Tim Duy's Fed Watch

Structural and Cyclical

For several months, I have been telling stories that decompose US economic activity into what I think of as cyclical and structural dynamics.  I believe the distinction is very important to firms, markets, and policymakers who need to be aware when one dynamic is clouding their view of the other.

 

The cyclical dynamics, in my opinion, are the most spectacular, the most visible.  The real cyclical fireworks began in the second half of 2008, as the energy price shock decimated household budgets, quickly followed by a financial shock that triggered an additional pullback in demand.  Firms unexpectedly found they had far too much excess capacity in this environment, and began the process of "rightsizing."  Job losses mounted even as falling energy costs and lower interest rates for those not credit constrained began to put a floor under spending.

 

Eventually, firms would realign capacity with the new level of demand, and job losses would taper off.  That would mark the early stages of the cyclical bottom, the point at which growths returns.  The initial growth spurt could be very rapid, as firms restock inventory and pent-up demand comes into play.  The additional of government stimulus will add additional fuel to the fire. 

 

Once the early stages of recovery are complete, the story shifts from cyclical to structural.  The boost from inventory correction, pent-up demand, and government stimulus fade, and the underlying growth rate, the fundamental rates of activity, becomes evident.  Now your expectations about the nation's economic direction depend on the weight you place on the structural factors.  If you place nearly zero weight on those factors, then growth remains fairly high as the economy rapidly returns to potential.  In effect, cyclical dynamics dominate your story; the Fed is simply flipping a switch that shifts the economy from high to low states and back again, a traditional post-WWII business cycle.  If you place heavy weight on structural stories, you talk about the inability to revert to past patterns of consumer spending growth due to excessive household debt, a reversion to global imbalances that supports outsized import growth, lack of an asset bubble to compensate for these structural problems, etc.  With these stories in your toolkit, you expect a low underlying growth rate - barely at potential growth - in which case the gap between actual and potential output remains distressingly high for possibly years to come.

 

I tend to view incoming data through both cyclical and structural lenses.  The employment report is a prime example.  Clearly, the steady improvement in the rate of deterioration of nonfarm payrolls since the spring follows the cyclical pattern as firms stop chasing demand down and thus stabilize their workforces.  Moreover, recent increases in temporary help hiring also points to firming labor demand in the months ahead.  It would seem that stronger growth does in fact have the desired impact on labor markets, and that fiscal stimulus helped accelerate recovery in the labor markets. 

 

At the same time, though, one has to wonder what happens as the stimulus begins to fade?  Will there be sufficient demand from other sectors to compensate for fiscal and monetary withdrawal?  It is worth recalling the patterns of labor market dynamics as we exited from the 2001:

 

 

After the post-recession boost  - inventory correction, pent-up demand, etc. - labor markets quickly returned to a period of stagnation that lasted until the housing bubble began to take hold.  What in the next two years can we expect to take the place of that bubble?  Furthermore, if you are worried about a relapse in the pace of growth, the ISM reports last week were not exactly comforting.  Both revealed an overall slowing of activity, and employment signals were not exactly consistent with a strong rebound in hiring anytime soon.  For that matter, the ADP report, while not one of my favorites to begin with, came in far below the actual NFP numbers, suggesting that maybe this employment report was a little stronger than the underlying trend. 

 

Also worth noting is the dismal reports on retail sales that appear to have largely slipped below the radar last week.  From the Wall Street Journal:

Many retailers are likely to start offering broader discounts and promotions before the end of the holiday shopping season in response to generally lackluster sales the stores reported for November, retailing experts said Thursday.

 

Overall, sales at stores open at least a year edged up less than 1% last month compared with a year earlier, according to data collected by Retail Metrics Inc., which catalogs sales at 30 retail chains. Wall Street analysts had been expecting a 2.2% increase.

Consumers did lay siege on retailers during the post-Thanksgiving shopping weekend, but kept to strict budgets, seeking out deals but shying away from anything not marked down.  Households in general appear to be adopting my wife's mantra:  "Fifty percent off just isn't good enough anymore."  Now retailers are faced with the prospect they thought leaner inventories could help them avoid, ongoing markdowns throughout the holiday seasons, albeit not as bad as last year.

 

The bottom line is that what you need to take away from the current economic environment varies widely.  Business in general should anticipate growth - growth that may be lackluster, vulnerable to policy withdrawal, and less dependent on consumer spending, but growth nonetheless.  And any growth will force firms to reevaluate their hiring, sales expectations, supplier efficiency, etc.  Don't be surprised if anecdotal stories of firms unable to find qualified workers start to emerge.  The skills of those who lost jobs may simply be inconsistent with the needs of employers.  In short, be prepared for scenarios that don't result in the end of the world as we know it, but still a different world with different patterns of activity.

 

This message to firms, however, is not nearly the whole story as far as policy is concerned.  Policymakers need to be much more focused on the gap in current activity relative to potential than the rate of activity itself.  Indeed, for all the excitement over the end of the recession, the 2.8% growth rate of 3Q09 is in the range of potential growth.  It won't close the output gap, and it won't generate enough job growth to do much more than keep unemployment from rising further.    Can the 2.8% number be maintain as fiscal stimulus fades and consumer spending ekes out historically meager gains?  That should be question number one for policymakers.  Number two should be:  What more can we do to ensure that we push well ahead of 2.8%?

 

And question number two three should be this:  Why did the US economy yield such horrible employment performance this decade?  The fact that we have just experienced a lost decade for jobs should be on policymaker's tongue.   But it is not, I suspect because in many ways the lost decade was hidden by the spectacular rise and fall of housing, leaving few to reflect on the meaning of an economy which would have been in a decade-long jobless recovery without an asset bubble in the middle.

 

Moreover, policymakers have been lulled into a certain complacency on the job picture because on the exodus from the labor markets, with civilian labor force participation peaking ahead of the last recession, thus keeping a "lid" on unemployment rates:

 

 

And a longer view:

 

 

The beginning of this decade marked the end of a 35 year trend of increasing labor force participation.  Is is a coincidence that this trend ended as the lost decade for US jobs began?  Are these trends reinforcing each other?  How so, and what does it imply about the prospects for jobs for the next decade?

 

But these, like the problematic imbalance between China and the US (if the imbalance re-exerts itself in the months ahead, how many of the recently lost US manufacturing jobs are likely to be recovered?), are very big questions.  Questions policymakers are not likely to have much time for as they are lulled into a false sense of security by positive growth and improving nonfarm payrolls numbers - especially if unemployment stops rising. 

 

The Administration has already made clear its concerns about the deficit.  On the monetary front, those who worry about the yawning gap in potential output believe that more easing is desperately needed.  The employment report, however, will tend to push policymakers in the other direction, a greater willingness to let the Fed's balance sheet contract, perhaps even deliberately rather than via the natural expiration of now unneeded financial market supports.  To be sure, a push to raise the Fed Funds rate is premature; I believe the Fed intends to keep rates at rock bottom levels in the face of high unemployment.  But this is not the relevant policy issue.  The relevant issue is whether or not Fed policymakers are prepared to do more to close the output gap.  Already, only St. Louis Federal Reserve President James Bullard looked open to such policy.  But I suspect his position will only get more lonely as job growth, even lackluster job growth, builds.  Indeed, the policy risk is a more rapid reversal of the Fed's balance sheet expansion as hawks like Richmond Federal Reserve President Jeffery Lacker - already concerned that the Fed needs to prove its independence - increasing argue with a more rapid exit from the emergency expansion even as while the main policy rate holds at zero.

 

Bottom Line:  Cyclical and structural forces are at play.  But be wary about confusing the two; I fear this to be a particular problem for policymakers.  Economic growth is likely to lead to complacency, but such complacency would be ill-advised when the decade's record on nonfarm payrolls leaves the job-generating capacity of the US economy in doubt. 

Bubbles and Policy

The Wall Street Journal carried a front page article today detailing changing views at the Federal Reserve regarding the policy treatment of emerging bubbles of speculative activity.  Much of the ground has been well tread.  Is monetary policy or regulatory policy the best mechanism to address bubbles?  I tend to favor the latter category, should we have a regulatory environment that is not essentially captured by those policymakers are supposed to regulate.  Interest rate policy is a rather blunt weapon that kills indiscriminately.  For instance, I am sympathetic with the view that interest rates were not necessarily too low during the build up of the housing bubble.  Indeed, relatively low rates of investment (equipment and software) growth suggests that real rates were actually too high.  But capital flowed to housing instead of more productive investment activities because that was the path of least resistance.  Policymakers could have chosen to put some grit on that path by, for example, aggressively evaluating lending standards with regards to products such as "Liar's Loans," etc., but chose to follow a hands off approach.

 

What caught my attention in the article was this passage:

Yet the question of whether and how to tackle bubbles before they burst is becoming a growing concern amid fears of new bubbles developing in commodities markets and in emerging economies. Gold prices are up more than 50% in a year's time. China's Shanghai Composite stock index is up more than 75% this year. Stocks in Brazil are up even more. Oil prices have rebounded. They remain far below last year's peaks but a return to those highs could fuel inflation in goods and services more directly than tech stocks or housing did.

I think it is important to recognize what bubbles should be the focus of Federal Reserve concerns.  After all, the Fed is charged with maintaining price stability and maximum sustainable employment in the United States.  Why should the Fed be concerned with housing prices in Hong Kong or stock prices in Brazil and China?  Don't those bubbles fall under the responsible of foreign central banks?  It seems clear that in such cases, the extent of the Fed's concerns should be limited to the regulatory arena.  Are US based banks lending into those bubbles, thereby setting the stage for negative feedback loops?  If so, raise capital requirements on that lending, tighten underwriting standards, etc.  Just don't derail the US recovery by raising rates to pop a bubble in Brazil.

 

I will admit that oil prices can be a bit more tricky.  The gains in oil prices seem silly given ongoing evidence that the world is awash in oil.  From the WSJ:

Café owner Ken Kennard sees the glut in the global oil market as a potential environmental threat to this sleepy seaside tourist hub.

 

Mr. Kennard is worried about a fleet of oil tankers -- almost 40 in all, each packing hundreds of thousands of barrels of crude and oil-derived products -- that have anchored several miles off the coast of southeast England in recent months.

 

The heavy traffic stems from a near-record excess oil supply, a byproduct of the recession, that is prompting producers to stash oil offshore until they can find customers. The excess supply hasn't stopped oil prices from surging almost 80% this year and padding the pockets of big oil producers like Royal Dutch Shell PLC and the Organization of Petroleum Exporting Countries.

To be sure, some of the rise in the price of oil is attributable to the decline in the Dollar, a natural consequence of low US interest rates and an important channel for the transmission of monetary policy.  But it is not clear that higher oil prices necessarily yield additional core inflationary pressure given the current institutional arrangements between labor and management.  The recent experience has been that individuals were not able to convert high inflation expectations in 2008 into higher wages.  Instead, the opposite occurred as consumption sunk and unemployment skyrocketed.  All which means the Fed would need to think long and hard about leaning against the oil price increase if that entailed contractionary monetary policies; the costs are potentially high relative to the benefits.  Here again, though, regulators need to be carefully evaluating the nature of lending into the oil space. 

 

My views on this topic have shifted somewhat over the past two years.  In early 2008, I was concerned that the Fed's rush to lower rates was contributing to destructive oil price bubble.  But, in retrospect, nations that pegged to the Dollar and thus imported the Fed's easy policy were just as much, if not more, to blame, as those central banks failed to maintain policies appropriate for domestic conditions.
 

In short, the Fed does need to be aware of the full set of consequences of their policy stance.    But bubbles abroad should not prevent the Fed from adopting the right policy stance for the US economy.  Indeed, many of the bubbles discussed now clearly should not be the responsibility of the Fed. 

Holiday Preparation

Critical part of the Christmas season - picking the right tree.

We still have one or two respectable trees in Oregon.

Ahead of Black Friday

We are embarking once again into that time of the year when reporters around the world become entranced and enthralled with that orgy of consumerism that defines Christmas in America.  Soon we will be tracking the ups and downs of holiday sales with a zeal that is unmatched by any other regular economic event.  Weary reporters - those who clearly disappointed their editors at some point during the year - will be dispatched to local big box stores across the nation to record the lines forming in anticipation of 5am openings on the fabled Black Friday.  We will be bombarded with hundreds if not thousands of conflicting reports regarding the amount and patterns of holiday shopping, leaving overworked and underpaid analysts awash in data as they desperately try to quantify, once and for all, the "true" state of consumer spending - and thus by extension, the true state of the economy - in America.

 

Oooo, how I have come to loathe this exercise.  And yet, here I am again, fretting over the financial state of US households in between checking off items on the Thanksgiving shopping list.  It is like a car wreck - you don’t want to watch, but you can't take your eyes off it.

 

Car wreck is something of an appropriate comparison.  Recently I have begun using charts of this sort to depict the current economic environment:

 

 

Not fancy econometrics, I know - most of my audiences are not interested in unit root tests.  The point, obviously, is that even as activity creeps upward, the gap between the past and current trajectory of consumer spending is likely still widening.  Much, much faster growth is necessary to close that gap.  And households as of yet are seeing nothing to convince them their fortunes are set to change, that some Christmas miracle awaits.  To be sure, Bloomberg trumpeted today's data:

Confidence among U.S. consumers unexpectedly rose in November as a brightening outlook masked growing concern over joblessness.

How much did the outlook brighten?  The story continues:

The Conference Board’s confidence index increased to 49.5 from 48.7 the prior month. The New York-based Conference Board’s index, which focuses on the labor market and purchase plans, averaged 58 in 2008 and 103.4 in 2007.

Not much brighter.  Indeed, Economix more accurately reports the dismal mood of consumers, noting:

Over the last 30 years, the index has averaged about 95. In November, it was 49.5, up from 48.7 the previous month.

Yes, for three decades the Conference Board measure of confidence has averaged nearly twice current levels.  This tells us something about the strength of consumer spending.  Using the parallel measure from the University of Michigan:

Real year over year growth in the 1% range is not going to bring households back to trend anytime soon.    To be sure, given the dependence of household on debt financed spending, it is arguably correct that past trends were unsustainable, that the only possible outcome from this mess was a permanent shock to the level of household spending.  That, however, is likely cold comfort to the millions of Americans - those not employed by Goldman Sachs, of course - who are just now realizing that their standard of living has shifted permanently lower.  Lacking sufficient income gains and the ability to use debt to cover up their relative poverty, households are not seeing a path to a brighter future.  And they will increasingly look for someone to blame.  No wonder the knives are sharpening for Treasury Secretary Timothy Geithner and Federal Reserve Chairman Ben Bernanke.  They are the public faces for an Administration that now owns this economy. 

 

And where are policymakers as we slog through the final month of 2009?  The Administration is poised to do virtually nothing:

The White House is lukewarm about proposals by congressional Democrats to introduce broad legislation to create jobs, instead favoring targeted measures that would be less likely to inflate the deficit, administration officials said.

 

There is as yet no agreement within the White House or in Congress on how to try to curb the U.S. jobless rate. But the differences in opinion suggest that rifts could emerge among Democrats as they wrestle with how to beat back the highest unemployment rate in a generation.

 

...Hamstrung by the nation's $1.4 trillion deficit and his pledge not to raise taxes on middle-class Americans, Mr. Obama is keen to avoid any measures suggestive of a second, big-ticket stimulus.

Indeed, the failure of the Administration to take bold moves early in the year now cripples it in any attempt to take bold action now.  Apparently, the best we can expect now is a "Cash for Caulkers" program that will dribble money into the economy, ensuring that we do little if any better than limp along.

 

Likewise, monetary policymakers too are caught in the headlights.  As has already been widely noted, the minutes of the most recent FOMC meeting reiterated the Fed's eagerness to reverse, not extend, policy: 

...Overall, many participants viewed the risks to their inflation outlooks over the next few quarters as being roughly balanced. Some saw the risks as tilted to the downside in the near term, reflecting the quite elevated level of economic slack and the possibility that inflation expectations could begin to decline in response to the low level of actual inflation. But others felt that risks were tilted to the upside over a longer horizon, because of the possibility that inflation expectations could rise as a result of the public's concerns about extraordinary monetary policy stimulus and large federal budget deficits. Moreover, these participants noted that banks might seek to reduce appreciably their excess reserves as the economy improves by purchasing securities or by easing credit standards and expanding their lending substantially. Such a development, if not offset by Federal Reserve actions, could give additional impetus to spending and, potentially, to actual and expected inflation. To keep inflation expectations anchored, all participants agreed that it was important for policy to be responsive to changes in the economic outlook and for the Federal Reserve to continue to clearly communicate its ability and intent to begin withdrawing monetary policy accommodation at the appropriate time and pace.

Read that carefully and realize this:  An apparently not insignificant portion of the FOMC believes that there is a terrible risk that banks loosen their credit standards and increase lending at a time when, even if the economy posts expected gain, unemployment remains at unacceptably high levels.  Silly me, I thought increased lending was the whole point of the exercise to lower interest and expand the balance sheet.  That whole credit channel thing.  If not to expand lending during a credit crunch, then what else are they expecting? 

 

I am in shock that this sentence made it into the minutes.  One can only conclude that a significant portion of policymakers are simply clueless.  Or, more disconcerting, they have lost all faith in the ability of financial institutions to channel capital into activities with any hope of financial returns.   Has the Fed now embraced the view that they manage the economy through little else then fueling and extinguishing bubbles?

 

At this juncture, only St. Louis Fed President James Bullard is signaling a willingness to at least keep the option of ongoing balance sheet expansion alive:

Federal Reserve Bank of St. Louis President James Bullard wants the Fed to continue to buy mortgage-backed securities beyond the March 2010 cutoff to give policy makers more flexibility as they seek to shepherd the economy toward recovery.

 

"I have advocated to keep the asset-purchase program open but at a very low level, and wait and see what happens, and as information comes in about the economy we can adjust that program while the federal-funds rate remains at zero," Mr. Bullard told Dow Jones Newswires in an interview Sunday. He said "no decision has been made" about the program's fate.

 

Mr. Bullard will be a voting member on the interest-rate-setting Federal Open Market Committee in 2010. In its statement after the November FOMC meeting, the central bank reiterated that it will continue to monitor its asset-purchase programs "in light of the evolving economic outlook and conditions in financial markets."

Maybe if unemployment continues to rise Bullard's vote will matter next year.  Maybe.

 

Considering what all this means in light of Black Friday, I tend to think Phil Izzo at the Wall Street Journal is on the right path:

New reports Monday didn’t paint an encouraging picture. The Conference Board released a survey of spending intentions that showed U.S. households expect to spend an average of $390 this season, down 7% from estimates of $418 last year. That number is especially distressing because consumers were unusually pessimistic last year as the financial crisis went into full swing just as holiday shopping was getting underway.

 

“Job losses and uncertainty about the future are making for a very frugal shopper. Retailers will need to be quite creative to entice consumers to spend, both in stores and online this holiday season,” said Lynn Franco, director of the Conference Board Consumer Research Center.

 

A separate report from retail-tracking firm NPD Group indicated consumers may not be flocking to the mall for Black Friday. Just 32% of respondents said that they expect to begin their holiday shopping on Thanksgiving weekend or earlier.

Still, more broadly, whether sales gain 2% or 4% this holiday season may have great influence on the animal spirits that govern equity markets, I doubt it would alter much what should be our overall assessment of the economy:  Economic activity is now increasing, something for which we should all be thankful this weekend.  The alternative would be very unpleasant.  But that growth should not lull us into policy complacency with regards to the very real economic stress felt across the nation.  By all forecasts, it simply falls far short of what is necessary to restore confidence among households.  2.8% just won't cut it.     

The Fed in a Corner

Over the years, I have warned a seemingly countless number of undergraduates that Fed's hold on monetary independence was tenuous at best.  Independence is not guaranteed by the Constitution.  Congress made the Fed, and Congress can unmake the Fed.   The Fed could only maintain the privilege of independence if policymakers pursued policy paths that fostered maximum, sustainable growth.  Deviating from such paths would have consequences.

 

The Fed is quickly learning the extent of those consequences, as Congress launches an assault on the Fed's independence. 

 

Some find the loss of support for the Fed puzzling.  Brad DeLong, for example, notes that Bernanke & Co. are doing exactly what they should have done:

First of all, from the day after the collapse of Lehman Brothers, the policies followed by the U.S. Treasury and the U.S. Federal Reserve and the U.S. administrations have been very helpful. They have been good ones. The alternative--standing back and watching the markets deal with the situation--would have gotten us a much higher unemployment rate than we have now. Credit easing by the Fed and support of the banking system by the Fed and the Treasury have significantly helped the economy: have kept things from getting much worse.

The Fed earns accolades from academics for its handling of the crisis, in particular since the Lehman failure.  Fair enough; I have few quibbles with policy since last fall.  But what about the years before Lehman, when the crisis was building?  Where was the Fed then?  Did they abdicate regulatory responsibility?  How did banks develop such incredible exposure to off-balance sheet SIV's?  How could the Fed ignore increasingly predatory lending in the mortgage market?  What exactly was Timothy Geithner, then president of the all important New York Fed, regulating and supervising?  Clearly not Citibank.

 

To be sure, there were plenty of other regulatory failures along the way, but the Fed - an independent Fed - should have been in a much better position to raise regulatory and supervisory roadblocks during the debt build-up compared to other, more politically susceptible  agencies.  The Fed's independence should have allowed it to be a leader, not a follower.  Ideological objections to regulation, apparently, prevented the Fed from looking for problems in their own backyard.  Rapid debt creation was justified as a response to asset appreciation, with little concern that the connection might just be a bit more self-reinforcing.

 

The resulting crisis left the Fed struggling to keep the ship afloat - and in that struggle the Fed stepped too deep into the realm of fiscal policy in an effort to keep the trains running on time.  But that mission creep was simply incompatible with the Fed's desire for secrecy.  This was all to predictable:  Like it or not, you cannot commit literally billions of dollars of taxpayer money and in the process secretly funnel money through AIG to the investment banking community without expecting just a little blowback.   The last I checked, this was still a democracy. 

 

Worse now for the Fed is the impression that monetary authorities work first and foremost for Wall Street.  Of course, Fed officials see this a bit differently - they see supporting Wall Street as their mechanism for supporting Main Street.  Ultimately, without the former, the latter is locked out of capital markets, and economic chaos follows.  The purpose of Wall Street is supposed to be to channel investment funds into Main Street.  But most Americans no longer view Wall Street as ultimately working in their best interests - maybe correctly.  This is the same Wall Street that aggressively pushed garbage loans onto the American people as policymakers praised the wonders of financial innovation.   When did the purpose of finance evolve into simply a mechanism to enrich the relative few at the expense of many?  And when did policymakers embrace this view?  As Paul Krugman has noted, the Fed cannot envision a world not dominated by the magic of structured finance.  Yet this is a world that failed us completely.

 

Ultimately, can you really blame Americans if they have lost their faith in the supposedly omnipotent Federal Reserve?

 

Now the Fed's relationship with the public is a mess.  And I suspect it is going to get much worse.  Free Exchange succinctly identifies the new challenge:

An independent central bank is crucial. Political control of monetary policy must inevitably lead to accelerating inflation and long-run economic instability. But at the moment, the American economy could use an increase in expected inflation. And a real threat to Fed independence would almost certainly deliver it, either because markets would anticipate increased political influence on monetary policy ever after, or because the Fed would seek to fend off pressure from Congress by easing further, which amounts to the same thing. But we don't actually want there to be a real threat to Fed independence, because that way uncontrolled inflation lies.

The Fed has made it clear that unemployment is expected to remain unacceptable high in the medium run while disinflationary pressures persist.  Yet policymakers have also made it clear that they believe they have done all they can, or are willing, to do to combat unemployment.  They equate credibility with maintaining a 1.7-2% inflation target.  Couldn't credibility be consistent with a 4% inflation target?  And wouldn't such a target be more appropriate in a zero interest rate world?  But alas, challenging the Fed now with their independence at stake will only convince policymakers to dig in their heels more aggressively. 

 

What if the only way to get the Fed to do the right thing is to strip them of their independence?  It is a real possibility, although disastrous in the long-run.  Yet look at the dithering from the Bank of Japan, still faced with a deflationary environment years and years after they pushed to zero rates:

It was no coincidence that the new government of Yukio Hatoyama chose the day when the Bank of Japan (BoJ) was holding a rate-setting meeting to make a lot of noise on the issue. Both the deputy prime minister and finance minister made concerned comments. Their unspoken message to the BoJ was clear: remove monetary-stimulus measures at your peril. At the end of its two-day meeting, the BoJ left its policy rate unchanged at 0.1%, and continued to use other measures, such as buying government bonds, that it believes make monetary policy “extremely accommodative.”

 

But the BoJ does not give the impression it is particularly concerned about prices. It believes there are not yet clear signals of a deflationary mindset in corporations or the public at large, and that a recovery in private demand will eventually pull the economy out of its slump.

Good Lord, we have been talking about pulling Japan out of its slump for TWO DECADES!  Fear of inflation combined with a perception that acquiescing to a higher inflation target would be akin to losing monetary independence has kept BoJ policy constrained for years, ensuring the citizens of Japan ongoing pain.  Is the Fed headed to the same place?  Maybe. 

 

I don't think the Fed can regain the trust of the public while at the same time protecting the secrecy of their actions to save Wall Street (moreover, it is not clear that such secrecy is now needed in any event).  The relationship between policymakers and financiers is now seen as far too cozy from the perspective of the public.  I think the Fed needs to make clear that they work for the people, not for Wall Street.  A strong statement by Federal Reserve Chairman Ben Bernanke that a firm that is too big too fail is simply too big - that we should no longer tolerate the expansion of financial firms to the point that they pose systemic risk - would be a good start.  Simply put, Bernanke's choice set is dwindling - either risk losing independence, or step up to the regulatory and policy plate like you intend to hit one out of the park.  If Wall Street is no longer working for Main Street, it is time to side with Main Street.       

Should the Fed Be Doing More?

Monetary policy looks to be at a protracted standstill - or even arguably becoming less accommodative as purchases of long dated securities draws to a close - despite incoming information that points toward persistently high unemployment rates and an ongoing disinflationary environment. Is policy stability the consequence of changing economic conditions, a perceived ineffectiveness of nontraditional policy, or a willingness of policymakers to be constrained by conventional policy limitations in the absence of impending financial doom? My sense is that all three elements are in play.

It is pretty clear that economic conditions changed dramatically mid-year as inventory correction and policy stimulus brought the recession to a close, at least if measured by growing output. To be sure the sustainability of the gains are in question. I hold little hope that growth could be sustained in the absence of the policy efforts to date, and the Administration is likely starting to realize that it underplayed its hand this year, offering far to little stimulus to effect stabilization from the all important jobs perspective. Calculated Risk sees growing potential for a second stimulus package (in spirit if not in name), the support for which will gain as concerns about midterm elections grow. Still, from the perspective of monetary policymakers, positive growth after such a long recession could only be met with a sigh of relief and, perhaps inevitably, a willingness to pause and assess the implications and impact of policy to date.

The problem with pausing, however, is that a combination of maximum sustainable growth and price stability are in fact the Fed's objective, we seem to be falling short on both measures. Unemployment continues to climb, nonfarm payrolls continue to fall, and core-PCE inflation continues to decelerate. Moreover, Fed forecasts suggest that these trends will continue for literally years. Leaving aside inflation fears that seem to be largely contained in a handful of what I think are crowded trades (gold and TIPS), what should the Fed be doing on the basis of actual, incoming data? Have they truly hit the limits of policy? This brings be to an ongoing debate between Paul Krugman and Scott Summner, with the recent participation of Joe Gagnon.

A starting point for further analysis is Krugman's assertion that conventional policy has been brought to a standstill. Zero is zero:

I keep seeing economics articles and blog posts that insist that we’re NOT in a liquidity trap (and, of course, that yours truly is all wrong) because the situation doesn’t meet the author’s definition of such a trap. E.g., the interest rates at which businesses can borrow aren’t zero; or there are still things the Fed could do, like buying long-term bonds or corporate debt, or something.

Well, my definition of a liquidity trap is, purely and simply, a situation in which conventional monetary policy — open-market purchases of short-term government debt — has lost effectiveness. Period. End of story.

Now, if you prefer a different definition of a liquidity trap, OK; call our current situation a banana, instead. But changing the name does not change the essential fact — namely, conventional monetary policy has lost effectiveness.

The loss of conventional monetary tools led Krugman, and many others, to conclude that stimulus efforts should focus on the fiscal side of the equation. In response, Scott Sumner has long argued that more aggressive monetary expansion was needed, to which Krugman replies that at zero rates, more money is ineffective at stimulating output:

A dozen years ago I would probably have agreed. But way back in 1998 I tried to think my way through Japan’s situation with a little intertemporal model, and surprised myself with the conclusion: under liquidity-trap conditions, it doesn’t matter at all what happens to M.

In that model, prices are assumed sticky in the short run, so P is predetermined. What, then, determines Y? Well, it’s a real thing — as opposed to a nominal thing. In the model it’s actually tied down by an Euler condition, by future consumption and the real interest rate (which is stuck thanks to the zero lower bound). Monetary policy has no traction at all against the right hand side of the equation.

Now, the equation still holds. But all that tells us is that any changes in the money supply are offset one for one by changes in velocity. Focusing on nominal spending makes you think that low nominal spending is the problem, a problem with a monetary solution; but actually it’s the symptom, and monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story).

Joe Gagnon delivers evidence that in a world with multiple interest rates, unconventional policy did in fact depress interest rates at longer horizons or on non-Treasury debt:

In recent months, central banks have purchased large quantities of longer-term assets. These purchases appear to have been effective at pushing down longer-term interest rates, which should stimulate economic activity. For example, the Federal Reserve (Fed) has purchased large quantities of longer-term agency-backed securities and Treasury bonds. The following table shows that Fed communications about such purchases had substantial effects on a range of long-term interest rates, including on assets that were not included in the purchase program, such as interest rate swaps and corporate bonds….Since March 19, the Fed has not made any substantive changes to its planned purchases of longer-term assets. Over this period, the 10-year Treasury yield has risen about 75 basis points and the corporate yield has fallen about 200 basis points, reflecting a relaxation of the extreme financial strains and flight-to-quality that characterized the first few months of this year. Conventional fixed mortgage rates, a key target of the Fed's policy easing, have changed little on balance since late March.

Which would appear to support the contention that unconventional policy does have a stimulus impact, and that monetary policy could push further by continuing the soon-to-end Treasury purchase program, and thus would it would be worth revisiting its expected conclusion. Still, would this be enough in light of the crux of Krugman's argument that is worth repeating: "... monetary policy doesn’t matter (unless it can affect expected future inflation, but that’s another story)."? Krugman elaborates:

We’re in a liquidity trap, with interest rates up against the zero bound. This means that conventional monetary policy isn’t sufficient. What should we do?

The first-best answer — that is, the answer that economic models, like my old Japan’s trap analysis, suggest would be optimal — would be to credibly commit to higher inflation, so as to reduce real interest rates.

But the key thing to recognize about this answer is that it’s all about expectations — the central bank only has traction over expected inflation to the extent that it can convince people that it will deliver that inflation after the liquidity trap is over. So to make this policy work you have to (i) convince current policymakers that it’s the right answer (ii) Make that argument persuasive enough that it will guide the actions of future policymakers (iii) Convince investors, consumers, and firms that you have in fact achieved (i) and (ii).

In reality, we haven’t even gotten anywhere near (i): the conventional wisdom is still that any rise in expected inflation above 2 percent is a bad thing, when it’s actually good.

From Krugman's perspective, the key is not simply increasing the money supply via increasing nonconventional purchases. The key is fundamentally changing inflation expectations. This fits with Brad DeLong's definition of quantitative easing:

Quantitative easing policy is the altering of market expectations of the long-run path of the money stock.

By this definition, I don't believe the Federal Reserve has pursued anything close to quantitative easing because policymakers have consistently defined their actions as temporary "credit easing." At best, they have acted to ensure that the long-run path of the money stock (and thus inflation) will not decline from previously stated objectives. But avoiding outright deflation is not the same as increasing expectations of inflation.

For his part, Sumner says this is what he has been saying all along:

Krugman should have been advocating monetary stimulus all along.　 The real problem is that his allies in government; Obama, Pelosi, Reid, etc., don’t even know the first best option exists.　 And how could they?　 How often is monetary　stimulus mentioned in columns　written by liberal pundits?　 　If they realized that they were about to get decimated in the 2010 midterm elections because a few nutty right-wingers at the Fed think the economy needs less stimulus, not more, there would be outrage in Congress and the Administration.　 They’d be marching down to the Fed (metaphorically of course, to avoid looking heavy-handed) and make it very clear that the Fed needs to produce robust growth in aggregate demand or else there will be big changes in the way the Fed is set up and regulated.　 If they don’t seem "receptive," then quietly tell the FOMC; "Think the Dodd bill is bad?　 You can’t even imagine how much worse we can make it."

I think a case can be made that in a world were interest rates have been pushed to zero, first in Japan, then in the US, etc., policymakers would be forced to rely on heighten inflation expectations should they hope to have an impact on activity - essentially, resetting the bar. Sumner essentially argues that resetting that bar is exactly what is needed. And Krugman appears to believe this as well, but ultimately he is correct on the political economy angle. The Fed seems in no way to be dissuaded from its central tendency for inflation in the range of 1.7-2%. And the challenge is much more widespread than Sumner implies. A "few nutty right-wingers at the Fed" almost certainly cannot include San Francisco Fed President Janet Yellen. Her last speech was instructive. She possess a clearly pessimistic outlook:

It’s popular to pick a letter of the alphabet to describe the likely course of the economy. The letter I would choose doesn’t exist in our alphabet, but if I were to describe it, it would look something like an "L" with a gradual upward tilt of the base.　With such a slow rebound, unemployment could well stay high for several years to come. In other words, our recovery is likely to feel like something well short of good times.

Note - several years of high unemployment! Regarding inflation:

...But experience teaches us that budget deficits do not cause inflation in advanced economies with independent central banks that pursue appropriate monetary policies. As for the Fed, you can be 100 percent certain that price stability will remain our objective, regardless of the stance of fiscal policy.

..I believe that the more significant threat to price stability over the next several years stems from enormous slack in the economy that is pushing inflation lower. Today, inflation is already very low. Over the past 12 months, consumer prices as measured by the personal consumption price index actually fell by one-half percent. After removing the effects of volatile food and energy prices, core prices rose by 1¼ percent.　 That’s below the 2 percent rate that I and most of my fellow Fed policymakers on the Federal Open Market Committee (FOMC) consider an appropriate long-term price stability objective. The public’s inflation expectations, which can independently influence inflation, remain well anchored, which is appropriate given the Fed’s record and its commitment to price stability. And with slack likely to persist for years and wages barely rising, it seems probable that core inflation will move even lower over the next few years.

Now we have several years of unemployment and lower core inflation over two years. Consider that forecast carefully - Janet Yellen, not a right-wing nut job, is giving a forecast that makes clear the Fed will fall short over the medium term in its pursuit of price and output stability. And not just by a narrow margin. What does this mean for policy?

...This landscape presents clear challenges for monetary policy. We face an economy with substantial slack, prospects for only moderate growth, and low and declining inflation.　 With the federal funds rate already at zero for all practical purposes, the Fed’s traditional policy tool is as accommodative as it can be. To provide more stimulus, the Fed has used unconventional policy tools, including emergency lending programs to promote liquidity and push longer-term interest rates lower. However, many of these programs are winding down or nearing completion. That is why the FOMC stated that "economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels of the federal funds rate for an extended period" following our meeting last week.

Yellen states policy now amounts to wait and see - or, possibly more accurately, be contractionary by allowing the existing unconventional tools to wind themselves down and not be replaced. That is because they viewed those tools not as expansionary in their own right, as efforts to change expectations about the long-run path of the money stock, but as temporary credit easing measures. In the absence of those measures, policy reverts back to the zero bound.

In short, Janet Yellen is saying that they are at the limits of policy despite an outlook that is inconsistent with sustainable output and stable prices. A cynic might point out that when Wall Street is in danger, the Fed rewrites the play book, but for Main Street, policymakers have only one message: We have done all we can do.

Moreover, she finishes up with the required warning from all Fed officials:

At some point, of course, we will have to tighten policy—and we certainly have the means and the will to do so. We are—and always will be—steadfast in our determination to achieve both of our statutory goals of full employment and price stability. Until that time comes though, we need to provide the monetary accommodation necessary to spur job creation and prevent inflation from falling any further below rates that are consistent with price stability.　Thank you very much.

The Fed has done all it can - or is willing - to do at this point. We have no intention to do more. Our focus is only on preparations to reverse what we have already done. The commitment to price stability remains unchanged.

Bottom Line: Economic conditions are improving, but at a pace that promises that unemployment will remain unacceptably high for years. Millions of workers left on the sidelines for years. Acceptable from a policy perspective? No. But is the Fed ready to engage in what would be the real next step for policy - a concerted effort to boost inflation expectations and regain control over monetary policy? A stated higher objective for inflation and a massive quantitative easing program to support achieving that ojective? No. There is simply nothing to suggest the Fed is waiting for anything other than the first chance to "normalize" policy in the traditional sense. That may still be a long time from now, but is nonetheless the shore the Fed seeks as they attempt to navigate out of unconventional policy, not deeper in.

Sustainable Growth?

October is becoming my lost month.  Between the beginning of Fall term and my annual conference in Portland, the month is a blur, and time to blog becomes a luxury.  Now, however, I can see the light at the end of the tunnel.  And we can also see the light at the end of the tunnel after this long recession, with a GDP report that confirms what everyone thought - the economy turned the corner in the third quarter of this year.   Policymakers undoubtedly breathed a sigh of relief, and rightly so.   That said, it is far too early for complacency; I found the underlying details less than comforting, especially in comparison to Wall Street's ebullient reaction to the data.

 

That the recession would end was never in doubt.  Indeed, the timing is almost exactly what one would expected given the steep declines in spending in the first half of 2008 that triggered the flood of job losses later in the year.  Spending, consumer spending most importantly, would not fall indefinitely, especially with the benefit of significantly lower energy costs beginning in the second half of last year.  Moreover, as the Wall Street Journal notes, rebuilding household balance sheets is not accomplished by just increased savings; a default can do the job much more quickly, quickly adding to household cash flow.  Indeed, I admit to being surprised that strategic defaults are not much higher. 

 

The more important question is what will be the durability and sustainability of the recovery in the years ahead?  The GDP report raises some significant red flags when considering this question.  The consumer spending number was clearly goosed by the Cash for Clunker program and a much slower pace of inventory depletion than expected, which combined to add almost 2 percentage points to the headline figure.  But auto sales have slipped back under the 10 million mark in September when the Clunkers program ended, with only a slight gain expected in October.  And the slower inventory depletion suggests that firms are further along than expected in realigning stockpiles with demand, and that future improvement will need to stem from more significant improvements in underlying demand (see James Hamilton for a more positive interpretation).

 

Growth was further boosted by a jump in residential construction, but, as Calculated Risk points out, this sector's future contributions are likely to remain under pressure from high home and rental vacancy rate.  Moreover, the impact of fiscal stimulus will fade as we move through next year, and there appears to be little political will to offer up additional stimulus.

 

Finally, note that net exports subtracted 0.53 percentage points of growth as import growth exceeded import growth.  A balanced, sustainable recovery requires, in my opinion, that net exports contribute to growth.  This showing reminds us of the ongoing dependence of US consumption on overseas production - stimulating consumption spending flows in  part right out to the economy via imports.  Recall also Federal Reserve Chairman Ben Bernanke's recent warning :

Another set of lessons that Asian economies took from the crisis of the 1990s may be more problematic.  Because strong export markets helped Asia recover from that crisis, and because many countries in the region were badly hurt by sharp reversals in capital flows, the crisis strengthened Asia's commitment to export-led growth, backed up with large current account surpluses and mounting foreign exchange reserves….To achieve more balanced and durable economic growth and to reduce the risks of financial instability, we must avoid ever-increasing and unsustainable imbalances in trade and capital flows.  External imbalances have already narrowed substantially as a consequence of the crisis...As the global economy recovers and trade volumes rebound, however, global imbalances may reassert themselves.  As national leaders have emphasized in recent meetings of the G-20, policymakers around the world must guard against such an outcome. 

Couple this with a Wall Street Journal story earlier this week:

For more than a year, China has kept the yuan largely unchanged against the dollar. So, like the dollar, the yuan has been falling steadily against the currencies of China's neighbors, including the Malaysian ringgit, the Indonesian rupiah and the South Korean won. That makes goods produced in those countries more expensive compared with China's.

 

"If you have one large economy in Asia lock itself against the U.S. dollar, everyone feels pressure," says Frederic Neumann, Asia economist for HSBC in Hong Kong. "Even 5% in this context feels painful."

The countries that compete with China are at a critical juncture. To stem the rise of their currencies against the yuan (and the dollar), central banks around Asia have in recent months been purchasing gobs of greenbacks and building their foreign reserves. And now those reserves are back up to precrisis levels.

 

At the same time, Asian economies are under pressure eventually to allow their currencies to rise and reduce their emphasis on exports to fuel growth. Some economists and international policy makers fear continued intervention in currency markets would reflect an unwillingness to break old habits of export growth driven by policies that kept currencies undervalued. Intervention can also raise the risks of domestic inflation.

Note also that the Europeans are growing frustrated with recent currency movements.  From Market News International (no link):

European central bankers, worried that the soaring euro could squelch a nascent economic recovery, are increasingly pressuring U.S. authorities to put some bite into their bark(ing) about a strong dollar, well-placed monetary sources told Market News International.

 

European monetary officials need the active support of U.S. and Chinese authorities to help restrain the euro and stem the greenback's slide, these sources said. Some noted that with the financial system awash in cash, it would be hard to mount an effective intervention in global currency markets.

The international political dynamics on this issue bear careful attention; it is not clear that the US and Europe will be able to tolerate Chinese currency policy indefinitely.  But do they have a choice?

 

Add in another concern - the jobless (or perhaps job-loss) recovery.  The underlying rate of economic growth (firms look through the Clunkers boost) remains well below  rates sufficient to generate job growth.  Indeed, as David Altig notes, the jobless recovery is almost certainly upon us once again, and if anything will prod the Administration to initiate a second stimulus package, it will be the prospect of sustained double-digit unemployment - an outcome that will only be aggravated if Chinese policy is to take advantage of the recession to consolidate more productive capacity behind its borders.  Perhaps then we develop a new dependency, with Chinese saving redirected to US consumers via the US government rather than the housing market. 

 

All of which boils down to a simply question:  Can the US and global economies rebalance to a sustained, healthy pattern of growth without the cooperation of Chinese policymakers?  In other words, can a Dollar depreciation against the Euro alone sustain a rebalancing?  I think not, which implies that global economic stability is being supported on a very vulnerable base at the moment.

 

How will the Fed view these numbers?  They will be relieved, but have much of the same skepticism regarding the sustainability of these numbers.  Policymakers know the economy is being push along by a wave of federal stimulus, and are uncertain of how much momentum would be left in that absence of that stimulus.  At the same time, however, the solid GDP showing will support already heightened worries that while interest rates need to be sustained at very low levels, officials may be late to the game when it comes to reversing the expansion of the balance sheet.   Note St. Louis Federal Reserve President James Bullard: 

“It is a little disappointing that private-sector economists are thinking so much about when we are going to move our fed funds rate up,” he said. “We are at zero. We are going to be there awhile. The focus should be more on” the Fed’s asset purchase program.

Given high unemployment and ongoing disinflation, there will be no rush to raise rates.  What will comes first is the contraction in the balance sheet - and positive GDP numbers will push the discussion further in that direction.

 

Bottom Line:  The GDP report is confirmation that the recession has come to an end.  But I am not ready to breath easy - too manu potentially unsustainable factors drove the boost, and too much remains dependent on federal stimulus.  Until the economy can stand on its own, it remains vulnerable to unsustainable, unbalanced patterns of growth.  And the negative contribution of trade to growth, especially coupled with growing tension over currency movements, is a warning sign that trade and capital flows are at risk of falling back into old and unehlpful patterns.

From Summer to Winter in 6.2 Seconds

October 3, 2009.  Early measurable snow in the Central Oregon Cascades at the 5,000 foot level:

 Should be a spectacular morning.

Hawkishness Dominates

As I await the employment report, I am reflecting on the flow of information over the past week and find myself somewhat dismayed by the apparent policy implications.  The spate of FedSpeak in recent days leaves one with the uneasy feeling that monetary policymakers are more willing to use unconventional monetary policy to support Wall Street than Main Street.  The most hawkish appear eager to normalize policy at the earliest opportunity possible, and even the dovish, grasping onto green shoots, appear to think they have done enough to support recovery.  It is as if the FOMC has concluded that the risks are now entirely one-sided toward inflation.  To be sure, Bernanke & Co. have shifted direction often during the past two years.  But the FOMC looks to be developing something of a blind spot with regard to downside risks to the economy, suggesting that even if the economy stagnates in a jobless recovery, the bar to further easing is very high. 

 

Governor Kevin Warsh fired the shot across the bow last week, first with a Wall Street Journal op-ed, followed by a speech that included the key paragraphs:

Ultimately, when the decision is made to remove policy accommodation further, prudent risk management may prescribe that it be accomplished with greater swiftness than is modern central bank custom. The Federal Reserve acted preemptively in providing monetary stimulus, especially in early 2008 when the economy appeared on an uneven, uncertain trajectory. If the economy were to turn up smartly and durably, policy might need to be unwound with the resolve equal to that in the accommodation phase. That is, the speed and force of the action ahead may bear some corresponding symmetry to the path that preceded it. Of course, if the economy remains mired in weak economic conditions, and inflation and inflation expectation measures are firmly anchored, then policy could remain highly accommodative.

 

"Whatever it takes" is said by some to be the maxim that marked the battle of the last year. But, it cannot be an asymmetric mantra, trotted out only during times of deep economic and financial distress, and discarded when the cycle turns. If "whatever it takes" was appropriate to arrest the panic, the refrain might turn out to be equally necessary at a stage during the recovery to ensure the Fed's institutional credibility. The asymmetric application of policy ultimately could cause the innovative policy approaches introduced in the past couple of years to lose their standing as valuable additions in the arsenal of central bankers.

While Warsh does note that weak economic conditions would defer tightening, the message is clear:  we are looking to tighten, and will do so aggressively when economic activity firms.  Moreover, we will do so preemptively, which means we are looking for opportunities prior to the emergence of very solid data.

 

Note one of the concerns identified by Warsh:

In my view, if policymakers insist on waiting until the level of real activity has plainly and substantially returned to normal--and the economy has returned to self-sustaining trend growth--they will almost certainly have waited too long. A complication is the large volume of banking system reserves created by the nontraditional policy responses. There is a risk, of much debated magnitude, that the unusually high level of reserves, along with substantial liquid assets of the banking system, could fuel an unanticipated, excessive surge in lending. Predicting the conversion of excess reserves into credit is more difficult to judge due to the changes in the credit channel.

Are we really worried about a lending explosion by itself, or that the regulatory environment remains so weak that financial institutions will quickly repeat the experience of this decade's debt bubble?  Considering the question always draws me back to this chart, which for me epitomizes the difference between the 1990s and the 2000s:

 

The 1990s saw a remarkable period of sustained, high levels of investment in equipment and software.  In contrast, a sustained period of very low interest rates during this decade was barely able to coerce firms to invest in the high single digits.  That, in my mind, is a critical problem, reflecting low expected returns to capital investment.  In effect, the policy error might not have been low rates.  Indeed, rates do not look to have been low enough to stimulate sufficient investment demand to absorb the productive capacity of the nation, the classic Keynesian problem:

This analysis supplies us with an explanation of the paradox of poverty in the midst of plenty. For the mere existence of an insufficiency of effective demand may, and often will, bring the increase of employment to a standstill before a level of full employment has been reached. The insufficiency of effective demand will inhibit the process of production in spite of the fact that the marginal product of labour still exceeds in value the marginal disutility of employment.

 

Moreover the richer the community, the wider will tend to be the gap between its actual and its potential production; and therefore the more obvious and outrageous the defects of the economic system. For a poor community will be prone to consume by far the greater part of its output, so that a very modest measure of investment will be sufficient to provide full employment; whereas a wealthy community will have to discover much ampler opportunities for investment if the saving propensities of its wealthier members are to be compatible with the employment of its poorer members. If in a potentially wealthy community the inducement to invest is weak, then, in spite of its potential wealth, the working of the principle of effective demand will compel it to reduce its actual output, until, in spite of its potential wealth, it has become so poor that its surplus over its consumption is sufficiently diminished to correspond to the weakness of the inducement to invest.

 

But worse still. Not only is the marginal propensity to consume weaker in a wealthy community, but, owing to its accumulation of capital being already larger, the opportunities for further investment are less attractive unless the rate of interest falls at a sufficiently rapid rate....

With the primary build out of the internet backbone complete, the US appeared to experience a dearth of traditional investment opportunities (I suspect that the need to expand production domestically was made moot by an international financial arrangement that favored the establishment of productive capacity overseas), and, like water flowing downhill, capital was thus allocated this decade to residential investment, which, we now know was more about consumption than investment, and the resulting economic activity was anemic by historical standards. 

 

This line of argument leads one to believe that withdrawing monetary stimulus would be a significant policy error, especially if investment growth remains constrained as we saw this decade.  In fact, it would lend additional credence to reports that the Fed needs to do much, much more - a massive, unsterilized expansion of the balance sheet - should they even hope to stimulate sufficient investment demand to absorb underutilized labor.  Instead, FOMC members appear to be concerned that stimulative policy will be the root cause of the next financial crisis.  That, however, appears to me to confuse monetary with regulatory policy.  The former should speak to inducement to invest, while the latter speaks to protecting against significant misallocations of capital.

 

Following the Warsh speech, Vice Chair Donald Kohn looked to tamp down expectations of an imminent rise in rates:

Although economic conditions have apparently begun to improve--partly in response to the extraordinary steps the Federal Reserve and other authorities have taken--resource utilization is quite low, inflation is subdued, and continuing restraints on credit are likely to constrain the speed of recovery. For that reason, as the FOMC stated last week, exceptionally low interest rates are likely to be warranted for an extended period. Given the highly unusual economic and financial circumstances, judging when the time is appropriate to remove policy accommodation, and then calibrating that removal, will be challenging. Still, we need to be ready to take the necessary actions when the time comes, and we will be.

Still, like Warsh, Kohn looks determined to find an opportunity to remove accommodation.  This despite expected high rates of unemployment.  From Bloomberg:

Federal Reserve Chairman Ben S. Bernanke said U.S. economic growth next year probably won’t be strong enough to “substantially” bring down the jobless rate, which may remain above 9 percent at the end of 2010.

 

“Most forecasters including the Fed are currently looking at growth in 2010, but not growth so rapid as to substantially lower the unemployment rate,” Bernanke said in response to questions at a House Financial Services Committee hearing today in Washington. Growth of 3 percent means the rate would “still probably be above 9 percent by the end of 2010,” Bernanke said.

Interesting how the Fed is encouraging expectations of policy withdrawal even though unemployment rates will remain unacceptably high through 2010.  And, if above 9 percent at the end of next year, certainly unacceptably high during 2011 as well.  Richmond Federal Reserve President Jeffrey Lacker even goes one step further in a Bloomberg interview:

The Federal Reserve will need to raise interest rates when the economic recovery is “firmly” in place, even if unemployment lingers near 10 percent, Federal Reserve Bank of Richmond President Jeffrey Lacker said.

 

“I am going to be looking for when growth reestablishes itself firmly enough that it is clear real interest rates need to rise,” Lacker said today in a Bloomberg Radio interview. “I think the growth outlook, particularly the consumer spending outlook, are more fundamental than labor-market conditions.”

 Seriously, raising rates even if unemployment is 10%?  LACKER SAYS THIS ON THE DAY WE GET CORE PCE INFLATION SLIDING TO 1.3% Y-O-Y!  This redefines the term "hawk."

 

From where does this fear of inflation emanate?    That brings us to perma-hawk Philadelphia Fed President Charles Plosser:

Unfortunately, slack was poorly measured and turned out to be not as significant as first estimated. Thus, the Fed's monetary expansion led to rising inflation for the balance of the 1970s. One lesson learned during this episode is that inflation expectations can matter a great deal, and if they become unanchored — that is, if the public comes to believe that the Fed will not do what is necessary to preserve price stability — then inflation can rise quickly regardless of the amount of so-called slack in the economy. The price we paid to regain control of inflation and the Fed's credibility to do so came in the form of the 1981-82 recession and was a steep one.

 

Consequently, just as the Fed has taken aggressive steps in flooding the financial markets with liquidity during this crisis to reduce the possibility of a second Great Depression, it will also have to take the necessary steps to prevent a second Great Inflation. Our credibility depends on it. As the economy and financial markets improve, the Fed will need to exit from this period of extraordinarily low interest rates and large amounts of liquidity. We recognize the costs that significantly higher inflation and the ensuing loss of credibility will impose on the economy if we fail to act promptly, and perhaps aggressively, when the time comes to do so. The Fed will need courage because I believe we will need to act well before unemployment rates and other measures of resource utilization have returned to acceptable levels. The issues of when and the pace at which we unwind the extraordinary measures taken during the financial crisis and recession are ones that are high on my list of priorities and are the subject of ongoing discussions within the Fed.

The experience of the 1970s is such a tired and faulted analogy.  To generate a wage-price inflation spiral, you need to explain the mechanism by which rising inflation expectations (which don't exist anyway) get translated into high wages.  I do not see that current institutional arrangements in the US allow this; nor do we see it in the data:

 

One could at least wait for significant - or any, for that matter - year over year gains in unit labor costs before declaring that we are at the doorstep of the 1970's.  Moreover, the seeds of that inflation did not sprout overnight; the signs were evident but ignored in the late 1960's.  Only in Plosser's mind exists the need for an imminent withdrawal of policy. 

 

Bottom Line:  The data this week has not been supportive of a rapid exit from accommodative policy.  Indeed, the opposite could very well be the case.  Despite this, Fed officials, albeit to varying degrees, are uniformly signaling that the actions to expand the balance sheet are only temporary and will be reversed absolutely as soon as possible, which only undermines the stimulative potential of those actions.  This is definitely not quantitative easing, and uncomfortably harkens back to the fear of inflation that constrained policy at the Bank of Japan.  It is interesting that Fed Chairman Ben Bernanke has worked so hard to avoid a repeat of that experience yet appears ready to risk repeating it nonetheless.

Rushing to the Exits?

A missive from a former colleague prompted me to reconsider the Fed's behavior in light of their most recent forecast and the evolution of economic data.  That in turn started to shed light on some little pieces of information sitting on my computer that I knew were important, but just couldn't quite see how they fit.  And has left me somewhat concerned that the Fed may be more likely than I believed to stifle the pace of the recovery by, at a minimum, halting the growth of policy accommodation.

 

The Fed gave and took at the September FOMC meeting.  Policymakers reiterated support for their near zero rate policy, while offering a slightly hawkish nuance that was noted by Jon Hilsenrath at the Wall Street Journal:

 

Today’s Federal Open Market Committee statement included a nuanced tip of the hat to hawks on the central bank’s policy making committee who think the Fed is putting too much weight on the argument that the economy’s substantial slack will drive down inflation.

 

Slack is the economy’s productive capacity that doesn’t get utilized — unemployed workers, empty hotel rooms, unsold homes, idle factory floors, etc. When there’s a lot of slack, it puts downward pressure on prices in the short-run. It’s one very important reason why the Fed has felt comfortable assuring markets that it is likely to keep interest rates exceptionally low for a long time. Because slack is likely to keep inflation low, the Fed will keep rates low.

 

But Fed officials have been engaged in an intense debate in recent months about how much slack matters. Some hawks believe other factors are more important ingredients in near-term inflation. One of those other factors is inflation expectations — if investors, businessmen and consumers expect more inflation, they could cause it by demanding higher prices and wages in anticipation. The Fed indirectly acknowledged this argument in the September statement: “With substantial resource slack likely to continue to dampen cost pressures and with longer-term inflation expectations stable, the Committee expects that inflation will remain subdued for some time.”

 

In previous recent statements, it hasn’t mentioned inflation expectations. It focused mostly on slack. Here’s how the Fed put it in August: “Substantial resource slack is likely to dampen cost pressures, and the Committee expects that inflation will remain subdued for some time.”

 

The practical implication of this little wording change? Keep an eye on measures of inflation expectations, such as inflation-protected Treasury bonds and University of Michigan surveys of consumers. They have been stable. But if they start rising, the Fed’s inflation view could change and tilt it toward a more hawkish stance.

 

The shift in wording, then, appears to be the result of some more hawkish FOMC members, illuminating the smidgen of  truth behind a rumor that was circulating earlier this month.  From Across the Curve:

I was not planted here at my work station yesterday but roaming through the myriad of emails I receive it seems that one of the reasons for the weakness yesterday was a report by an advisory firm, Smick Medley, that the Federal Reserve at its upcoming meeting would comment on and discus raising rates sooner rather than later.

Given the FOMC's own forecast, any consideration of tightening seems silly:

 

While the Fed may find it necessary to raise the estimate of GDP growth for this year on the back of a relatively sharp inventory correction, unemployment is almost certain to exceed the range for this year, and even if it didn't, it remains unacceptably high through 2011.  Moreover, the downward pressure on pricing has increased in recent months, bringing the core-PCE forecasts into question:

On top of this, the concern of some hawks that inflation expectations will suddenly trigger a wage price spiral seems simply silly unless one can explain how, given current institutional arrangements in the US, price increase will translate into wage increases.  Indeed, unit labor costs are giving you the exact opposite story:

 

And employment compensation for the private sector is likewise trending down:

Sure, one could turn to the commodity markets for inflation signals, but I think the critical price there is oil, which is finding the $72 mark extremely challenging to break through.  That may have something to do with reports that quantity supplied to running well ahead of quantity demanded:

Crude oil declined for a second day in New York after a U.S. government report showed a larger-than- expected increase in fuel stockpiles in the world’s largest energy-consuming nation.

 

Gasoline stockpiles in the U.S. surged 5.4 million barrels last week, the Energy Department said. That’s more than the 500,000-barrel increase forecast in a Bloomberg News survey of analysts. Diesel and heating oil inventories jumped 2.9 million barrels, double what was expected. Crude oil supplies climbed 2.86 million barrels last week.

 

“The market has a glut of crude oil and refined products right now,” Victor Shum, a senior principal at consultants Purvin & Gertz Inc. in Singapore, said in a Bloomberg Television interview. “If we get a big correction in equities, the loss of optimism in that demand recovery will continue to drive down prices.”

 And even if oil broke through the $72 mark, if $150 oil couldn't trigger a wage-price spiral, what is $80 oil going to do?  The Fed's seeming eagerness halt monetary accommodation also runs in contrast to forecasts that they really need to be doing much, much more to support growth.  From Goldman Sachs (no link):

In recent months, we have argued that the zero lower bound (ZLB) on nominal interest rates represents a meaningful constraint on monetary policy in particular and economic policy in general. Specifically, combining a variant of the Taylor Rule for monetary policy with our forecast for growth and inflation, we have long concluded that the Federal Open Market Committee (FOMC) would want to push its target for the federal funds rate significantly below zero – to levels of -6% or lower – if it had that option.

The -6% number suggests a much, much more aggressive expansion of the balance sheet, while the Fed in contrast is willing to let the current programs play themselves out over the course of the next six months.

 

So, given the unemployment outlook is sad, wage growth continues to deteriorate, core inflation is falling, and we seem to lack an institutional arrangement to force higher prices, should they even emerge, into higher wages, what is the Fed thinking?  Should they really be worried about winding down programs?  Are they really confident enough that an inventory correction that will undoubtedly spike GDP numbers will also translate into sustainable growth?   Even knowing full while that after the last recession, the US economy languished despite the inventory correction, only to be revived on the back of the housing bubble?  In effect, the Fed looks to be putting much weight on the cyclical story playing out, while ignoring the structural story of the necessity of asset bubbles to fuel growth.   Pondering this, a little noticed Bloomberg report jumped to mind:

Federal Reserve policy makers are concerned about making “a colossal policy error” leading to higher inflation if they don’t withdraw extraordinary monetary stimulus soon enough, said Laurence Meyer, vice chairman of Macroeconomic Advisers LLC and a former Fed governor.

 

“When you talk to committee members you see a little bit more angst than you’d expect,” Meyer said in an interview yesterday at the Kansas City Fed’s monetary policy conference in Jackson Hole, Wyoming. “In public they say they’re confident they’ll get it right, they’re confident they have the tools to get it right. But when you talk to them in private there’s some concern there.”

So, added to the Medley rumor, the pieces start to fall together.  Internally, perhaps a wide range of FOMC members believe, in their hearts if not in the data, that they have gone so far that the balance of risks have shifted toward inflation.  But this is troubling; the basis for the inflation story falls entirely on the Fed's expansion of its balance sheet.   Just a meager $1.3 trillion expansion give or take in the wake of an over $11 trillion decline in household wealth?  And the bulk of that expansion is sitting in excess bank reserves?   Not really much of an inflation story.  But why else are they so eager to withdraw?  Just to prove to critics they can?  With much fanfare, from Bloomberg today:

The Federal Reserve and U.S. Treasury said they’re scaling back emergency programs aimed at combating the financial crisis, reducing support for firms that now have an easier time getting funding.

 

The central bank today said it will further shrink auctions of cash loans to banks and Treasury securities to bond dealers, reducing the combined initiatives to $100 billion by January from $450 billion. The Treasury has “begun the process of exiting from some emergency programs,” the chief of the government’s $700 billion financial-rescue fund said separately.

Bottom Line.  The Fed is moving toward the exit as they look toward the conclusion of their securities purchases programs.  But it is not clear that such a move is justified by their own forecasts or the inflation/wage/employment data.  There may be an internal fear they have gone too far, a fear that the hawks can exploit. To be sure, I see no reason to expect the Fed will raise rates for a long time.  And the Fed maintains it policy flexibility, claiming to be ready to revive asset purchases should economic or financial conditions justify.  But I now suspect the bar for renewed expansion of Fed accommodation may be much higher than I had anticipated.  And that the dominant push for expansion would have to come from financial market conditions, while they would be willing to tolerate persistently high unemployment rates so long as U. Michigan inflation expectations say elevated, regardless of the actual inflation data.