Category Archive for: Monetary Policy [Return to Main]

Friday, June 22, 2012

Fed Watch: What Fiscal Union Means

Tim Duy:

What Fiscal Union Means, by Tim Duy: I was looking over FT Alphaville's recent summary of Nomura's Richard Koo's work on the root cause of imbalances in the Eurozone.  The main thrust of the thesis is that the ECB held interest rates low last decade to support Germany because Maastrict rules forbid a fiscal policy solution to Germany's woes.  But rates were excessively low for the periphery, triggering the emergence of bubbles and unsustainable imbalances. Basically, the root of the problem was a one-size-fits-all monetary policy worsened by an inflexible fiscal structure.  

So far so good.  What caught my eye was this quote from Koo:

Unfortunately there have been growing calls in the eurozone for fiscal union. But that would only make the problem worse by forcing the same fiscal policy on all countries, regardless of whether they were in a balance sheet recession.

This is true with regards to what is emerging as "fiscal union" in the Eurozone, largely a commitment to strict fiscal targets.  This, however, is not how I would define a fiscal union.  When I use the term fiscal union, I am thinking of a centralized budget authority capable of making automatic internal transfers.  

Paul Krugman has provided some very good examples of the importance of such internal transfers in the United States.  For example, see his discussion of Texas and the Savings and Loan crisis:

The cleanup from that crisis cost taxpayers about $125 billion (pdf), back when that was real money. As best I can tell, around 60 percent of the losses were in Texas (pdf). So that’s around $75 billion in aid — not loans, outright transfer.

Texas GDP was about $300 billion in 1987. So this was equivalent to giving — not lending, not even taking an equity stake — Spain 25 percent of its GDP to bail out its banks.

And in the US it wasn’t even treated as an interstate political issue.

Also, see his Florida example:

So as I read it, between falling tax payments without any corresponding fall in federal benefits, plus safety-net aid — not counting Medicaid, which would make the number even bigger — Florida received what amounted to an annual transfer from Washington of $31 billion plus, or more than 4 percent of state GDP. That’s a transfer, not a loan. And it’s very big.

These are examples of how assymetric shocks are cushioned within a fiscal union.  Transfers, not loans.  For the Eurozone to be successful, they need this kind of fiscal infrastructure.  Unfortunately, I think they are light-years away from such a union, and what they think is a fiscal union - strict deficit limits - is something very different, a union that as Koo says will make conditions worse, not better.  One of the many reasons I remain a Euroskeptic.

Wednesday, June 20, 2012

Fed Watch: Where to Next?

Tim Duy yet again (which is good since I'm having severe connectivity issues):

Where to Next?, by Tim Duy: This will be my final FOMC post-mortem. At least I hope so. I remain as frustrated at the outcome of this meeting as in the run-up to the meeting. Reviewing what I already wrote as well as comments across the web leaves me with this:

  1. The general argument that supported expectations of QE3 was broadly correct. The basis of this argument was a deterioration in the forecast matched with moderating inflation data and increasing downside risks. A solid argument in light of speeches by Vice Chair Janet Yellen and San Francisco President John WIlliams. And this line of thought was consistent with the Fed's actual projections. The Fed, however, did not follow through on their own projections, which is frustrating. It strikes me as a sloppy communications strategy.
  2. The Fed wants to see more data before making another move. This seemed to be evident in Bernanke's press conference. I suspected this might be the case, but am surprised that while they are sufficiently uncertain of the data to forestall QE, they were certain enough to mark down theirforecasts.
  3. The labor market remains a critical indicator. It is clear from the final sentence that sustained progress in labor market conditions would prevent additional easing, and vice versa. At least this seems clear - arguably, by this metric the Fed would already embraced QE3. Again, they want more data. The possibility that seasonal adjustment issues are at play in the data weighs heavily on their minds.
  4. The Fed is very uncertain about the impacts of additional QE. This uncertainty is probably the most significant impediment to additional easing. It is really the only explanation for Bernanke's hesitation to do more now; clearly the forecast justifies additional action as it indicates the Fed does not expect to meet either its employment or inflation mandates.
  5. The form of additional easing remains uncertain. Like other officials, Bernanke did not close the door on additional asset purchases. I noted earlier, however, that the statement no longersingles out balance sheet operations as the next tool. Arguably, this change was simply necessary to eliminate the "composition" of the balance sheet option, as the Fed's ability to change the composition via twisting will expire at the end of the year. That said, they could still change the composition by shifting between Treasuries and mortgage assets, so the composition tools is not necessarily dead. Or they could be signalling an intention to use communications tools as an alternative to QE; Yellen has suggested this possibility.  My baseline scenario is that if additional easing is deemed necessary, asset purchases will be the likely option. Still, I think it is worth being on the look-out for other options.

Bottom Line: It is as if at each meeting Federal Reserve Chairman Ben Bernanke moves half-way again to additional easing, but never seems to get there. It is one of those philosophical problems. Maybe next time he will make it. If the employment data falters. And he believes the data. And he believe that QE will be effective. And if a blessing of unicorns marches down Constitution Avenue.

Fed Watch: This Is Just Sad

Tim Duy once again:

This Is Just Sad, by Tim Duy: The FOMC just released their statement, dashing hopes for QE3. We are still waiting on the press conference, but some quick thoughts. First, the Fed does not appear to be particularly worried by recent weak data:

Information received since the Federal Open Market Committee met in April suggests that the economy has been expanding moderately this year. However, growth in employment has slowed in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending appears to be rising at a somewhat slower pace than earlier in the year. Despite some signs of improvement, the housing sector remains depressed. Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.

I suspect that the weak tone to recent data was countered by the relatively solid anecdotal tone of the Beige Book. They do not appear to have marked down their forecasts as substantially as many believed. Also, they may want additional data to confirm any recent weakness.

Second, they continue to state the case for more easing:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

Yet, despite making a clear case for aggressive policy, they still don't follow it to its logical conclusion. This is indeed maddening and is the primary reason market participants expect sizable QE is coming. The FOMC sets ups the justification for easing meeting after meeting, and then simply does not deliver.

Third, consider the final line:

The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

Now compare it to April:

The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.

In April they specifically pointed to the balance sheet as the tool of choice. Now they just promise further action. Sounds like they intentionally want to take the focus off the balance sheet. This could be a very important signal about the direction of future policy. Do they view further QE as largely ineffective given low interest rates and constrained credit channels, and now reserve its use for only the most dire circumstances? If not the balance sheet, then what? Communication? Perhaps I am reading too much into this line, but it seems to be a significant change. I sure hope some reporter asks about this line at the press conference. Hint, hint.

Finally, we still have a dissenter, Richmond Federal Reserve President Jeffrey Lacker. The tone of the data was insufficient to change his mind that Operation Twist should end as scheduled.

Bottom Line: Internally at the Fed, the risk/reward trade off still does not favor additional QE.

Fed Watch: Twist It Is

Tim Duy:

Twist It Is, by Tim Duy: The FOMC just released their statement, dashing hopes for QE3. We are still waiting on the press conference, but some quick thoughts. First, the Fed does not appear to be particularly worried by recent weak data:

Information received since the Federal Open Market Committee met in April suggests that the economy has been expanding moderately this year. However, growth in employment has slowed in recent months, and the unemployment rate remains elevated. Business fixed investment has continued to advance. Household spending appears to be rising at a somewhat slower pace than earlier in the year. Despite some signs of improvement, the housing sector remains depressed. Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.

I suspect that the weak tone to recent data was countered by the relatively solid anecdotal tone of the Beige Book. They do not appear to have marked down their forecasts as substantially as many believed. Also, they may want additional data to confirm any recent weakness.

Second, they continue to state the case for more easing:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

Yet, despite making a clear case for aggressive policy, they still don't follow it to its logical conclusion. This is indeed maddening and is the primary reason market participants expect sizable QE is coming. The FOMC sets ups the justification for easing meeting after meeting, and then simply does not deliver.

Third, consider the final line:

The Committee is prepared to take further action as appropriate to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

Now compare it to April:

The Committee will regularly review the size and composition of its securities holdings and is prepared to adjust those holdings as appropriate to promote a stronger economic recovery in a context of price stability.

In April they specifically pointed to the balance sheet as the tool of choice. Now they just promise further action. Sounds like they intentionally want to take the focus off the balance sheet. This could be a very important signal about the direction of future policy. Do they view further QE as largely ineffective given low interest rates and constrained credit channels, and now reserve its use for only the most dire circumstances? If not the balance sheet, then what? Communication? Perhaps I am reading too much into this line, but it seems to be a significant change. I sure hope some reporter asks about this line at the press conference. Hint, hint.

Finally, we still have a dissenter, Richmond Federal Reserve President Jeffrey Lacker. The tone of the data was insufficient to change his mind that Operation Twist should end as scheduled.

Bottom Line: Internally at the Fed, the risk/reward trade off still does not favor additional QE.

Tuesday, June 19, 2012

Fed Watch: Two Days Until the Fog Lifts

Tim Duy:

Two Days Until the Fog Lifts, by Tim Duy: Some additional stories to consider as await the outcome of this week's Fed meeting. First, tonight's Jon Hilsenrath WSJ article detailing the Fed's concern about the credit divide:

The housing bust left behind millions of people with credit records damaged by plunging home prices, lost jobs, past overspending or bad luck. Many are now walled off from the low interest rates engineered by the Federal Reserve to spur the economy and remedy the aftereffects of the borrowing boom...

...Shrunken access among credit have-nots is triggering more than personal plight. It has weakened the influence of the Fed—one of the best hopes for spurring stronger economic growth—and raised doubts within the central bank about whether it is doing much to reduce unemployment...

That underwriting conditions have tightened dramatically is not exactly a new story - as Hilsenrath writes, the Fed released a report urging Congress to take action to ease credit conditions in mortgage markets. What is interesting is the timing, coming just two days ahead of what is likely to be a somewhat contentious FOMC meeting. The underlying context of the story is that if credit market channels are clogged, additional action on the part of the Federal Reserve will have little impact. Consider this in terms of the risk/reward trade off that Fed official like to cite when discussing options for additional easing. They may be hesitant of taking the risk that all they get from additional easing is criticism from lawmakers - and no shortage of it during an election year - in return for very little benefit.

The article also highlights the Fed's fetish with low interest rates. They should forget about trying to keep interest rates low, and instead enact policies that support enough growth such that interest rates begin to rise. This is of course how policy is supposed to operate - long-term rates rise as market participants believe the Fed will need to raise short term rates in response to real inflationary pressures, not just the phantom ones in the minds of a subset of monetary policymakers.

With that in mind, Zero Hedge posts Goldman Sachs' FOMC preview Q&A. Goldman is expecting a new round of QE, largely on the expectation that the Fed will significantly mark down its economic forecast as well as feel a need to respond to the European crisis (in effect, doing the job the ECB has abdicated). This is a greater policy response than the more generally expected extension of Operation Twist, but also a completely reasonable expectation given the some of the Fedspeak we have heard. Goldman, however, suggests the Fed might go one step further:

If it is specified as a "stock" of purchases, we would expect a similar size as in past programs, i.e. $400bn-$600bn over 6-9 months. However, it is also possible that the program would be specified as a "flow" of purchases of perhaps $50bn-$75bn per month.

I believe the emphasis was added by Zero Hedge. Given that the Fed has repeatedly emphasized that it is the stock of holdings, not the flow, that is important, this would represent a major policy shift. The Fed would be finally utilizing the expectations channel, effectively promising to hold policy steady rather than promising a discrete end date.

While I would greatly welcome open-ended QE, it seems like a pretty big leap for a central bank that just a few weeks ago was expected to hold policy constant. Moreover, I am hard-pressed to say that economic or financial conditions have deteriorated such that the Fed would shift gears so quickly. This doesn't feel like 2008. I am not even sure it feels like last fall when the Fed embarked on Operation Twist. That said, the Fed might suspect, or know, that Europe is going down the tubes on the back of some let's just say some questionable economic policy making. Better to get ahead of that curve. Well ahead.

Bottom Line: More grist to chew on as the Fed's two-day meeting begins, with one take away that the Fed might opt to do less than expected, and another much more.

Fed Watch: The Monday After

Tim Duy (I missed this one yesterday):

The Monday After, by Tim Duy: Today is the first day after the "crucial" Greek vote. Except that vote was probably not all that crucial. Nothing fundamental has changed in Europe over the weekend. At best, all that has been accomplished is pushing out the end-game once again.

The Financial Times reports that Greece is on the verge of forming a government:

Antonis Samaras, leader of Greece’s New Democracy, began talks to form a coalition government on Monday following his party’s failure to secure an outright majority in the country’s election.

If Europe thought this would be the end of the story on the last bailout, think again:

Mr Samaras told reporters after his meeting with Mr Tsipras that he would invite all pro-European parties to join a coalition government.

He also restated his determination to seek “alterations” to the bailout by renegotiating the terms with Greece’s creditors.

Bloomberg reports that German Chancellor Angela Merkel just says "nein" to such bluster:

German Chancellor Angela Merkel said Greece shouldn’t be granted leeway on terms for its bailout, rejecting signals from her foreign minister that creditors may relent on austerity measures...

...“The important thing is that the new government sticks with the commitments that have been made,” Merkel told reporters at the G-20 meeting in the Mexican resort of Los Cabos. “There can be no loosening on the reform steps.”

Yes, another showdown is certain. Merkel will give up only the slightest sliver of ground, almost ensuring the Greek economy remains locked in a never ending cycle of austerity. And according to rumor this is exactly why Alexis Tsipras, the leader of Syriza, has no interest in joining with New Democracy in a coalition government, instead leaving the inevitable failure of this next bailout on the shoulders of his opponents.

And while the world learns about Greek politics, the real story is Spain. Clearly, market participants saw nothing good in the Greek results for the trajectory of Spain's problems. Yields on 10-year debt surged solidly above 7% today:


Of course, if European policymakers expected a pro-Euro Greek outcome to bring relief to Spain and Italy (now above 6%), they were sure to be disappointed. Hopes for a firewall around Greece are so 2011. The fire has already jumped that line, and it looks as if Europe has yet to send any firefighters to battle the blaze. Meanwhile, the only institution that can move quickly remains committed to standing on the sidelines. To be sure, ECB President Mario Draghi signalled that the ECB has room to move, but he did not signal the timing. For the sake of the Spanish people, it really needs to be sooner than later.

Bottom Line: This Monday feels like all the others. The latest Greek vote is behind us, but the the dysfunctional political and economic system that is Europe remains.

Friday, June 15, 2012

Fed Watch: ECB Ready to Play?

Tim Duy:

ECB Ready to Play?, by Tim Duy: Draghi blinks. After dropping the ball and holding rates steady at the last meeting, ECB President Mario Draghi is signaling he is ready to get back into the game. Via Reuters:

The euro zone economy faces serious risks and no inflation threat, European Central Bank President Mario Draghi said on Friday in comments that heightened expectations the ECB could cut interest rates or take other policy action soon.

Draghi also said the ECB stood ready to provide further liquidity to solvent banks, stressing that its provision of ultra-cheap 3-year funds, or LTROs, late in 2011 and early this year had averted a major credit crunch...

...There are serious downside risks here," Draghi told the annual ECB Watchers conference in Frankfurt. "This risk has to do mostly with the heightened uncertainty."

I am not so sure about this "heightened uncertainty" line. It seems pretty certain that Spain is in trouble if rates hold at these levels or head higher, and this is the immediate problem. Draghi might have in mind bringing down rates with another stab at the temporary solution the LTROs provided last year. Helpful, but still only temporary. It would be more helpful if he switched gears to outright quantitative easing via government bond purchases (oddly, though, the expectation is that the Federal Reserve will do more than Europe in response to a European problem).

What would be most helpful is a clear signal that the ECB will not let the Eurozone collapse because default fears are driving unpleasant dynamics. Consider this helpful chart from Frances Woolley:


Woolley comments:

The convergence of bond yields after the Euro was introduced reveals that the pre-Euro yield differences were almost entirely based on inflation and exchange rate risk. No one ever seriously considered the possibility that an EU country might not be able to repay its debt. That's what they were thinking...

Prior to the introduction of the Euro, the presence of independent central banks prepared to serve as a lender of last resort for the fiscal authorities meant that there was no serious default risk. There would, of course, be inflation (soft-default) and exchange rate risk, but no hard-default risk. You can't really default when you can print the currency in which your debt is denominated. After Lehman, though, the possibility of default appears, and the ECB does nothing to dispel such fears. Moreover, the Greek debt restructurings dispelled any remaining doubts about European sovereign debt - the lack of a central bank backstops means serious default risk.

So now we can't rule out a possibility of Spanish default, which drives interest rates higher, which in turn increases the probability of default. This of course then feeds into the dynamics for Italy, and then maybe France. The only entity that can break the cycle is the ECB, but they have been so far unwilling to do so, putting the pressure on fiscal authorities to break the cycle. Unfortunately, the job is simply too big and complicated for the fiscal authorities to complete in a timely fashion, especially when running Merkel's race against the markets.

What we really need is a European Central Bank that can manage exchange rate and inflation risk while also addressing default risk. Without such a fully functional central bank, Europe will at best limp along under constant economic distress. Ultimately, Draghi will need to create such a central bank before the fiscal plumbing is in place if he wants to hold the Eurozone together. Which is why he will always blink first.

Or at least I hope he will.

Fed Watch: Communications Failure

Another one from Tim Duy:

Communications Failure, by Tim Duy: Reading Cardiff Garcia's preview of next week's Fed meeting, I was struck by this chart from Nomura:


The extensive discussion of options with arguments for and against reminded me of the fog that hangs over this next meeting.  We really have no idea what the Fed is going to do or why they are going to do it.  Reasonable analysis ranges from nothing to massive quantitative easing. 
To be sure, I am certain of some things.  For example, that swap lines will be expanded in the event of a severe market disruption. I am stunned that this was actually considered new information yesterday - it seems that actions along these lines is a no-brainer.  But absent the all-bets-are-off-financial-collapse story, I am a bit shaken by the uncertainty going into this meeting.
This strikes me as a major communications failure on the part of the Federal Reserve.  The problem, I suspect, is that they don't know exactly what they would do if more easing is called for, which is why we  see talk of all possible options - doing nothing, extending Operation Twist, communication changes, and additional assets purchases.  They can't tell us what they don't know.
I worry that the Federal Reserve has spent much more intellectual effort on procedures to tighten policy, and not enough effort on additional easing policy.  Indeed, easing has really been on an ad-hoc basis.  Moreover, we don't really know the triggers for additional easing because officials repeatedly refer to the risk/reward trade off, suggesting that they think the rewards are relatively small at this point, which suggests that the bar must be very high.  But many policymakers seem to have a hair trigger for additional easing, so which is it?  It the bar high or low?  Judging by Federal Reserve Chairman Ben Bernanke's past behavior, I tend to think the bar is pretty high.  Perhaps this is just my pessimism talking.
It would be very helpful if at the next FOMC meeting policymakers could agree to a specific path for additional easing, if needed, and eliminate the ad-hoc approach.  In other words, put as much effort toward explaining how they would move forward as put toward how they would move back.

Thursday, June 14, 2012

"Inflation Targeting is Dead"

Jeff Frankel takes up the question of inflation targeting versus nominal GDP targeting, and concludes that nominal GDP targeting has many advantages:

Nominal GDP Targeting Could Take the Place of Inflation Targeting, by Jeff Frankel: In my preceding blogpost, I argued that the developments of the last five years have sharply pointed up the limitations of Inflation Targeting (IT)...   But if IT is dead, what is to take its place as an intermediate target that central banks can use to anchor expectations?
The leading candidate to take the position of preferred nominal anchor is probably Nominal GDP Targeting.  It has gained popularity rather suddenly, over the last year.  But the idea is not new.  It had been a candidate to succeed money targeting in the 1980s, because it did not share the latter’s vulnerability to shifts in money demand.  Under certain conditions, it dominates not only a money target (due to velocity shocks) but also an exchange rate target  (if exchange rate shocks are large) and a price level target (if supply shocks are large).   First proposed by James Meade (1978), it attracted the interest in the 1980s of such eminent economists as Jim Tobin (1983), Charlie Bean (1983), Bob Gordon (1985), Ken West (1986), Martin Feldstein & Jim Stock (1994), Bob Hall & Greg Mankiw (1994), Ben McCallum (1987, 1999), and others.
Nominal GDP targeting was not adopted by any country in the 1980s.  Amazingly, the founders of the European Central Bank in the 1990s never even considered it on their list of possible anchors for euro monetary policy.  ...
But now nominal GDP targeting is back, thanks to enthusiastic blogging by Scott Sumner (at Money Illusion), Lars Christensen (at Market Monetarist), David Beckworth (at Macromarket Musings), Marcus Nunes (at Historinhas) and others.  Indeed, the Economist has held up the successful revival of this idea as an example of the benefits to society of the blogosphere.  Economists at Goldman Sachs have also come out in favor. 
Fans of nominal GDP targeting point out that it would not, like Inflation Targeting, have the problem of excessive tightening in response to adverse supply shocks. ...
In the long term, the advantage of a regime that targets nominal GDP is that it is more robust with respect to shocks than the competitors (gold standard, money target, exchange rate target, or CPI target).   But why has it suddenly gained popularity at this point in history...?  Nominal GDP targeting might also have another advantage in the current unfortunate economic situation that afflicts much of the world:  Its proponents see it as a way of achieving a monetary expansion that is much-needed at the current juncture.
Monetary easing in advanced countries since 2008, though strong, has not been strong enough to bring unemployment down rapidly nor to restore output to potential.  It is hard to get the real interest rate down when the nominal interest rate is already close to zero. This has led some, such as Olivier Blanchard and Paul Krugman, to recommend that central banks announce a higher inflation target: 4 or 5 per cent.  ...  But most economists, and an even higher percentage of central bankers, are loath to give up the anchoring of expected inflation at 2 per cent which they fought so long and hard to achieve in the 1980s and 1990s.  Of course one could declare that the shift from a 2 % target to 4 % would be temporary.  But it is hard to deny that this would damage the long-run credibility of the sacrosanct 2% number.   An attraction of nominal GDP targeting is that one could set a target for nominal GDP that constituted 4 or 5% increase over the coming year - which for a country teetering on the fence between recovery and recession would in effect supply as much monetary ease as a 4% inflation target - and yet one would not be giving up the hard-won emphasis on 2% inflation as the long-run anchor.
Thus nominal GDP targeting could help address our current problems as well as a durable monetary regime for the future.

It's hard to figure out how to fix the world if you don't have a reliable model that can explain what went wrong. The optimal money rule in a model depends upon the the way in which changes in monetary policy are transmitted to the real economy. Is it because of price rigidities? Wage rigidities? Information problems? Credit frictions and rationing? The best response to a negative shock to the economy varies depending upon what type of model the investigator is using.

Thus, for the moment we need robust rules. Inflation targeting works well in models with Calvo type price-rigidities, and a Taylor type rule often emerges from models in this general class, but is this the most robust rule in the face of model uncertainty? We don't know the true model of the macroeconomy, that ought to be clear at this point. Does inflation targeting work well when the underlying problem is a breakdown in financial intermediation or other big problems in the financial sector? I'm not at all convinced that it does - some of the best remedies in this case involve abandoning a strict adherence to an inflation target in the short-run.

So, in the best of all worlds I'd prefer to have a model of the economy that works, find the optimal policy rule for that model, and then execute it. In the world we live in, I want robust rules -- rules that work well in a variety of models and in the face of a variety of different types of shocks (or at least recognize that the rule has to change when the source of the problem switches from, say, price rigidities to a breakdown in financial intermediation). One message that comes out of the description of NGDP targeting above is that this approach does appear to be more robust than inflation targeting. It's not always better, in some models a standard Taylor type rule is the best that can be done. But it's becoming harder and harder to believe that the Great Recession can be adequately described by models of this type, and hence hard to believe that we are well served by policy rules that assume price rigidities are the main source of economic fluctuations.

Fed Watch: Devil's Advocate

Tim Duy:

Devil's Advocate, by Tim Duy: Expectations are building for Federal Reserve action next week. Bloomberg hits on a key point:

Chairman Ben S. Bernanke told lawmakers last week the “central question” confronting the Federal Reserve at its next meeting is whether growth is fast enough to make “material progress” reducing unemployment.

The answer may well be no...

...“They’re not closing that employment gap as fast as they’d like, so I suspect it adds up to more action to get things moving again,” said Michael Feroli, chief U.S. economist at New York-based JPMorgan Chase & Co. and a former researcher for the Federal Reserve Board in Washington. “Bernanke has a clear economic mandate, and we’re still far from achieving it.”

I think there are two issues at play, the forecast itself and the risk to that forecast. On the first point, I am not convinced that incoming data have proved sufficient to measurably change the forecast. On the key jobs issue, I keep getting pulled back to this from Bernanke's testimony:

This apparent slowing in the labor market may have been exaggerated by issues related to seasonal adjustment and the unusually warm weather this past winter. But it may also be the case that the larger gains seen late last year and early this year were associated with some catch-up in hiring on the part of employers who had pared their workforces aggressively during and just after the recession. If so, the deceleration in employment in recent months may indicate that this catch-up has largely been completed, and, consequently, that more-rapid gains in economic activity will be required to achieve significant further improvement in labor market conditions.

I sense a great deal of uncertainty in the paragraph, suggesting to me that Bernanke would like to see more data before committing to a new policy path. Of course, one could point to the weak tenor of the most recent string of initial claims reports as additional evidence of a flagging job market:


That said, I am still hard-pressed to see that this is sufficient to believe the steady downtrend in claims has been disrupted:


There is also the general sense that softer inflation numbers give the Fed room to act, particularly with headline CPI inflation now down below 2% year-over-year:


On this point I would caution that the downward move in headline has yet to be confirmed by core. This should be a symmetric game. Just as core inflation never rose fast enough to justify concerns about headline inflation, sticky core inflation in the face of declining headline inflation would signal to the Federal Reserve that they should not yet reduce their inflation forecasts.

I would also add that the anecdotal evidence is less dire, to say the least. The most recent Beige book:

Reports from the twelve Federal Reserve Districts suggest overall economic activity expanded at a moderate pace during the reporting period from early April to late May. ...

Manufacturing continued to expand in most Districts. Consumer spending was unchanged or up modestly. New vehicle sales remained strong and inventories of some popular models were tight. Sales of used automobiles held steady. Travel and tourism expanded, boosted by both the business and leisure segments. Demand for nonfinancial services was generally stable to slightly higher since the last report, and several Districts noted strong growth in information technology services. Conditions in residential and commercial real estate improved. Construction picked up in many areas of the country. Lenders in most Districts noted an improvement in loan demand and credit conditions. Agricultural conditions generally improved, and spring planting was well ahead of its normal pace in most reporting Districts. Energy production and exploration continued to expand, except for coal producers who noted a slight slowing in activity.

Wage pressures overall were modest. Hiring was steady or increased slightly, and contacts in a number of Districts reported difficulties in finding qualified workers, particularly those with specialized skills. Price inflation remained modest across Districts, and overall cost pressures eased as the price of energy inputs declined. Economic outlooks remain positive, but contacts were slightly more guarded in their optimism.

Confirming that relatively upbeat view is this from Bloomberg:

Rising truck shipments show the U.S. economic expansion is intact, even amid concerns that a slowdown in retail sales and Europe’s sovereign-debt crisis could stall growth.

Two measures of trucking activity signal the industry remains steady and has even “firmed up” since mid-May, according to Ben Hartford, an analyst in Milwaukee with Robert W. Baird & Co. The data complement anecdotal information from carriers that freight demand ended May on a strong note after more weakness than anticipated earlier in the month, he said.

“Trucking trends are reflective of an economic environment that is stable, not deteriorating,” Hartford said.

To me, the upshot is that the data flow over the past two years has been sloppy, possibly a reflection seasonal adjustment issues, leaving the general rule of avoiding excessive optimism and excessive pessimism as the best bet. That rule argues for a relatively limited changes to the Fed's forecast.

If the Fed follows the above line of thinking, they will hold steady next week. In other words, there is a nontrivial risk that financial market participants are getting ahead of the Fed. That said, even if the forecast does not change materially, it seems pretty clear that the risks to the downside have increased. Indeed, the ECB is working overtime to ensure the risks remain to the downside. This argues for additional action, especially with a block of Fed officials - including Vice-Chair Janet Yellen, San Francisco Federal Reserve President John Williams, and Chicago Federal Reserve President Charles Evans - who likely already desired more easing under the most recent forecast.

Bottom Line: I think you can tell a story that the most recent data is not sufficient to move Fed forecasts, in which case it remains possible that the Fed does not implement any changes next week. I have to admit to being a little nervous that we get a Fed "leak" over the next few days in an effort to reset expectations ahead of the meeting. Still, given the increased downside risks to the forecast, it is hard for me to make this my baseline scenario, especially given the very dovish Yellen/Williams/Evan contingent, which is why I expect some action next week. But much still rests on Bernanke, who has surprised by positioning himself to the hawkish side of the center. After all, if he believed the Yellen/Williams/Evans stories, he would have eased already. He hasn't, suggesting that he has a pretty high bar to additional easing, and we just might not have crossed that bar.

Wednesday, June 13, 2012

Easing by the Fed Seems Likely, But What Form Will it Take?

Just a quick note to reinforce what Tim Duy said here. Many policymakers at the Fed would like to provide more help for the economy, but fear of inflation among other members of the monetary policy committee -- enough to matter -- makes it unlikely that the Fed will expand the size of its balance sheet (as another round of QE would do). The way around this is to enact or suggest policies such as "forward guidance," "Operation Twist," and "sterilization" that attempt to ease policy without changing the size of the balance sheet. Forward guidance, for example, tries to adjust inflationary expectations -- there is an implicit promise of future action to maintain low rates, but it does not require any action when it is announced (and Fed members are denying it was an explicit promise in any case), while Operation twist and sterilization both exchange short-term for long-term assets (sell short-term, purchase long-term) in an attempt to force long-term interest rates even lower than they already are (and hopefully stimulate investment and the consumption of durables).

If the Fed is inclined to ease more, its instinct will be to look at these types of policies first, policies that try to help the economy without increasing the risk of inflation. But as we've seen recently, these types of policies are also limited in their effectiveness precisely because of their cautious nature.

Of course, if Europe falls apart, all bets are off -- in that case the Fed may get more aggressive. But for now I expect the Fed to continue to try to find clever ways of doing something without really doing anything at all.

Fed Watch: Is Anyone Answering the Phones at the ECB?

Tim Duy:

Is Anyone Answering the Phones at the ECB?, by Tim Duy: As of today, the Spanish bank bailout remains a phenomenal policy failure. Spanish bond yields continue to rise, with the impact of the ECB's LTRO operations now effectively negated:


Worse, this policy disaster extends now into Italy, with short term debt now taking a hit:

The Rome-based Treasury sold the one-year bills at 3.972 percent, 1.63 percentage points more than the 2.34 percent at the previous auction on May 11. Investors bid for 1.73 times the amount offered, down from 1.79 times last month.

And long-term yields in Italy are heading higher as well:


The only player left on the field that can move fast enough and with enough firepower to pull Europe back from the brink is the ECB, and the pressure is on them to act. From Bloomberg:

Spanish Prime Minister Mariano Rajoy said today he’ll “battle” central bankers refusing to buy debt from peripheral nations. Rajoy published a letter to European Union leaders calling for the European Central Bank to buy debt from the countries struggling to shore up their finances.

“That is the battle we have to wage in Europe,” Rajoy told the Spanish parliament in Madrid today. “I am waging it.” His Italian counterpart, Mario Monti, told lawmakers in Rome Europe faces a “crucial” moment.

The leaders of southern Europe’s biggest economies went on the offensive as bond yields jumped following the announcement of a bailout for Spanish banks that was intended to quell concern over the countries’ finances. The decline wiped out the effects of 1 trillion euros in ECB loans for euro-region banks that had held yields in check since December.

Truly desperate pleas, but will they fall on deaf ears? For their part, the ECB seems content build upon the policy inaction at the last policy meeting and continue to do nothing:

Bundesbank board member Andreas Dombret this week said the ECB won’t buy more government bonds to ease the market tensions while Swedish central bank governor Stefan Ingves today said it’s hard to see what else the ECB could do for Spanish lenders.

“We have done our part,” Dombret said in a June 11 interview in London. “Now it’s up to the political leaders to deliver on the fiscal and structural policy side.”

It is never a good sign when the monetary authority - the lender of last resort - is no longer willing to buy your bonds. If the ECB sees only risk at these rates, why should private investors jump into the pool?

Honestly, I find it incomprehensible to believe that the ECB will not soon come to the aid of Spain and Italy with additional bond purchases. Only the most irresponsible policy body would take such a risk. To not do so almost guarantees the destruction of the Eurozone and a deepening recession if not depression throughout Europe. They cannot possibly believe that fiscal and structural reforms will bear sufficient fruit in any reasonable time frame. Nor can they possibly believe that Spain and Italy can implement a IMF-type structural reform program in the absence of the competitive boost provided by currency devaluation.

Or can they? If they do believe these things - that they can do no more, the job is entirely on the shoulders of fiscal policymakers - then we all need to be afraid, very afraid. Because when the ECB fully abdicates its role as a provider of financial stability for the Eurozone, all Hell is going to break loose.

Fed Watch: Easing Seems Likely, But of What Form?

Tim Duy:

Easing Seems Likely, But of What Form?, by Tim Duy: The Federal Reserve meeting is bearing down upon us. We have witnessed a variety of Fed views across the spectrum over the past two weeks presenting a number of options: Continue Operation Twist, expand balance sheet operations, extend the forward guidance, other non-specified communication tools, or just plain do nothing. I would say on net the balance of talk leans toward some kind of action, although we do not know the intentions of Federal Reserve Chairman Ben Bernanke. There was no strong hint in his testimony last week. Given his revealed preferences over the past six months, I tend to believe that he is hesitant to undertake additional balance sheet operations at this time. I don't think he sees the appropriate risk/reward trade off for such an action. An extension of Operation Twist (limited though by the Fed's dwindling supply of short-term securities) seems to be a reasonable middle ground (I was probably a little pessimistic on this point last week), as it at least doesn't move policy backwards.

Last week, San Francisco Federal Reserve President John Williams presented a rather dour economic forecast:

Putting it all together, my forecast calls for real gross domestic product to expand at a moderate pace of about 2¼ percent this year and about 2½ percent next year. I expect the unemployment rate to remain at or a bit above 8 percent for the remainder of this year, and then gradually decline to a little above 7 percent by the end of 2014.

More important for policy is his view of the risks to that forecast:

However, the uncertainty around this forecast is great.

Notably, not only is the uncertainty great, he appears to believe that the vast majority is tail risk on the wrong side of his forecast. Europe featured prominently as a risk, with his conclusion:

Recurrent spikes in fear and uncertainty are followed by piecemeal actions that buy time. What hasn’t emerged is a credible, comprehensive solution to Europe’s problems.

The single biggest reason for the Fed to ease next week is the ongoing European turmoil. Reading between the lines, it seems clear that Williams - and I suspect this sentiment is pervasive on Constitution Ave. - believes the Europeans are generally clueless and institutionally incapable of resolving their crisis. If the Fed believes Europe is on the fast track to economic depression, the rational response is to act now to cushion the blow to the US.

Yesterday, Williams widened his scope:

While the global financial system is stronger than it was three years ago, it remains vulnerable. The European sovereign debt crisis threatens banks in that continent, and, by extension, elsewhere. Clearly, it represents a significant threat to financial stability. In the worst case, the European crisis could undermine the financial improvements in North America and Asia. But this crisis is by no means the only risk. Economic trends in many parts of the world appear to be deteriorating. Although growth in the United States remains moderate, Europe looks to be in recession. And, in China, recent indicators point to a marked deceleration in growth. Many large global financial institutions remain highly leveraged and rely on volatile wholesale funding. Others are still working through troubled loan portfolios. Efforts by regulators to close loopholes exposed by the crisis remain a work in progress. They will take years to complete.

In other words, the world has only deteriorated further in the last week. How should the Fed respond? Williams was a little cagey last week:

In sum, I see the Fed falling short on both our maximum employment and inflation mandates for some time. And the turmoil in Europe and government fiscal retrenchment in the United States raise the danger that the economy could perform worse than I expect. For these reasons, it’s crucial that we maintain our current highly stimulatory monetary policy stance. As part of this, we’ve stated our intention to keep our benchmark short-term interest rate at exceptionally low levels at least through late 2014.

We must also stand ready to do even more if needed to best achieve our statutory goals of maximum employment and price stability....

I find this irritating - Williams sees the Fed falling short of its mandate, with the risks all on the downside, yet his response is that we should just maintain existing policy? Apparently, we need things to get worse:

...If the outlook for growth worsens to the point that we no longer expect to make sustained progress on bringing the unemployment rate down to levels consistent with our dual mandate, or if the medium-term outlook for inflation falls significantly below our 2 percent target, then additional monetary accommodation would be warranted.

What I think is going on is that, left to his own devices, Williams would have eased already, and is certainly even more inclined to do so given the deteriorating economic environment in the last week alone. He is not willing to call for additional easing directly, however, as he doesn't want to risk contradicting the decision of the FOMC.

How should the Fed proceed? According to Williams:

In such circumstances, an effective tool would be further purchases of longer-maturity securities, potentially including agency mortgage-backed securities. Past purchases have succeeded in lowering borrowing costs and improving financial conditions, thereby supporting economic recovery.

I highlight this line because it differs slightly from what Yellen said last week:

If the Committee were to judge that the recovery is unlikely to proceed at a satisfactory pace (for example, that the forecast entails little or no improvement in the labor market over the next few years), or that the downside risks to the outlook had become sufficiently great, or that inflation appeared to be in danger of declining notably below its 2 percent objective, I am convinced that scope remains for the FOMC to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions.

Yellen includes forward guidance as a tool, although she later notes that:

...the effects of forward guidance are likely to be weaker the longer the horizon of the guidance, implying that it may be difficult to provide much more stimulus through this channel.

The communications tool could be an alternative to balance sheet tools at this next FOMC meeting. The same thought was reiterated yesterday by Atlanta Federal Reserve President Dennis Lockhart, although he is not in the easing camp just yet:

"I don't think any of the options should be taken off the table under the current circumstances. But I'm not convinced at this moment that the circumstances quite yet call for additional action," Lockhart told reporters.

He added that an adjustment to the way the U.S. central bank communicates, as opposed to asset purchases, is a possible easing tool if needed.

As an aside, Lockhart disappoints with this:

"It remains to be seen whether that picture holds, therefore it remains to be seen whether we might need further action to sustain that level of attractive interest rates for borrowers," Lockhart said of the ultra low yields.

"It does in some respects take the pressure off, to do something about financial conditions per se," he added.

He sees lower yields as an excuse not to act. The correct response is to see yields as a signal that they should act.

My instinct is that the Fed will want to take some action at the next meeting. As a baseline, consider this concluding remark from David Altig and John Robertson:

In such an environment, it is probably good to remember that standing pat with central bank asset purchases does not necessarily mean standing still with monetary policy.

Doing nothing is not an option. But I sense they will not be eager to expand the balance sheet. I am having trouble seeing Federal Reserve Chairman Ben Bernanke as wanting to pursue the latter option without what he feels is a compelling financial or economic reason. Perhaps I am too pessimistic on this point, but whenever I read the list of current FOMC voting members I see a group of people that well before today wanted to ease more or were willing to ease more if Bernanke has pushed in that direction. It's not the official "hawks," but "hawk-light" Bernanke that is the obstacle to additional asset purchases.

The Fed could opt for a communications only strategy. But of what form would the communication take? Optimally, I would be hopeful for the state-contingent approach that Chicago Federal Reserve President Charles Evans once again promoted today:

The Chicago Fed chief again lobbied for the central bank to take more aggressive steps to stimulate growth.

The Fed’s current policy is to keep the short-term federal-funds rate near zero at least through late 2014. Mr. Evans favors “improved forward guidance” for conditions that would warrant a funds rate increase. He would like to see the Fed specify that it won’t raise the rate until the U.S. unemployment rate falls below 7%, or if inflation rises above 3%, which is above the Fed’s 2% inflation target.

A 7% jobless rate is still too high, “but it’s in the right direction,” Mr. Evans said.

A clearer policy about the Fed’s “forward intentions” for the funds rate would eliminate some of the uncertainty among hesitant entrepreneurs, he added.

The challenge I see is that I can't imagine Bernanke willing to accept inflation up to 3%. I just don't see it happening. I don't think the Fed is ready to provide guidance dependent on economic outcomes, and certainly not anything that contradicts their newly minted statement committing to a 2% inflation target.

Excluding the Evans approach, what is left? Extending the horizon of the period of low rates, which Yellen suggests is not particularly effective? Moreover, I am not sure they have enough clarity on the economic outlook to extend the horizon on exceptionally low rates, which just proves how unwieldy this tool really is. It would be so much easier to set up macroeconomic targets that would trigger a rate hike rather than an arbitrary time frame. Possibly just a sternly worded easing bias given the prevalence of downside risks? I do worry that the latter is all we will get next week.

Bottom Line: The Fed is running out of room to maneuver in the absence of expanding the balance sheet further. And I don't see that Bernanke wants to take that road in the absence of a more significant downturn in the economy. They can continue Operation Twist, but they have limited room on that front given the dwindling supply of short-term assets. Some sort of communication tool is also on the table. Absolutely nothing is not really on the table. So my expectations at this point, in order of likelihood are: 1.) Continue Operation Twist , 2.) communicate a clear easing bias with a hair-trigger, 3.) combine communication with continuing Operation Twist, making is clear that if conditions deteriorate further, Operation Twist will be converted to outright asset purchases when the scope for twisting ends, or 4.) additional asset purchases.

Sorry for the long post; this is a tough nut to crack. Too many options; this was easier when it was all about 25bp.

Monday, June 11, 2012

Paul Krugman: Another Bank Bailout

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

Another Bank Bailout, by Paul Krugman, Commentary, NY Times: Oh, wow — another bank bailout, this time in Spain. Who could have predicted that?
The answer, of course, is everybody. In fact, the whole story is starting to feel like a comedy routine: yet again the economy slides, unemployment soars, banks get into trouble, governments rush to the rescue — but somehow it’s only the banks that get rescued, not the unemployed.
Just to be clear, Spanish banks did indeed need a bailout. ... What’s striking, however, is that even as European leaders were putting together this rescue, they were signaling strongly that they have no intention of changing the policies that have left almost a quarter of Spain’s workers — and more than half its young people — jobless.
Most notably, last week the European Central Bank declined to cut interest rates. This decision was widely expected, but that shouldn’t blind us to the fact that it was deeply bizarre. Unemployment in the euro area has soared, and all indications are that the Continent is entering a new recession. Meanwhile, inflation is slowing, and market expectations of future inflation have plunged. By any of the usual rules of monetary policy, the situation calls for aggressive rate cuts. But the central bank won’t move.
And that doesn’t even take into account the growing risk of a euro crackup. ...
Put all of this together and you get a picture of a European policy elite always ready to spring into action to defend the banks, but otherwise completely unwilling to admit that its policies are failing the people the economy is supposed to serve.
Still, are we much better? America’s near-term outlook isn’t quite as dire as Europe’s, but the Federal Reserve’s own forecasts predict low inflation and very high unemployment for years to come — precisely the conditions under which the Fed should be leaping into action to boost the economy. But the Fed won’t move.
What explains this trans-Atlantic paralysis in the face of an ongoing human and economic disaster? Politics is surely part of it — whatever they may say, Fed officials are clearly intimidated by warnings that any expansionary policy will be seen as coming to the rescue of President Obama. So, too, is a mentality that sees economic pain as somehow redeeming, a mentality that a British journalist once dubbed “sado-monetarism.”
Whatever the deep roots of this paralysis, it’s becoming increasingly clear that it will take utter catastrophe to get any real policy action that goes beyond bank bailouts. But don’t despair: at the rate things are going, especially in Europe, utter catastrophe may be just around the corner.

Sunday, June 10, 2012

"Christina Romer Calls for the Fed to Do More. Much More"

Christina Romer via Brad DeLong:

It’s the Fed’s Time to Step Up: The argument for additional monetary action is straightforward. By law, the Fed is supposed to aim for maximum employment and stable prices. But the unemployment rate is 8.2 percent — a good two percentage points above what even the most pessimistic members say is its sustainable level. Moreover, the spate of disappointing data and the deepening crisis in Europe make continued weakness all too likely….

Some Fed members contend that monetary policy has already done its share…. Both the Fed’s chairman and its vice chairwoman have talked about the need for additional near-term fiscal stimulus as part of a gradual deficit-reduction plan. And many Fed committee members have called for a more aggressive housing policy…. I agree that we need more effective fiscal and housing policies. But neither is likely to happen… the Fed is the only plausible source of immediate help for the American economy. It was set up as an independent body precisely so that somebody can do what’s right when politicians can’t or won’t.

I find a related argument even more frustrating: that the Fed shouldn’t act because Congress wouldn’t like it and might retaliate…. But it also raises a key question: what are Fed policy makers saving their independence for? If rescuing millions of Americans from the torment of unemployment isn’t a reason to risk their independence, what is?

In 1958, when the Fed was taking an unpopular stand to fight inflation, a very wise Fed chairman, William McChesney Martin, said this: “If the System should lose its independence in the process of fighting for sound money, that would indeed be a great feather in its cap and ultimately its success would be great.” The current Fed chairman, Ben S. Bernanke, should add the phrase “and full employment”… and paste that line on his bathroom mirror….

Thursday, June 07, 2012

Bernanke's Disappointing Testimony

Two posts on Bernanke's testimony, one from me and one from Tim Duy. First, I posted this at CBS (the editors wanted this one to be more news than commentary, so I held back on saying how disappointed I was in the outcome -- but I did try to make it clear anyway, or at least hint in that direction -- Tim has this covered):

Ben Bernanke: No change in policy unless conditions deteriorate further, by Mark Thoma: Federal Reserve Chairman Ben Bernanke said today that the risks to the economy have increased, and the Fed is prepared to take action if conditions deteriorate. But in his testimony before the Congressional Joint Economic Committee there was no indication that the Fed is prepared to alter policy at this point.
Expectations that the Federal Reserve might ease policy were raised this week when three regional bank presidents, John Williams of San Francisco, Dennis Lockhart of Atlanta, and Eric Rosengren of Boston all seemed to indicate a willingness to consider further easing. Remarks by Federal reserve governor Janet Yellen also encouraged speculation that Bernanke might hint at a change in policy at the next monetary policy meeting.
But with Bernanke's testimony, expectations that the Fed will change course soon have been all but eliminated. Instead, the Fed will stay in "wait and see" mode on the belief that its policy stance is already highly accommodative, and further easing is only called for if the economy begins to show signs of weakening further, or turns downward. In particular, the Fed fears deflation above all else, and any sign that inflationary expectations are plunging would likely motivate the Fed to action.
But for now the Fed believes it has done enough despite that fact that a large number of economists outside the Fed are urging immediate action to help the recovery along, and more importantly to ensure against future problems in Europe or a spike in oil prices. There is lag between the time the Fed alters policy and when it affects the economy, and the wait and see approach is risky in that it can cause the Fed to end up behind the curve. Nevertheless, the Fed feels the risks of acting now, in particular the risk of inflation, trumps fears about present and future economic growth.
Chairman Bernanke also discussed fiscal policy in his testimony, and urged lawmakers to put the budget deficit on a long-run sustainable path without "unnecessarily impeding the current economic recovery." He cited the fiscal cliff as an immediate concern, and he is clearly worried about the impact on the economy if there is a large reduction in the federal deficit while the economy is struggling to recover. The Fed chief indicated they would very much appreciate help from lawmakers in the short-run, he mentions infrastructure spending frequently when discussing this topic, as well as in the long-run. Like most mainstream economists, he is calling for more stimulus in the short-run, or at least no reduction in what is already being done, and a plan for a sustainable long-run budget. Whether Congress can deliver or not is an open question, stimulus in the short-run is surely a long shot given the political gridlock that currently exists in Congress, and the long-run brings a high degree of uncertainty as well. But however this turns out, as Bernanke notes it will have consequences for monetary policy and the Fed would feel more confident in its own abilities with more support from Congress.
The main message from Bernanke's testimony is that while the Fed is aware that the risks to the economic outlook have increased, it is not yet convinced that current troubles are anything more than a bump in the road, and worries about the future are not enough to motivate action. That may change if conditions deteriorate, but like the Fed we will just have to "wait and see."

Next, Tim Duy:

Federal Reserve Chairman Ben Bernanke did not deliver another Jackson Hole speech in today's testimony to the Senate. Instead, he stuck to his usual style of delivering just the facts, or at least his version of the facts, and letting us pick apart the implications for monetary policy. On on critical issue, the jobs report, he takes both sides of the debate:

This apparent slowing in the labor market may have been exaggerated by issues related to seasonal adjustment and the unusually warm weather this past winter. But it may also be the case that the larger gains seen late last year and early this year were associated with some catch-up in hiring on the part of employers who had pared their workforces aggressively during and just after the recession. If so, the deceleration in employment in recent months may indicate that this catch-up has largely been completed, and, consequently, that more-rapid gains in economic activity will be required to achieve significant further improvement in labor market conditions.

On net, I think Bernanke would like to see more data before he committed to further easing, which would push additional action into later this summer or early fall. The near-term path of fiscal policy is also weighing on his mind:

Another factor likely to weigh on the U.S. recovery is the drag being exerted by fiscal policy. Reflecting ongoing budgetary pressures, real spending by state and local governments has continued to decline. Real federal government spending has also declined, on net, since the third quarter of last year, and the future course of federal fiscal policies remains quite uncertain, as I will discuss shortly

He later covers much of the previous ground on fiscal spending - maintain short-run stimulus while defining a path to longer-term consolidation. Overall, though, the fiscal cliff is also an issue that does not need immediate attention.

As an aside, note that Bernanke's repeated warnings about the fiscal cliff imply something interesting about his views on the limits to monetary policy. Specifically, he does not think the Federal Reserve can offset entirely the negative impact of the cliff. If the Fed could offset the impact, then why worry about it? After all, the fiscal cliff does put the federal budget back on a sustainable path. He should just embrace the cliff and let the Fed compensate with additional easing. That is, of course, unless he thinks the Fed is really at the end of its rope.

The only real hint that easier policy is imminent is his concern about Europe:

Nevertheless, the situation in Europe poses significant risks to the U.S. financial system and economy and must be monitored closely. As always, the Federal Reserve remains prepared to take action as needed to protect the U.S. financial system and economy in the event that financial stresses escalate.

The question is if he sees the risks tilted to the downside, the view of his colleague Vice Chair Janet Yellen. If there is anything that will drive immediate action, it is the European risk. In the absence of that never ending crisis, he would treat the labor report as a wait-and-see issue. But if that situation continues to deteriorate and roil US markets over the next two weeks, additional action seems likely. But of what form? Guidance, twist, or purchases? That still remains an open question.

The most disappointing part of the speech was his thoughts on inflation expectations:

Longer-term inflation expectations have, indeed, been quite well anchored, according to surveys of households and economic forecasters and as derived from financial market information. For example, the five-year-forward measure of inflation compensation derived from yields on nominal and inflation-protected Treasury securities suggests that inflation expectations among investors have changed little, on net, since last fall and are lower than a year ago.

Bernanke doesn't appear to see that the inability to hold market-based inflation expectations at a consistent level as a problem:


What's wrong with this picture? Notice the volatility of expectations after the recession (Ryan Avent has made this point as well). The Fed claims to have some mythical "credibility," but it certainly isn't evident in this graph. If anything, it is clear that the Fed has failed miserably in establishing credible expectations for either 2 percent or stable inflation. Instead, what they have created is very unstable expectations because of start-stop policy. It is almost ludicrous to place so much blame on Congress for the unstable fiscal picture when they themselves are creating an unstable financial and economic environment.

The source of instability is the Fed's insistence on putting a time limit on every policy. When the US economy was operating above the zero bound, the Federal Reserve would never issue a statement to the effect of "We instruct the New York open-market operations desk to target the federal funds rate at 3.75% for a period of six months." Of course, that would be silly. It would create too many discrete points in the policymaking process that are devoid of macroeconomic context. But that is exactly what the Federal Reserve does now - effectively setting policy to have an end date without a clear expectation of why that end date is important.

And it isn't important. It is just arbitrary. The Federal Reserve would have been better off to buy a set quantity of assets every week, adjusting that number as they might the interest rate, until certain macroeconomic objectives are met. This would let the expectations channel shoulder some of the work by laying out a clear path for monetary policy. Moreover, they would probably need to buy fewer assets overall. Instead, now we have policy scheduled to end discretely in the absence of the consideration of the macroeconomic backdrop, thus disrupting the expectations channel because market participants don't know what will trigger continuation of the policy. It simply isn't the way to manage the monetary affairs of the nation.

Bottom Line: Bernanke gives few hints. I think he would let the data play itself out a bit more before changing the current policy path. But the European crisis is throwing that wrench in his plans. And if market turmoil persists, and risks remain tilted to the downside, then more easing is coming.

Ben Bernanke: No change in policy unless conditions deteriorate further

Fed Watch: Yellen Gives a Green Light

Tim Duy:

Yellen Gives a Green Light, by Tim Duy: Quick one tonight. After a succession of Fed speakers pouring cold water on the idea of further easing, Federal Reserve Vice Chair Janet Yellen opened the door for additional easing at the next FOMC meeting. Perhaps I have simply been too pessimistic in my concern that we would need to wait until later this summer. Yellen gets to the point quickly, at the end of the second paragraph:

As always, considerable uncertainty attends the outlook for both growth and inflation; events could prove either more positive or negative than what I see as the most likely outcome. That said, as I will explain, I consider the balance of risks to be tilted toward a weaker economy.

A tilt in the balance of risks to the weaker side argues for easier policy. On the labor market:

Smoothing through these fluctuations, the average pace of job creation for the year to date, as well as recent unemployment benefit claims data and other indicators, appear to be consistent with an economy expanding at only a moderate rate, close to its potential.

Obviously, we need better than potential to close the output gap - a gap that Yellen believes to exist. She clearly believes the dominant problems are cyclical, not structural. Still, she recognizes that cyclical unemployment can become structural if leftunattended. Again, a reason for additional stimulus. She identifies housing, the fiscal cliff, and Europe as actual and potential drags on US economic activity. And she dismisses the idea that a large output gap is inconsistent with current inflation:

...substantial cross-country evidence suggests that, in low-inflation environments, inflation is notably less responsive to downward pressure from labor market slack than it is when inflation is elevated. In other words, the short-run Phillips curve may flatten out. One important reason for this non-linearity, in my view, is downward nominal wage rigidity--that is, the reluctance or inability of many firms to cut nominal wages.

Europe is clearly on her mind:

The deterioration of financial conditions in Europe of late, coupled with notable declines in global equity markets, also serve as a reminder that highly destabilizing outcomes cannot be ruled out.

One might think that the inner chamber at the Federal Reserve thinks their European counterparts are clueless. And they would be right. I am not impressed by this paragraph:

Of course, much of this revision in interest rate projections would likely have occurred in the absence of explicit forward guidance; given the deterioration in projections of real activity due to the unanticipated persistence of headwinds, and the continued subdued outlook for inflation, forecasters would naturally have anticipated a greater need for the FOMC to provide continued monetary accommodation. However, I believe the changes over time in the language of the FOMC statement, coupled with information provided by Chairman Bernanke and others in speeches and congressional testimony, helped the public understand better the Committee's likely policy response given the slower-than-expected economic recovery. As a result, forecasters and market participants appear to have marked down their expectations for future short-term interest rates by more than they otherwise would have, thereby putting additional downward pressure on long-term interest rates, improving broader financial conditions, and lending support to aggregate demand.

In some sense, this is right - market participants expect that economic conditions will be such that the Fed will need to keep interest rate low for a long time. But the Fed should not be content with low rates. If policy was effective, longer term interest rates would rise in expectation of eventual Fed tightening. The collapse of rates - again - is an indication that the Fed needs to be doing much, much more. And Yellen is a dove! Note also that although expectations of additional easing seemed to set a fire underneath Wall Street today, 10-year Treasury yields gained a meager 6bp. Credit markets are not easily impressed.

Yellen concludes that the Fed has room to do more - should they want to:

If the Committee were to judge that the recovery is unlikely to proceed at a satisfactory pace (for example, that the forecast entails little or no improvement in the labor market over the next few years), or that the downside risks to the outlook had become sufficiently great, or that inflation appeared to be in danger of declining notably below its 2 percent objective, I am convinced that scope remains for the FOMC to provide further policy accommodation either through its forward guidance or through additional balance-sheet actions.

Bottom Line: Of course, Yellen is just one of the committee, but an important one. And I think she would be perfectly happy to ease in this environment. The risks tilting to the downside are key. The twist is that she opened the door for additional easing via forward guidance. Market participants are really looking for something bolder, on the order of QE3. And I don't think an extension of Operation Twist will do the trick. That has a short half-life given the Fed's dwindling stock of short-term securities. One more caveat: Yellen, I believe, would have supported easier policy before now. What really matters is Federal Reserve Chairman Ben Bernanke. Tomorrow we learn if he follows Yellen and gives a green light for further easing.

Tuesday, June 05, 2012

Fed Watch: More Cold Water

One more from Tim Duy:

More Cold Water, by Tim Duy: This is an extension of my last post. I see St. Louis Federal Reserve President James Bullard also spoke today, and downplayed the employment report:

The recent nonfarm payrolls report was disappointing, but not enough to substantially alter the contours of the U.S. outlook.

He suggested seasonal distortions are at work - although, if they are at work, it means that the gains we saw earlier were outsized. In other words, once again, expectations for high growth were excessive - which should suggest to Bullard that his earlier concerns that tightening would occur sooner than 2014 were misplaced. He later makes this interesting comment after reviewing the path of Treasury yields:

One possible FOMC strategy is to simply pocket the lower yields and continue to wait-and-see on the U.S. economic outlook.

He doesn't really appreciate the negative signal currently sent by global interest rates. I don't think the US needs lower rates at the moment, what it needs is policy that actually induces higher rates in response to an improving economic environment. I imagine that, since Bullard believes the economy is operating at potential output, he might think lower rates are helpful as they would be consistent with easing some resource constraint, but I interpret the lower rates as evidence of being well below potential output.

Moreover, Bullard continues to believe that monetary policy is easy:

Current policy is already very easy, as the policy rate remains near zero and the balance sheet remains large.

If policy was easy, market participants would expect the Fed to raise interest rates sooner, and thus longer term yields would rise. If anything, the fall in rates implies that the Fed will need to keep interest rates low for a longer period. Policy is not easy.

Bullard also dismisses financial market distress as an artifact of the European crisis:

The global problems are clearly being driven by continued turmoil in Europe.

China might be a bigger driver than we realize, but I digress. Given that this is a European problem, the Fed is helpless:

A change in U.S. monetary policy at this juncture will not alter the situation in Europe.

This is one of those things that makes you shake your head in the wonder of it all. The point of further easing would not be to alter the situation in Europe - THE POINT IS TO PREVENT THE SITUATION IN EUROPE FROM WASHING UP ON US SHORES. You know, offer a counterweight to softer demand Moreover, if easier policy induces a weaker Dollar which then in turn prompts easier policy at the ECB (one can can dream), then the Fed is in fact altering the situation in Europe. So US monetary policy might, just might, have an important role even if the proximate cause of the distress is in Europe.

Bottom Line: Bullard downplayed the employment report adn doesn't sound like he wants additional easing. Like the stance of his colleague Dallas Federal Reserve President Richard Fisher, not a surprise. This kinds of comments keep me on edge that the pace of policy change will be slower than market participants believe. But again, this is an issue of how far the regional bank presidents are behind the policy curve. They could be close, they could be far. We will get a better idea in the back half of this week.

Fed Watch: Cold Water on QE3?

Tim Duy:

Cold Water on QE3?, by Tim Duy: I am supposed to be working on a fifty-minute presentation on the global economy, but am struggling to wrap my mind around all the moving pieces at this time. It would be easier if I had two or three hours. So, in the meantime, I choose to procrastinate with a little Fed-watching.

It seems that market participants are looking for the Fed to ride to the rescue with another round of quantitative easing. I doubt that conditions are dire enough to deliver that outcome at the next meeting, but could easily see a European-driven deterioration in financial markets driving such an outcome. A lot could hinge on tomorrow's ECB meeting - they really need to cut rates to at least sustain some expectation channel. Consensus view, however, is no policy change. From the Wall Street Journal:

Although a rate cut this week can't be ruled out entirely, the central bank is likely to hold off this time while potentially starting to prepare the ground for a rate cut at its next meeting in July or later.

Behind the curve, per usual. I think no action is going to be a significant disappointment, so I am hoping to be surprised. Quite honestly, doing nothing is really almost impossible to imagine as it would represent complete and total failure on the part of the ECB. Still, I don't put it past them.

We have a couple of new comments in the wake of last week's disappointing jobs report. One from a credible policymaker, via the Wall Street Journal:

"I'd have to see a substantial change in my outlook" to be convinced the Fed should do more, Ms. Pianalto, 57 years old, said Friday, in the second of two exclusive interviews with The Wall Street Journal over consecutive days. "I don't think this employment report, in and of itself, is likely to lead to a substantial change in my outlook. Consequently, it would not lead me, at this time, given what I know about my outlook, to change my position on policy." It was her first interview with a national news outlet in her 10 years as a regional Fed chief.

Sounds like middle-ground contentment with current policy. I don't think Cleveland Federal Reserve Bank President Sandra Pianalto would say something that was not broadly consistent with the dominate view with in the Fed. That said, there is some wiggle room here. The current baseline is for Operation Twist to come to an end. Arguably, not continuing the program could be seen as doing less, while continuing is just maintaining the status quo. Indeed, extending Operation Twist is the path of least resistance for policymakers should they want to act.

Turning to less-credible policymakers, we also got comments from Dallas Federal Reserve President Richard Fisher. Via Reuters:

Asked directly whether the May jobs report could prompt the central bank to embark on a third round of quantitative easing, or QE3, Fisher said the Fed must be careful not to overreact to economic data. "Short of an implosion, I cannot support further quantitative easing," he said.

No surprise here, but I would say that Fisher's confidence is waning. He can't support further easing, but doesn't say it will not happen. This is less certain than his comments earlier this year that QE3 is a "fantasy."

More important guidance is still coming. Pianalto's message might be consistent with the last FOMC meeting, but we have frequently seen the regional presidents fall behind the thinking at the Board of Governors. Tomorrow night we get some insight into the Board with a speech by Vice-Chair Janet Yellen, followed on Thursday with Senate testimony by the Chairman Ben Bernanke. These are really the speeches to watch, and both will have to tread carefully. Considering the relative fragility of financial markets, they will not want to send mixed signals going into this next meeting.

Bottom Line: Arguably, Pianalto and Fisher threw cold water on the idea of further action. The former voice is credible, but could easily be behind the curve. The latter voice is simply not credible. More important signals should come latter this week. If Yellen and/or Bernanke (I suspect they will coordinate) follow in Pianalto's footsteps and downplays the jobs report, the expectation should be for steady policy later this month. But if Yellen/Bernanke embrace the report, we should anticipate an extension of Operation Twist at a minimum.

Saturday, June 02, 2012

Catastrophic Credibility

Paul Krugman today:

Catastrophic Credibility, by Paul Krugman: A little while ago Ben Bernanke responded to suggestions that the Fed needed to do more — in particular, that it should raise the inflation target — by insisting that this would undermine the institution’s “hard-won credibility”. May I say that what recent events in Europe, and to some extent in the US, really suggest is that central banks have too much credibility? Or more accurately, their credibility as inflation-haters is very clear, while their willingness to tolerate even as much inflation as they say they want, let alone take some risks with inflation to rescue the real economy, is very much in doubt. ...

I took this up in a recent column:

Breaking through the Inflation Ceiling: At some point during the recovery, the Fed may face an important decision. If the inflation rate begins to rise above the Fed’s 2 percent target and the unemployment rate is still relatively high, will the Fed be willing to leave interest rates low and tolerate a temporary increase in the inflation rate?
Probably not. Even though higher inflation can help to stimulate a depressed economy, Ben Bernanke, Chairman of the Federal Reserve, is not in favor of allowing higher inflation because it could undermine the Fed’s “hard-won inflation credibility.” And recent Fed communications seem to be setting the stage for the Fed to abandon its commitment to keep interest rates low through the end of 2014. This adds to the likelihood that the Fed will raise interest rates quickly if inflation begins increasing above the 2 percent target even if the economy has not yet fully recovered.
As I’ll explain in a moment, that’s the wrong thing to do. But first, why does the Fed put so much value on its credibility?
An abundance of credibility allows the Fed to bring the inflation rate down from, for example, 5 percent to 2 percent at minimal cost to the economy. It also makes it less likely that inflation will become a problem in the first place, because high credibility makes long-run inflation expectations less sensitive to temporary spells of inflation. So maintaining high credibility has substantial benefits.
Does this mean the Fed should do its best to keep the inflation rate at 2 percent?
Sticking to a 2 percent target independent of circumstances is not optimal. There are times, such as now, when allowing the inflation rate to drift above target would help the economy. Higher inflation during a recession encourages consumers and businesses to spend cash instead of sitting on it, it reduces the burden of pre-existing debt, and it can have favorable effects on our trade with other countries.  
If inflation begins to rise before the recovery is complete the Fed could, for example, announce that it is willing to allow the inflation rate to stay above target temporarily in the interest of helping the economy. But once unemployment hits a pre-set rate, for example 6.25 percent,  or core inflation rises above some predetermined threshold, for example,  5 percent, then, and only then, will the Fed step in and take action. And it should leave no doubt at all about its commitment to step in if either condition is met.
But there is a tradeoff to consider. Allowing a temporary spell of higher inflation during the recovery does pose some risk to the Fed’s credibility. I think the risk is small precisely because the Fed has been so careful to establish its inflation fighting credibility in the past. And the risk is even smaller with the 5 percent limit on the Fed’s tolerance for inflation described above. But the risk is there.
When the economy is near full employment, the tradeoff between the risk to credibility and the prospect for a faster recovery is unattractive. There’s little room to stimulate the economy and hence little room to benefit from a higher inflation rate. And the loss of credibility is potentially large because creating inflation in such a circumstance – when the economy is already growing robustly – would be viewed as irresponsible. Thus, the tradeoff is negative overall.
But when there is considerable room for the economy to expand, as there is now, the potential benefits from the increase in employment  that this policy is likely to bring about are much larger. Why the Fed places so little weight on these benefits when unemployment remains so high is a mystery.
In comparison to the risks to credibility, which are smaller than they are near full employment, the benefits are large and the tradeoff is positive rather than negative. There does come a point when the tradeoff is negative again – hence the 6.25 percent unemployment and 5 percent inflation triggers described above – but in the interim we should be willing to allow modestly higher inflation. I have no doubt that, once the economy has finally recovered, the Fed will ensure that the inflation rate is near its target value, so long-run credibility is not at risk.
If inflation begins to rise before the economy has fully recovered, the Fed shouldn’t react as though its world is coming to an end and immediately begin reversing its stimulus efforts. The resulting increase in interest rates would make the recovery even slower. In fact, given the net benefits that more inflation would provide right now, the Fed should try to raise the inflation rate through additional stimulus programs.
Unfortunately, the Fed has made it abundantly clear that’s not going to happen. But at the very least the Fed should continue its present attempts to help the economy, even if that means a temporary increase in the inflation rate.

Friday, June 01, 2012

Will the weak employment report prompt action from policymakers?

Here's a quick reaction to today's employment report:

Will the weak employment report prompt action from policymakers?

It won't, but it should.

Monday, May 28, 2012

Plosser on the Risks from Europe

Philadelphia Fed president Charles Plosser on the risks from Europe:

Q&A: Philadelphia Fed President Charles Plosser, by Brian Blackstone, WSJ: On whether Europe could have a significant effect on the U.S. economy:
Plosser: Europe is clearly near recession. That impacts the U.S. in part through trade ... but Europe is not our largest trading partner at the end of the day. The thing that people really worry about is you have some financial implosion in Europe and markets freeze up and you have some serious financial disruptions.
There are several ways this could go. At one level the U.S. has been trying to insulate itself from that risk. The Fed and regulators have tried to stress to money market funds, for example, to reduce their exposure to European financial institutions. So on a pure exposure basis I would say U.S. financial institutions are taking the steps they need to ensure that ... financial distress in Europe it doesn’t necessarily lead to distress for them...
People have made the analogy that an implosion in Europe would be a Lehman Brothers-type event. It might be a Lehman Brothers-kind of event for Europe. And if the market is sort of indiscriminate in whom they withdraw funding to, you could have indiscriminate funding restrictions on U.S. institutions just because everybody’s scared.
There’s another scenario that is exactly the opposite. There might be–and you already see some of this–a flight to safety. So rather than the markets freezing access to short-term funding for U.S. institutions, you could have a flood of liquidity that gets withdrawn from European institutions ... and floods into the United States. That’s exactly the opposite problem.
On which scenario is more likely:
Plosser: I don’t have the answer to that. ... I don’t think a flood of liquidity is a huge problem. That would be manageable. The bigger problem is if it dries up for everybody. The Fed still has the tools it used during the crisis. ... So I think we have the tools at our disposal if they become necessary. ...

Thus, he thinks the Fed can handle whatever comes its way, and hence sees no need to alter his forecast:

On his economic forecasts:
Plosser: I’m still looking for 2.5% to 3% growth over the course of this year. I think the unemployment rate is going to continue to drift downward to 7.8% by the end of this year. I would think for 2013 we’ll see similar developments. As long as that’s continuing then I don’t see the case for ever increasing degree of accommodation.

Since he believes output will grow no matter what happens in Europe, inflation is the biggest risk:

On inflation:
Plosser: I think headline will drift down just because of oil and gasoline. It will be interesting to see what happens with the core. The inflation risk we have is longer term. The problem is that as the U.S. economy grows we have provided substantial amounts of accommodation. We have $1.5 trillion in excess reserves. Inflation is going to occur when those excess reserves start flowing into the economy. When that begins to happen we’ll have to restrain it somehow. The challenge for the Fed is will we act quickly enough or aggressively enough to prevent that from happening.
It may be a challenge politically when we have to start selling assets, particularly if we have to start selling (mortgage backed securities) to shrink the balance sheet and to prevent those reserves from becoming money.

My view is different. I'm more worried about output and employment being affected by events in Europe than he is, and less worried about long-run risks from inflation (both the chance that it will happen and the consequences if it does). So I see a far greater need for policymakers -- monetary and fiscal -- to take action now as insurance against potential problems down the road.

It is interesting, however, that he sees the political risk as the primary challenge  for controlling inflation for a supposedly independent Fed, especially since several Fed presidents recently assured us that politics plays no role whatsoever in the Fed's decision making process (I also wonder why he didn't mention raising the amount paid on reserves as a way of keeping reserves in the banks).

Finally, I'm glad he said "I don’t see the case for ever increasing degree of accommodation," rather than saying he thought we needed to begin reducing accommodation. We may not get any further easing, but perhaps there's a chance we can keep what we have, at least for now.

Saturday, May 26, 2012

"We Need a Hegemon Who Won't Drive Us Crazy..."

Tyler Cowen is pessimistic:

We may be entering a new world where international cooperative arrangements, in environmental areas as well as finance, are commonly recognized as impossible.  If the core European nations cannot coordinate effectively, what can we expect in dealings with China, Russia and other countries that have less of a common background and understanding?

What is the answer?:

We are realizing just how much international economic order depends on the role of a dominant country — sometimes known as a hegemon — that sets clear rules and accepts some responsibility for the consequences.

Which reminds me of something Brad DeLong wrote awhile back:

We Need a Hegemon Who Won't Drive Us Crazy...: ...monetary policy is and always has been about supporting asset prices at a level that allows firms that ought to be expanding to obtain finance and expand profitably. And ever since 1825 the central bank has done this by, whenever it needs to, taking long-duration and risky assets into its own portfolio--and thus off of the stock that must be held by the private sector whose risk tolerance has collapsed. Given that there are going to be sudden shocks to risk and duration tolerance on the part of global investors, we need a global institution to provide support for asset prices in an emergency: a global lender of last resort.
That lender of last resort needs two things if it is to function. First, it needs to be able to "print money"--to have its own liabilities be and be perceived to be the safest assets in the world so that when it borrows it calms markets by giving them more of the high-quality short-duration low-risk paper for which they suddenly have such a great craving. Second, it needs to know what it is buying--to have sufficient regulatory oversight and control over global finance to be able to limit the growth of potentially toxic assets beforehand and then to understand what prices it should offer when it does decide that it is time to support the market.
As my old teacher Charlie Kindleberger taught me (or, rather, taught Barry Eichengreen, who in turn taught me), when the global financial system has had a hegemonic lender-of-last-resort with the power and the will to exercise this function, things have gone relatively well. And when the possible candidates for the role have lacked either the power or the will, things have gone relatively badly.
Back in the 1997-1998 crisis the U.S. Federal Reserve and Treasury acting alongside the IMF had the power and the will. Right now the U.S. Federal Reserve and the Treasury in cooperation with the IMF and the ECB have the power (but they may not have the will). In the future the world is likely to become a more complicated place without a single hegemonic and dominant public financial institution. To my mind, this creates grave dangers for the next quarter century. ...

[Brad's response was part of a roundtable at The Economist on an article written by Dani Rodrik. I participated as well, and said pretty much the same thing.]

Friday, May 25, 2012

Fed Watch: Is QE3 Just Around the Corner?

Tim again:

Is QE3 Just Around the Corner?, by Tim Duy: From the Wall Street Journal today:

As measured by Treasury bonds, inflation expectations are falling amid heightened concerns that the discord in Europe will threaten U.S. growth. Some observers say that the lowered outlook for inflation gives the Federal Reserve more leeway to stimulate the economy, possibly through another round of quantitative easing. In "QE," the Fed pumps money into the financial system through asset purchases.

Financial market participants are anticipating Fed action. Are monetary policymakers on the same page? St. Louis Federal Reserve President James Bullard yesterday:

Bullard said he believes the European Central Bank is committed to backing the continent's brittle banking system, and therefore the risks to the U.S. economy are smaller than some analysts perceive.

Indeed, Bullard added he expects the U.S. economy to perform better than many forecasters anticipate and that the Fed will therefore need to raise interest rates in late 2013, not late 2014 as its policy committee is currently indicating.

Minneapolis Federal Reserve President Narayana Kocherlakota yesterday:

“I see these changes as a signal that our country’s current labor-market performance is much closer to ‘maximum employment,’ given the tools available to the [Fed], than the post-World War II U.S. data alone would suggest,” Kocherlakota said. “As I’ve argued in the past, appropriate policy should be responsive to such signals.”...

...Earlier in May, Kocherlakota said the Fed should start looking at tightening monetary policy in the next six to nine months. He said he saw inflation at around 2% this year and 2.3% in 2013, numbers that signal the need to start exiting the central bank’s current ultra-easy policy.

Arguably, neither Bullard not Kocherlakota are critical voices in the FOMC. More interesting are today's comments from New York Federal Reserve President Wiliam Dudley. From the Wall Street Journal:

Expectations for U.S. economic growth, while “pretty disappointing” at around 2.4%, is sufficient to keep the central bank from easing monetary policy, Federal Reserve Bank of New York President William Dudley said.

“My view is that, if we continue to see improvement in the economy, in terms of using up the slack in available resources, then I think it’s hard to argue that we absolutely must do something more in terms of the monetary policy front,” Dudley said in an interview with CNBC, aired Thursday.

Dudley is considered part of the inner circle; if he doesn't think the Fed needs to do something more, the baseline scenario should be that QE3 is not on the table.

At least for the moment. Simply put, I think market participants are getting ahead of the Fed. My suspicion is that the Fed will need to see a weaker data flow in the months ahead to justify getting back into the game. And I don't think the TIPS-derived inflation expectations are lower enough to trigger action either. I think we need to go down at least another 25bp if not 50bp until the Fed pulls the trigger:


That said, of course the risks to the outlook could shift by the June meeting. The trend in new orders for nondefense, nonair durable goods suggests that some of the global weakness is catching up with the US:



That said, no clear sign that industrial demand has rolled over. Overall, it seems unlikely that the data flow as a whole will turn fast enough to prompt the Fed into easing next month. Only the next employment report stands out as a potential deal breaker. In general, though, I would think you need at a minimum the Q2 GDP report to justify additional easing - which pushes us out to the July/August meeting at least.
So if we take the US data off the table, then we are looking for financial disruption, which is obviously a possibility given the current unpleasantness in Europe. Indeed, we should not be surprised if the Fed needs to further improve dollar liquidity abroad (an action that is sure to be taken as a sign that QE3 is imminent; expect Fed speakers to deny a policy shift is afoot). And note that the next FOMC meeting is just 2 days after the June 17 Greek vote - and that could be the vote heard round the financial world that prompts the Fed to act.
Bottom Line: The data flow is soft, but Dudley indicates it is not soft enough to ease. And while some are pointing to falling TIPS-derived inflation as  given the Fed room to move, they have traditionally delayed until conditions are more dire (they are not exactly prone to overshooting in the first place). The Fed doesn't think they will ease further; they think their next move will be to tighten. Which means that financial conditions will need to deteriorate dramatically to prompt action in June. So if you are looking for the Fed to ease in just four weeks, you are looking for financial markets to turn very, very ugly. Lehman ugly. And I wish that I could say that it won't happen, but European policymakers are hell-bent to push their economies to the wall while worshipping at the alter of moral hazard.

Thursday, May 24, 2012

Fed Watch: Rumors and Threats

Tim Duy:

Rumors and Threats, by Tim Duy: From the Wall Street Journal's MarketBeat blog this morning:

“We’re now in a very sentiment-driven, rumor-driven, nonsense-driven market that’s prepared to grasp onto anything,” Dow Jones’s Katie Martin said this morning on the Markets Hub.

One of the only things holding the euro up, she said, is the so-called “announcement risk,” the fear that the eurocrats will actually pull together some kind of solution. But it’s just a hope, she said

From Bloomberg this afternoon:

U.S. stocks rose, sending the Standard & Poor’s 500 Index higher for a fourth day, after Italian Prime Minister Mario Monti said a majority of leaders at a European Union summit backed joint European bonds.

Timing is important on this one. From the Financial Times:

But summit leaders agreed such measures were months – and, in the case of eurozone bonds, years – away, and some officials have in recent days begun to express concern that the EU has not properly prepared itself for the whirlwind that could strike if a new Greek government defaults on its bailout loans and is forced out of the euro.

Most of Europe might support Eurobonds, but it isn't going to happen in the near-term. Interestingly, Monti also laid down his own gauntlet to Germany. From Bloomberg:

Italian Prime Minister Mario Monti said Germany has an interest in ensuring that no country leaves the euro.

Monti said that, in a hypothetical case, Germany would be harmed should Italy “one day leave the euro.” A weak “new lira” would put German exports at a disadvantage, though an exit from the currency region would also harm Italy, Monti said in an interview today on Italian television La7.

While “anything can happen in Greece,” the nation is likely to remain in the 17-nation currency, Monti said.

A clear escalation of the doctrine of mutually assured financial destruction - now Italy has its hand on the button. The more hands on the button, the greater the chance that someone pushes it. Meanwhile, while European politicians fiddle, Europe burns. From Reuters:

The euro zone's private sector has sunk further into the doldrums this month as new orders shrivel, forcing firms to run down backlogs and slash workforces, key business surveys showed on Thursday.

And worryingly for policymakers, a downturn that started in smaller periphery members is taking root in the core countries of Germany and France, whose tepid growth had been keeping the troubled bloc afloat.

For his part ECB President Mario Draghi is throwing down his own gaunlet:

We are living at a critical juncture in the history of the Union. The sovereign debt crisis has exposed serious weaknesses in the institutional framework; in this context, the difficulties in finding common solutions are having a negative impact on market valuations. The extraordinary measures taken by the ECB have gained us time; they have preserved the functioning of monetary policy.

But we have now reached a point where European integration, in order to survive, needs a bold leap of political imagination. It is in this sense that I have referred to the need for a “growth compact” alongside the well-known “fiscal compact”.

That sounds to me like he is saying their is not much more that the ECB can or will do. Policymakers need to get their act together. I'll see your moral hazard, and double it. See who blinks first.

Moreover, it is increasingly clear it's not just Europe anymore. Ed Harrison reiterates that this is turning into a global slowdown:

Me, I am more concerned about the global growth slowdown in emerging markets than the crisis in Europe. This is a big, big story but no one is talking about it because Europe is sucking up all of the air. It’s not only Europe here. The reality is we are seeing a global economic backdrop with nearly every major developed and developing country slowing – all with less policy space across the board. That is not bullish.

The world looks riskier with each passing day.

Fed Watch: The Fed and the Fiscal Cliff

One more from Tim Duy:

The Fed and the Fiscal Cliff, by Tim Duy: Ryan Avent has an ambitious post, in which he claims the Federal Reserve will resist proclaiming it has the tools to offset the fiscal cliff, should it even occur:

The Fed could therefore proclaim to the world that will maintain aggregate demand growth (in the form of, say, nominal income growth) at all costs, and that it would by no means allow the fiscal cliff to knock the economy off its preferred path. It could explain in great detail what specific steps it would be willing to take to achieve this goal, so as to boost its credibility. And if demand expectations as reflected in equity or bond prices showed signs of weakening ahead of the cliff, the Fed could preemptively swing into the action to establish the credibility of its purpose.

The Fed will almost certainly not do this.

Why? Because the Fed is thinking about moral hazard, specifically, that if it promises to protect the economy against reckless fiscal policy Congress will have no incentive to avoid reckless fiscal policy...

I understand where Avent is going with this. The Fed should be concerned that Congress will never get its act together if the Fed is always there to bail them out. But reading the comments by Minneapolis Federal Reserve President Narayana Kocherlakota today makes me think his concerns are at least for the moment misplaced. From the Chicago Tribune:

The U.S. Federal Reserve, which has kept short-term rates near zero since December 2008, may need to ease monetary policy further if U.S. unemployment rises or inflation falls, a top Fed official said on Wednesday.

Those are possible outcomes if U.S. lawmakers allow a raft of tax breaks to expire on schedule at the end of the year, pushing the nation over a "fiscal cliff" in 2013, Minneapolis Fed President Narayana Kocherlakota said in answer to an audience question after a talk at the Black Hills Knowledge Network.

But, he added, "I don't see that that is a policy choice that the Congress and President wind up making," he said.

That sounds to me like a pretty explicit promise to step up if Congress falls down on the job. Likewise, St. Louis Federal Reserve President James Bullard, via Reuters:

"If there was a sharp slowdown in the U.S. I do think we'd have further scope to take action, we'd be taking on more risk, but we could do it if the situation called for it," he said.

I take this to implicitly include a fiscal cliff slowdown. So it seems to me that at least some monetary policymakers are already promising, explicitly or implicitly, to offset the fiscal cliff.

My guess is that in a low-inflation environment, monetary policymakers would have little reason to engage in moral hazard games, in that any hesitation on their parts would not be credible. It seems pretty likely they would step on the monetary gas, even if doing so allowed Congress another year of reckless behavior. Not doing so would be a clear violation of the dual-mandate. As such, are they really able to play coy?

Whether they accurately gauge the impact of the fiscal cliff and engage in the appropriate degree of easing, however, is another matter entirely.

Fed Watch: Total Failure

Tim Duy:

Total Failure, by Tim Duy: With the crisis once again nipping at their heels, European policymakers accomplished exactly what was expected of them. Absolutely nothing. From the FT:

European leaders put off any decisions on shoring up the region’s banks at a late-night summit on Wednesday despite rising concerns that instability in Greece was undermining confidence in the eurozone’s financial sector.

Instead, the heads of the EU’s main institutions were given the task of drawing up proposals for closer fiscal co-ordination in time for another summit next month, including plans that could include a path towards a Europe-wide deposit guarantee scheme and, in the longer term, commonly-backed eurozone bonds.

The trouble is that Europe doesn't have a month to wait for another summit. I am not confident they even have a week. But not to fear - the ECB is expected to step into the breech once again. At least that is the hope. But notice the irony. Germany doesn't want Eurobonds because of the moral hazard risk. They don't want to get stuck paying for Southern Europe's profligacy. At the same time, the ECB does want to act as lender of last resort for fear that will only encourage policymakers to put off hard decisions on fiscal union. Moral hazard to the right, moral hard to the left. The only path left is gridlock - and failure.

In the meantime, the Wall Street Journal reports on accelerating plans for a Greek exit.

European officials are stepping up contingency planning for a possible Greek exit from the euro zone, even as Europe's leaders struggled to overcome differences on how to resolve the currency bloc's crisis at a summit meeting here.

And, for good measure, St. Louis Federal Reserve President James Bullard let's us know that he sleeps easy at night. Via Reuters:

"I'm one that thinks that Greece could exit, and it could be handled in an appropriate way without causing too much damage, either in Europe or in the U.S.," St. Louis Federal Reserve Bank President James Bullard told Reuters.

I wish I could be so confident.

Saturday, May 19, 2012

Do the FOMC Meeting Minutes or the New Fed Appointments Change the Expected Path for Monetary Policy?

I wrote this the other day and then forgot to post it at CBS and/or here:

Information in the minutes from the April 24-25 meeting of the Federal Reserve's policymaking committee released last week led many observers to conclude that monetary easing was more likely than we thought. The confirmation of Jeremy Stein and Jerome Powell as Federal Reserve governors on Thursday did little to alter that view since most believed these appointments would do little to change the balance of power in monetary policy meetings. However, the real news from these two events isn't about potential changes in the policy outlook, it's that current policy is now even more entrenched than before.

The key reason that many analysts changed their policy outlook was language in the minutes from the last meeting of the Federal Open Market Committee, in particular this phrase: "Several members indicated that additional monetary policy accommodation could be necessary if the economic recovery lost momentum or the downside risks to the forecast became great enough." However, the fact that "several members" of the committee favored more easing if the economy deteriorates "enough" was well known before the minutes were released. The speeches given by presidents of the regional Fed banks, members of the Board of Governors, and most importantly Chairman Bernanke himself, made this clear. Thus, the minutes confirm the commitment to existing policy -- stay the course for now unless conditions change dramatically in either direction -- rather than signaling a deviation from it.

The appointment of Jeremy Stein and Jerome Powell as Federal Reserve governors, the first time all seven positions on the Board of Governors have been filled since April 2006, also gives more gravity to existing policy. Both appointees are experts in the operation of financial markets, expertise that is needed at the Board. But they are not experts on the use of monetary policy tools such as quantitative easing to stabilize the economy, and are thus likely to defer to majority opinion on these matters, Chairman Bernanke's opinion in particular. This gives majority opinion more weight making it harder to change.

There is a final factor that will tend to lock present policy in place, the upcoming election. The Fed is historically reluctant to do anything in election years that appears to favor one party over the other. Thus, big policy moves are unlikely unless there is a clear justification for them. A substantial deterioration in the economy would provide the needed justification, but the hurdle for what constitutes "substantial" is larger in a presidential election year.

Together, all of these factors point to more persistence in current policy. If the economy takes a large unexpected downward turn, or if inflation begins to rise to worrisome levels policy could change, but for now present policy is firmly anchored in place.

Friday, May 18, 2012

Fed Watch: Closer to Colliding

Tim Duy:

Closer to Colliding, by Tim Duy: Each passing day brings the runaways trains closer to collision.  

The European strategy to scare the Greek people into voting for pro-austerity parties was always risky. My tendency is to think it will drive voters in the other direction, this is especially the case if voters come to believe they hold the real leverage. And that is exactly the strategy that is emerging. From the Wall Street Journal:

The head of Greece's radical left party says there is little chance Europe will cut off funding to the country and if it does, Greece will repudiate its debts, throwing down a gauntlet that could increase tensions between Greece's recalcitrant politicians and frustrated European creditors...

..."Our first choice is to convince our European partners that, in their own interest, financing must not be stopped," Mr. Tsipras said in an interview with The Wall Street Journal. "If we can't convince them—because we don't have the intention to take unilateral action—but if they proceed with unilateral action on their side, in other words they cut off our funding, then we will be forced to stop paying our creditors, to go to a suspension in payments to our creditors."

Europe and the Greece are locked in a battle of mutually assured financial destruction. Nor can European leaders afford to take Tsipras' threats lightly:

According to recent opinion polls, Mr. Tsipras' party is poised to win the most votes in repeat elections next month, bettering its surprise second-place finish in an inconclusive May 6 vote that left no party or coalition with enough seats in Parliament to form a government. With Mr. Tsipras poised to win pole position in the coming vote, it raises the risk that Greece will soon face a showdown with its European creditors over the contentious austerity program that Athens must implement in order to receive fresh aid.

If Europe caves and gives in to Greek demands, however, a new set of challenges to the austerity agenda will arise. How long would it be before the people of Spain or Italy or Portugal or Ireland realize that they too have much more leverage than they ever imagined. Can the Troika cave to Greece while remaining credible with other troubled economies?  I doubt it - which I think increases the risk that the core of Europe will believe it necessary to create a moral hazard example out of Greece.  

Of course, this worked so well with Lehman Brothers. We will just foget about that little detail for the moment.

Thursday, May 17, 2012

"Is Inflation Targeting Really Dead?"

David Altig argues that flexible inflation targeting "is far from dead":

Is inflation targeting really dead?, by David Altig: Harvard's Jeffrey Frankel (hat tip, Mark Thoma) is the latest econ-blogger to cast an admiring gaze in the direction of nominal gross domestic product (GDP) targeting. Frankel's post is titled "The Death of Inflation Targeting," and the demise apparently includes the notion of "flexible targeting." The obituary is somewhat ironic in that at least some of us believe that the U.S. central bank has recently taken a big step in the direction of institutionalizing flexible inflation targeting. Frankel, nonetheless, makes a case for nominal GDP targeting:

"One candidate to succeed IT [inflation targeting] as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980's, since it did not share the latter's vulnerability to so-called velocity shocks.

"Nominal GDP targeting was not adopted then, but now it is back. Its fans point out that, unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand—the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway."

That's certainly true, but a nominal GDP target is consistent with a stable inflation or price-level objective only if potential GDP growth is itself stable. Perhaps the argument is that plausible variations in potential GDP are not large enough or persistent enough to be of much concern. But that notion just begs the core question of whether the current output gap is big or small. At least for me, uncertainty about where GDP is relative to its potential remains the key to whether policy should be more or less aggressive.

In another recent blog item (also with a pointer from Mark Thoma), Simon Wren-Lewis offers the opinion that acknowledging uncertainty about size of the output gap actually argues in favor of being "less cautious" about taking an aggressive policy course. The basic idea is familiar. It is a simple matter to raise rates should the Fed overestimate the magnitude of the output gap. But with the short-term policy rates already at zero, it is not so easy to go in the opposite direction should we underestimate the gap.

No argument there. As I pointed out in a May 3 macroblog item, Atlanta Fed President Dennis Lockhart has said the same thing. But, as I argued in that post, this point of view is only half the story. Though I agree that the costs are asymmetric with respect to the downside with respect to the FOMC's employment and growth mandate, they look to me to be asymmetric to the upside with respect to the price stability mandate. And I view with some suspicion the claim that we know how to easily manage policy that turns out to be too aggressive after the fact.

My issues are not merely academic. In an important paper published a decade ago, Anasthsios Orphanides made this assertion:

"Despite the best of intentions, the activist management of the economy during the 1960s and 1970s did not deliver the desired macroeconomic outcomes. Following a brief period of success in achieving reasonable price stability with full employment, starting with the end of 1965 and continuing through the 1970s, the small upward drift in prices that so concerned Burns several years earlier gave way to the Great Inflation. Amazingly, during much of this period, specifically from February 1970 to January 1977, Arthur Burns, who so opposed policies fostering inflation, served as Chairman of the Federal Reserve. How then is this macroeconomic policy failure to be explained? And how can such failures be avoided in the future?...

"The likely policy lapse leading to the Great Inflation …can be simply identified. It was due to the overconfidence with which policymakers believed they could ascertain in real-time the current state of the economy relative to its potential. The willingness to recognize the limitations of our knowledge and lower our stabilization objectives accordingly would be essential if we are to avert such policy disasters in the future."

With this historical observation in hand, it seems a short leap to turn Wren-Lewis's thought experiment on its head. Arguably, the last several years have demonstrated that nonconventional policy actions have been quite successful at short-circuiting the disinflationary spirals that pose the central downside risk when interest rates are near zero. (If you can tolerate a little math, a good exposition of both theory and evidence is provided by Roger Farmer.)

On the opposite side of the ledger, we know little about the conditions that would cause the Fed to lose credibility with respect to its commitment to its inflation goals, and very little about the triggers that would cause inflation expectations to become unanchored. Thus, I think it not difficult to construct a plausible argument about the risks of being wrong about the output gap that is exact opposite of the Wren-Lewis conclusion.

I end up about where I did in my previous post. Flexible inflation targeting, implemented in such a way that the 2 percent long-run inflation target rate exerts an observable gravitational pull over the medium term, feels about right to me. Despite what Frankel seems to believe, I think that idea is far from dead.

Break Them Up

This was unexpected:

Federal Reserve Bank of St. Louis President James Bullard said Thursday that banks deemed “too big to fail” should be split up. “We do not need these companies to be as big as they are,” Bullard said. His remarks come a week after J.P. Morgan Chase & Co. disclosed a $2 billion trading loss. “We should say we want smaller institutions so that they can safely fail if they need to fail,” he said...

I don't like excessively large banks because of the economic and political power that they have. For me, that is the main reason to break them up (especially since I have yet to see convincing evidence that we need banks this large in order to exploit economies of scope and scale).

But when it comes to stabilizing the financial system, it's not so clear. If we break a big bank into smaller banks, and a systemic shock hits that threatens to cause all of the small banks to fail, it may be harder to shore up the system and prevent a domino-style collapse than it would be if there was just one large bank to deal with. The Great Depression, for example, was characterized by the failure of many, many smaller banks rather than the toppling of a few large, systemically important institutions.

But that is not an insurmountable problem. A coordinated policy across the smaller banks can be equivalent to policy at a single, large institution, and we simply have to be ready to implement the appropriate policies when trouble threatens. So although it may be somewhat easier to deal with one bank rather than, say, 10 or 20, that's not a reason to allow banks to be so large. So I'm glad to see Bullard's comments.

However, Tim Duy is less pleased with his views on inflation:

Don't Let the Data Get in the Way of Your Story, by Tim Duy: St. Louis Federal Reserve President James Bullard:

The main risk lies in potentially overcommitting to the ultra-easy monetary policy, reigniting the global inflation debacle of the 1970s.

Ten-year inflation expectations via the Cleveland Federal Reserve:


Bullard is obviously a Serious Central Banker, because Serious Central Bankers only see inflation everywhere.

Undue fear of inflation generally among FOMC memebers is holding policy back. There are those who favor more aggressive policy, but not enough to make a difference.

Are You Feeling Lucky?

Give all the uncertainties about Europe, and additional worries about other things such as oil prices, if we could buy insurance against future economic problems, now would be a good time to do it.

Oh wait, we can. That insurance is called monetary and fiscal policy. Like all insurance it does come with some cost, and yes -- again like all insurance -- there's a chance we won't need it. But if we bet against the car wreck and it happens anyway -- and the odds of collateral damage from a wreck in Europe are high right now -- we'll be sorry.

Keep in mind, too, that some forms of insurance don't have to be very costly. In fact, in some cases the benefits could outweigh the costs even if Europe, oil prices, etc. do not turn out to be problems. What I have in mind is infrastructure spending. Infrastructure spending gives us the extra demand we need to provide insurance against a shock to demand from Europe, etc. And we could use the extra demand in any case given the high level of unemployment right now, so there are benefits even if the insurance is not needed. Thus, there are benefits on the demand side no mater what happens.

But infrastructure spending also has important supply side effects. Improved infrastructure would enhance future growth (and the additional jobs the spending would generate would help to prevent permanent losses to the economy associated with long-term unemployment). The higher growth alone yields benefits to the economy that exceed the cost of the investment (costs that are extraordinarily low due to rock bottom interest rates), and when the deamnd side/insurance benefits are added in, it seems to be a no-brainer. Unfortunatley, there are far too many "no brainers' in Congress right now to allow such sensible policy to go forward.

Wednesday, May 16, 2012

Frankel: The Death of Inflation Targeting

Jeffrey Frankel says inflation targeting is falling out of favor, but it's not clear what will replace it:

The Death of Inflation Targeting, by Jeffrey Frankel, Commentary, Project Syndicate: It is with regret that we announce the death of inflation targeting. The monetary-policy regime, known as IT to friends, evidently passed away in September 2008. The lack of an official announcement until now attests to the esteem in which it was held, its usefulness as an ornament of credibility for central banks, and fears that there might be no good candidates to succeed it as the preferred anchor for monetary policy. ...
Regardless of the form it took, IT began to receive some heavy blows a few years ago... Perhaps the biggest setback hit in September 2008, when it became clear that central banks that had been relying on IT had not paid enough attention to asset-price bubbles. ... [A]nother major setback was inappropriate responses to supply shocks and terms-of-trade shocks. ... CPI targeting ... tells the central bank to tighten policy in response to an increase in the world price of imported commodities – exactly the opposite of accommodating the adverse shift in the terms of trade. ...
One candidate to succeed IT as the preferred nominal monetary-policy anchor has lately received some enthusiastic support in the economic blogosphere: nominal GDP targeting. The idea is not new. It had been a candidate to succeed money-supply targeting in the 1980’s, since it did not share the latter’s vulnerability to so-called velocity shocks.
Nominal GDP targeting ..., unlike IT, it would not cause excessive tightening in response to adverse supply shocks. Nominal GDP targeting stabilizes demand – the most that can be asked of monetary policy. An adverse supply shock is automatically divided equally between inflation and real GDP, which is pretty much what a central bank with discretion would do anyway.
A dark-horse candidate is product-price targeting, which would focus on stabilizing an index of producer prices... Unlike IT, it would not dictate a perverse response to terms-of-trade shocks.
Supporters of both nominal GDP targeting and product-price targeting claim that IT sometimes gave the public the misleading impression that it would stabilize the cost of living, even in the face of supply shocks or terms-of trade-shocks, over which it had no control. ...

Fed Watch: FOMC Minutes

Tim Duy:

FOMC Minutes, by Tim Duy: The FOMC minutes are released tomorrow. Calculated Risk gives us the Goldman Sachs preview:

We expect that the April FOMC minutes ... will include a discussion of possible easing options. ... The first set of options center around the Fed's balance sheet, and we think that the discussion might include the benefits of mortgage purchases, the potential for more “twisting,” and the pros and cons of sterilized asset purchases.

I understand where this comes from - Operation Twist is coming to an end next month, and the two-day meeting in April seems like a natural chance to discuss future options. That said, I am drawn to the minimal interest in this topic in March:

The Committee also stated that it is prepared to adjust the size and composition of its securities holdings as appropriate to promote a stronger economic recovery in a context of price stability. A couple of members indicated that the initiation of additional stimulus could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

Given the last FOMC statement, it doesn't look like the Fed's baseline outlook shifted much between then and the April meeting. And I don't see Federal Reserve Chairman Ben Bernanke's press conference or the most recent Fedspeak as being particularly supportive of additional action. Which leads me to believe that even if the Fed discussed some hypothetical easing options, they will downplay this as conditional on a marked deterioration in economic conditions. I don't think we are there yet. I just don't see much support for additional easing at this point, albeit plenty of support to not tighten either. That said, I would expect market participants to seize upon even the slightest hint of QE3 given the fragility that is currently driven by Europe.

Tuesday, May 15, 2012

"The Austrian Analysis of the Great Depression and the Recent Recession are Wrong"

Bruce Bartlett:

What Rule Should the Fed Follow?, by Bruce Bartlett, Commentary, NY Times: ...[T]he “Austrian” theory of the Great Depression ... says that even though there was no inflation during the 1920s, somehow or other inflation nevertheless caused the Great Depression. According to ... the Austrian school ... there was actually some sort of double-secret inflation because the money supply increased. They believe the same thing is happening right now.
When the Austrian theory was first put forward, conservative economists were keen to refute the widespread view that capitalism itself had caused the Great Depression and that the cure was full-bore socialism. The Austrians ... and others, were desperate to show that government was responsible...
Although the Austrian theory was initially viewed sympathetically by conservative economists..., it was abandoned when it became clear that there is no Austrian cure for depressions; the only course ... is to suck it up, let unemployment rise, and purge the mal-investment no matter how painful. Anything ... whatsoever the government does to ... counteract the economic downturn ... is inherently counterproductive...
In the 1960s, conservative economists adopted a different view. The government error was ... responding inappropriately to a garden-variety recession that began in August 1929. ... This “monetarist” theory of ... Milton Friedman and Anna Schwartz ... argued that if the Fed had acted as a lender of last resort, as it was created to do, it could have stopped the Great Depression in its tracks...
The monetarist theory was a far more attractive explanation for the Great Depression that also blamed government. It was largely adopted by conservatives except for a few Austrian holdouts... One attraction of the monetarist theory is that it allows for government action to respond to economic downturns, as opposed to the Austrian do-nothing policy.
When economic downturns arise, monetarists say the Fed should respond by expanding the money supply, not through an expansionary fiscal policy, as Keynesian economics recommends. ...
In the years since, however, the monetarist theory has lost favor among conservatives. They now assert, along with the Austrians, that the only “cure” for recessions is not to sow their seeds in the first place. Those seeds, all conservatives now agree, are sown primarily by the Fed, especially by holding interest rates “too low.”
Thus almost all conservatives, including many regional Federal Reserve bank presidents, believe the Fed should raise interest rates soon to prevent a reemergence of inflation, another boom and, inevitably, another bust that may be even worse than the one we have yet to emerge from. ...
The Austrian analysis of the Great Depression and the recent recession are wrong, I think. Unfortunately, that will not deter the conservatives.

David Glasner comments:

All in all, a worthwhile and enlightening discussion, but I couldn’t help wondering . . . whatever happened to Hawtrey and Cassel?

And Paul Krugman has argued the monetarist view has been tested in this recession (and in Japan), and failed.

...whatt Friedman ... argued was that the Fed could easily have prevented the Great Depression with policy activism; if only it had acted to prevent a big fall in broad monetary aggregates all would have been well. Since the big decline in M2 took place despite rising monetary base, however, this would have required that the Fed “print” lots of money.
This claim now looks wrong. Even big expansions in the monetary base, whether in Japan after 2000 or here after 2008, do little if the economy is up against the zero lower bound. The Fed could and should do more — but it’s a much harder job than Friedman and Schwartz suggested.
Beyond that, however, Friedman in his role as political advocate committed a serious sin; he consistently misrepresented his own economic work. What he had really shown, or thought he had shown, was that the Fed could have prevented the Depression; but he transmuted this into a claim that the Fed caused the Depression.
And this debased and misleading version is what has filtered down to the likes of Ron Paul, who then use it to argue against the very activism Friedman was really advocating.
Bad Milton, bad.

Wednesday, May 09, 2012

Fed Watch: On Negative Interest Rates

Tim Duy:

On Negative Interest Rates, by Tim Duy: Scott Sumner writes:

I don’t think Keynesians should be arguing that lower real interest rates are the key to recovery. A bold and credible monetary stimulus that was expected to produce much faster NGDP growth might well raise long term risk-free interest rates.

This point doesn't get explained well - and I probably won't do any better, but I will give it a try anyway. A simple way to think about this is the basic IS-LM story (without wanting to get into a big debate about the efficacy of IS-LM):


In this version, the IS curve has shifted so far to the left that it intersects with the LM curve at the horizontal section - the zero bound problem. If I set i equal to the nominal interest rate and assume positive inflation, this translates to a negative real rate. Full employment, however, is only consistent with a nominal interest rate below zero, which implies a lower real interest rate as well. Given the zero bound on nominal rates, Keynesians (using the term loosely; labels can get sloppy), turn their attention to reducing the real interest rate.

Given the zero bound, we talk about ways to shift the IS curve to the right. Usually, these discussions take on two forms. The first is fiscal policy via deficit spending, which I am very confident will do the trick, but I am also very confident it really doesn't "fix" the economy. The instant you back off the fiscal accelerator, the economy falters. In my mind, fiscal policy is undoubtedly necessary in the near-term as a stop-gap measure, but in the long-term is leading the US down the Japanese path of endless deficit spending.

The second policy response is monetary, typically raising inflation expectations. This in turn lowers real interest rates - and this is the important part - at all nominal interest rates. This, like fiscal policy, induces a rightward shift in the IS curve:


At the zero bound, higher inflation expectations lowers the real interest rate, hence the Keynesian preoccupation. But I think the key here is the rightward shift of the IS curve past the zero bound "kink" at which point nominal and real rates begin to rise and we lift off the zero bound. We can talk about different mechanisms to accomplish this, but moving sustainably beyond that kink should be the ultimate policy goal.

Thus, ultimately I think you can have a focus on negative real interest rates as a stop on the path to Sumner's desired outcome. And I completely agree with Sumner (and I think I am paraphrasing him correctly here) in that the failure of interest rates both real and nominal to rise represents an absolute, unmitigated, unacceptable, and quite frankly irresponsible failure on the part of the Federal Reserve:



One would think the Fed would sit up and take notice that the US government sold 10 year debt at a record low interest rate today as a sign that they need to do more, not less. Notice also the failure of either real or nominal rates to get a boost after Operation Twist. This is evidence of the pointlessness of that effort. For all the grief I have given St. Louis Federal Reserve President James Bullard, he certainly had it right last year when he said:

A strategy aimed at lowering longer-term borrowing costs, sometimes referred to as a twist operation, would help drive down longer-term borrowing costs for businesses, economists say.

But James Bullard, president of the St. Louis Fed, said the effectiveness of such a strategy is questionable.

"A twist operation would not have very much effect," Bullard told Reuters Insider in an interview. "It's been analyzed many times, and the general tenor of that analysis is that it did not have very much effect."

Finally, notice that I also put the variable "confidence" into the specification for the IS curve. Here I am offering another mechanism by which we can think that QE has an impact by signaling that policymakers have an intention and a desire to maintain the pre-recession path of nominal spending (here I am paraphrasing Brad DeLong). The failure to maintain that path has undermined confidence in that agents now have less certainty in the future path of income. If policymakers let the path of nominal spending shift downward once, why should we not expect them to do it again?

Bottom Line: I don't think what Sumner describes as a Keynesian focus on negative real interest rates is inconsistent with his views on what should happen in the presence of a credible monetary policy committed to actually lifting us off the zero bound.

"Central Banks Should Do Much More"

In the Financial Times, Roger Farmer notes a close association between Fed policy and stock market values:

[1] Is the date at which QE1 began, [2] Is the date at which the Fed started to buy mortgage backed securities, [3] Is the date at which QE1 ended, and [4] Is the date of the Jackson Hole conference at which the Fed announced that it would begin QE2.

How can central banks use this information? He says the stock market crash *caused* the Great Recession. Thus, if the Fed can raise stock market values, and the graph above suggests it can, it will turn the economy around and reduce unemployment:

The stock market crash of 2008 caused the Great Recession. If this relation is truly causal, then central banks can do a great deal to alleviate persistent unemployment. ...
The chart shows that when the Fed began to purchase mortgage backed securities in March of 2009, the stock market began to rally. When QE1 ended a year later, the market tanked and equities did not recover until the Fed saw the error of its ways. When the Fed announced the beginning of QE2, at the Jackson Hole conference in April of 2010, there was a third turning point in the market and the beginning of a new bull market.
The coincidence of these market turning points with the beginning and ending of Fed asset purchase programs is not accidental.  The Fed moves markets!
So what! Who cares if a bunch of Wall Street investors make money? ... There is a connection between the stock market and the welfare of the average citizen... When the stock market plummets, so do the prospects of the average worker.

In the paper he cites as making the case that the relationship is causal, i.e. that stock market values cause unemployment (the argument is theoretical), he says:

I realize that correlation is not causation and these graphs do not prove that the stock market crash caused the Great Depression. However, they do suggest to me that a theory that does make that causal link deserves further consideration.

The paper includes the following graphs:

Figure 1: Unemployment and the Stock Market During the Great Depression

Figure 2: Unemployment and the Stock Market over the Last DecadeFarmer4

I am not yet fully convinced that causality runs from stock values to unemployment, it seems more likely that economic conditions cause both. However, I agree that central banks should do more, and this is evidence that the case for doing more can be derived from more than one theoretical construct, i.e. that it is relatively robust.

Tuesday, May 08, 2012

Inflation Can Help to Stimulate a Depressed Economy

If inflation begins to increase before the economy has fully recovered, the Fed shouldn't panic:

Federal Reserve Policy: Exceptions Improve the Rule: At some point during the recovery, the Fed may face an important decision. If the inflation rate begins to rise above the Fed’s 2% target and the unemployment rate is still relatively high, will the Fed be willing to leave interest rates low and tolerate a temporary increase in the inflation rate?
Probably not. Even though higher inflation can help to stimulate a depressed economy, Ben Bernanke, Chairman of the Federal Reserve, is not in favor of allowing higher inflation because it could undermine the Fed’s “hard-won inflation credibility.” And recent Fed communications seem to be setting the stage for the Fed to abandon its commitment to keep interest rates low through the end of 2014. This adds to the likelihood that the Fed will raise interest rates quickly if inflation begins increasing above the 2% target even if the economy has not yet fully recovered.
As I’ll explain in a moment, that’s the wrong thing to do. But first, why does the Fed put so much value on its credibility? ...[continue reading]...

Friday, May 04, 2012

Symmetric Goals, Asymmetric Risks

David Altig:

Symmetric goals, asymmetric risks, by David Altig: Mark Thoma has been hanging out with my boss or at least was at the same conference, where Thoma had a chance to try out his reporter chops:

"I just got out of a press conference with Dennis Lockhart (Atlanta Fed president) and Charles Evans (Chicago Fed president). I can't say there was any real news, but I did manage to ask a question... I asked whether the 2% inflation target was truly symmetric."

Thoma got an answer, though seemingly not one that left him totally convinced:

"Both insisted that the target is symmetric. However, Lockhart said that we know much more about the effects of inflation than deflation, and that preventing deflation was therefore job number one (which doesn't really answer the question). He didn't explain what he is so afraid of if inflation goes up...
"Evans, while explicitly agreeing the target was symmetric, made comments that indicated that it may not be. He said the Fed has not done a very good job of communicating its tolerance around the 2 percent target, both up and down, and they need to improve. But if the target is really symmetric, simply saying that (along with the tolerable range) is all that is required. Talking separately about tolerance for over and under-shooting isn't needed."

Evans' and Lockhart's statements stand on their own, but we've collected some information via the Atlanta Fed's Business Inflation Expectations survey that helps me think about the Thoma question. The chart below plots the answers, collected in the January and April surveys, to the following query: "Projecting ahead, to the best of your ability, please assign a percent likelihood to the following changes to unit costs per year over the next five to 10 years."

Distribution of Respondent Expectations for Unit Costs

The question focuses on unit labor costs in order to elicit responses about what businesses may actually be planning for, as opposed to their guesses about a more abstract concept of overall inflation. The question focuses on expectations five to ten years into the future because the inflation goal of the Federal Open Market Committee (FOMC) is explicitly a long-run objective.

The obvious pattern in these survey responses is their asymmetry to the upside. The most probable outcome, according to the respondents, is that long-term costs will rise in a range that includes the FOMC's long-run inflation objective. But they also put an almost 50 percent probability on annual outcomes higher than 3 percent. Less than 20 percent probability is placed on costs rising at rates of less than 1 percent.

This picture is one of asymmetric risks to the inflation outlook, and as such it is an important element in thinking through policy choices. Symmetry in the sense of having an equal distaste for misses on either side of an objective does not necessarily imply symmetry with respect to the risks of meeting that objective.

To begin with, the Fed does have a dual mandate. Disinflation or, in the extreme, deflation has the potential to be problematic for growth and employment when interest rates are very low. The reason, if you buy the analysis, is that, with no room for rates to move lower, a decline in inflation raises the real cost of borrowing. A higher cost of borrowing restrains spending, creating an additional drag on economic activity in already tough circumstances.

The reverse argument has, of course, been made for temporarily tolerating inflation that is somewhat higher than the long-run objective. But even if you aren't quite sold on the wisdom of that approach—and I'll get to that in a bit—it is clear that, with policy rates near zero, misses to the downside on inflation bring risks to the Fed's growth mandate that are not implied by misses to the upside. Hence President Lockhart's comment regarding the importance of preventing deflation.

So why not respond to this asymmetric risk to growth by taking a chance on higher inflation? That question takes us back to the chart above. Taken at face value, the probabilities reported by our survey respondents suggest that the FOMC has been pretty successful in convincing folks that very low rates of inflation or deflation will not be allowed to set in. Perhaps this conviction is not surprising given the relatively aggressive responses of the committee to the disinflation scares of 2003 and 2010.

But the response to asymmetric risks to growth at low inflation rates may have had the effect of inducing asymmetric risks to the upside with respect to Fed's price stability mandate. Again taken at face value, the results of our business inflation expectations survey definitely imply a one-sided bet by businesses on how the FOMC might miss on its inflation objective. That could well explain why one would be so concerned if inflation rises. Just as there are asymmetric risks associated with below-objective inflation when it comes to the Fed's growth and employment mandate, there are asymmetric risks associated with above-objective inflation when it comes to the price stability mandate.

Thursday, May 03, 2012

"Gauging the Benefits, Costs, and Sustainability of U.S. Stimulus"

[Another travel day, and then hopefully back to normal tomorrow.]

Did the stimulus work? According to a collaboration between Fitch Ratings and Oxford economics, the answer is yes:

Government stimulus moves may have ended recession, by Jim Puzzanghera, Los Angeles Times: Without the unprecedented stimulus actions by the federal government triggered by the 2008 financial crisis, the Great Recession might still be going on, according to a study by Fitch Ratings. ...
The boost from those policies helped the nation's gross domestic product increase 3% in 2010 and 1.7% last year; absent the stimulus, the U.S. "might still be mired in a recession," according to the study, done in conjunction with Oxford Economics.
The U.S. economy would have seen little or no growth the last two years without the policies, the report says, and those actions appear "to have significantly softened the severity of the decline" in GDP in the year immediately after the recession ended in mid-2009.
Though the Fed's monetary policy actions were helpful, fiscal stimulus by Congress and the White House "had the strongest positive impact on consumption during the recent recovery," the study found.

This is a graph from the Fitch report (which I got by email, available here with registration):


From the Fitch summary of the report:

Stimulative Policies Driving Recovery: To better understand the future sustainability of the current U.S. economic recovery, Fitch Ratings and Oxford Economics have collaborated to analyze how much of the U.S.’s postcrisis economic growth is attributable to policy actions by the federal government and the Federal Reserve. Oxford Economics’ Global Economic Model (GEM) suggests that the U.S. policy response to the recession increased aggregate GDP by more than 4% two and three years after the trough of the last crisis than otherwise would have been the case (see graph...). These policies helped to support GDP growth of 3.0% in 2010 and 1.7% in 2011, implying that the U.S. might still be mired in a recession absent this stimulus. ...
Credit Implications: The current level of uncertainty associated with the future growth trajectory of the U.S. economy increases risk in general. This uncertainty, in turn, has the potential to affect the creditworthiness and credit ratings of all U.S. sectors, including corporates, municipal finance, and structured finance. A scenario of lower U.S. growth could also have global rating implications, particularly on foreign firms that rely on the U.S. as an export market. Until it becomes clearer that the economy can continue to grow sustainably without the support of stimulative policies, Fitch anticipates limited future rating upgrades within the sectors most closely tied to the U.S. economy.

Tuesday, May 01, 2012

Please Sirs, May We Have Some More?

Nobel Prize winner Robert Engle says more inflation would help:

New York University professor Robert Engle said policy makers should consider allowing slightly higher inflation as a way to spur the U.S. economy, joining fellow Nobel Prize winner Paul Krugman who says it could reduce unemployment.

“A little bit of inflation would do a whole lot of good for the U.S. economy, would certainly do a lot of good for the housing market,” Engle, who won the Nobel Prize in economics in 2003...

Is the Fed's Inflation Target Symmetric?

I just got out of a press conference with Dennis Lockhart (Atlanta Fed president) and Charles Evans (Chicago Fed president). I can't say there was any real news, but I did manage to ask a question. After forgetting to introduce myself, and the organization I write for like everyone else did, I asked whether the 2% inflation target was truly symmetric. I noted that the projections from members of the FOMC looked more like a ceiling than a central point, and that the comments made by Dennis Lockhart in the previous session made me wonder if, in fact, he thought there were asymmetric costs to over and under-shooting. I also asked Lockhart in particular what he is so afraid of if the inflation rate goes up temporarily.

Both insisted that the target is symmetric. However, Lockhart said that we know much more about the effects of inflatio0n than deflation, and that preventing deflation was therefore job number one (which doesn't really answer the question). He didn't explain what he is so afraid of if inflation goes up, and I didn't have enough experience to realize I should follow up. Wish I had (I'll bea t the Atlanta Fed in two weeks, so maybe I'll get another chance)

Evans, while explicitly agreeing the target was symmetric, made comments that indicated that it may not be. He said the Fed has not done a very good job of communicating its tolerance around the 2 percent target, both up and down, and they need to improve. But if the target is really symmetric, simply saying that (along with the tolerable range) is all that is required. Talking separately about tolerance for over and under-shooting isn't needed.

Finally, in the session prior to the press conference featuring Evans and Lockhart (among others), Evans seemed to endorse NGDP targeting. He didn't use those words exactly, but toward the end of the session he did talk about the advantages that come with this approach to monetary policy. I took it as an endorsement, though he might object to characterizing it that way. I think he's around today, and if I see him again, I will ask directly. (However, before the press conference started we were chatting and I told him I had just tweeted "Evans just endorsed NGDP targeting." He didn't object, so make of that what you will).

Friday, April 27, 2012

"NGDP Targeting: Some Questions"

David Andolfatto has some questions for supporters of NGDP targeting (David's request to point him in the direction of past defenses of NGDP targeting reminds me of this from David Beckworth responding to some questions I posed in a post that explained why Bernanke and Mishkin do not think that targeting nominal GDP growth is better than targeting inflation. However, as I recently noted in a post highlighting the close connection between NGDP and inflation targeting, I've learned some things since then and one or two of the questions would differ today):

NGDP Targeting: Some Questions, Macromania: Let me start by saying that the idea of a NGDP target does not sound outlandish to me. But I feel the same way about price-level and inflation targeting. The first order of business for a central bank is, in my view, is to provide a credible nominal anchor. Probably not  much disagreement about this out there.

Proponents of NGDP targeting, however, like Scott Sumner and David Beckworth, for example, seem to believe very strongly in the vast superiority of a NGDP target--not just as a policy that would mitigate the effects of future business cycles--but also as a policy that should be adopted right now by the Fed to cure (what they and many others perceive to be) an ongoing "aggregate demand deficiency." 

What I am curious about is not that they believe this, but how strongly they believe in it. I respect both of these writers a lot, so naturally I am led to ask myself how they came to hold such a strong belief in the matter. What is the theoretical underpinning for NGDP targeting? And what is the empirical evidence that leads them to believe that an NGDP target right now is a cure for whatever ails us right now? 

One way to seek answers to these questions is to spend hours perusing their past blog posts. I'm sure they must have answered these questions somewhere. But I figure it will be more efficient for me to just state my questions and have them (or somebody else) point me in the right direction for answers.

First, let us consider the (or a) theoretical justification for NGDP targeting in general. Actually, David was kind enough to point me a nice paper on the subject: Monetary Policy, Financial Stability, and the Distribution of Risk (Evan F. Koenig). Here is the abstract:

In an economy in which debt obligations are fixed in nominal terms, but there are otherwise no nominal rigidities, a monetary policy that targets inflation inefficiently concentrates risk, tending to increase the financial distress that accompanies adverse real shocks. Nominal-income targeting spreads risk more evenly across borrowers and lenders, reproducing the equilibrium that one would observe if there were perfect capital markets. Empirically, inflation surprises have no independent influence on measures of financial strain once one controls for shocks to nominal GDP.

Alright, fine. The argument hinges on the existence of nominal debt obligations. Well, not just debt that is stated in nominal terms, but debt that is fixed in nominal terms (renegotiation is ruled out). This is, of course, a story that goes back at least to Irving Fisher (1933): The Debt-Deflation Theory of Great Depressions.

I've always like the Fisher story. And it obviously has an element of truth to it. But admitting this is different than asserting that the mechanism is quantitatively important, especially for generating decade-long recessionary episodes.

First of all, as I alluded to above, people can and do renegotiate the terms of nominal debt obligations if things get too far out of whack. True, renegotiation (including outright default) is costly and imperfect, but it happens nevertheless. And to the extent it does, nominal debt is not as "fixed" as some make it out to be. It would be good to know how much renegotiation does or does not happen out there.

Second, even if renegotiation is quantitatively unimportant, we should consider the dynamics of debt creation and retirement. At any point in time there is an outstanding stock of nominal debt, with terms negotiated in the past on the basis of future price level paths (among other things, of course). We should also keep in mind that new debt agreements are being formed, and old agreements are being retired continuously throughout time. How big are these flows relative to the outstanding stock of debt?

I think the answer to the previous question is important for understanding how long the real effects of a "negative price-level shock" can be expected to last. If "debt turnover" is high, then such a shock cannot reasonably be expected to generate a decade of subnormal economic performance.

We are presently more than 3 years out from the sharp decline in the price-level that occurred in the fall of 2008. How much new nominal debt has been issued since then--debt that would have presumably been negotiated with expectations of a new price-level path? Does anybody know?  In particular, if one is advocating a return to the old price-level path right now, what does this mean for the creditors who have extended loans over the past 3 years? Should we care? Why or why not?

I have not even touched upon the practical feasibility of NGDP targeting--I'll save this for another day. But for now, I'd like to know the answers to my questions above. Who knows, I too may become one of the faithful! 

A good weekend to all. 

Fed Watch: Bernanke's Shift

Tim Duy:

Bernanke's Shift, by Tim Duy: There has been a fierce counterattack to Federal Reserve Chairman Ben Bernanke's assertion that he is indeed the same Professor Bernanke that advised the Bank of Japan a decade ago. See, for example, Brad DeLong, David Beckworth, and Ryan Avent. DeLong identifies this 1999 Bernanke quote:

[Si]nce 1991 inflation has exceeded 1% only twice... the slow or even negative rate of price increase points strongly to a diagnosis of aggregate demand deficiency…. [C]ountries that currently target inflation… have tended to set their goals for inflation in the 2-3% range, with the floor of the range as important a constraint as the ceiling….

and concludes that Bernanke previously believed the inflation target should be between 2 and 3 percent, with 2 percent being a floor. One could infer, then, that Bernake at one point believed in a symmetric objective around 2.5 percent, with a hard floor and ceiling on 50bp of either side of that objective. Now the Fed has sanctified a 2 percent target.

This shift is important and evident in the path of inflation, and was my point in this post. Prior to the recession, headline PCE inflation was running about 2.4 percent a year. Now the trend is a smidgen above 2 percent:


DeLong, in another post, does a similar picture using core-CPI. I have tended to shift to headline number number because that is the Fed's stated target and there is widespread misunderstanding about the relevance of core-inflation in the policymaking process. Indeed, the belief that policymakers are somehow misleading the public about the true path of inflation runs deep in the Fed itself. Note that Beckworth takes a different direction, focusing on the path of nominal demand rather than inflation and reaches a similar conclusion - the we are witnessing an attack of the body snatchers.

I think we can conclude, by Bernanke's statement's in the past and the actual path of inflation now, that Bernanke has embraced the recession as yet another exercise in opportunitistic disinflation in which the Fed can knock another 40bp off the expected rate of inflation.

The story gets more interesting. In his press conference, Bernanke says:

So it's not a ceiling, it's a symmetric objective and we tend to bring inflation close to 2 percent. And in particular, if inflation were to jump for whatever reason and we don't have, obviously, don't have perfect control of inflation, we'll try to return inflation to 2 percent at a pace which takes into account the situation with respect to unemployment.

Avent rightly calls foul on this claim:

Perhaps more telling, the Fed gives a range for projected inflation over the next three years with 2% as the upper extent. If the Fed does indeed have a symmetric approach to the target, as Mr Bernanke asserted yesterday, one would expect 2% to be at the middle of the range, not the top. This is particularly damning as the Fed's estimate of the natural rate of unemployment doesn't appear at all in the projected unemployment-rate range over the next three years; the closest the Fed comes to meeting that side of the mandate is in 2014, when the bottom end of the projected unemployment-rate range gets within 0.7 percentage points of the top end of the natural-rate range.

Bernanke is clearly misleading us when he claims the target is symmetric as the Fed's own projections clearly treat the target as a hard ceiling. The next words out of Bernanke's mouth are also telling:

The risk of higher inflation, you say 2-1/2 percent, well, 2-1/2 percent expected change might involve a distribution of outcomes. Some of which might be much higher than 2-1/2 percent.

This was the topic my post earlier this week. Monetary policy is not neutral with regards to the distribution of income and wealth. The Fed does not want inflation to exceed the 2 percent inflation target as that will result in a new distribution. The subsequent alterations to the outcomes will not be symmetric; some will gain more than 2.5 percent, some will lose more.

Note - and I think this is important - when Bernanke's Fed took the opportunity to shift down the path of inflation by sanctifying the 2 percent target, they were comfortable with the subsequent shift in the distribution of outcomes. And consider that shift. At a time when households were overwhelmed with excessive debt, the Fed deliberately chose to increase the real burden of the debt by changing the inflation trajectory.

Why one would use a balance sheet recession to shift downward the path of prices is certainly something of a mystery. But it does imply that the Fed wanted to induce a new distibution of outcomes, even knowing that the beneficiaries would not be households.

Bottom Line: Bernanke is being disingenous in his defence. Despite his claims that his earlier views only applied to deflation, his writings still appear at odds with his willingness to embrace a new price and aggregate demand paths. Moreover, the Fed's own forecasts clearly do not support his contention that the target is symmetric, but indeed a hard ceiling. The Fed must also know that the by reducing the path of inflation they have knowing altered the distribution of outcomes in a way that is likely to slow the pace of recovery. Finally, with inflation near 2 percent, I suspect the bar toward another round of QE is higher than many believe.

GDP Growth Could be Higher

GDP growth for the first quarter, as noted in the post below this one, is estimated to be 2.2%. That is not as high as it needs to be to recover in a decent amount of time, and one of the problems is that government spending has declined during the recession. This has been driven largely by cuts at the state and local level, and it is holding back GDP growth.

I probably should have used the mediocre growth in the first quarter to call, yet again for more aggressive monetary and fiscal policy -- fiscal policy in particular. What are we thinking making cuts like this as the economy is trying to recover from such a severe recession? But what's the use? Policymakers have made it very clear they are unwilling to do more to try to help the unemployed. In fact, many policymakers would like to do less and it's only because of gridlock on Congress, and gridlock on the Fed's monetary policy committee that the cuts (austerity) haven't been worse, and interest rates are still low.

So I probably should have noted the need for more aggressive policy, but thought, why bother? I suppose there's value in pointing out the failure, but at this point that shouldn't be news.

Wednesday, April 25, 2012

Fed Policy Remains on Hold

My reaction to the Fed's Press Release from its monetary policy meeting that ended today.

Fed Policy Remains on Hold: (MoneyWatch) COMMENTARY The Federal Reserve just concluded a two-day meeting to decide what's next for monetary policy, and as was widely expected the Federal Reserve decided to keep policy on hold. Interest rates are still expected to remain extraordinarily low through late 2014, and there is no change in the Fed's other programs intended to stimulate the economy such as its program "to extend the average maturity of its holdings of securities" and reinvest principle as the assets mature.

The question is whether this is the correct policy. Presently, the Fed is missing its employment target, and it is also below its declared inflation target of 2 percent. As the statement says, "the Committee anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate." So there is no risk of overshooting the inflation target according to the Fed, only a risk of undershooting it.

If that's true, if the Fed is likely to undershoot both of its targets -- the committee believes that in the worst case it will only hit its inflation target, not exceed it -- then why not pursue more aggressive policy?

The answer, despite what the press release says about low inflation risks, is fear of inflation. In particular, it is the fear that inflation expectations will become unmoored. The Fed believes that expectations of inflation are largely self-fulfilling. If people expect prices to go up, they will take actions such as demanding wage increases that will make that happen, and the expectation will be validated. Then, as inflation begins rising, that can then lead to further increases in expected inflation which will also be self-fulfilling, and an upward spiral is set in motion.

Is this fear realistic? Some of us, myself included, think the Fed should overshoot the inflation target in the short-run since that would stimulate the economy, then bring inflation back to target once the economy nears full employment. But the Fed seems unwilling to tolerate even the possibility that inflation might cross the 2 percent threshold.

I think the Fed should have more faith in itself. It is still paralyzed by the 1970s when the self-fulfilling inflation expectations scenario above played out to the detriment of the economy. But the inflation didn't just happen without the central banks participation, policy mistakes had a lot to do with the outcome. Does the central bank think it has learned nothing? Would it really stand by and watch inflation rates go into the double digits without taking corrective action?

If inflation expectations begin to rise, and there's no sign of that presently, the Fed has the tools to bring them back down again if it has the will to use them. Is that the problem? Is the Fed worried that it won't have the courage to bring down inflation if it is called for (which would likely slow the economy)? If the unemployment rate is still relatively high and inflation begins accelerating, would the Fed be unwilling to try to fix the problem?

If unemployment is still too high, there's no reason to fix the problem. That's the policy that is called for. The important question is what happens as we approach full employment, and I have little doubt that the Fed will take appropriate action in such a case. I just wish the Fed had more faith in itself. If it did -- if it was absolutely clear that the appropriate action will be taken as the economy reaches full employment -- then long-term expectations would not be a problem.

Monday, April 23, 2012

Fed Watch: Distributional Impacts of Monetary Policy

Tim Duy:

Distributional Impacts of Monetary Policy, by Tim Duy: Dean Baker, responding to this Wall Street Journal article, sees an opportunity to make us aware on the distributional impacts of monetary choices. Specifically, Baker responds to the claim that inflation erodes earnings:

Actually, most wages follow in step with inflation, although some workers do see declines in real wages when inflation rises.

People seem to forget the connection between inflation and wages. A sustained increase in inflation needs to be accompanied by a matching increase in wages, otherwise higher inflation would simply undermine real purchasing power, leading to slower growth and a subsequent decline in the inflation rate. To be sure, as Baker notes, while on average higher inflation is matched with higher nominal wages, it does not affect all workers equally - workers with less bargaining power could see their real wages decline even if average real wages hold constant.

Baker identifies this basic chart (I replaced CPI with PCE inflation) to support his argument (click on figures for larger versions):

Notice that Baker correctly shifts from real wages to the broader measure of real compensation. He says:

These series give the basic story, although they are not perfect for reasons that you do not want to hear about. If you can see a negative relationship (i.e. higher inflation leads to lower real wage growth) you have better eyesight than me.

In fact, the correlation between these two series is 0.36. In other words, there is a weak positive relationship between inflation and real compensation - although I would be wary about calling it a causal relationship, and instead only point out that although it is often claimed that inflation erodes real wages, this is not obvious. What is more evident, and causally related, is the link between productivity and real compensation:

The correlation is 0.75, and the story is a familiar one - we expect that higher productivity growth results in higher real wage growth. That said, a careful eye will notice that the growth rates are not identical, yielding this well-known result:

Certainly since the 1980s, the gap between output and real compensation is rising. Another version of this issue is that labor's share of income has been falling since 1980. What is of course curious is that this occurs despite the sustained period of disinflation. Those who claim that inflation erodes real wage growth seem to miss that the period since 1980 has seen real compensation growth slow to a pace below productivity growth despite falling inflation. This issue is taken up by Steve Randy Waldman at interfluidity with a thought provoking post:

An increase in unit labor costs can mean one of two things. It can reflect an increase in the price level — inflation — or it can reflect an increase in labor’s share of output. The Federal Reserve is properly in the business of restraining the price level. It has no business whatsoever tilting the scales in the division of income between labor and capital.

Yet throughout the Great Moderation, increases in unit labor costs were the standard alarm bell cited by Fed policy makers as an event that would call for more restrictive policy. And all through the Great Moderation, except for a brief surge during the tech boom, labor’s share of output was in secular decline...

...even if the Fed didn’t “cause” the decline in labor’s share, Great Moderation monetary policy made it very difficult for labor’s share to grow...

...Since the early 1990s, all actors in the US political system have understood that policies that increase unit labor costs risk a response by the “inflation fighting” central bank, whose “credibility” was swaggeringly defined as a willingness to provoke recession rather than risk inflation. In this environment, the decline of labor unions and their shift in focus from wage growth to working conditions was understandable...

Waldman is saying that the Federal Reserve is at least complicit in allowing the competition between capital and labor to be tilted toward capital (not sure this should be a surprise - I don't see a revolving door between the Federal Reserve and the AFL-CIO). In other words, monetary policy has a direct impact on the distribution of income. It's not just simply raising and lowering interest rates to affect the level of output - it has an impact on how the subsequent output is split up. Waldman offers some policy advice:

All of this is one more reason to prefer the NGDP path target promoted by Scott Sumner and his merry Market Monetarists. It might prove difficult in practice to target inflation without paying some especial attention to wage growth. But a central bank can target the path of aggregate expenditure without playing favorites about who pays what to whom. Simple neutrality by the central bank in the contest between capital and labor would be a huge improvement over the status quo.

Note that even if the central bank is no longer playing "favorites", monetary policy would still have a distributional impact. For example, reverting to the pre-recession path of nominal spending would likely entail a temporarily higher rate of inflation than currently expected. And higher than expected inflation will indeed create some winners and losers:

However, the biggest losers are creditors who are almost by definition wealthy, since people owe them money. If a creditor has lent out $100 million at 2 percent interest (e.g. buying a 10-year U.S. or German government bond) and the inflation rate rises from 2 percent to 4 percent, this creditor has lost an amount equal to 100 percent of his expected income or 2 percent of his wealth. This is a far larger loss than any worker could experience as a result of this increase in the inflation rate.

Who would be the winners?

Also, most workers are debtors to some extent. They are likely to have mortgage debt, credit care debt, student loan debt and or car debt. A higher rate of inflation means that they can repay this debt in money that is worth less than the money they borrowed.

And once again, we get to the same place - changing monetary policy at this juncture would likely have significant impacts on the distribution of income and wealth. And an unwillingness to alter this current distribution is likely another reason we would not expect the Federal Reserve to change their basic policy framework away from the current 2 percent inflation target regime.

Friday, April 20, 2012

"Plutocrats and Printing Presses"

Paul Krugman:

Plutocrats and Printing Presses, by Paul Krugman: These past few years have been lean times in many respects — but they’ve been boom years for agonizingly dumb, pound-your-head-on-the-table economic fallacies. The latest fad — illustrated by this piece in today’s WSJ — is that expansionary monetary policy is a giveaway to banks and plutocrats generally. Indeed, that WSJ screed actually claims that the whole 1 versus 99 thing should really be about reining in or maybe abolishing the Fed. And unfortunately, some good people, like Daron Agemoglu and Simon Johnson, have bought into at least some version of this story.
What’s wrong with the idea that running the printing presses is a giveaway to plutocrats? Let me count the ways.
First, as Joe Wiesenthal and Mike Konczal both point out,... quantitative easing isn’t being imposed on an unwitting populace by financiers and rentiers; it’s being undertaken, to the extent that it is, over howls of protest from the financial industry. ...
Beyond that, let’s talk about the economics. The naive (or deliberately misleading) version of Fed policy is the claim that Ben Bernanke is “giving money” to the banks. What it actually does, of course, is buy stuff, usually short-term government debt but nowadays sometimes other stuff. It’s not a gift.
To claim that it’s effectively a gift you have to claim that the prices the Fed is paying are artificially high, or equivalently that interest rates are being pushed artificially low. And you do in fact see assertions to that effect all the time. But if you think about it for even a minute, that claim is truly bizarre.
I mean, what is the un-artificial, or if you prefer, “natural” rate of interest? As it turns out,... the natural rate of interest is the rate that would lead to stable inflation at more or less full employment.
And we have low inflation with high unemployment, strongly suggesting that the natural rate of interest is below current levels... Fed policy isn’t some kind of giveway to the banks, it’s just an effort to give the economy what it needs.
Furthermore, Fed efforts to do this probably tend on average to hurt, not help, bankers. Banks are largely in the business of borrowing short and lending long; anything that compresses the spread between short rates and long rates is likely to be bad for their profits. And the things the Fed is trying to do are in fact largely about compressing that spread...
Finally, how is expansionary monetary policy supposed to hurt the 99 percent? Think of all the people living on fixed incomes, we’re told. But who are these people? ... The typical retired American these days relies largely on Social Security — which is indexed against inflation. ...
No, the real victims of expansionary monetary policies are the very people who the current mythology says are pushing these policies. And that, I guess, explains why we’re hearing the opposite. It’s George Orwell’s world, and we’re just living in it.

We shouldn't let fiscal policymakers -- who have their own set of "agonizingly dumb, pound-your-head-on-the-table economic fallacies" to support inaction -- off the hook either.

Monday, April 16, 2012

Fed Watch: On Labels

Tim Duy:

On Labels, by Tim Duy: I generally follow the convention of referring to monetary policymakers as "hawks" or "doves." But what really do these terms mean? Are they appropriate or meaningful distinctions? On this topic, Cleveland Federal Reserve President Sandra Pinalto says:

I’ve been part of the Federal Reserve for a long time, more than 28 years. Those labels actually came into play when there wasn’t agreement around an inflation objective. There were some members of the Committee who felt a higher rate of inflation was appropriate. Those individuals were dubbed doves. And there were some that felt that we needed a lower rate of inflation. In fact, one of my predecessors, Lee Hoskins, was focused on achieving zero inflation. And he was considered a hawk.

We now have agreement and a statement by the Committee that 2 percent is the appropriate level of inflation. So I don’t think the titles of hawks and doves are useful when the Committee has stated that we have a 2 percent inflation goal.

If there are titles that people want to use, I would like to be labeled someone who is open-minded. Or someone who is pragmatic...

Pinalto's point is that now that the FOMC has settled in on a 2% inflation target, there is no distinction between hawks and doves. Is this true?

I see her point, but would offer some caveats. First is that perhaps we could consider the entire FOMC as hawks relative to a more dovish policy such as a 4% inflation target. Second is that Chicago Federal Reserve President Charles Evans has supported aggressive policy even if inflation rose as high as 3%. this would seem to be a contradiction to Pianlto's claim that there are no hawks or doves; Evans certainly appears to be a dove relative to the 2% inflation target.

Also, the 2% target is not written in law. Will this become a litmus test in Senate confirmation hearings for Federal Reserve governors? The lack of distinction between hawks and doves might simply be a transitory affair if future policymakers have different views - or the economy necessitates different views.

These issues aside, I still think Pinalto's point is well taken. So how should we use the terms "hawks" and "doves" at a time when most policymakers have coalesced around the same target? I tend to think of the distinction in terms of the policymaker's inflation forecast. A hawk is a policymaker who perceives a greater upside risk to the inflation forecast and thus anticipates policy will turn tighter sooner than later. On the other side, doves tend to see less upside risk to the inflation forecast, or even downside risk, and thus do not anticipate a tighter policy in the near term. (Of course, you could argue that labels are not necessary to begin with, which may be true, but I think will ultimately occur as a means of identifying the different positions of policymakers).

To be sure, these are state contingent labels. Deeper into a tightening cycle, a hawk would be a policymaker more inclined toward further rate hikes, a dove less inclined. And during an easing cycle, a dove would be inclined to cuts rates sooner and perhaps more deeply. But in either case, the distinction between a dove and a hawk is the relative timing and or pace of policy changes necessary to achieve the 2% inflation target.

Bottom Line: The hawks/doves distinction has lost some of its original interpretation as the Fed settles in on a 2% target. That said, policymakers still have different interpretations of the appropriate policy path given their economic forecast, and those interpretations can separate policymakers into camps that can still be labeled (for ease of exposition rather than a normative judgement) as generally hawks or doves. In general terms then, a hawk sees current policy as more likely to be too loose than too tight, a dove sees vice-versa, thus imparting some information about the relative views on policy direction. But Pinalto's final point also defines what we really want in a policymaker - an open-mind, rather than one entrenched in a particular vision of the economy regardless of the realities of the data. A policymaker who might be a hawk or a dove as circumstances change.

Sunday, April 15, 2012

"The ECB’s Lethal Inhibition"

Barry Eichengreen:

The ECB’s Lethal Inhibition, by Barry Eichengreen, Commentary, Project Syndicate: Last December, with Europe’s financial system on the brink of disaster, the European Central Bank stunned the markets with an unprecedented intervention... The ECB’s surprise liquidity operation put the continent’s crisis on hold. But now, just fourth months later, matters are again coming to a head. The big southern European countries, Spain and Italy, battered by austerity, are spiraling into recession. ... So, will it be once more into the breach for the ECB?
The hurdles to further monetary-policy action are high, but they are largely self-imposed. At its most recent policy meeting, the ECB left its policy rate unchanged, citing inflation half a percentage point above the official 2% target. ...
A second argument against further monetary-policy action is that it should be considered only as a reward for budgetary austerity and structural reform, areas in which politicians continue to underperform. ...
With governments hesitating to do their part, the ECB is reluctant to support them. In its view, rewarding them with monetary stimulus ... only relieves the pressure on national officials to do what is necessary.
If this is the ECB’s thinking, then it is playing a dangerous game. Without spending and growth, there can be no solution to Europe’s problems. Absent private spending, budget cuts will only depress tax revenues, requiring additional budget cuts, without end. There will be no economic growth at the end of the tunnel, and political support for structural reforms will continue to dissipate.
The ECB is preoccupied by moral-hazard risk... But it should also worry about meltdown risk... The ECB will object, not without reason, that ... a ... cut in policy rates or “quantitative easing” by another name will do nothing to enhance the troubled southern European economies’ competitiveness.
True enough. But, without economic growth, the political will to take hard measures at the national level is unlikely to be forthcoming. ...