Questions and Answers, by Tim Duy: I thought this might be an easier way to get back into the game after an extended hiatus.
Does the economy need more stimulus?
Always good to start with a softball question - YES! The US economy is two years into an economic expansion, and yet the unemployment rate remains above 9 percent. National output growth averaged just 0.7 percent in the first two quarters of the year. Job growth was zero in August, albeit with some downward pressure from the Verizon strike. Output is $1 trillion below CBO potential – and the gap is expanding. The 30-year inflation indexed Treasury bond just traded at 90 basis points. None of which should be happening two years into an expansion. Yet here we are.
Will the private sector provide the needed stimulus?
Federal Reserve President Dennis Lockhart summarizes the situation:
It is necessary that the process of deleveraging plays itself out, which may take several more years. When economies are deleveraging they cannot grow as rapidly as they might otherwise. It is obvious that as consumers reduce spending they divert more of their incomes to paying off debt. This shift in consumer behavior increases the amount of capital available for financing investment. But higher rates of business investment are not likely to fully offset weakness in consumer spending for some time, as businesses continue to grapple with uncertainties about the future.
Lacking the equity wealth provided by the housing bubble, households are simply unable to sustain the debt loads of years past. Hence, deleveraging continues. Without anyone else to pick up the slack, it is tough to see how we eek out anything other than subpar growth, trend growth (2.5 - 3.0%) at best. Not enough to quickly lift the economy back to trend output.
Will the government provide the needed stimulus?
On the fiscal side, the answer is no, or at least not yet. As Paul Krugman points out, fiscal policy is already contractionary, while the recently passed budget deal promises only more austerity. And, via Brad DeLong, Macroadvisors predicts that President Barack Obama’s impending jobs plan is not likely to provide much if any of an economic boost. That leaves monetary policy as the only game in town. And here we can anticipate that more easing is coming. But will it be enough to pull the economy from its slump? At this point, almost certainly not.
Why will monetary policy fall short?
Here again it is useful to refer back to Lockhart’s recent speech:
Given the weak data we've seen recently and considering the rising concern about chronic slow growth or worse, I don't think any policy option can be ruled out at the moment. However, it is important that monetary policy not be seen as a panacea. The kinds of structural adjustments I've been discussing today take time, and I am acutely aware that pushing beyond what monetary policy can plausibly deliver runs the risk of creating new distortions and imbalances.
Lockhart is not ruling out additional policy responses, but makes obvious his view the Fed is nearly, if not already, out of bullets to deal with a balance-sheet recession. Moreover, he shows his sympathy with the camp, I think best identified with the views of Kansas City Federal Reserve President Thomas Hoenig, that the Fed at this point risks doing more harm than good. This, I believe, represents the center of FOMC thought at the moment. This group is simply not inclined to initiate a new large scale easing in the absence of clear deflationary pressures. The five and ten-year TIPS breakevens are 1.81 and 2.05 percent, respectively. Combined, I believe they argue, at least from the Federal Reserve point of view, for more easing, but nothing dramatic.
But didn’t the most recent FOMC minutes reveal a more dovish constituency?
Yes. From the minutes:
A few members felt that recent economic developments justified a more substantial move at this meeting, but they were willing to accept the stronger forward guidance as a step in the direction of additional accommodation
Chicago Federal Reserve Bank President Charles Evans is a good example of this group. Via a recent CNBC interview:
In his view, QE needs to stay in place until unemployment plunges to 7 percent or if inflation gets past 3 percent. Core inflation, which strips out food and transportation, is about 1.8 percent, though the number is 3.6 percent including the more volatile measures.
Evans is a voting member on the fed Open Market Committee and traditionally has been among its more dovish members when it comes to interest rates and inflation.
"Strong accommodation needs to be in place for a substantial period of time," he said. "If we could sort of make everybody understand that this is going to be in place for a longer period of time, we could knock out some of that restraint that comes about when people talk about premature tightening."
As far as I am concerned, he is preaching to the choir. There has been a remarkably irresponsible tendency of Fed policymakers to turn hawkish at the slightest hint of economic improvement. I think this belies their discomfort with the expansion of the balance sheet, and renders the rest of us unsure of their commitment to the dual mandate. And I believe the Fed needs to accept the possibility of higher inflation.
What can the Fed do at this point?
The usual suspects: Reduce the interest paid on reserves, extend the maturity of the Fed’s portfolio, expand the balance sheet further, shift the portfolio in favor of mortgage-backed securities to support the housing market, make a firm commitment to zero interest rates regardless of the inflation outcome, or raise the inflation target from 2 percent to 3 or 4 percent. I suspect the first three are most likely in play, although the magnitude of an additional balance sheet expansion will likely fall short of what is needed.
Wait a second. Didn’t the Fed already commit to zero interest rates until 2013?
No – they just said that given current forecasts, they anticipated an extended period on low interest rates. This does have some value in marginalizing the hawks. That said, the minutes make clear this is only a soft commitment:
Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.
What we really need is a hard commitment that can weather a period of higher inflation.
Where is Federal Reserve Chairman Ben Bernanke is this mix?
It appears that Bernanke is right of the dovish contingent revealed in the most recent FOMC minutes. I think this first became evident in his June press conference, when he made clear the bar to QE3 was high. The bar was high because inflation expectations had rebounded, and inflation was the only clear target the Fed had control over. This basic idea was evident in Bernanke’s Jackson Hole speech:
The Federal Reserve has a role in promoting the longer-term performance of the economy. Most importantly, monetary policy that ensures that inflation remains low and stable over time contributes to long-run macroeconomic and financial stability. Low and stable inflation improves the functioning of markets, making them more effective at allocating resources; and it allows households and businesses to plan for the future without having to be unduly concerned with unpredictable movements in the general level of prices.
Once inflation is close to the Federal Reserve’s target, Bernanke apparently sees little else monetary policy can do to relieve the cyclical pressures on the economy:
Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank.
I think the Bernanke’s focus on the 2 percent inflation target will severely limit the magnitude of additional easing to support job growth. It is increasingly my opinion that to lift the economy beyond the zero bound, we need a commitment by the Fed to lift inflation above 2 percent to allow nominal spending to return to the pre-recession trend. This is policy the Fed Chair appears dead set against, leaving only half-measures.
Note, however, the above only applies when inflation and inflation expectations are near the Fed’s target. I do believe Bernanke will press for more dramatic action should deflationary pressures become evident. I just don’t think we are there yet.
Would a shift to additional mortgage-backed assets help?
It wouldn’t hurt, and could push mortgage rates down further and thus encourage additional refinancing. Back in the day I would have been worried that the Fed risked looking like it was trying to sustain bubble-level prices, but I think we are beyond that. Still, note the problem in mortgage markets is deeper than interest rates – the problem is the inability to finance due to tougher underwriting standards and underwater mortgages. I am not confident that lower rates would alleviate these challenges. This seems more like the purview of the US Treasury, which could push for all federally guaranteed mortgages to be refinanced at a lower interest rate, regardless of the loan to value ratio.
Are we headed for recession?
I would not discount the possibility of recession given the US economy was clearly operating near stall-speed in the first half of the year. That said, it would be easier to embrace the recession story had the US economy ever returned to trend output during the recovery. As noted earlier, the economy is operating well below trend, and typical sources of strong downdrafts in demand – housing and autos – remain below pre-recession levels. Indeed, the absence of any rebound in housing is striking. Under these circumstances, I find it easier to embrace the “Japan” scenario, a sustained period of choppy and low growth. Recession or not, a tragedy by any measure.
What’s going on in Europe?
The Europeans are vexed with a political establishment that is not conducive to maintaining a single currency (of course, we too in the US are vexed with a dysfunctional political establishment, just a different one). In particular, they lack a mechanism to make sizable fiscal transfers within the Euro area. This is simply an important element of running a “one size fits all” monetary policy. As it stands, Euro-policymakers are attempting to enforce IMF-style austerity packages on troubled economies without the usual currency depreciation that helps offset the resulting fiscal contraction. It is obvious this approach is not working – Greek two-year debt is trading at 50 percent and the spread on Italian and Spanish debt widens. Paul Krugman asks where is the ECB? Where indeed? Perhaps they see their earlier debt-buying efforts as a failure, thus concluding the problem is a solvency problem, not a liquidity problem. And there is no European solution for a solvency problem, other than more austerity for troubled economies. Where does this end? Either the Euro-area comes together as a strong fiscal union or the periphery is jettisoned from the Euro. It really looks like the smart money is on the latter outcome. Drachmas anyone?
Update: 10:09PM PST
I see the ECB was not completely asleep at the wheel and was buying bonds. From the Wall Street Journal:
The ECB purchased Italian and Spanish government bonds Monday in a bid to keep 10-year borrowing costs from rising further above 5%—a threshold analysts say is key to their ability to finance their high debt loads. The ECB has purchased over €50 billion in bonds since reactivating the program four weeks ago.