career both as an academic economist and as a government official and policy-maker. He is justly admired for his contributions as an economist and well-liked by his colleagues and peers as a human being. So it gives me no pleasure to aim criticism in his direction. But it was pretty disturbing to read Professor Taylor’s op-ed piece (“A Slow-Growth America Can’t Lead the World”) in today’s Wall Street Journal, a piece devoid of even the slightest attempt to make a reasoned argument rather than assemble a hodge podge of superficial bromides about the magic of the market and the importance of fiscal discipline and sound monetary policies. It is almost surprising that Taylor failed to mention motherhood, apple pie, and American flag while he was at. Even more disturbing, Taylor proceeds, with no hint of embarrassment, to trash the half-hearted attempts by the Federal Reserve to use monetary policy to promote recovery even though the Fed’s policies are similar to, though much less aggressive than, the “quantitative easing” that he applauded the Japanese government and the Bank of Japan for adopting from 2002 to 2004 to extricate Japan from a decade-long period of deflation and slow growth starting in the early 1990s. ... Oh my what a difference four or five years make. Things do change, don’t they?
Monday, October 31, 2011
Brad DeLong tells the ECB to start acting like a central bank:
The ECB’s Battle against Central Banking, by Brad DeLong, Commentary, Project Syndicate: ...The ECB continues to believe that financial stability is not part of its core business. As its outgoing president, Jean-Claude Trichet, put it, the ECB has “only one needle on [its] compass, and that is inflation.” ...
Perhaps the most astonishing thing about the ECB’s monochromatic price-stability mission and utter disregard for financial stability – much less for the welfare of the workers and businesses that make up the economy – is its radical departure from the central-banking tradition. ...
Saturday, October 29, 2011
Christina Romer tells Ben Bernanke that we need "aggressive actions," including adopting a nominal GDP target, to "help to heal the economy"
No disagreement here about the need for more forceful monetary policy actions. We could use more help from fiscal policy too.
Thursday, October 27, 2011
I have some comments on the GDP report:
The main message is that even though the number improved over last quarter, "policymakers should not conclude that they are off the hook."
... Sixty years ago Hayek was arguing against an extreme version of Keynesian doctrine that viewed increasing aggregate demand as a panacea for all economic ills. Hayek did not win the battle himself, but his position did eventually win out, if not completely at least in large measure. Today, however, an equally extreme version of Hayek’s position seems to have become ascendant. It denies that increasing aggregate demand can, under any circumstances, increase employment. I don’t know what Hayek would think about all this if he were alive today, but I suspect that he would be appalled.
Tuesday, October 25, 2011
I guess this is former student day (Tim Duy, Steven Ongena -- now I learn from them):
Loose monetary policy and excessive credit and liquidity risk-taking by banks, by Steven Ongena and José-Luis Peydró, Vox EU: A question under intense academic and policy debate since the start of the ongoing severe financial crisis is whether a low monetary-policy rate spurs excessive risk-taking by banks. From the start of the crisis in the summer of 2007, market commentators were quick to argue that, during the long period of very low interest rates from 2002 to 2005, banks had softened their lending standards and taken on excessive risk.
Indeed, nominal rates were the lowest in almost four decades and below Taylor rates in many countries, while real rates were negative (Taylor 2007, Rajan 2010, Reinhart and Rogoff 2010, among others). Expansionary monetary policy and credit risk-taking followed by restrictive monetary policy possibly led to the financial crisis during the 1990s in Japan (Allen and Gale 2004), while lower real interest rates preceded banking crises in 47 countries (von Hagen and Ho 2007). This time the regulatory arbitrage for bank capital associated with the high degree of bank leverage, the widespread use of complex and opaque financial instruments including loan securitization, and the increased interconnectedness among financial intermediaries may have intensified the resultant risk-taking associated with expansive monetary policy (Calomiris 2009, Mian and Sufi 2009, Acharya and Richardson 2010).
During the crisis, commentators also continuously raised concerns that a zero policy interest rate combined with additional and far-reaching quantitative easing, while alleviating the immediate predicament of many financial market participants, were sowing the seeds for the next credit bubble (Giavazzi and Giovannini 2010).
Recent theoretical work has modeled how changes in short-term interest rates may affect credit and liquidity risk-taking by financial intermediaries. Banks may take more risk in their lending when monetary policy is expansive and, especially when afflicted by agency problems, banks’ risk-taking can turn excessive.
Indeed, lower short-term interest rates may reduce the threat of deposit withdrawals, and improve banks’ liquidity and net worth, allowing banks to relax their lending standards and to increase their credit and liquidity risk-taking. Acute agency problems in banks, when their capital is low for example, combined with a reliance on short-term funding, may therefore lead short-term interest rates – more than long-term rates – to spur risk-taking. Finally, low short-term interest rates make riskless assets less attractive and may lead to a search-for-yield by those financial institutions that have short time horizons.1
Concurrent with these theoretical developments, recent empirical work has begun to study the impact of monetary policy on credit risk-taking by banks. Recent papers that in essence study the impact of short-term interest rates on the risk composition of the supply of credit follow a longstanding and wide literature that has analyzed its impact on the aggregate volume of credit in the economy, and on the changes in the composition of credit in response to changes in the quality of the pool of borrowers.2
In Jiménez et al (2011), our co-authors and we use a uniquely comprehensive credit register from Spain that, matched with bank and firm relevant information, contains exhaustive loan (bank-firm) level data on all outstanding business loan contracts at a quarterly frequency since 1984:IV, and loan application information at the bank-firm level at a monthly frequency since 2002:02.
Our identification strategy consists out of three crucial components:
(1) Interacting the overnight interest rate with bank capital (the main theory-based measure of bank agency problems) and a firm credit-risk measure
(2) Accounting fully for both observed and unobserved time-varying bank and firm heterogeneity by saturating the specifications with time*bank and time*firm fixed effects (at a quarterly or monthly frequency), and when possible, also controlling for unobserved heterogeneity in bank-firm matching with bank*firm fixed effects and time-varying bank-firm characteristics (past bank-firm credit volume for example).
(3) Including in all key specifications – and concurrent with the short-term rate – also the ten-year government-bond interest rate, in particular in a triple interaction with bank capital and a firm credit risk measure (as in (2)).
Spain offers an ideal setting to employ this identification strategy because it has an exhaustive credit register from the banking supervisor, an economic system dominated by banks and, for the last 22 years, a fairly exogenous monetary policy.
We find the following results for a decrease in the overnight interest rate (even when controlling for changes in the ten-year government-bond interest rate):
(1) On the intensive margin, a rate cut induces lowly capitalized banks to expand credit to riskier firms more than highly capitalized banks, where firm credit risk is either measured as having an ex ante bad credit history (ie, past doubtful loans) or as facing future credit defaults.
(2) On the extensive margin of ended lending, a rate cut has if anything a similar impact, ie, lowly capitalized banks end credit to riskier firms less often than highly capitalized banks.
(3) On the extensive margin of new lending, a rate cut leads lower-capitalized banks to more likely grant loans to applicants with a worse credit history, and to grant them larger loans or loans with a longer maturity. A decrease in the long-term rate has a much smaller or no such effects on bank risk-taking (on all margins of lending).
Our results in Jiménez et al (2011) suggest that, fully accounting for the credit-demand, firm, and bank balance-sheet channels, monetary policy affects the composition of credit supply. A lower monetary-policy rate spurs bank risk-taking. Suggestive of excessive risk-taking are their findings that risk-taking occurs especially at banks with less capital at stake, ie, those afflicted by agency problems, and that credit risk-taking is combined with vigorous liquidity risk-taking (increase in long-term lending to high credit risk borrowers) even when controlling for a long-term interest rate.
In work with Vasso Ioannidou, we also investigate the impact of monetary policy on the risk-taking by banks (Ioannidou et al 2009). This study focuses on the pricing of the risk banks take in Bolivia (relying on a different and complementary identification strategy to Jiménez, et al 2011 and studying data from a developing country). Examining the credit register from Bolivia from 1999 to 2003, we find that, when the US federal-funds rate decreases, bank credit risk increases while loan spreads drop (the Bolivian economy is largely dollarized and most loans are dollar-denominated making the federal-funds rate the appropriate but exogenously determined monetary-policy rate). The latter result is again suggestive of excessive bank risk-taking following decreases in the monetary-policy rate. Hence, despite using very different methodologies, and credit registers covering different countries, time periods, and monetary policy regimes, both papers find strikingly consistent results.3
There are a number of natural extensions to these studies. Our focus on the impact of monetary policy on individual loan granting overlooks the correlations between borrower risk and the impact on each individual bank’s portfolio or the correlations between all the banks’ portfolios and the resulting systemic-risk impact of monetary policy. In addition, both studies focus on the effects of monetary policy on the composition of credit supply in only one dimension, ie, firm risk. Industry affiliation or portfolio distribution between mortgages, consumer loans and business loans for example may also change. Given the intensity of agency problems, social costs and externalities in banking, banks’ risk-taking – and other compositional changes of their credit supply for that matter – can be expected to directly impact future financial stability and economic growth. We plan to broach all such extensions in future work.
Disclaimer: Any views expressed are only those of the authors and should not be attributed to the Banco de España, the European Central Bank, or the Eurosystem.
The U.S., seeking to attract investors who might otherwise avoid Treasuries amid a $1.3 trillion budget deficit, is considering the sale of floating- rate notes in what would be its first new security since it began offering inflation-linked debt 14 years ago.
The Treasury Department said this month it asked Wall Street’s biggest bond dealers for recommendations on structuring securities with coupons that rise or fall with benchmark rates. Officials are scheduled to gather with the 22 primary dealers, who include Goldman Sachs Group Inc. and JPMorgan Chase & Co., on Oct. 28 as it decides whether to go further during their regular meeting that precedes each quarterly refunding.
I find this idea intriguing. On the surface, with US 10-year debt hovering around 2 percent, there seems to be plenty of demand to dry up whatever Treasury issues. And it looks like a wise move to lock in as much debt as possible at those low rates. That said, at some point in the future (hopefully) rates will rise, and it is easy to see an inflection point where investors, wary that monetary policy may shift abruptly, would be wary to add to their Treasury holdings. Having a floating rate product on hand could be important in such circumstances, preventing any abrupt funding shortfalls and rates spikes by offering investors a form of insurance against rising rates.
Daniel Indiviglio at the Atlantic offers up some potential problems with such a product. First, he correctly notes the desire to lock in today's low rates. Second:
Tying U.S. debt costs to how interest rates rise and fall could also be dangerous. For every $1 billion in floating-rate debt that the Treasury issues, a 0.5% (50 basis point) increase in interest rates would result in its debt costs rising by $5 million. You can imagine how quickly U.S. debt costs could rise if the government had something like $1 trillion in floating rate debt and interest rates jumped a few percent in a year. Suddenly, the government would have to issue tens of billions of dollars in additional debt just to keep up with rising interest rates.
As I noted, I think this product would be particularly useful in the expected transition to higher rates and would not expect it to be a primary funding mechanism. I can also see a benefit in a mechanism that explicitly penalizes the fiscal authority for overspending should actual fiscal constraints emerge in the future. Consider it something of an automatic stabilizer - more spending power automatically emerges when the economy dips and debt costs fall, and vice-versa. Indiviglio offers another potential problem:
And if you think that the government puts too much pressure on the Federal Reserve to act now, just wait until it directly controls a portion of the nation's interest costs. Floating-rate note would likely include a benchmark rate controlled by the Fed. So if the U.S. is ever struggling to meet its debt obligations, the Fed may feel obligated to keep interest rates lower than it otherwise would. If it increases rates, a payment shock could affect U.S. financial stability. Due to this, floating-rate debt could lead to higher inflation, since the Fed may feel pressured to leave interest rates lower for longer.
I thought the Federal Reserve would be a natural buyer of such debt. Consider the current (what I think overplayed) worry that the Federal Reserve is threatened by huge captial losses on its existing portfolio when interest rates rise. There is some concern that the Fed will resist raising rates to avoid the erosion of it capital base, as it would lose some of its independence if monetary policymakers needed a capital injection from the US Treasury. In addition, there is a related concern that should the Fed need to raise interest on reserves abruptly to control inflation, then the Fed's expenses will surge well above the interest paid on its Treasury portfolio. Yet again another trip for a Treasury bailout.
While I was not concerned much about these scenarios, note that they would both be eliminated if the Fed held a significant portion of floating rate debt in its portfolio. It would automatically create a revenue stream to support higher interest on reserves. Obviously, the risk of capital loss would recede. Moreover, a large Federal Reserve holding of such debt would protect the taxpayer as well - higher debt servicing cost would just flow right back to the US Treasury (after Federal Reserve expenses). Finally, note then-Federal Reserve Governor Ben Bernanke made a similar proposal in his famous 2003 Japanese monetary policy speech. Essentially, a floating rate portfolio eliminates some imagined or real constraints on monetary policy, reducing the risk that additional quantitative easing will turn inflationary.
In short, I think the US Treasury has good reason to consider adding floating rate debt - and should find a ready buyer not only in Wall Street, but just across town.
Sunday, October 23, 2011
I've been making these points in various ways since the crisis started, but with frustratingly little notice or effect. Maybe Brad DeLong will have more luck:
DeLong Smackdown Watch: Nominal GDP Targeting Through Unconventional Monetary Policy and Through Fiscal Policy Edition, by Brad DeLong: Duncan Black complains because he thinks I have not been critical enough of nominal GDP targeting via unconventional monetary policy alone:
Eschaton: Why Don't They Lend Me $30 Billion On The Security Of My Cats?: If we're going to actually move to more "unconventional" monetary policy, can we please recognize that the reason to do so is largely because conventional monetary policy - acting through the banking system - isn't working? We should understand that it isn't working because it almost destroyed the world a few years ago and is about to do so again because, you know, nothing changed and the overpaid assholes who almost destroyed the world then are still in charge. If we're going to give out dodgy loans, how about giving dodgy loans to people who might do something with the money other than visiting the Great Casino?
I will report to the reeducation camp tomorrow...
I have been saying that coordinated fiscal and monetary policy--jen-U-ine helicopter drops or simple government-print-and-buy-useful-stuff--is the superior way to accomplish nominal GDP targeting, and that doing so via monetary policy alone runs risks.
But I have not been saying so loudly enough.
Look: targeting the nominal GDP path via monetary policy alone in a liquidity trap is a bet that private-sector financiers will:
be confident that the policy will not be reversed when the economy emerges from its liquidity trap,
be confident that the policy will succeed and that they should start spending now in anticipation of the faster nominal GDP growth that the policy will produce, plus
a little bit of taking risk onto the Federal Reserve's balance sheet and so freeing up private financier risk-bearing capacity to expand their loan portfolio.
Mostly, that is, the policy is a policy that succeeds if it is generally expected to succeed and fails if it is generally expected to fail. It thus has the confidence fairy nature.
To the extent that the policy does not have the confidence fairy nature, it is because it changes asset supplies here and now and thus private financiers' incentives to lend and businesses' incentives to produce. It does so because the policy involves swapping one asset for another asset that is not the same.
Right now because we are in a liquidity trap short-term Treasury bills and cash are effectively, for the moment, the same asset: they are both short-term zero-yield safe nominal government liabilities. Very few believe that the Federal Reserve's buying Treasury bills for cash and saying: "See! We are doing something! Nominal GDP growth will be faster! You should raise your expectations of real growth and inflation and act accordingly!" would actually do anything. By contrast, if the Federal Reserve buys long-term Treasury or agency or private debt the assets it is buying carry an expectational term premium, duration risk, and (perhaps) default risk: they are not identical to the assets that they are selling. Because the private sector's asset holdings change, private-sector financiers and businesses have incentives to change their behavior even if they don't buy the appearance of the confidence fairy at all--and the fact that they will change their behavior even if they don't believe is a reason for people to believe.
The superiority of unconventional monetary policy thus works off of the fact that the assets the government is buying are different than the assets it is selling--and thus the more different the assets it buys from the assets it sells, the greater the non-confidence-fairy bang from the policy.
What asset is most different from cash?
With a helicopter drop, the Federal Reserve sells cash and it buys… nothing at all. Cash and nothing are pretty different assets. Add cash to private-sector portfolios and take nothing away, and portfolios have shifted in meaningful ways and people will change what they do.
With print-money-and-buy-useful-things, the government sells cash and buys… roads, bridges, research into public health, flu shots, killer robots--all kinds of things that are very very different indeed from cash.
Thus--as Milton Friedman's teacher Jacob Viner knew well back in 1933--coordinated fiscal and monetary expansion via printing money and buying useful stuff (or handing it out via helicopter drops) is a policy that really does not have the confidence fairy nature. Because it does not require confidence to start working, it will (probably) work much more rapidly and certainly.
Friday, October 21, 2011
I am starting to think the Fed might do more for the economy:
This caught my eye:
Simon Johnson ... said that a current member of the Fed told him he was “disappointed there hadn’t been a ticker-tape parade” for policymakers who, in the central banker’s mind, had saved the economy.
Suppose the fire department fails to do adequate inspections, and a big fire breaks out because of it. If that same fire department puts it out and saves the day, do we cheer them for cleaning up their own mess? I think not.
Wednesday, October 19, 2011
Getting Nominal: “Market monetarists” like Scott Sumner and David Beckworth are crowing about the new respectability of nominal GDP targeting. And they have a right to be happy. My beef with market monetarism early on was that its proponents seemed to be saying that the Fed could always hit whatever nominal GDP level it wanted; this seemed to me to vastly underrate the problems caused by a liquidity trap. My view was always that the only way the Fed could be assured of getting traction was via expectations, especially expectations of higher inflation –a view that went all the way back to my early stuff on Japan. And I didn’t think the climate was ripe for that kind of inflation-creating exercise.
At this point, however, we seem to have a broad convergence. As I read them, the market monetarists have largely moved to an expectations view. And now that we’re almost four years into the Lesser Depression, I’m willing, out of a combination of a sense that support is building for a Fed regime shift and sheer desperation, to support the use of expectations-based monetary policy as our best hope.
And one thing the market monetarists may have been right about is the usefulness of focusing on nominal GDP. As far as I can see,the underlying economics is about expected inflation; but stating the goal in terms of nominal GDP may nonetheless be a good idea, largely as a selling point, since it (a) is easier to make the case that we’ve fallen far below where we should be and (b) doesn’t sound so scary and anti-social.
I still believe that the chances of success will be a lot larger if we have expansionary fiscal policy too; but by all means let’s try whatever we can…
Let's try to answer this question by using… the IS-LM model!
If you are--as we are right now--in a liquidity trap, with extremely interest-elastic money demand, then expansionary monetary policy that involved the Federal Reserve buying financial assets for cash:
- will have next to no effect on the short-term safe nominal interest rate--it's already zero.
- will decrease the long-term safe nominal interest rate to the extent that your open-market operations today change people's expectations of what your target for the short-term safe nominal interest rate in the future.
- will decrease the long-term safe real interest rate to the extent that it decreases the short-term nominal interest rate and changes expectations today of what inflation will be in the future.
- will decrease the long-term risky real interest rate to the extent that it decreases the long-term safe real interest rate and to the extent that the assets purchased for cash by the Federal Reserve free up the risk-bearing capacity of private investors and lead to a reduction in risk spreads.
- will increase spending to the extent that it decreases the long-term risky real interest rate and to the extent that private spending responds positively to decreases in the long-term risky real interest rate.
Lots of steps here, some of which may well be weak.
By contrast, the alternative expansionary policy is for the government to print money and spend it buying useful things. Then:
- The buying of useful things raises spending.
- Financing it by printing money rather than issuing bonds means no increase in interest rates to crowd out private spending.
- Financing it by printing money rather than promising to levy future taxes means no increase in the present value of future tax liability to crowd out private spending.
- Financing it by printing money means no worries about any increase in fears of some future government default.
By contrast, if we tried to target nominal GDP through fiscal policy alone--through borrowing and spending buying useful things:
- The buying of useful things raises spending.
- Financing it by issuing bonds might mean an increase in interest rates that would crowd out private spending.
- Financing it by promising to levy future taxes means an increase in the present value of future tax liability that might crowd out private spending.
- Financing it by issuing bonds means a possible increase in fears of some future government default.
To try to target nominal GDP using either only monetary policy or only fiscal policy seems hazardous. To coordinate--monetary and fiscal expansion, money printing-financed purchase of useful things--seems to be the winner.
Yep, as I've been arguing since this started, we need attack the unemployment problem aggressively with both barrels of the policy gun.
Thursday, October 06, 2011
Don't Let Monetary Policy Off The Hook, by Tim Duy: Re-reading Federal Reserve Chairman Ben Bernanke’s latest testimony to Congress left me increasingly puzzled by his conclusion:
Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.
This is a clear effort to shift the focus away from monetary policy onto the fiscal side of the equation. But I think there is a significant flaw in that position. Fiscal policymakers will be completely unable to address medium- or long-term budget issues as long as there exists a sizable output gap and high levels of unemployment. Persistently low levels of output will necessitate deficit spending, and low interest rates will justify that spending. That is the lesson of Japan. Nor will the economy naturally gravitate toward such any other outcome – we are stuck in a liquidity trap. That is also the lesson of Japan.
Assuming the proximate cause of the current US economic environment is indeed a liquidity trap, then a solution to that problem lays solely in the hands of monetary policymakers. In short, the primary economic challenge is to lift the US from the zero bound floor; until that happens fiscal policy will limp along like that of Japan, with ever-growing debt that does little than serve as a partial stopgap. The deficit spending becomes a long-run outcome rather than a short-run solution.
Simply put, the Federal Reserve needs to take responsibility for ending the liquidity trap. Instead, as Scott Sumner summarizes:
The Fed has plenty of credibility, that’s not the problem. The problem is that they are using the credibility to assure investors that low inflation is here to stay. With the right target, there would probably be no need for massive quantitative easing, or other extraordinary policies.
First and foremost, low inflation is the primary objective of Fed policy. They have repeatedly set expectations that the increase in the balance sheet is only temporary, and will be reversed as soon as possible. On not one but two occasions this cycle they prematurely shifted gears to setting expectations for tighter policy, which is effectively the same thing as engaging in tighter policy. They have offered a half-hearted attempt to remedy this situation by announcing a commitment to low rates, but have made it remarkably clear it is not a real commitment. From the Fed minutes:
Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.
Fear of inflation prevents the Federal Reserve from making an unconditional commitment. And therein lies the stumbling block to real policy change. It is virtually impossible to imagine reestablishing the pre-recession nominal GDP trend, and entirely impossible to regain the pre-recession price trend, without accepting a temporary acceleration of inflation along the way.
More succinctly, we will not lift the economy off the zero-bound without accepting higher than 2% inflation. Since the Federal Reserve has made it clear they will not accept inflation greater than 2%, the economy will not clear the zero-bound. And if the economy does not clear the zero-bound, we will be faced with perpetual and unavoidable deficit spending.
Deficit spending is not accommodated by the Federal Reserve via low interest rates; it is made necessary because the Federal Reserve sees no urgency ending the lower bound challenge. Which means it is ridiculous to believe that the Fed can dump off this problem on fiscal policymakers. How can the state of monetary policy have deteriorated so much that now even Bernanke claims “regulation” is holding back the economy? Yet here we are.
Where should the Fed go from here? First and foremost, they need to make a commitment to pull away from the zero-bound. As Sumner suggests, they need this commitment clearly defined by a target such as reestablishing nominal GDP or price level. The need to implement open-ended action to achieve this target. My suggestion is to announce they will make permanent additions to their balance sheet by purchasing on the secondary market $5 billion of US Treasury securities every week until the target is reached. I think they need to make permanent additions to be credible – they have clearly expressed that previous balance sheet expansions should be viewed only as temporary.
Won’t this amount to monetization of deficit spending? Yes, but if Sumner is correct, less than might be feared, as the commitment is more important than the size of the purchases. And I already arrived at the conclusion, aided by Bernanke’s 2003 speech, that the situation requires a greater coordination of monetary and fiscal policy. Moreover, even if sizable purchases are required, there is no reason this needs to be a problem. As Bernanke has already explained, the Fed simply needs to make clear its target and once that target has been reached, they will adjust policy appropriately to maintain the nominal GDP or price level trend. In other words, purchases will be suspended and policy will by that point revert to traditional interest rate management, with the possible reduction of the portion of the balance-sheet expansion that to-date has been viewed as temporary.
Once the Fed achieves normal monetary conditions, the ball will be back in the hands of fiscal policymakers, who may then soon understand that policy is a lot different when interest rates create real constraints on spending and taxes. But that is a battle for another day.
Bottom Line: It is ludicrous for the Fed to declare the primary economic responsibility is now on fiscal policy. As long as we are in a liquidity trap, fiscal policy is stuck in a never-ending cycle of deficit spending. Absent that spending, the economy will simply slip backwards into recession again and again. The exit from the liquidity trap can only come from the monetary side of the equation. Try as he might Federal Reserve Chairman Ben Bernanke cannot escape his policy responsibilities. And we shouldn’t let him.
Wednesday, October 05, 2011
... One reason why Keynes’s great book is so difficult to explain is that it is no masterpiece of clarity. ... I want to emphasize two of its themes, because they ... point directly to the reason why Keynesian economics, born in the 1930s, has become dramatically relevant again today. Back then, serious thinking about the general state of the economy was dominated by the notion that prices moved, market by market, to make supply equal to demand. Every act of production, anywhere, generates income and potential demand somewhere, and the price system would sort it all out so that supply and demand for every good would balance. Make no mistake: this is a very deep and valuable idea. ... Much of the time it gives a good account of economic life. But Keynes saw that there would be occasions, in a complicated industrial capitalist economy, when this account of how things work would break down.
The breakdown might come merely because prices in some important markets are too inflexible to do their job adequately; that thought had already occurred to others. It seemed a little implausible that the Great Depression ... should be explicable along those lines. Or the reason might be more fundamental, and apparently less fixable. To take the most important example: we all know that families (and other institutions) set aside part of their incomes as saving. They do not buy any currently produced goods or services with that part. Something, then, has to replace that missing demand. There is ... a natural counterpart: saving today presumably implies some intention to spend in the future, so the “missing” demand should come from real capital investment, the building of new productive capacity to satisfy that future spending. But Keynes pointed out that there is no market or other mechanism to express when that future spending will come or what form it will take. ... The prospect of uncertain demand at some unknown time may not be an adequately powerful incentive for businesses to make risky investments today. ...
So a modern economy can find itself in a situation in which it is held back from full employment ... not by its limited capacity to produce, but by a lack of willing buyers for what it could in fact produce. The result is unemployment and idle factories. ... There are some forces tending to push the economy back to full utilization, but they may sometimes be too weak to do the job in a tolerable interval of time. But if the shortfall of aggregate private demand persists, the government can replace it through direct public spending, or can try to stimulate additional private spending through tax reduction or lower interest rates. ... This was Keynes’s case for conscious corrective fiscal and monetary policy. Its relevance for today should be obvious. ...
A second characteristically Keynesian theme meshes very well with the first. In a complex economy, many business decisions have to be made in a fog of uncertainty. This is especially true of investment decisions... The standard practice is to focus on the uncertainty and think about it in terms of probabilities, which at least allow for an orderly analysis... Keynes preferred to focus on the fog. He thought that some of the important uncertainties were essentially incalculable. They would end up being dealt with in practice by a mixture of apprehensiveness, rules of thumb, herd behavior, and what he called “animal spirits.” The point of this distinction is not merely philosophical: it suggests that long-term investment behavior will sometimes be irregular, unstable, and given to doldrums and stampedes. ...
He also discusses Irving Fisher, Joseph Schumpeter, John Maynard Keynes, Friedrich Hayek, and John Stuart Mill.
Tuesday, October 04, 2011
The Fed Drops the Ball, by Tim Duy: (Note: I am feeling bearish today, especially looking back to lost opportunities to get ahead of the current environment.)
By mid-summer it was evident the recovery was in jeopardy, that the slowdown in economic activity could not be entirely explained by temporary factors, that unemployment would remain unacceptably high, and that the slow motion train wreck that is the European experiment would be resolved only in the aftermath of financial chaos.
The Fed had the opportunity to get ahead of the curve. They chose not to. To be sure, they offered some half-hearted support to the existing policy stance. But this amounts to bring a knife to a gunfight.
At this point, we are faced with mounting recession forecasts. The Economic Cycle Research Institute publicly announced their recession call last week, confidently expecting to extend their 3-0 forecasting record. Nouriel Roubini already offered up his recession call. Today, Goldman Sachs placed 40% odds on recession in 2012.
And in the Goldman Sachs call lays the obstacle to an aggressive monetary response, as opposed to the simple rearranging of the deck chairs currently underway. There may be widespread belief that the seeds of the recession are planted and beginning to sprout, but the near-term data certainly will not confirm a recession is underway. From the Wall Street Journal:
So far, as many economists point out, the worst readings on the economy come from sentiment measures rather than hard numbers on economic activity.
The pessimism among consumers and businesses alike may be reactions to political uncertainty and the volatility in the stock market, while the nuts-and-bolts data on the U.S. economy look better.
In the latest round of data, August construction spending surprisingly rose 1.4% when a 0.4% drop was expected. September factory activity beat forecasts as well. The Institute for Supply Management said the sector’s expansion strengthened for the first time since June.
The data point to real gross domestic product growing at an annual rate above 2% in the third quarter, more than double the pace of the first half.
The economy was not in recession in the third quarter, which means the backward looking data flow through this month will not be particularly dire. We are really looking for whatever acceleration we see in third quarter GDP growth to ebb in the fourth quarter, a bad omen for the fiscal drag we will experience as the payroll tax credit expires. On top of that, you have to believe in unicorns and fairies if you think the European crisis is going to go anywhere other than from bad to worse in the next three months. The lesson of the past two years is the Europeans will arrive late and bring a club to the gunfight. Indeed, while today’s late rally was credited to the latest round of optimism on Europe, via Bloomberg:
Equities rebounded after the S&P 500 fell below 1,090.89, the closing level required to give the index a 20 percent slump from the three-year high reached on April 29. Stocks rose after the Financial Times quoted Olli Rehn, European commissioner for economic affairs, as saying there is an “increasingly shared view” that the region needs a coordinated approach to halt the sovereign debt crisis. After U.S. markets closed, Belgian Prime Minister Yves Leterme said a “bad bank” to hold Dexia SA (DEXB)’s troubled assets will be set up.
the reality is likely less optimistic:
“People are looking for optimism anywhere they can get it,” said Christopher Bury, co-head of fixed-income rates at Jefferies & Co., one of the 22 primary dealers that trade with the Federal Reserve. “You have these random stories and the market reacts, but how many times have we been down this road where these are just words?”
One additional note on the global environment – signs are emerging that the long running Chinese property boom is running into trouble. From Deustche Bank and via Business Insider:
In recent weeks, the number of phone calls received by an author of this report from China-based property agents has increased several fold, indicating a significant rise in the urgency for developers to raise cash from selling properties. A property consultant told us that he recently received requests to help raise RMB10bn for cash-strapped small and medium-sized property developers – this amount is a huge multiple of what he is used to dealing with. In the offshore market, where many Chinese developers seek foreign currency funding due to lack of access to domestic funds (the domestic stock, bond and trust loan markets are closed to them due to policy tightening, and banks are also very stringent), their USD bond yields have surged to 20-25% in past weeks from around 10% before August. This means that even the offshore markets are now largely closed to Chinese developers…
The Chinese government will act to cushion the downside for their property sector, but what will be the consequences of even a short-term slowdown for a global economy already on the downside?
Put aside the non-recessionary real economy data and instead turn to the financial markets for hints. There the signals are decidedly more pessimistic. Equities are heading into bear market territory, interest rates are collapsing, spreads between Treasuries and corporate debt are widening, commodity prices are in virtual free-fall, and the TED spread, while still well short of the highs reached during the financial crisis, have more than doubled from 15bp in the spring to 38bp now.
There is no way to read the ongoing financial turmoil as anything other than increasing fear that a recession is underway. Perhaps it is all simply a growth scare, and that in a few months we will wonder what all the fuss was about. But ECRI believes it is already too late for that story:
A new recession isn’t simply a statistical event. It’s a vicious cycle that, once started, must run its course. Under certain circumstances, a drop in sales, for instance, lowers production, which results in declining employment and income, which in turn weakens sales further, all the while spreading like wildfire from industry to industry, region to region, and indicator to indicator. That’s what a recession is all about.
About the only good news is that, as pointed out by Goldman Sachs, perhaps the downside will remain limited:
The downside risk is of course that these financial spillovers--or conceivably some other shock, perhaps greater fiscal tightening in 2012 than we now anticipate--prove sufficient to push the US economy into recession; both a quantitative model and our subjective assessment put recession risk in the neighborhood of 40% at this point. For now, we still think the base case is that the US economy avoids this outcome. The cyclical sectors of the economy are already quite depressed--in particular, homebuilding is barely above the depreciation rate of housing--so downside looks more limited.
Cold comfort, according to ECRI:
It’s important to understand that recession doesn’t mean a bad economy – we’ve had that for years now. It means an economy that keeps worsening, because it’s locked into a vicious cycle. It means that the jobless rate, already above 9%, will go much higher, and the federal budget deficit, already above a trillion dollars, will soar.
Here’s what ECRI’s recession call really says: if you think this is a bad economy, you haven’t seen anything yet. And that has profound implications for both Main Street and Wall Street.
With the US, we know that fiscal policy is off the table as gridlock rules the day in Washington. What more, it looks like the Federal Reserve resistance to additional action is at least partly based on a conviction this is no longer a problem for monetary policy – it is up to fiscal policy now. To be sure, financial markets today were at least initially buoyed by Federal Reserve Chairman Ben Bernanke’s comment:
The Committee will continue to closely monitor economic developments and is prepared to take further action as appropriate to promote a stronger economic recovery in a context of price stability.
But, after financial market participants sober up, they should recognize that this is nothing new. The Fed will offer more support. A hint from Bernanke as quoted by the Wall Street Journal:
Republicans also pressed the Fed chairman on the risk that the central bank could be stirring inflation with its efforts to pump money into the financial system to bring down interest rates. Mr. Bernanke dismissed such worries. He said a spurt in consumer prices earlier this year was already receding and that unemployment was a bigger threat.
"Right now, frankly, we're much further away from full employment than we are from price stability," he said. With that comment was a hint: The Fed might not be hurrying to do more to help the economy right now, but it is still leaning in that direction.
The only question is when and how much. Already, though, it is arguably too late. Recession or just slow growth, the policy delay will weigh heavily on the unemployed. Moreover, the Fed chair gives us little reason to believe he has much to offer:
Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.
How different is this view from that of Dallas Federal Reserve President Richard Fisher in defending his last dissent?
One other factor gave me pause and that was, and remains, the moral hazard of being too accommodative. For years, I have been arguing that monetary policy cannot solve the problem of substandard economic performance unless it is complemented by fiscal policy and regulatory reform that encourages the private sector to put to work the affordable and abundant liquidity we are able to create as the nation’s monetary authority. These actions are not within the Fed’s purview; they are the business of Congress and the president.
I fail to see the wisdom in neglecting policy options simply because Congress is falling down on the job.
It seems that Bernanke is more center-right of Fed policymakers than center-left. Which suggests that he will need to be dragged kicking and screaming into another round of asset purchases. And, unfortunately, we will first need to see more citizens added to the ranks of the unemployed for that to happen.
Perhaps events will evolve in such away that the current round of pessimism will prove unfounded. But even if we avoid recession, the slow growth and constant threat of recession serve as a reminder that policymakers have fallen far short of doing what is needed to lift the economy from the zero bound. And, worse yet, neither monetary nor fiscal authorities appear particularly worried about achieving such a goal.
A few remarks on Bernanke's testimony before Congress:
Saturday, October 01, 2011
Tim Duy says that while Ben Bernanke suggested that the main unemployment problem was cyclical, not structural in his speech at Jackson Hole, Federal Reserve policymakers are increasingly adopting the structural view. Unfortunately, the belief that unemployment is mostly structural is a self-fulfilling proposition:
Too Late For The Unemployed?, by Tim Duy: The debate about whether unemployment is cyclical or structural unemployment arose last year. At this point, it looks like Federal Reserve policymakers increasingly favor the structural side of the debate.
Federal Reserve Chairman Ben Bernanke, speaking at Jackson Hole, suggested that cyclical unemployment remains the primary economic challenge:
Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view--the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow.
Note that he does not conclude the long-term unemployed are by definition structurally unemployed. Still, he continues to suggest that cyclical unemployment can turn structural:
In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.
But, as is well known, he throws the ball to the fiscal authorities:
Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank. We have heard a great deal lately about federal fiscal policy in the United States, so I will close with some thoughts on that topic, focusing on the role of fiscal policy in promoting stability and growth.
But is it already too late? Has the cyclical unemployment turned structural? This week, serial-dissenter Philadelphia Federal Reserve President Charles Plosser embraced the structural view:
These numbers are troubling, especially when more than 40 percent of the unemployed, or some 6 million people, have been out of work for 27 weeks or longer. This underscores that we should not expect any easy solution. Millions of unemployed workers may take longer to find jobs because their skills have depreciated or they may need to seek employment in other sectors. These structural issues will take time to resolve. Jobs and workers will need to be reallocated across the economy, which is a long and slow process.
Plosser takes the rise in long-term unemployment as an indication of structural unemployment. He then extends the point to fight the last war:
We have provided a great deal of monetary accommodation to the economy, and given the stubbornness of the unemployment rate in responding to these efforts, we should be cautious and vigilant that our previous accommodative policies do not translate into a steady rise in inflation over the medium term even while the unemployment rate remains elevated. Creating an environment of stagflation, reminiscent of the 1970s, will not help businesses, the unemployed, or the consumer. It is an outcome we must carefully guard against.
Likewise, the centrist Atlanta Federal Reserve President Dennis Lockhart also speaks of structural factors with respect to the long-term unemployed, even invoking a comparison with Europe:
I was concerned by not only the persistence of high unemployment but also the complicated internal dynamics of the current labor market. To me, it is not clear to what degree structural factors are impeding the filling of job vacancies. And with some 43 percent of the unemployed out of work for more than six months, it is not clear to what extent the long-term unemployed are becoming a class of permanently unemployed, creating a problem resembling the so-called structural unemployment of some European countries. Further, it is not clear why participation in the labor force continues to fall. Finally, it is not clear what level of unemployment should be considered the natural or equilibrium rate under current circumstances.
Not to be outdone, the difficult-to-categorize St. Louis Federal Reserve Chairman James Bullard also looks to Europe for guidance. From his presentation this week:
- Unfortunately, unemployment rates have a checkered history in advanced economies over the last several decades.
- In particular, “hysteresis” has been a common problem, in which unemployment rises and simply stays high.
- This occurred in Europe during the last 30 years.
- If such an outcome happened in the U.S., and monetary policy was explicitly tied to unemployment outcomes, monetary policy could be pulled off course for a generation.
Now, it seems to me premature to be looking to Europe as an example. It seems reasonably obvious the unemployment problem is the result of a severe negative shock to spending. You might say no, it is structural in that we can no longer rely on housing to support incomes. But that just boils down to a spending problem - unemployment was at the natural rate as long as households and firms had the ability and willingness to spend. Moreover, I am a bit hard pressed to see how America was transformed into Europe in just three years. That said, I am not the policymaker. It appears Federal Reserve members increasingly embrace the structural unemployment story, and that suggests they will hesitate to bring out substantial additional stimulus until the see greater evidence of deflation. Of course, the longer we drag our heels on the unemployment crisis, the more easily it will be for policymakers to wash their hands of the issue, as the cyclical unemployment eventually will become structural.
Thursday, September 29, 2011
Federal Reserve Bank of Philadelphia President Charles Plosser voted against Operation Twist -- the recent attempt for the Fed to help the economy -- because:
“The actions taken in August and September tend to undermine the Fed’s credibility by giving the impression that we think such policies can have a major impact on the speed of the recovery. It is my assessment that they will not,” ... “We should not take certain actions simply because we can.”
“If we act as if the Fed has the ability to solve all our economic problems, the credibility of the institution is undermined,” Plosser said. “The loss of that credibility and confidence could be costly to the economy because it will make it much harder for the Fed to implement effective monetary policy in the future,” he said.
He certainly isn't acting like "the Fed has the ability to solve all our economic problems," (and two other Fed officials dissented along with him). In addition, the Fed officials who voted for this action have been careful to say this won't, in fact, solve all of our problems. They've said it can help modestly, and given the state of the economy even modest help is vary valuable, but they have not implied this will suddenly and magically fix our problems. So I really don't see how this action undermines credibility. Fed officials have been clear this is no magic bullet, but they think it could help some and things are so bad -- and the threat of inflation so low -- that they feel compelled to try.
But from Plosser's point of view, the Fed can't do much at all at this point, and the fear of inflation down the road trumps concerns about unemployment now. Plus, the Fed can't do anything about unemployment anyway:
“I am skeptical that this will do much to spur businesses to hire or consumers to spend, given the ongoing structural adjustments occurring in the economy and the uncertainties posed by the fiscal challenges both here and abroad,” Plosser said. Meanwhile, “we should be cautious and vigilant that our previous accommodative policies do not translate into a steady rise in inflation over the medium term even while the unemployment rate remains elevated.”
He is saying that unemployment is largely structural ("given the ongoing structural adjustments") even though it's clear that a large part of it is cyclical, and that uncertainty over fiscal policy is holding the economy back even though bond yields show no sign of this whatsoever. Thus, in his view the structural problems combined with uncertainty are holding back employment, and there's nothing the Fed can do about it.
Is he worried about inflation in the near term? No:
with many commodity prices now leveling off or falling, and inflation expectations relatively stable, inflation will moderate in the near-term
And why should we trust his forecasts in any case? He keeps seeing green shoots that aren't there:
“I was expecting GDP growth in 2011 to be 3% to 3.5%. Now, I expect GDP growth to be less than 2% in 2011, but to gradually accelerate to around 3% in 2012.” He added “I do not believe the current data signal that we are on the precipice of a so-called double-dip recession.”
So he keeps expecting growth that never comes, and uses those expectations along with the excuse that it's structural/uncertainty forestall policy action. What if his forecast for 3% growth in 2012 is as wrong as his previous forecast, and what if there is a double-dip? What if the unemployment problem is largely cyclical like most analysts say? What if, as many have concluded, uncertainty is not the problem? Is he really so certain about his forecasts and views about what's holding the economy back given his track record? With near term inflation falling, why not at least try to do more? Why should inflation risk trump the risk of continued sluggish growth (which in and of itself alleviates inflation concerns if it happens)? Is somewhat higher inflation down the road -- if it even happens -- really more worrisome than a period of elevated unemployment?
And why should this action produce inflation in any case? Operation Twist doesn't change the size of the Fed's balance sheet, it changes the average duration of the assets the Fed holds. If the balance sheet doesn't expand how, exactly, does that create inflation pressure to any significant degree? If there's no inflation pressure, what is the real concern? It appears to be the credibility argument and the fact that unemployment can't be helped -- it's structural/uncertainty -- but as noted above the structural/uncertainty claim is easy to rebut, and the concerns over credibility ring hollow. So he might at least consider the possibility that he has this wrong.
For me, one of the most frustrating thing about policy over the last several years is the continued insistence from some Fed officials that good times are just around the corner so any action they take will be inflationary. They have been wrong again and again, yet the optimism about future growth -- green shoots -- remains. Like Paul Krugman, I have been warning about a slow recovery since at least 2008, and warning about seeing green shoots that aren't there for almost as long, and it's disappointing to see policymakers continue to use the promise of good times just ahead -- especially policymakers who have been wrong again and again -- along with the easily refuted claim that the problem is all uncertainty and structural issues as an excuse to stand against doing more to try to help the unemployed (however modestly).
Wednesday, September 28, 2011
A few quick and somewhat scattered comments on Bernanke's speech today:
Opinions and Rumors, by Tim Duy: Federal Reserve President Richard Fisher today attempted to defend his ongoing policy dissent. He gives plenty of material to work with, beginning with his version of research ahead of an FOMC meeting:
Before every FOMC meeting, I survey a select group of 30 or so private business and banking operators, imparting no information about monetary policy but listening carefully to their perspectives on developments in the economy as seen at the ground level. For weeks leading up to the meeting, there was speculation in the financial markets and in the press that an Operation Twist was being contemplated. I received an earful of opinions on these rumors.
A big red flag right away. He claims to listen to survey contacts on the state of the economy, but does he tell us what they said about the economy? No, of course not. Instead, he emphasizes that he heard a lot of opinions about rumors. Pay very close attention to what Fisher is saying. He is saying he does not attempt to make policy on the basis of economic fact. He believes policy should be made on the basis of random speculation. I guess it is too much work to look beyond that random speculation. He continues:
What I gleaned from those conversations was as follows:
Embarking on an Operation Twist would provide an even greater incentive for the average citizen with savings to further hoard those savings for fear that the FOMC would be signaling the economy is in worse shape than they thought.
The economy is in worst shape than the FOMC believed just months ago. Is it Fisher’s contention that the Fed’s best policy is to attempt to hide this fact? Apparently so – good luck establishing a credible monetary policy when the stated intent is to lie about the actual state of the economy.
They might view an Operation Twist as setting the stage for a new round of monetary accommodation―a QE3, if you will. Such a program was considered redundant by business operators given their surplus of undeployed cash holdings and bankers’ already plentiful excess reserves.
Actually, apparently market participants came to exactly the opposite conclusion and, realizing the path to QE3 was longer than initially believed, bid down long-term inflation expectations. More:
In addition, such a program might frighten consumers by further driving down the yields they earn on their savings and/or lead to long-term inflation that would erode the value of those savings;
I don’t know how you drive yields down any further, as the average savings account is paying nearly zero percent. And the second sentence doesn’t follow from the first – if rates are near zero, it is only because the environment is decidedly non-inflationary. See the point above. Again, the lack of significant action on the part of the Federal Reserve is dragging down inflation expectations and real interest rates. Only in Fisher’s fantasy land is the opposite happening. More objections:
The earning power of banks, both large and small, would come under additional pressure by suppressing the spread between what they can earn by lending at longer-term tenors and what they pay on the shorter-term deposits they take in;
I think this point gets overplayed. The prime-lending rate has been locked up at 3.25% since the beginning of 2009. The spread between the prime lending rate and short-term deposit rates:
Sure enough spread between the two has hovered around 300bp since 1990, holding true to the rule of thumb that the prime rate is 300bp plus the fed funds rate. Another example - the 24 month personal loan rate was 12.41% in 2006 when 1 month CD rates were 5%. Now the same loan rate is 11.47%, for a much wider spread. Same story with credit card rates, which have only come down a fraction of the amount of short rates. All of which makes me doubt this concern that Fed policy is deterring lending activity by crushing yields on Treasury debt (although I can see where it erodes the earnings on any Treasury debt held by the banking sector). Indeed, the opposite is occurring. Lending activity is on the rise for at least one segment of the market:
Apparently someone is lending money, although admittedly the consumer market is more challenging. If anything, the necessity of the banking community to earn a spread places a lower limit on lending rates, which explains the 3.25% prime rate which in turn would limit the uptake of loans (and justifies the use of higher inflation expectations to bring down real rates).
The ability to lend, however, is not only determined by the rate spread, but also by the demand from credit-worthy borrowers – and that demand has been sorely lacking as households deleverage. See also this note from the Wall Street Journal suggesting Operation Twist was a subsidy for banks. A final point is that looking through FDIC reports, the net interest margin has hovered within 25bp of 3.5% for the last decade. In 2Q11 it was 3.61% and in 2Q05 it was 3.49%. True enough, a few basis point lower spread is meaningful. But what is more important at this point is to see even higher loan growth to profit on that margin. And that is what the Fed is trying to induce. If the Fed allows the economy to slow and loan demand to falter, a slightly higher margin might not be sufficient to prop up earnings, not to mention the impact of additional loan-loss provisions that would come into play. In short, lots of dynamics on this issue. More from Fisher:
Pension funds would have to reassess their potential returns, with the consequence that public and private direct-benefit plans would have to set aside greater reserves that might otherwise have gone to investments stimulating job creation
Yes, low interest rates place an additional burden on pension funds, just as low rates squeeze the returns for savers. But is it the Fed driving rates lower, or is the Fed just following the economy. I think it is more the latter than the former. If the Fed was actually pursuing an aggressive monetary policy, the economy would firm and long rates rise. The problem is that, contrary to the belief at Constitution Ave., the Fed's commitment to supporting economic activity is only half-hearted. And does Fisher really believe everything would be better if the Fed hiked rates by 200bp? Would pension funds really be better off if we knocked 25% off of equity valuations? More:
Expanding the holdings of the Fed’s book of longer-term debt would likely compound the complexity of future policy decisions. Perversely, the stronger the economy, the greater the losses the Fed would incur as interest rates rise in response and the prices of those longer-term holdings depreciate. The political incentive to hold rates down might then become stronger precisely when we want to initiate tighter monetary policy. This concern, of course, would be a good news/bad news issue: The good news is that it would stem from a stronger economy; the bad is that might hurt our maneuverability and, in doing so, might undermine confidence in the Fed to conduct policy independently.
This concern over the Fed’s balance sheet is way overblown. First, San Francisco Federal Reserve economist Glenn Rudebusch addressed this issue earlier this year, concluding that:
Such interest rate risk appears modest, especially relative to the Fed's policy objectives of full employment and price stability
Second, then Governor Ben Bernanke already dismissed this concern in 2003, and noted very clearly it would be a mistake to allow such concerns to prevent the central bank from acting. The Fed should simply reach an agreement with Treasury to take this concern off the table entirely, otherwise Fisher and his ilk will just continue to use it as an excuse to justify inaction. And, quite frankly, rather than basing policy on "opinions on these rumors," wouldn't a real policymaker attempt to explain why such opinions are unfounded? He continues:
One other factor gave me pause and that was, and remains, the moral hazard of being too accommodative. For years, I have been arguing that monetary policy cannot solve the problem of substandard economic performance unless it is complemented by fiscal policy and regulatory reform that encourages the private sector to put to work the affordable and abundant liquidity we are able to create as the nation’s monetary authority.
The argument here is that the Fed is enabling a dysfunctional fiscal process by attempting to aid the economy. In other words, according to Fisher, the Fed needs to let the economy collapse to prove a point about fiscal policy. That sounds great around the coffee table, but in reality, such wanton disregard for economic welfare only promises to leave behind a mountain of collateral damage.
Finally, Fisher channels former Federal Reserve Chairman Paul Volker:
Paul Volcker, who has the scars on his back from his Herculean effort to rein in inflation in the 1980s, wrote of this in the New York Times on Sept. 18. He reminded us that once unleashed, inflation combines with stagnation to make stagflation, the most painful of all combinations for the poor, for workers, for job seekers, for bond and stock holders and for businesses trying to navigate the economy.
I addressed this last week. Ultimately, for all his antics, this is what Fisher is about - hard money. He might claim that:
…while I remain on constant watch for signs of inflationary impulses, I believe the most urgent issue is job creation and the reduction of the scourge of unemployment.
but in reality he sees nothing but economic apocalypse in 3% inflation. He cannot wrap his mind around one simple fact – the 1970’s began with 2.5% unemployment. We are currently facing unemployment above 9%. Apples and oranges. But Fisher is simply too intellectually lazy to attempt to differentiate between apples and oranges. For him, policy begins and ends with a single idea: Hard money is just morally good. And he will base policy on any "opinions on these rumors" that sound like they support his ideological conviction.
Tuesday, September 27, 2011
I have a new column on the need for Federal Reserve independence:
I expect disagreement on this one. The emphasis is on the long-run, but I wish I would have had the space to talk more about the short-run, i.e. that the Fed could be more aggressive in the short-run and allow inflation to rise temporarily without abandoning its commitment to long-run price stability. That's implied by the statement that "I don’t think the voice of the unemployed is adequately represented in monetary policy decisions," but it may not be clear. I also wish I would have had the space to talk about why a return to the gold standard -- which is behind some of the attacks on the Fed -- is a bad idea.
Friday, September 23, 2011
Several people have asked me in recent days if the Fed's aggressive attempts to get the economy going will lead to galloping inflation to go along with our weak economic growth. It is possible that this might occur down the road, of course, but I don't see it happening just now. The slack labor market has kept growth in nominal wages low, and labor represents a large fraction of a typical firm's costs. A persistent inflation problem is unlikely to develop until labor costs start rising significantly. Notice in the graph above that the period of stagflation during the 1970s is well apparent in the nominal wage data. The same thing is not happening now. This is one reason I think the Fed is on the right track worrying more about the weak economy than about inflationary threats.
Thursday, September 22, 2011
At the moment ten-year Treasury bonds are selling at a present-value discount of20 14%, and thirty-year Treasury bonds are selling at a present-value discount of 45%. Guess that half of these discounts are expectations of interest rate changes and half are rewards for risk bearing. Then if the Fed buys half 10-year and half 30-year bonds it takes risk currently valued at $60 billion off of the private sector's balance sheet. A ten-year corporate investment project of about $150 billion carries $60 billion worth of risk with it, so if this works and if the risk-bearing capacity freed-up by this version of quantitative easing is then deployed elsewhere, we will have an extra $150 billion of business investment over the year or so it takes to roll out this program and for it to have its effect.
Still, the outcome is too little:
$150 billion is, as Christina Romer likes to say "not chopped liver"--not even in a $15 trillion economy. But it is about 1/10 of our current problem--maybe less when you reflect that our current-problem is a multi-year problem.
I am skeptical that taking on longer-term US debt really draws off much if any risk-bearing capacity off the public's balance sheet, thereby freeing up capacity for additional business investment. I am even more skeptical that even if such risk were reduced, firms would take advantage. There is plenty of cash already on corporate balance sheets, but little incentive to put it to work in an economic environment characterized by slow and uncertain patterns of growth.
I think market participants are also skeptical that this is even a marginally effective policy - note that as of last week, the ten-year TIPS breakeven was just a notch under 2%. As of right now, the breakeven has plunged to 1.72%. Not exactly a ringing endorsement of the Fed's actions. Indeed, quite the opposite - the Fed's relative inaction is intensifying disinflationary expectations.
Simply put, it sure looks like the Fed is playing around at the wrong margins. Barry Ritholtz summarizes:
There is no calvary coming to the rescue.
Will the calvary eventually come? It will not be long before we are right back where we were last fall - a 1.5% ten-year breakeven, pushing the Fed toward another round of quantitative easing. But will the Fed have the stomach to bring it out in meaningful quantities to compensate for operating on the weak margins of monetary policy? They need to stop thinking on the order of hundreds of billions and start thinking on the order of trillions. And they need to be willing to allow inflation to rise above 2% to be most effective. It seems, however, that this is too big a package to expect from the Fed.
Bottom Line: We need policy that decisively lifts the economy off the zero bound. Policies that work through traditional avenues, primarily the credit channel, have been ineffective. Surely effective would be a cooperation between fiscal and monetary authorities - print the money and spend it. We are faced with increasing expectations if disinflation coupled with fears to spend more because of the size of the deficit. There should be more than ample room for policy coordination, and that policymakers are not more aggressive at this point is bewildering. Inaction on the part of the Administration and the Federal Reserve is endangering both of them politically. The former is risking the White House, the latter is only adding fuel to the fire of right-wing criticism by engaging in half-measures with minimal, difficult to quantify results. Caught in the middle is the American people, staring at the possibilty of another lost decade.
I have some comments at NPR:
FOMC Reaction – The Extended Version, by Tim Duy: Earlier I posted my quick reaction to the FOMC statement. Now it is time for some extended comments. First off, the Fed sees increasing risks of disappointing news in the months ahead. The August sentence:
Moreover, downside risks to the economic outlook have increased.
was changed to:
Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets.
The downside risks are now “significant,” and we can thank the Europeans for that. I already commented on the twist operation – I tend to think it is too little to have much impact, largely just changing the composition of already safe assets. There was a reaction at the long end of the curve, with the 30 year yield down nearly 20bp. I am sure the Fed is pleased with that; the stock market, however, did not view it as much of a silver bullet, and sold off 2.5%.
What I didn’t have a chance to digest earlier was this:
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities.
That the debt overhang in mortgage markets is weighing on the recovery is not much of a secret. The Fed views that overhang as hampering the effectiveness of monetary policy, and rightfully so. By keeping assets in the mortgage markets, the Fed is hoping to encourage even lower rates and, by extension, a greater pace of refinancing. Worth a try, to be sure. I don’t know that this addresses the critical impediments to refinancing – underwater mortgages and tighter underwriting conditions. Yes, if we allow the loan to value ratio of federally insured mortgages to increase, then we can get some traction. And the Fed’s move may be in anticipation of such action – I am hoping this is so.
Increased opportunities to refinance, however, may not have as much of an immediate impact as would normally be the case. It depends on the ratio of households that refinance into another 30-year mortgage, reducing their payments by extending the payoff date at a lower interest rates versus those that refinance into a 15-year mortgage and reduce their current consumption to save more.
For what it is worth, here is what I am doing. With my children now in kindergarten and first grade, we finally experienced a drop in child-care expenses. The drop just happens to be almost exactly what I need to refinance into a 15-year mortgage. Better to pay down debt than allow my standard of living to ratchet up. And, quite frankly, paying down debt at a more rapid pace is pretty much the best safe investment right now. Holding cash in the bank yields nothing, paying down the mortgage debt at least earns around 4-5% depending on your mortgage, tax-free. That said, in the long-run, by holding rates low, the Fed is contributing to balance sheet restructuring. I just tend to think the process would be quicker and more effective via wage inflation.
The Fed reiterated their expectation that rates will hold near zero through 2013, and once again committed to additional action should it be necessary. Of course, arguably it is already necessary. Still, it is the marker that keeps hopes of another round of quantitative easing alive.
Ezra Klein argues the Fed struck a blow for independence today, coming in slightly above expectations and effectively ignoring the thinly-veiled Republican threat. Yes, kudos to Federal Reserve Chairman Ben Bernanke on that point. Stan Collender nails this one – the Republicans have effectively put an end to fiscal stimulus, and now hope to derail monetary stimulus as well. I think the Republican leadership is doing themselves a disservice with this line of attack. Quite frankly, the remaining monetary tools are very weak, and the willingness of the Federal Reserve to ramp them up to levels that might be effective is very low. In effect, the Republicans are needlessly taking a hard line position on this one. The Fed isn’t going to come to the rescue. The numbers are simply too big – remember Goldman Sach’s $10 trillion figure for the Fed’s portfolio if they wanted to deliver the correct level of policy accommodation in 2009? Something like that is not even on the outer edges of the radar screen.
Bottom Line: I think Fed official believe they are being bold; I see them as continuing to ease policy in 25bp increments. Expect that to continue. Assuming the economy fails to regain momentum, the Fed will follow up with additional action – QE3 will be the next stop. Ignore the dissents; they are background noise. Don’t expect miracles; expect small moves, the equivalent of 15bp here, 25bp there. The real leverage could potentially come from fiscal policy leveraging the easy monetary policy. Print the money and spend it. Open up the refinancing channel. Overall, make the objective of national economic policy simply be to decisively move us off the zero bound. Not deficits, not the dual mandate, just commit to pulling us off the bottom.
Wednesday, September 21, 2011
Here's the FOMC statement. The big news is the attempt to lower long-term interest rates by shifting $400 billion of the Fed's portfolio from short-term to long-term assets (i.e. what has been described as a "twist"):
Press Release, Release Date: September 21, 2011: Information received since the Federal Open Market Committee met in August indicates that economic growth remains slow. Recent indicators point to continuing weakness in overall labor market conditions, and the unemployment rate remains elevated. Household spending has been increasing at only a modest pace in recent months despite some recovery in sales of motor vehicles as supply-chain disruptions eased. Investment in nonresidential structures is still weak, and the housing sector remains depressed. However, business investment in equipment and software continues to expand. Inflation appears to have moderated since earlier in the year as prices of energy and some commodities have declined from their peaks. Longer-term inflation expectations have remained stable.
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee continues to expect some pickup in the pace of recovery over coming quarters but anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate. Moreover, there are significant downside risks to the economic outlook, including strains in global financial markets. The Committee also anticipates that inflation will settle, over coming quarters, at levels at or below those consistent with the Committee's dual mandate as the effects of past energy and other commodity price increases dissipate further. However, the Committee will continue to pay close attention to the evolution of inflation and inflation expectations.
To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee decided today to extend the average maturity of its holdings of securities. The Committee intends to purchase, by the end of June 2012, $400 billion of Treasury securities with remaining maturities of 6 years to 30 years and to sell an equal amount of Treasury securities with remaining maturities of 3 years or less. This program should put downward pressure on longer-term interest rates and help make broader financial conditions more accommodative. The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate.
To help support conditions in mortgage markets, the Committee will now reinvest principal payments from its holdings of agency debt and agency mortgage-backed securities in agency mortgage-backed securities. In addition, the Committee will maintain its existing policy of rolling over maturing Treasury securities at auction.
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The Committee discussed the range of policy tools available to promote a stronger economic recovery in a context of price stability. It will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate.
Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; William C. Dudley, Vice Chairman; Elizabeth A. Duke; Charles L. Evans; Sarah Bloom Raskin; Daniel K. Tarullo; and Janet L. Yellen. Voting against the action were Richard W. Fisher, Narayana Kocherlakota, and Charles I. Plosser, who did not support additional policy accommodation at this time.
On the run, so very quick reaction:
1. This shifts the duration of the balance sheet, but it does not change its size. I would have preferred balance sheet expansion, i.e. QE3, as that would have a much better chance of helping the economy. But the inflation hawks on the committee will not tolerate further expansion in the balance sheet due to worries about inflation.
2. It's not big enough.
3. Even if it causes rates to fall, will consumers and businesses respond?
That is, this might help some, but not enough to solve our employment crisis -- not by any means. Thus, this does not alleviate the need for Congress to implement serious job creation programs as soon as possible.
The unemployment crisis needs to be attacked vigorously, and we need aggressive action from both monetary and fiscal policymakers. But neither the Fed nor Congress has the will to do more than half-hearted measures at this point, and even that might be too much for Congress.
I wish the people making these decisions had to face what households struggling to find a job endure daily -- the world policymakers see from their insulated shell is very different from the world of the unemployed. Maybe then they'd finally get it and, more importantly, do what needs to be done.
Update: Tim Duy reacts to the decision.
Update: Via Daniel Indiviglio:
...But the other action announced by the Fed shouldn't be overlooked. Previously, it was reinvesting its maturing mortgage securities in new Treasuries. By instead targeting agency mortgage securities, it will more directly push down mortgage interest rates. The size of this effort is not provided, in large part because its size will depend on external factors.
As prepayments from mortgage refinancing increase, so will the amount of money the Fed will reinvest. And with mortgage rates heading towards historical lows due to this campaign, you should expect to the Fed provided lots of principal with which to reinvest. It wouldn't be surprising to see $40 to $45 billion per month in reinvested in agency mortgage securities through this effort. That's about the amount of monthly maturing principal reinvestment from mortgage securities we saw last year as rates were dropping. So this effort could actually outweigh Operation Twist.
This letter from Senators McConnell, Boehner, Kyl, and Cantor crosses a line that shouldn't be crossed:
Dear Chairman Bernanke,
It is our understanding that the Board Members of the Federal Reserve will meet later this week to consider additional monetary stimulus proposals. We write to express our reservations about any such measures. Respectfully, we submit that the board should resist further extraordinary intervention in the U.S. economy, particularly without a clear articulation of the goals of such a policy, direction for success, ample data proving a case for economic action and quantifiable benefits to the American people.
It is not clear that the recent round of quantitative easing undertaken by the Federal Reserve has facilitated economic growth or reduced the unemployment rate. ...
We have serious concerns that further intervention by the Federal Reserve could exacerbate current problems or further harm the U.S. economy. ...
Sen. Mitch McConnell, Rep. John Boehner, Sen. Jon Kyl, Rep. Eric Cantor
I think speaking out individually is fine, e.g. a member of Congress stating his or her views on monetary policy in a speech is not a problem. That's part of the public dialogue.
But an official letter from members of the House and Senate to the Fed is more official, and more threatening to the Fed's independence than a speech from an individual member of Congress. Robert Reich explains the objections:
The Republican’s Latest Ploy to Keep the Economy Lousy through Election Day, by Robert Reich: ...To say it’s unusual for a political party to try to influence the Fed is an understatement.
When I was Secretary of Labor in the Clinton Administration, it was considered a serious breach of etiquette — not to say potentially economically disastrous — even to comment publicly about the Fed. Everyone understood how important it is to shield the nation’s central bank from politics.
If global investors suspect the Fed is responding to political pressure of any kind, investors will lose trust in the nation’s monetary policies. Even if the pressure is to tighten the money supply and keep interest rates high, it’s still politics. And once politics intrudes, lenders of all stripes worry that it will continue to intrude in all sorts of ways. The inevitable result: Lenders charge more for lending us money.
The letter puts Bernanke and his colleagues in a huge bind. If they decide against another round of so-called “quantitative easing” to lower long-term rates and boost the economy, they may look like they’re caving to congressional Republicans. If they decide to go ahead notwithstanding, they’re bucking the Republicans and siding with Democrats. Either way, they’re open to the charge they’re playing politics.
Congressional Republicans evidently don’t care. They want Obama out, whatever the cost. Besides, they’ve never met a government institution they don’t mind trashing.
There's more to it than higher interest rates. History tells us that politicizing monetary policy is a bad idea -- giving control of the money supply to politicians generally leads to high inflation -- and for this reason most countries have a monetary authority with some degree of independence. Thus, the GOP's politicization the Fed in the name of preventing inflation is puzzling (unless of course, inflation hawkery is cover for another agenda).
Tuesday, September 20, 2011
Not the 1970s, by Tim Duy: Today former Federal Reserve Chairman Paul Volker pulled out the specter of the 1970’s to rail against those suggesting room for a higher inflation target, holding special contempt for the obviously insidious President of the Chicago Federal Reserve Charles Evans:
So now we are beginning to hear murmurings about the possible invigorating effects of “just a little inflation.” Perhaps 4 or 5 percent a year would be just the thing to deal with the overhang of debt and encourage the “animal spirits” of business, or so the argument goes.
It’s not yet a full-throated chorus. But remarkably, at least one member of the Fed’s policy making committee recently departed from the price-stability script.
Having the central bank embrace inflation would shock economists and Fed watchers who view price stability as the foremost goal of monetary policy. But there are worse things than inflation. And guess what? We have them today. A little more inflation might be preferable to rising unemployment or a series of fiscal measures that pile on debt bequeathed to future generations.
Of course, Volker’s amazement that someone might suggest a higher inflation target is a consequence of his conviction that the 1970’s was the worst economic decade ever:
…Economic circumstances and the limitations on orthodox policies are indeed frustrating. After all, if 1 or 2 percent inflation is O.K. and has not raised inflationary expectations — as the Fed and most central banks believe — why not 3 or 4 or even more? Let’s try to get business to jump the gun and invest now in the expectation of higher prices later, and raise housing prices (presumably commodities and gold, too) and maybe wages will follow. If the dollar is weakened, that’s a good thing; it might even help close the trade deficit. And of course, as soon as the economy expands sufficiently, we will promptly return to price stability…
…Some mathematical models spawned in academic seminars might support this scenario. But all of our economic history says it won’t work that way. I thought we learned that lesson in the 1970s. That’s when the word stagflation was invented to describe a truly ugly combination of rising inflation and stunted growth…
…It is precisely the common experience with this inflation dynamic that has led central banks around the world to place prime importance on price stability. They do so not at the expense of a strong productive economy. They do it because experience confirms that price stability — and the expectation of that stability — is a key element in keeping interest rates low and sustaining a strong, expanding, fully employed economy.
Note the conviction that high inflation is not compatible with strong growth. Now take a quick look at some of the economic outcomes of periods beginning with 1970 and 2000:
I don't want to romanticize the 1970s. I think we all recognize that the 2.5% unemployment rate at the end of the 1960’s was below the natural rate and thus incompatible with low inflation. The subsequent decade of economic mismanagement did permit both inflation and unemployment to rise, although certainly some of the latter can be attributed to the unusually low unemployment at the beginning of the decade. That said, the above numbers stack up pretty impressively compared to the 2000s. Arguably in recent years productivity did accelerate, at least temporarily, but didn’t appear to translate into better job or wage growth. But overall, I am thinking the inflationary 1970s look pretty good right now relative to the price stability of the last decade.
Of course, in the background, the unexpected inflation of the 1970s drove a redistribution of wealth, and it is this that is probably Volker’s real complaint. My first undergraduate economics professor told a story of how all the student loans he took out in the late 60s and early 70s evaporated in real terms a decade later. Perhaps Volker would have preferred that he had been weighed down by those debts instead - a situation not unlike today, were the debt overhang is a weight on household spending.
What is even more sad is that Volker fails to recognize why some argue for higher inflation:
My point is not that we are on the edge today of serious inflation, which is unlikely if the Fed remains vigilant. Rather, the danger is that if, in desperation, we turn to deliberately seeking inflation to solve real problems — our economic imbalances, sluggish productivity, and excessive leverage — we would soon find that a little inflation doesn’t work. Then the instinct will be to do a little more — a seemingly temporary and “reasonable” 4 percent becomes 5, and then 6 and so on.
I don’t think I have heard anyone who believes that inflation is a cure to sluggish productivity. Indeed, see above – during the recession productivity was anything but sluggish. No one thinks that higher inflation will spark higher productivity, only that higher inflation can be a tool to lift the economy from the lower bound allowing output to rise to the productivity-enhance level of potential output. Excessive leverage is a real problem, and in fact one that can be addressed via inflation. A commenter on an earlier piece notes that even what I perceive as lower levels of inflation could quickly erode the debt overhang, albeit not as quickly as I might like. How a central banker cannot recognize that unanticipated inflation erodes real debt loads is simply unfathomable.
And Volker uses the general term “economic imbalances,” but offers no explanation to what he is referring. Arguably, the major economic imbalance is the foreign central bank-induced trade deficit, which has contributed to a global imbalance in patterns of production and consumption. Recall that he appears to recognize the role of the dollar in any rebalancing:
If the dollar is weakened, that’s a good thing; it might even help close the trade deficit.
But seems to lose sight of this later:
At a time when foreign countries own trillions of our dollars, when we are dependent on borrowing still more abroad, and when the whole world counts on the dollar’s maintaining its purchasing power, taking on the risks of deliberately promoting inflation would be simply irresponsible.
I thought the purpose of the Federal Reserve was to promote the economic interest of the United States – that is its primary responsibility. And how can any economic imbalances be resolved if we remain dependent on borrowing from abroad? Wouldn’t we be better off discouraging those capital flows and allowing for export and import-competing industries to expand? And wouldn’t the rest of the world be better off if the US helped ease their inflationary pressures by providing additional goods and services to the global economy rather than attempting to absorb the excessive production of other nations? (And if you believe that those capital inflows represent confidence in the US economy, I have a bridge to sell you. Take out the purchases by foreign central banks and see what happens.)
Bottom Line: The constant comparisons to the 1970s are increasingly tiresome. At the end of the day, in the 1970s we were not in a liquidity trap. Today we are. The world is simply different. And we need policymakers that recognize that difference, not dinosaurs who refuse to do anything but live in a narrow view of their youth.
Monday, September 19, 2011
Tim Duy says he has "trouble seeing the FOMC doing anything really big at this point":
Rearranging the Deck Chairs, by Tim Duy: Here we are, again staring down the barrel of an FOMC meeting while deeply entrenched in a subpar equilibrium, with output well below the pre-recession trend and unemployment stuck in the high single digits. What will the Fed bring to the table this time around? Considering the magnitude of the economic challenge, expectations are low: A modification of the FOMC statement to reflect an increasingly pessimistic outlook couple with some version of “Operation Twist,” an effort to reduce longer-term interest rates by extending the duration of the Fed’s portfolio of Treasury securities. There is an outside change the Fed lowers interest on reserves, but I view that as unlikely at this juncture. Even more unlikely is another round of quantitative easing. I don’t think there is much appetite at the Fed for additional asset purchases given the inflation numbers and the stability of longer-term inflation expectations relative to the events that prompted last fall’s QE2.
Will additional Fed action accomplish much if anything? I admit to being increasingly skeptical that the Fed is doing much more than pushing on a string. Interest rates on are less than 1 percent out to five year, which pretty much means whatever the Fed is doing at that horizon is just shifting around the composition of risk free assets. There is some room as you move to the 10-year horizon – at least there you have 200 basis points to play with. But even with some room to maneuver, in order to have significant impact, I think they need to be throwing around some big numbers when it comes to Operation Twist. Via Marketwatch, former Federal Reserve Vice-Chair Alan Blinder:
Blinder agreed that “some version of twist” is “the likely next step.” The Federal Open Market Committee will meet for two days next week to determine whether and how to ease further.
Blinder said the program needed to be large to have a meaningful impact.
“The twist is a sufficiently weak instrument so to do it in tiny amounts it almost becomes laughable,” he said.
Likewise, the same holds for another round of quantitative easing. Recall that estimates of the interest rate effect of QE2 were relatively modest, on the order of 20bp. I am not sure that any of us believe that another 20bp will be the bullet that pulls us out of the slump.
So if the Fed wants to have any meaningful impact, it needs to do something really, really big, and even then, a “meaningful” outcome is not assured. And, in any event, I have trouble seeing the FOMC doing anything really big at this point – it seems the center of the Fed questions the basic effectiveness of policy to do much more than raise inflation given what are increasingly perceived as structural impediments to growth. It could be the Fed is inclined to take additional actions only to look like they are doing something.
Moreover, there is this ongoing concern the Fed is doing nothing more than aggravating the lending situation by crushing down longer-term yields. The logic is that banks need some interest rate spread to justify lending. In the current environment, they see no reason to take on additional lending to any but the safest clients – not enough margin to justify the risk of a loan default.
What can be done to steepen the yield curve and this induce additional lending while at the same time holding long term rates low to encourage borrowers to line up at the bank? Override the zero lower bound to induce negative short-term interest rates. Blinder again:
Blinder said the Fed could first cut the interest rate on excess reserves to zero “just to make sure that there are not some unintended consequences that are horrendous,” he said.
The rate could then be pushed into negative territory.
The notion is strongly opposed by banks, who view it as a tax.
Blinder doesn’t disagree with that characterization.
“The whole notion is you should tax things you don’t like people to do, and subsidize things that are essential,” he said.
“One thing we don’t like is banks just piling up idle reserve,” he said. “We would like to push that money out of the banks and have them do something with it.”
Although some money will undoubtedly go into super-safe money funds, “the hope is that some fraction goes into increased lending,” he said.
You get the idea – whatever money the Fed has injected into the economy via QE2 has been reabsorbed by the Fed in the form of excess reserves rather than supporting loan growth in the economy. To solve that problem, charge banks for holding reserves at the Fed, thus inducing them to get their acts together and start lending.
Americans are pumping money into bank accounts at a blistering pace this year, sending deposits to record levels near $10 trillion on escalating fears that the U.S. economy is on the verge of another implosion.
There's no sign that the flood into checking, savings and money market accounts is slowing down. In the last three months, accounts at U.S. commercial banks have increased $429 billion, or 10%, almost double the increase for all of last year.
The money is coming in fast! Good news? No:
There's one big problem: Banks don't want your money.
"Banks and credit unions are doing everything they can to get rid of the cash except make loans," said Mike Moebs, a Lake Bluff, Ill., banking consultant.
He said banks are driving away deposits by refusing to renew CDs at higher rates and by imposing fees on checking accounts for depositors who don't use other, profitable financial services as well.
The banking sector is reacting to a flood of money by trying to push back the tide, not by opening up the loan spigot. If the Fed pushes the interest on reserves into negative territory, will that be enough to spur lending? Or will banks simply do more of what they are already doing? The path of least resistance is to keep doing more of the same.
And if consumers are only charged for money they hold in the bank, effectively earning negative interest rates themselves, will they spend more money, or just start stuffing their mattress? And maybe start stuffing it twice as fast. You know its bad when banks won’t take your money. Time to dust off the Roubini portfolio – dried food, ammunition, and gold. I guess that is how gold can go off the charts in both an inflationary or deflationary environment.
In short, it is not evident that more monetary policy will make its way down to the heart of the problem:
Bankers such as Robert H. Smith, former chairman of L.A.'s Security Pacific Corp., say the industry is being throttled by a combination of the weak economy and regulations that were tightened in the aftermath of the financial crisis.
"What little demand that is out there for loans is regarded very skeptically [by the banks] because of the pressures from the regulators," said Smith, who sold Security Pacific to Bank of America 20 years ago and is now a founding director of Commerce National Bank in Newport Beach.
Which came first, the chicken or the egg? Is the economy weak because lending is tepid, or vice-versa? The lack of potential borrowers with sufficient cash flow who actually want to borrow money clearly hampers the effectiveness of monetary policy through either traditional or nontraditional channels.
So what is left? I keep coming back to the same conclusion. That to be effective at this juncture, additional monetary policy must be coordinated with additional fiscal policy. The Fed creates the money, fiscal policymakers ensure it gets into the hands of someone who will spend it, boosting demand until interest rates rise and the pool of ready and willing borrowers swells. At that point the banking sector has someone to loan to and a spread to work with.
Bottom Line: When the Fed meets this week, will they accommplish anything more than rearranging the deck chairs? I increasingly see the need for dramatic action to decisively lift the economy off the zero bound. The comparisons to Japan and getting a little too close for comfort; it is easy to how the US economy limps along for the next decade characterized by rock-bottom interest rates and never-ending fiscal deficits.
Wednesday, September 14, 2011
Adam Posen urges central banks to take aggressive action:
How to do more, by Adam Posen, External Member of the Monetary Policy Committee, Bank of England: We do want more, and when it becomes more, we shall still want more. And we shall never cease to demand more until we have received the results of our labor. - Samuel Gompers, May 2, 1890
Something's better than nothing, yes! But nothing's better than more.
- Stephen Sondheim, Sung by Madonna in the movie, Dick Tracy, 1990
Both the UK and the global economy are facing a familiar foe at present: policy defeatism. Throughout modern economic history, whether in Western Europe in the 1920s, in the US and elsewhere in the 1930s, or in Japan in the 1990s, every major financial crisis-driven downturn has been followed by premature abandonment—if not reversal—of the macroeconomic stimulus policies that are necessary to sustained recovery. Every time, this was due to unduly influential voices claiming some combination of the destructiveness of further policy stimulus, the ineffectiveness of further policy stimulus, or the political corruption from further policy stimulus. Every time those voices were wrong on each and every count. Those voices are being heard again today, much too loudly. It is the duty of economic policymakers including central bankers to rebut these false claims head on. It is even more important that we do the right thing for the economy rather than be slowed, confused, or intimidated by such false claims.
Make no mistake, the right thing to do right now is for the Bank of England and the other G7 central banks to engage in further monetary stimulus. If anything, it is past time for us to do so. The economic outlook has turned out to be as grim as forecasts based on historical evidence predicted it would be, given the nature of the recession, the fiscal consolidations underway, and the simultaneity of similar problems across the Western world. Sustained high inflation is not a threat in such an environment, and in fact the inflation that we have suffered due to temporary factors in the UK is about to peak.1 If we do not undertake the stimulative policy that the outlook calls for, then our economies and our people will suffer avoidable and potentially lasting damage. I will recap the argument for doing more in a moment.
My main purpose in speaking to you today is to explain how the Bank of England, and by extension other central banks, should do more to ease monetary policy at this juncture. I hope to convince you that doing more would be not only desirable, but constructive for the economy as a whole, effective as stimulus, and feasible without political compromise. A large part of this argument rests on asking you as sensible listeners to see through the distortions and falsehoods that have cropped up again in the aftermath of this crisis as in the past. Some common sense can be just as useful in appraising monetary policy as in evaluating the overall worth and likely success of other services for which the public contracts with technical experts. After such appraisal, I hope that you will agree with my arguments that:
- More monetary ease will lead to greater restructuring of the economy in the right and necessary direction;
- More of the same Quantitative Easing [QE] program that the Bank already undertook would be where to start, especially if done on sufficient scale;
- More cooperation between the Bank and HM Government to promote investment and credit to small and medium business should be the beneficial next step.
Monetary policymakers must also free themselves from unfounded concerns and take these necessary actions. There are too many excuses for passivity being offered, none of which stand up to scrutiny or to the data. In essence, central banks can improve matters by doing more, even if we have to act alone. In so doing, we would make constructive actions by other policymakers in the fiscal and financial arenas outside of our remit more – not less – likely, and those actions more likely to succeed when undertaken.
Almost certainly, even if we were to do everything right on monetary policy (and we certainly will not get everything right, despite the best of intentions), there will still be suffering and ongoing problems from economic adjustment. And the benefits of our right policies may not turn out to be self-evident. But it is our responsibility and our duty to make things better if we can. Central bank officials have wasted too much time over the last year worrying about how their institutions would appear to markets, to politicians, and to the public, were we to undertake more stimulus. Sometimes you have to do the right thing even if it may be misperceived. I believe that by explaining how doing more would work, as I am trying to do today, the chances may increase that we will do the right thing on monetary policy now, and that it will be recognized as right later if not immediately.
1 Unless there is a sufficiently persistent supply shock to energy prices to more than offset the influence of declining rates of global growth on those prices for the next couple of years – something oil futures markets do not price in at present (in fact, they price in the opposite). ...[continue reading]...
Monday, September 12, 2011
A Modest Monetary Proposal, by Tim Duy: I have been reading and rereading Raghuram Rajan’s piece questioning the effectiveness of proposals to raise inflation targets. I tend to be pretty sympathetic to such proposals; traditional monetary policy obviously hit it limit long ago, and active commitments to higher inflation to depress real rates seems to be a logical next step. That said, Rajan has a number of good points questioning both the implementation and efficacy of higher inflation targets. Can the Federal Reserve credibly commit to higher inflation? Can they credibly commit to regain control over inflation at some later time? Most striking, I think, was Rajan’s reflection, that a small inflation increase really will not do much good at all:
Moreover, the central bank needs rapid, sizeable inflation to bring down real debt values quickly – a slow increase in inflation (especially if well signaled by the central bank) would have limited effect, because maturing debt would demand not only higher nominal rates, but also an inflation-risk premium to roll over claims.
A mechanism to rapidly accelerate the process of household rebalancing would be extremely helpful. It is not clear that an inflation target of 3 percent is such a mechanism. Something more dramatic is required.
Would that something more dramatic be QE3? I see that over the weekend, St. Louis Federal Reserve President James Bullard came out in favor of QE3 should more easing be necessary. From the Wall Street Journal:
In an interview with the Business News Network, James Bullard said “I still think our most potent weapon is to do more QE3 if necessary,” in a reference to the QE2 bond buying program that ended in the summer.
He goes on to undermine the policy that Fed seems to be coalescing around:
Bullard said the experience of the 1960s-era “Operation Twist,” when the Fed and Treasury together worked to try to push down long-term borrowing rates, should be cautionary. Bullard said that effort was not particularly effective, which is why more outright purchases would most likely be the way to go.
My sense is that Bullard prefers whatever policy option produces the biggest headline for him. That said, he is probably right on this one – a portfolio rebalancing is a move in the right direction, but don’t expect miracles. But could any miracles really be expected from more quantitative easing? As Rajan notes:
Start with the question of whether central banks that have spent decades establishing and maintaining anti-inflation credibility can generate faster price growth in an environment of low interest rates. Japan tried – and failed: banks were too willing to hold the reserves that the central bank released as it bought back bonds.
To be most effective, monetary policy needs to push on some variable that will have a substantial impact on demand. Trading safe assets for cash at near zero interest rates just doesn’t accomplish that. But it’s the only biggish lever we seem to have left, but it simply is not direct enough. What is needed is to get the money in the hands of someone who will use it, rather than just sloshing around banks as excess reserves. If it is stuck in the banking system, it can’t create demand that at least causes a big shift in the prices of both goods and wages.
Maybe at this point we need to be thinking about something a little more direct – one of the proposals floating around is to use Fannie and Freddie to purchase nearly all the outstanding mortgages and refinance them at lower interest rates regardless of loan to value ratios. Better yet, to apply some consistent system of principle reduction for everyone, not just underwater mortgages. Lift the entire boat at once, rather than trying to discern between the most and least deserving lifeboats.
Something like this is not a new idea, but it gets held up by, among other things, by the issue of the cost. So maybe the Treasury needs to issue a class of bonds the Federal Reserve agrees to purchase and hold – essentially monetizing the rebuilding of household balance sheets and freeing future tax payers from the burden of repaying the debt.
I suspect that this entails a sharp, one time increase in the price level, and this is the tricky part. The Fed would have to both accept that increase and make clear they are committed to return to their 2 percent target. I don’t think this is impossible, but it might be difficult to accomplish quickly. Also note that once we can lift up off the zero-bound, traditional monetary policy can come back into play to manage inflation. Moreover, they have room to reduce the remainder of the balance sheet, but, when all is said and done, they should not expect to return to the pre-crisis trend, and instead acknowledge the one-time shock to the balance sheet.
Bottom Line: Rather than the more indirect approaches left to monetary policy, maybe there is room for a one-time effort to monetize the rebalancing of household balance sheets, which perhaps can be viewed as a more “modest” alternative to monetization of general government spending. Perhaps the former can be more credibly contained to a one-time event.
Friday, September 09, 2011
Ben Speaks, by Tim Duy: Federal Reserve Chairman Ben Bernanke took the stage today, providing few hints about the path of monetary policy in the months ahead. Market participants were hoping for more specific details on what the Fed has up its sleeve at the next meeting, but got more of the same:
In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. My FOMC colleagues and I will continue to consider those and other pertinent issues, including, of course, economic and financial developments, at our meeting in September and are prepared to employ these tools as appropriate to promote a stronger economic recovery in a context of price stability.
More interesting was his extended comments on inflation:
However, inflation is expected to moderate in the coming quarters as these transitory influences wane. In particular, the prices of oil and many other commodities have either leveled off or have come down from their highs. Meanwhile, the step-up in automobile production should reduce pressure on car prices. Importantly, we see little indication that the higher rate of inflation experienced so far this year has become ingrained in the economy. Longer-term inflation expectations have remained stable according to the indicators we monitor, such as the measure of households' longer-term expectations from the Thompson Reuters/University of Michigan survey, the 10-year inflation projections of professional forecasters, and the five-year-forward measure of inflation compensation derived from yields of inflation-protected Treasury securities. In addition to the stability of longer-term inflation expectations, the substantial amount of resource slack that exists in U.S. labor and product markets should continue to have a moderating influence on inflationary pressures. Notably, because of ongoing weakness in labor demand over the course of the recovery, nominal wage increases have been roughly offset by productivity gains, leaving the level of unit labor costs close to where it had stood at the onset of the recession. Given the large share of labor costs in the production costs of most firms, subdued unit labor costs should be an important restraining influence on inflation.
A couple of points. First, he takes the inflation boogeyman off the table for the time being. Not only are temporary factors easing, but long-term expectations remain stable and wage gains are subdued. Focus more, however, on the inflation expectations story – clearly Bernanke is not phased by the deterioration in the five and ten year-forward breakevens. The ten year in particular still hovers well above the levels that triggered QE2.
So where are we at? The deterioration in the real economy coupled with moderating inflation suggests more easing is at hand. Indeed, we know there is a growing dovish FOMC group that desires more aggressive policy. But how aggressive? Chicago Federal Reserve President Charles Evans desires a relatively aggressive stance that includes allowing inflation to drift up to 3% at least temporarily. But I don’t think we will get something like that. And I can’t see a return to quantitative easing short of a real deflation threat – I don’t see the core of the FOMC or Bernanke himself supportive of such a step at this time. Ditto for allowing the inflation target to drift upward.
If higher inflation targets and an open-ended program of quanitative easing are off the table, what’s left? As I noted earlier this week, the usual suspects, with the extending the duration of the Fed’s portfolio high on the list of market expectations. See Neil Irwin's piece at the Washington Post.
What I have trouble seeing is a strong commitment about the path of monetary policy. More soft commitments, yes. But not a locked in stone, willing to endure higher inflation commitment. Consider, for example, this week’s speech by San Francisco Federal Reserve President John Williams. He seems open to additional policy:
Despite these efforts, the recovery slowed to a crawl this year. But what does this mean for monetary policy? After all, monetary policy cannot cure all that ails our economy, which in large measure involves the aftereffects of the mortgage lending boom, the housing crash, and the resulting financial crisis. But, monetary policy can help limit the damage and provide support to other areas of the economy.
Williams sounds supportive of additional action, which he made more clear in comments. Via Reuters:
"There's still considerable room for monetary accommodation to improve financial conditions," San Francisco Federal Reserve Bank President John Williams told reporters after a speech to the Rotary Club of Seattle. "My main concern is really not the concern that inflation is going to be too high over the medium term. I think my main concern really is the pace of recovery and the high degree of unemployment."
"If anything more monetary accommodation seems appropriate than not," he added.
Still, something dramatic, moving into the relm of Evans? Note the mixed message. Yes, there is more we can do to prevent the patient (his analogy later) from deteriorating further, but the medicine is limited. How does this play into monetary policy? He continues:
The monetary policy situation is similar. Like the hospital patient, the economy took a turn for the worse and faces heightened risks. In addition, inflation is expected to drift down. These circumstances called for additional monetary easing. At our August meeting, the FOMC took a step in that direction, issuing a statement that we are likely to keep the federal funds rate at exceptionally low levels at least through mid-2013.
Arguably, if data continues to disappoint heading into the next meeting, the same logic will hold true, and the Fed will embrace some additional easing. So far, so good. But then he undermines the FOMC statement, first by dismissing it relevance:
In one respect, this wasn’t such big news. Even before the announcement, financial market participants generally didn’t expect the Fed to raise rates much earlier than mid-2013.
Then he backtracks and claims:
But it was news in the sense that it removed uncertainty and helped financial markets better understand our intentions.
I like that, removing uncertainty is a good thing. But then he puts the uncertainty right back into the mix:
Note also that we are not tying our hands by making this announcement. We haven’t made a guarantee. We will alter our policy as appropriate if circumstances change.
When is a commitment not a commitment? When made by the Federal Reserve. Which makes me wary of any supposed policy guidelines. Most policymakers - even increasingly dovish ones such as Williams - don’t want to have their hands tied, and few other than Evans are interested in seeing inflation drift above 2%. Williams on inflation, via Bloomberg:
When asked by reporters whether he would be willing to tolerate higher inflation if it brought down unemployment, Williams said, “I don’t think there’s a tradeoff. I don’t think that’s really a choice we can make over the long term.”
“We have to focus on keeping inflation relatively low over the medium term and again keeping employment as close as we can to the maximum sustainable level,” he said.
Still others don’t believe additional policy will do much good. And quite frankly, I am sympathetic with that view. If the Fed is going to have an impact, policymakers need to go big time. 20 basis points on the long-end of the yield curve through a maturity extension just is not going to cut it. Allowing inflation to drift up to 3% is not going to cut it. Chopping the interest rate on reserves in half is not going to cut it. Half commitments to policy paths are not going to cut it. I am not even confident committing to a rate of 1% on the ten year will cut it, unless fiscal policymakers take advantage of such a gift and step up government spending. I am not sure the private sector will want to make many 1% loans – financial institutions need some spread to make a profit. These are all things that probably won’t hurt and should be tried, but don’t expect miracles either.
What would work? I am sympathetic to the notion that if fiscal policymakers can address the mortgage mess, then lower interest rates that encourage refinancing can help. But this isn't something the Fed can do alone. I am also sympathetic to targeting an asset price that you are very confident will stimulate demand. And that brings you to the hand played by the Swiss National Bank – commit to currency depreciation. Set a target for the dollar, and purchase foreign assets in unlimited quantities to achieve that goal.
Bottom Line: Bernanke continues to hold his cards close to his chest. The data flow, and the subsequent forecast implications, justifies additional easing. Indeed, Bernanke’s inflation view appears to take out one impediment to such easing. That said, the lack of concern about the path of longer-term inflation expectations still suggests additional easing will fall short of what we saw during last year's deflation scare. The composition of the portfolio seems high on the list, although I am hesitant to believe there is a lot of traction to be gained when the ten year rate is hovering around 2%. Steps in the right direction, to be sure, but, as Federal Reserve officials continue to emphasize, nothing that will rapidly restore economic vibrancy.
Wednesday, September 07, 2011
It's nice to see that at least one member of the FOMC gets it, and is willing to act:
The Fed's Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy, by Charles Evans, President, FRB Chicago: In the summer of 2009, the U.S. economy began to emerge from its deepest recession since the 1930s. But today, two years later, conditions still aren’t much different from an economy actually in recession. GDP growth was barely positive in the first half of the year. The unemployment rate is 9.1%, much higher than anything we have experienced for decades before the recession. And job gains over the last several months have been barely enough to keep pace with the natural growth in the labor force, so we’ve made virtually no progress in closing the "jobs gap".
The Federal Reserve has responded aggressively to the deep recession and weak recovery, cutting short-term interest rates to essentially zero and purchasing assets that expanded its balance sheet by a factor of three. But since undertaking the so-called QE2 round of asset purchases last fall, the Fed’s aggressive policy actions have been on hold.
Some believe that this pause is entirely appropriate. They claim that the economy faces some kind of impediment that limits how much more monetary policy can do to stimulate growth. And, on the price front, they note that the disinflationary pressures of 2009 and 2010 have given way to inflation rates closer to what I and the majority of Fed policymakers see as the Fed’s objective of 2%. These considerations lead many to say that when adding up the costs and benefits of further accommodation, the risk of over-shooting our inflation objective through further policy accommodation exceeds the potential benefits of speeding the improvement in labor markets.
I would argue that this view is extremely, and inappropriately, asymmetric in its weighting of the Fed’s dual objectives to support maximum employment and price stability.
Suppose we faced a very different economic environment: Imagine that inflation was running at 5% against our inflation objective of 2%. Is there a doubt that any central banker worth their salt would be reacting strongly to fight this high inflation rate? No, there isn’t any doubt. They would be acting as if their hair was on fire. We should be similarly energized about improving conditions in the labor market.
In the United States, the Federal Reserve Act charges us with maintaining monetary and financial conditions that support maximum employment and price stability. This is referred to as the Fed’s dual mandate and it has the force of law behind it.
The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%. So, when unemployment stands at 9%, we’re missing on our employment mandate by 3 full percentage points. That’s just as bad as 5% inflation versus a 2% target. So, if 5% inflation would have our hair on fire, so should 9% unemployment. ...[continue reading]...
Tuesday, September 06, 2011
Questions and Answers, by Tim Duy: I thought this might be an easier way to get back into the game after an extended hiatus.
Does the economy need more stimulus?
Always good to start with a softball question - YES! The US economy is two years into an economic expansion, and yet the unemployment rate remains above 9 percent. National output growth averaged just 0.7 percent in the first two quarters of the year. Job growth was zero in August, albeit with some downward pressure from the Verizon strike. Output is $1 trillion below CBO potential – and the gap is expanding. The 30-year inflation indexed Treasury bond just traded at 90 basis points. None of which should be happening two years into an expansion. Yet here we are.
Will the private sector provide the needed stimulus?
Federal Reserve President Dennis Lockhart summarizes the situation:
It is necessary that the process of deleveraging plays itself out, which may take several more years. When economies are deleveraging they cannot grow as rapidly as they might otherwise. It is obvious that as consumers reduce spending they divert more of their incomes to paying off debt. This shift in consumer behavior increases the amount of capital available for financing investment. But higher rates of business investment are not likely to fully offset weakness in consumer spending for some time, as businesses continue to grapple with uncertainties about the future.
Lacking the equity wealth provided by the housing bubble, households are simply unable to sustain the debt loads of years past. Hence, deleveraging continues. Without anyone else to pick up the slack, it is tough to see how we eek out anything other than subpar growth, trend growth (2.5 - 3.0%) at best. Not enough to quickly lift the economy back to trend output.
Will the government provide the needed stimulus?
On the fiscal side, the answer is no, or at least not yet. As Paul Krugman points out, fiscal policy is already contractionary, while the recently passed budget deal promises only more austerity. And, via Brad DeLong, Macroadvisors predicts that President Barack Obama’s impending jobs plan is not likely to provide much if any of an economic boost. That leaves monetary policy as the only game in town. And here we can anticipate that more easing is coming. But will it be enough to pull the economy from its slump? At this point, almost certainly not.
Why will monetary policy fall short?
Here again it is useful to refer back to Lockhart’s recent speech:
Given the weak data we've seen recently and considering the rising concern about chronic slow growth or worse, I don't think any policy option can be ruled out at the moment. However, it is important that monetary policy not be seen as a panacea. The kinds of structural adjustments I've been discussing today take time, and I am acutely aware that pushing beyond what monetary policy can plausibly deliver runs the risk of creating new distortions and imbalances.
Lockhart is not ruling out additional policy responses, but makes obvious his view the Fed is nearly, if not already, out of bullets to deal with a balance-sheet recession. Moreover, he shows his sympathy with the camp, I think best identified with the views of Kansas City Federal Reserve President Thomas Hoenig, that the Fed at this point risks doing more harm than good. This, I believe, represents the center of FOMC thought at the moment. This group is simply not inclined to initiate a new large scale easing in the absence of clear deflationary pressures. The five and ten-year TIPS breakevens are 1.81 and 2.05 percent, respectively. Combined, I believe they argue, at least from the Federal Reserve point of view, for more easing, but nothing dramatic.
But didn’t the most recent FOMC minutes reveal a more dovish constituency?
Yes. From the minutes:
A few members felt that recent economic developments justified a more substantial move at this meeting, but they were willing to accept the stronger forward guidance as a step in the direction of additional accommodation
Chicago Federal Reserve Bank President Charles Evans is a good example of this group. Via a recent CNBC interview:
In his view, QE needs to stay in place until unemployment plunges to 7 percent or if inflation gets past 3 percent. Core inflation, which strips out food and transportation, is about 1.8 percent, though the number is 3.6 percent including the more volatile measures.
Evans is a voting member on the fed Open Market Committee and traditionally has been among its more dovish members when it comes to interest rates and inflation.
"Strong accommodation needs to be in place for a substantial period of time," he said. "If we could sort of make everybody understand that this is going to be in place for a longer period of time, we could knock out some of that restraint that comes about when people talk about premature tightening."
As far as I am concerned, he is preaching to the choir. There has been a remarkably irresponsible tendency of Fed policymakers to turn hawkish at the slightest hint of economic improvement. I think this belies their discomfort with the expansion of the balance sheet, and renders the rest of us unsure of their commitment to the dual mandate. And I believe the Fed needs to accept the possibility of higher inflation.
What can the Fed do at this point?
The usual suspects: Reduce the interest paid on reserves, extend the maturity of the Fed’s portfolio, expand the balance sheet further, shift the portfolio in favor of mortgage-backed securities to support the housing market, make a firm commitment to zero interest rates regardless of the inflation outcome, or raise the inflation target from 2 percent to 3 or 4 percent. I suspect the first three are most likely in play, although the magnitude of an additional balance sheet expansion will likely fall short of what is needed.
Wait a second. Didn’t the Fed already commit to zero interest rates until 2013?
No – they just said that given current forecasts, they anticipated an extended period on low interest rates. This does have some value in marginalizing the hawks. That said, the minutes make clear this is only a soft commitment:
Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.
What we really need is a hard commitment that can weather a period of higher inflation.
Where is Federal Reserve Chairman Ben Bernanke is this mix?
It appears that Bernanke is right of the dovish contingent revealed in the most recent FOMC minutes. I think this first became evident in his June press conference, when he made clear the bar to QE3 was high. The bar was high because inflation expectations had rebounded, and inflation was the only clear target the Fed had control over. This basic idea was evident in Bernanke’s Jackson Hole speech:
The Federal Reserve has a role in promoting the longer-term performance of the economy. Most importantly, monetary policy that ensures that inflation remains low and stable over time contributes to long-run macroeconomic and financial stability. Low and stable inflation improves the functioning of markets, making them more effective at allocating resources; and it allows households and businesses to plan for the future without having to be unduly concerned with unpredictable movements in the general level of prices.
Once inflation is close to the Federal Reserve’s target, Bernanke apparently sees little else monetary policy can do to relieve the cyclical pressures on the economy:
Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.
I think the Bernanke’s focus on the 2 percent inflation target will severely limit the magnitude of additional easing to support job growth. It is increasingly my opinion that to lift the economy beyond the zero bound, we need a commitment by the Fed to lift inflation above 2 percent to allow nominal spending to return to the pre-recession trend. This is policy the Fed Chair appears dead set against, leaving only half-measures.
Note, however, the above only applies when inflation and inflation expectations are near the Fed’s target. I do believe Bernanke will press for more dramatic action should deflationary pressures become evident. I just don’t think we are there yet.
Would a shift to additional mortgage-backed assets help?
It wouldn’t hurt, and could push mortgage rates down further and thus encourage additional refinancing. Back in the day I would have been worried that the Fed risked looking like it was trying to sustain bubble-level prices, but I think we are beyond that. Still, note the problem in mortgage markets is deeper than interest rates – the problem is the inability to finance due to tougher underwriting standards and underwater mortgages. I am not confident that lower rates would alleviate these challenges. This seems more like the purview of the US Treasury, which could push for all federally guaranteed mortgages to be refinanced at a lower interest rate, regardless of the loan to value ratio.
Are we headed for recession?
I would not discount the possibility of recession given the US economy was clearly operating near stall-speed in the first half of the year. That said, it would be easier to embrace the recession story had the US economy ever returned to trend output during the recovery. As noted earlier, the economy is operating well below trend, and typical sources of strong downdrafts in demand – housing and autos – remain below pre-recession levels. Indeed, the absence of any rebound in housing is striking. Under these circumstances, I find it easier to embrace the “Japan” scenario, a sustained period of choppy and low growth. Recession or not, a tragedy by any measure.
What’s going on in Europe?
The Europeans are vexed with a political establishment that is not conducive to maintaining a single currency (of course, we too in the US are vexed with a dysfunctional political establishment, just a different one). In particular, they lack a mechanism to make sizable fiscal transfers within the Euro area. This is simply an important element of running a “one size fits all” monetary policy. As it stands, Euro-policymakers are attempting to enforce IMF-style austerity packages on troubled economies without the usual currency depreciation that helps offset the resulting fiscal contraction. It is obvious this approach is not working – Greek two-year debt is trading at 50 percent and the spread on Italian and Spanish debt widens. Paul Krugman asks where is the ECB? Where indeed? Perhaps they see their earlier debt-buying efforts as a failure, thus concluding the problem is a solvency problem, not a liquidity problem. And there is no European solution for a solvency problem, other than more austerity for troubled economies. Where does this end? Either the Euro-area comes together as a strong fiscal union or the periphery is jettisoned from the Euro. It really looks like the smart money is on the latter outcome. Drachmas anyone?
Update: 10:09PM PST
I see the ECB was not completely asleep at the wheel and was buying bonds. From the Wall Street Journal:
The ECB purchased Italian and Spanish government bonds Monday in a bid to keep 10-year borrowing costs from rising further above 5%—a threshold analysts say is key to their ability to finance their high debt loads. The ECB has purchased over €50 billion in bonds since reactivating the program four weeks ago.
Friday, September 02, 2011
There is a lot of discussion on how the Fed will react to the jobs report in its meeting this month, e.g. here and here. My view is that if the Fed is moved to action by the report -- and it is not at all certain that they will be -- they will do the least they possibly can while still looking like they are doing something about the problem.
What is the least they can do while still satisfying the demand for action? One option is to change the average duration of the assets they hold on their balance sheet by trading short-term for long-term assets (i.e. lengthen the average duration of the portfolio). This could bring down the long end of the yield curve a bit -- not much as there isn't all that much room for long-term rates to fall -- and perhaps stimulate economic activity. However, it's hard to see how a fall in long-term interest rates of such a small magnitude will produce a change in investment and a change in the consumption of durables such as cars and refrigerators of the magnitude that is needed. If there is a response from consumers and businesses to a small drop in the long-term rate, it will be far, far short of what we need.
Another option would be to cut the rate the Fed is paying on reserves held in banks. Ben Bernanke has stated this would disrupt the overnight federal funds market, so I think this is unlikely, but it could be cut, say in half from its current level of 0.25%, or even to zero. Any change in this rate can be reversed quickly if needed, so it's not a very risky option -- that's why I think it is one potential response -- but again I don't think it would do a lot of good. The problem isn't the supply of loans, it's the demand, and this wouldn't do much to stimulate new demand.
The Fed has already used up another option that doesn't require much actual action -- committing to low interest rates for an extended period of time -- but so far that hasn't seemed to have helped much. The options after that such as QE3 or adopting (and then trying to hit) a higher inflation target require much more action from the Fed and are likely to be resisted.
But things are much worse than the Fed thought they would be, the green shoots they keep pointing to whither away as soon as they depend upon them, and it's time -- way past time actually -- to quit hoping things improve and take the possibility of an extended period of stagnation seriously. I blame fiscal policymakers more than the Fed, fiscal policy is our best hope for job creation and we should have had a large job creation program in place long ago. But we need both policy barrels pointed at this problem, it's too large to solve without both policies working together, and it's time for the Fed to quit hoping a miracle saves them from the hard decisions they need to make and to move forward with more aggressive policy.