Tim Duy's Fed Watch

Opportunistic Disinflation?

Ryan Avent responding to Brad DeLong's interpretation of the most recent FOMC statement, comes down easy on the Fed:

...a strict reading of the Fed statement suggests that the central bank is planning to keep rates low because the economy is likely to remain weak. In that case, the rate forecast wouldn't be expected to raise inflation and wouldn't be stimulative. I shy away from the strict interpretation of the statement, because it would make no sense to add the language in the first place if that's what the Fed were actually saying. Perhaps too charitably, I lean toward a view that the Fed is trying to raise inflation expectations without spooking its critics, internal and external.

Fair enough, I see that.  But what has been nagging at the back of my mind is the decline in TIPS measured inflation expectations since the recession:

Of course, these are not perfect measures of inflation expectations, but they still tell an interesting story.  Consider that in 2006 and 2007, the average five and ten year inflation expectations were 2.38% and 2.41%, respectively.  Since 2010, the averages are 1.80% and 2.14%.  A reasonably sharp 58bp decline at the five year horizon, and a smaller 27bp decline at the ten year horizon.  So, at first blush, if the Fed is trying to raise inflation expectations to the pre-recession rates, they have not been particularly successful, especially in the near term.

The interesting question, however, is does the Fed want to return inflation expectations to the pre-recession rates?  The transfer from TIPS inflation expectations to Fed policy is not perfectly smooth.  TIPS returns depend on the CPI; the Fed targets the PCE price index.  So instead of focusing on the level of TIPS inflation expectations, consider the roughly 30bp decline in the ten-year horizon.  Presumably, the longer-run fits better with the Fed's objectives.  And we know the target is 2%, courtesy of the explicit policy statement released at the last FOMC meeting.

Now consider the pre-recession headline PCE price index trend.  What should be the beginning of sample?  Honestly, I don't know.  But for convenience, let's consider the period from 2000:1 through 2007:12, which should be long enough to form reasonable inflation expectations, and extrapolate that trend forward: 

The PCE price index is currently tracking below that trend, which would seem to open the door to more aggressive policy.  But that trend represents inflation running at 2.3%, about 30bp above the Fed's target.  Now fast forward 12 months and consider the trend since 2008:12: 

That trend line represents a rate of inflation of just a bit above 2%, right in line with the Fed's target.  And 30bp less than the pre-recession trend.  Or about the same as the 30bp decline in the ten-year TIPS inflation expectation.  

You see where I am going with this.  The Fed was facing something higher than 2% inflation prior to the recession.  Now they are looking at 2% inflation, which is also now the official target.  It seems to me they might have used the recession to bring down the path of prices and along with it inflation expectations - something that might surprise the Fed's critics from both sides of the aisle. 

Oil Prices - It's What Everyone is Talking About

Via Ryan Avent, Matt Yyglesias opines on the link between oil prices and monetary policy:

But it looks to me as if a demand-side oil issue is really just the same old issue of the trade deficit and the international balance of payments and not the second coming of a 1970s-style oil price shock. Perhaps it's a monetary policy issue. We send dollars abroad in exchange for oil, but then the dollars get sent back in exchange for bonds. That ought to lower interest rates and induce investment in the United States, but nominal interest rates are already at zero so the loop is cut. Even so, higher gas prices should push the price level up which pushes real interest rates down which induces investment in the United States. The chain will only be broken here if the Fed decides to ignore its own self-guidance and target headline inflation instead of core inflation.

There is a lot going on in these few sentences, but I am going to focus on the last two lines.  As a point of clarification, the Fed does not target core inflation.  Refer to the Fed's freshly printed statement on long-run goals and strategy:

The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

That's headline inflation, not core inflation. Of course, there is a near-term focus on core inflation, but not as a target, but as a guide to the path of headline inflation.  Monetary policymakers should be wary about overreacting to movements in headline inflation if they are not evident in core inflation.  

Consider also that the Fed is setting inflation expectations at 2 percent.  Technically, expected, not current, inflation should be a determinant of investment spending. Which means that a spike in headline inflation should not stimulate investment spending via this channel assuming inflation expectations remain anchored.  And, at this point, inflation expectations appear anchored:

Still below what we saw last spring.  To be sure, we could see inflation expectations edge up, but anything significant would draw the attention of the Federal Reserve.  I think they are pretty serious about that 2 percent target.  In other words, I would be cautious about reading too much into a drop in ex-post real interest rates due to a rise in energy costs.  

Note that this is a criticism of Fed policy at the zero bound, that by locking in inflation expectations at 2 percent they have effectively placed their most powerful remaining policy tool off-limits.  

I could imagine that higher-gas prices induce additional investment via some other mechanism, such as increased purchases of energy efficient machinery, etc.  But this would not necessarily be a sufficient offset to other, negative impacts of higher energy prices.

In any event, we are all struggling to extract a signal from the data - is this primarily a "good" shock that indicates improving global activity, or a "bad" shock due to a supply constriction?  Arguably, both factors are at play - see Jim Hamilton here.  Putting aside the possibility of a bad shock for the moment (I think we all agree that a supply disruption stemming from a conflict with Iran would be fairly negative, especially for Europe), I tend to see the challenge in terms similar to this from Reuters:

Looking past the near-term uncertainty surrounding Iran, Andrew Sentance, a former member of the Bank of England's Monetary Policy Committee, said high and fluctuating prices for energy were part of a "new normal" economic climate in which Asia is the main engine of global growth.

Periodic bursts of inflation would add to the volatility of what was likely to be disappointing growth in the West for quite some time, according to Sentance, a senior economic adviser to PricewaterhouseCoopers, an accounting and advisory firm.

"This strong growth in Asia and other emerging markets is putting considerable pressure on markets for energy and other commodities and that is one of the reasons why we are finding growth so difficult to achieve," he told a conference organized by the Institute of Economic Affairs, a free-market think tank in London.

"That's not just a short-term phenomenon. It's a secular issue that's going to persist through the middle of this decade," he said.

Even if higher oil prices are a symptom of improving global growth (a "good" shock) and do not trigger a US recession, they will certainly place some additional strain on US household budgets, which will in turn depress growth relative to what it would have been in the absence of the higher oil prices (consider instead the relatively low and stable prices of oil during much of the US boom during the 1990s).  In effect, we could be running up against a global bottleneck that places something of a speed-limit on US (and global) growth. 

Addendum:

As to the international finance story Yglesias tells, I think this does come back to a monetary policy story, but I think the direction might be backwards.  I am still working this one out:

Yglesias is telling a story of recycling petro-dollars.  In order to finance a given level of trade deficit, the dollar outflow must be recylced back into the US economy as a dollar inflow that supports some type of domestic absorption.  I shy away from using the term "investment" strictly as it could support government spending or even consumption spending (think of households borrowing against home equity to buy a boat).  If foreigners don't not want to recyle their dollars back into the US economy via financial inflows, the value of the dollar falls to stimulate exports and deter imports, thus improving the external deficit.  

Now, to Yglesias' point, we may have something of an interesting situation whereby foreign investors find themselves holding dollar assets as cash or near-cash equivalents (low yielding Treasuries).  And unless the federal government utilizes that potential via expanded borrowing (note that in the private sector, savings exceeds investment already), little additional demand is supported.  Now it is interesting that foreign investors would prefer to hold relatively low-yielding assets rather than using their dollars to purchase US goods and services, but such is the outcome of so many dollars being held for central banks around the world.

As Yglesias' says, the "loop" is cut, but not necessarily because of the zero bound, but by the global demand for dollars, which arguably is the cause of the zero bound.  Which then does brings us back to Yglesias' point that this is a monetary policy issue - policymakers could more actively drive down the value of the dollar by raising inflation expectations, thus making it increasingly unattractive for foreigners to hold cash or cash equivalents, and force the funds into either demand for US goods and services or investment goods.  Certainly, however, policymakers would view this as a risky strategy, and thus have not gone down this road.

 

Who Thinks Unemployment Isn't Too High

I noticed this line in the most recent Fed minutes:

While overall labor market conditions had improved somewhat further and unemployment had declined in recent months, almost all members viewed the unemployment rate as still elevated relative to levels that they saw as consistent with the Committee's mandate over the longer run.

"[A]lmost all" means that as least one FOMC member does not believe that the unemployment rate is not well above the natural rate.  Who is it?  

Will They Or Won't They?

Calculated Risk reads this passage in a recent speech by San Francisco Federal Reserve President John Williams:

This is a situation in which there’s no conflict between maximum employment and price stability. With regard to both of the Fed’s mandates, it’s vital that we keep the monetary policy throttle wide open. 

and concludes:

QE3 is coming.

Dallas Federal Reserve President Richard Fisher states:

“In my view, it’s not going to happen,” he said. “It’s a fantasy. Wall Street keeps dangling QE3 out there [but] I just don’t see it happening.”

I guess we are going to see who knows more about monetary policy - CR or Fisher.  My instinct tells me CR, but Fisher seems just a little too certain to dismiss entirely.  Reviewing the most recent minutes, one find to the now oft-repeated line:

 A few members observed that, in their judgment, current and prospective economic conditions--including elevated unemployment and inflation at or below the Committee's objective--could warrant the initiation of additional securities purchases before long.

Presumably, Williams is among the few.  I would like the Fed to publish their definition of a "few."  In my book that is three or less, which is well short of the the majority necessary to shift policy.  That said, the next line of the minutes is:

Other members indicated that such policy action could become necessary if the economy lost momentum or if inflation seemed likely to remain below its mandate-consistent rate of 2 percent over the medium run.

Now you have a solid majority willing to move forward with QE3 if the economy sags or inflation remains below 2%.  The recent US data flow, however, has been generally positive, and it is hard to ignore the steady drop in initial unemployment claims.  To be sure, we have been fooled by seemingly upbeat data in the past.  But  I suspect the median FOMC member will be wary about dismissing the generally positive data - sooner or later, some parts of the US economy, such as home building, are going to come back on line.  Which leaves us pondering inflation data.  With gasoline prices marching higher, headline inflation will head in that direction as well.  Typically, however, the Fed will look toward core inflation as a gauge of where headline will eventually settle, and recently core has been soft:

Still, notice the recent uptick.  And if FOMC members want to focus on the year-over-year numbers, it looks like core and headline are set to converge at the 2% mark:

All in all, I tend to view the Fed as generally in wait and see mode.  I doubt very much the case is as clear cut as Fisher or CR believes.  However, I tend to think the general mood of the FOMC favors CR's position, as long as core inflation stays on the weak side of 2%.  But if inflation ticks up and general economic data remains solid, hope of QE3 may quickly be dashed.

Again With Potential Output

St. Louis Federal Reserve President James Bullard graciously responded to my most last post regarding his much considered speech.  I actually do not enjoy drawing Bullard's attention, in that it makes me fear that one day I will find that my access to FRED has been disabled.

On what Bullard and I agree on is this:  There are different estimates of potential GDP.  I discussed this point last year:

Now, before you roll your eyes, as I am inclined to do, note the CBO estimate of potential output is not the only estimate.  Menzie Chinn reminds us of the variety of estimates of potential output, some of which suggest that, at the moment, the output gap is actually positive. 

In that post I discussed some possible reasons we might consider a downward shock to potential GDP.  Near the end, I concluded with this:

While not discounting the probability that some structural factors are at play, the primary challenge facing the US economy is insufficient demand.  Optimally, I think the best solution to this challenge is that demand emerges from the external sector – and here I mean NET exports, export and import competing industries.  This source of demand would support needed structural change, ultimately for the good of the US and global economies.  This adjustment requires a relatively complicated expenditure-switching story on a global basis.  I don’t know how to avoid such a story.  Barring this outcome, one falls back on fiscal policy, which can surely do the job, but risks maintaining the current pattern of global imbalances.  And perhaps such concerns are overblown; after all, so far the fears of a Dollar/current account crisis have not emerged.

Bullard takes a different approach.  First, he rejects the CBO estimate offhand because it is not the outcome of "full DSGE model" and "there is nothing about the CBO potential calculation that allows "bubble" levels of output."  Before we reject the CBO model outright, it is worth considering it basic effectiveness as a guide:

I see two recent episodes of output in excess of CBO potential, both of which were associated with what I believe were asset-price bubbles and also induced monetary tightening to stem inflationary pressures (which seems to contradict Bullard's assertion that the CBO estimate leaves no room for bubbles).  If this was a significant overestimate of potential output in during the housing bubble, I would have expected more severe inflationary pressures. 

Of course, even if the CBO estimates were roughly correct during the bubble, perhaps there has been a significant downward shift in potential.  And here again I think Bullard and I can find common ground - potential output is not a measured variable, it is estimated.  We really shouldn't blindly follow such estimates, but instead look for corroboration in other data.  I tend to fall back on unit labor costs for a signal that wages pressures are outstripping productivity growth and threatening to sustain an inflationary dynamic:

I don't see a reason for concern at this point.  But put aside the CBO estimate for a moment, and move onto the crux of Bullard's argument:

If households and businesses had ignored the house price developments as a sort of amusing side show, it would not have been so important.  But our rhetoric about the decade suggests otherwise.  Households consumed more through cash-out refinancing, developers built more, borrowing increased, Wall Street produced new financially-engineered products to feed the boom, and ancillary industries like transportation thrived.  Output went up, and labor supply was higher than it otherwise would have been. 

There are two parts to this theory.  One is a demand side story - the debt-fueled housing bubble supported consumption and investment, supporting actual GDP growth.  I don't think anyone disagrees with that view.  The second part of the story is supply side, that the extra activity induced additional labor supply.  With the housing bubble now popped, all of the related output and labor supply now melts away:

So, what Irwin's picture is doing is taking all of the upside of the bubble and saying, in effect, "this is where the economy should be."  But that peak was based on the widespread belief that "house prices never fall."  We will not return to that situation unless the widespread belief returns.  I am saying that the belief is not likely to return--house prices have fallen dramatically and people have been badly burned by the crash.  So I am interpreting your admonitions on policy as saying, in effect, please reinflate the bubble.  First, I am not sure it is possible, and second, that sounds like an awfully volatile future for the U.S., as future bubbles will burst once again. 

Now, I agree that the bubble cannot be reflated, nor should it.  But this leads into what I don't like about Bullard's story housing bubble story.  From my post last July:

Also arguing for a largely demand side explanation to the current weak employment numbers is what looks like a pretty obvious link between asset bubbles and full employment over the last decade.  As long as households had a mechanism to support demand, achieving full employment was not a problem.  If not households, then why can’t another form of demand fill the gap?

In Bullard's model, the housing bubble popped, and millions of people who were employed are no longer employed, nor should we expect them to be employed (or to reenter the labor force) as there is no way to do so absent another bubble.  This seems to me an obvious place for fiscal policy and monetary policy to step into the breach and compensate for the lost demand.  That millions of people's labor and output be lost simply because they no longer believe that housing prices don't always rise is a gross waste of resources.

You can tell a story in which that bubble-driven demand was necessary to compensate for negative equilibrium interest rates for risk free assets (driven by excessive saving by Asian central banks and aging demographics in the developed world).  Rather than wait for another asset bubble to come along and lift demand, or twiddle your thumbs hoping another recession doesn't hit while you are at the zero bound, you could pull out the old-Bernanke playbook and implement an even more aggressive mix of fiscal and monetary policy to compensate for the lost demand and flood the world with risk free assets.  

Now, as to Bullard's appeal instead to a New Keynesian framework, I am more sympathetic.  Basu and Fernald opine:

..the major effects of the adverse shocks on potential output seem likely to be ahead of us. For example, the widespread seize-up of financial markets has been especially pronounced only in the second half of 2008. We expect that as the effects of the collapse in financial intermediation, the surge in uncertainty, and the resulting declines in factor reallocation play out over the next several years, short-run potential output growth will be constrained relative to where it otherwise would have been. 

This is similar to my thoughts that somewhere in the background there is need for some structural change, toward export and import competing industries.  That said, I still find it hard to believe that this is the primary story given that the downturn negatively affected employment across almost all industries.  If structural adjustment was the primary issue, I would have anticipated a narrower range of affected industries.  

Bottom Line:  Bullard and I agree that there are different estimates of potential output.  I think that if he wants to throw out the CBO estimate, he needs to provide another estimate to serve as a policy guide.  And I would agree that any estimate, CBO included, needs to be continuously monitored in the light of actual incoming data.  I still disagree with his asset-bubble model of potential GDP shifts.  At its core it is a demand story with maybe a second-order labor supply aspect, and does not explain why no other source of demand can compensate for the lost housing bubble and induce higher labor supply.   In the past I have considered reallocation stories similar to what can be derived from a time-varying NK measure of potential output, but again question that this is the primary concern at the moment.

It's Worse Than You Think

The last few days have seen a number of reactions to St. Louis Federal Reserve President James Bullard's recent speech, inflation targeting in the USA.  Critical reactions came from Scott Sumner, Noah Smith, Mark Thoma, and Paul Krugman.  I think so far the only real support for Bullard comes from David Andolfatto here and here.

Bullard was moving in this direction last month, but he really didn't outline his thinking.  Now he has, and sadly revealed that there really wasn't that much thinking at all.  Bullard attempts to argue against the "output gap" framework shaping monetary policy:

The recent recession has given rise to the idea that there is a very large “output gap” in the U.S. The story is that this large output gap is “keeping inflation at bay” and is fodder for keeping nominal interest rates near zero into an indefinite future. If we continue using this interpretation of events, it may be very difficult for the U.S. to ever move off of the zero lower bound on nominal interest rates. This could be a looming disaster for the United States. I want to now turn to argue that the large output gap view may be conceptually inappropriate in the current situation. 

First off, Bullard just flat out does not understand the definition of potential output:

The key to the large output gap story is the use of the fourth quarter of 2007 as a benchmark for where we expect the economy to be today. The idea is to take that level of real output, assume the real GDP growth rate that prevailed in the years prior to 2007, and project out where the “potential” output of the U.S. should be. 

Estimates of potential GDP are not simple extrapolations of actual GDP from the peak of the last business cycles. They are estimates of the maximum sustainable output given fully employed resources.  The backbone of the CBO's estimates is a Solow Growth model.  So I don't think that Noah Smith is quite accurate when he says:

So, basically, what we have here is Bullard saying that the neoclassical (Solow) growth model - and all models like it - are wrong. He's saying that a change in asset prices can cause a permanent change in the equilibrium capital/labor ratio. 

Bullard can't be saying the Solow growth model is wrong because he doesn't realize that such a model is the basis for the estimates he is criticizing.  

Second, as as already been widely circulated, Bullard then attempts to use a demand side shock to justify his contention that estimates of potential GDP are too high:

A better interpretation of the behavior of U.S. real GDP over the last five years may be that the economy was disrupted by a permanent, one-time shock to wealth.  In particular, the perceived value of U.S. real estate fell substantially with the 30 percent decline in housing prices after 2006. This shaved trillions of dollars off of the wealth of the nation. Since housing prices are not expected to rebound to the previous peak anytime soon, that wealth is simply gone for now. This has lowered consumption and output, and lower levels of production have caused a significant disruption in U.S. labor markets. 

Follow the links above to Sumner and Krugman for rebuttals to this line of thought.  Brad DeLong tries to give Bullard a little help by noting that the bubble may have influenced labor force participation rates, but DeLong also notes these are at best small and were not Bullard's argument in any event.  Bullard's chain of thinking is not so sophisticated.  Sure, you can argue that he does have labor in the equation:

I mentioned that a wealth shock significantly upsets labor market relationships. This is because output declines, so less labor is required. It takes a long time for those displaced by the shock to find new working relationships. 

But again, this is a demand side story.  If output were higher, then so too would be the demand for labor.  Simply put, Bullard simply moves from the wealth effect to a drop in consumption, and assume that drop in consumption represents a shock to potential GDP, inexplicably confusing demand and supply.

I don't think there is much of a viable defense of Bullard - he gets both the empirics and the theory wrong.  He doesn't attempt to define a change in the factors of production that would lead to a shift in potential GDP, nor does he attempt to argue that the estimates of potential GDP are wrong, either from a time series trend/cycle decomposition framework or a CBO Solow growth framework.  But note that it gets worse when he extends his faulty logic to policy:

I have argued that the large output gap view may be keeping us all prisoner—tethering our expectations for output, in effect, to the collapsed bubble in housing. It is setting a very high bar for the U.S. economy, one that may not be appropriate given the nature of the shock that the economy has suffered. Importantly, it may influence the FOMC’s near-zero rate policy far into the future, since output is continually viewed as falling short of the high-bar benchmark. 

But the near-zero rate policy has its own costs. If we were proposing to remain near-zero for a few quarters, or even a year or two, one might argue that such a policy matches up well with the short-term business cycle dynamics of the U.S. economy. But a near-zero rate policy stretching over many years can begin to distort fundamental decision-making in the economy in ways that may be destructive to longer-run economic growth.

In particular, the lengthy near-zero rate policy punishes savers in the economy... 

According to Bullard, monetary policy is stuck at near zero-interest rates because of overestimation of the output gap, and as a consequence savers are suffering. First, if the output gap is smaller than estimated, or the economy outperforms, the Fed can change course and raise interest rates.  They have only issued a forecast, not a commitment.  

And, second,  I have been through this before - while I am very sympathetic to the plight of savers, Bullard does not consider that the Fed is merely following the lead of the economy.  Another way to think about the situation is that the supply of savings and the demand for investment currently would clear only at a negative interest rate - see Paul Krugman here. Also note the excess of private saving over private investment, which is exactly what you would expect if the market clearing interest rate was below the zero bound:

If the Fed's zero-interest rate policy is leading to fundamental distortions in the economy, it is because the Fed is not taking seriously enough the need to lift the economy away from the zero-bound.  And I don't know that they can push the economy off the zero-bound if they limit their policy options with a strict two percent inflation target. 

Bullard also shows significant sympathy for the notion that Fed policy is a net drag on activity:

These low rates of return mean that some of the consumption that would otherwise be enjoyed by the older, asset-holding households has been pared back. In principle, the low real interest rates should encourage younger generations to borrow against their future income prospects and consume more today. However, this demographic group faces high unemployment rates and tighter borrowing constraints, which may limit its ability and willingness to leverage up to finance consumption. Consequently, the consumption of the older generations may be damaged by the low real interest rates without any countervailing increase in consumption by other households in the economy. In this sense, the policy could be counterproductive. 

If you truly believe this argument, then you must believe that a higher Federal Funds rate will have a net positive impact on output.  But I have yet to see a convincing argument as to why this should be so - raising rates will only make matters worse if the market clearing rate is already negative.  Note also that the ECB's last two forays into the realm of tighter policy have not been particularly successful, to say the least.

Bottom Line:  Bullard really went down an intellectual dead end last week.  He criticized the focus on potential output, but revealed that he doesn't really understand the concept of potential output either empirically or theoretically.  He then compounds that error by arguing against the current stance of monetary policy, but fails to provide an alternative policy path.  And the presumed policy path, tighter policy, looks likely to only worsen the distortions he argues the Fed is creating.  I just don't see where Bullard thinks he is taking us.

 

 

 

 

 

 

 

 

 

Another Experiment?

In the fall of 2008, US authorities conducted a financial market experiment.  They allowed a large and heavily interconnected firm, Lehman Brothers, to file for bankruptcy, apparently under the belief that the consequences should be limited as everyone knew this was coming.  I think that, in retrospect, US policymakers wished they had pursued an alternative path.  The experiment was not exactly successful.

Now it seems that European policymakers are willing to risk yet another such experiment.  To be sure, they could still pull the rabbit out of the hat, but it is starting to look like the Troika and Greece have was they call in divorce court "irreconcilable differences."  Via the Financial Times:

Lucas Papademos, the Greek premier, failed to make party leaders accept harsh terms in return for a second €130bn bail-out, pushing Athens closer to a disorderly default as early as next month...

...After five hours of discussions, the three leaders of Greece's national unity government had not accepted demands by international lenders for immediate deep spending cuts and labour market reforms as part of a new medium-term package.

The Troika does not look ready to back down either:

The talks with the three leaders of a national unity government came after the government failed to persuade the so-called “troika”– representatives of the European Commission, European Central Bank and International Monetary Fund – to ease conditions for the rescue deal.

Patience with Greek politicians has evaporated among its creditors. During a conference call on Saturday, eurozone finance ministers bluntly told Athens to deliver on its promises and agree to reforms or face default next month.

Apparently, the Troika is playing serious hardball:

Eurozone officials are deliberately refusing to allow Greece to sign off on a €200bn bond restructuring plan because the threat of default is the leverage they have to convince recalcitrant Greek ministers to implement necessary cuts.

Now, perhaps Greece's leaders are just putting up a fight to look good to their voters and thus this will all blow over tomorrow morning with another last minute deal cobbled together that no one really believes will work.  Indeed, everyone already knows the numbers are too small:

A further complication is the uncertainty over supplementing the €130bn bail-out to take account of the deteriorating economic position in Greece.

Some officials believe around another €15bn is needed – funds that Germany and other countries have said they are unwilling to provide.

It doesn't really make sense for Greece to accept a deal they know is doomed to failure from the start. Especially as the terms of the deal - including a steep wage cut to improve competiveness - is virtually guaranteed to plunge the Greek economy deeper into recession.  

Fundamentally, the problem is as it always was - any decent adjustment program has the stick and the carrot.  The carrot usually comes partly in the form of a currency devaluation that accelerates the process of adjustment by providing stimulus via the external accounts.  This short-run stimulus allows for structural changes to take root.  The approach to Greece has always been just the stick - more austerity and structural change, no carrot.

And I have to admit that I find the enforced wage-cutting a draconian solution.  Will this policy eventually be applied to Spain and Portugal and Ireland?  Is this the future of Eurozone economic policy?  There are two ways to reduce competitive imbalances.  Inflate German wages up, or deflate everyone else down.  I think the former would prove to be a lot more fun than the latter.

Truth be told, I honestly believe that Greece is beyond saving without a significant transfer, not loan, that buys real time for the Greek economy to adjust.  That is the only way to compensate for the lack of currency adjustment and is the conclusion I wish the Troika would ultimately reach.  But, I am also starting to think that the ECB has made the Troika overconfident.  When the ECB finally decided that yes, serving as lender of last resort, at least to the financial system, is actually the job of a central bank, they dramatically eased financial market stress throughout Europe.  That stress, however, was Greece's leverage.  Absent that stress, the Troika appears to believe Greece is backed into a corner with no other way out but to submit to Troika demands.

This is a dangerous game.  Sometimes the person backed into a corner makes a sucide run at their attackers.  And maybe Greece has nothing else to lose at this point.  To be sure, they will suffer a devastating blow if they exit the Euro, but at least it will be the process of self-determination, rather than the devastating blow of Troika imposed austerity.

And, while I am thinking about it, what exactly is the policy precedent the Troika is trying to set?  That it is acceptable to force European citizens - a whole people - into poverty?  When does this become a human rights issue?

In any event, I don't think financial market participants are really prepared for Greece to make a suicide run.  Why should they be?  This whole episode is like The Boy Who Cried Wolf.  Everytime we come to the brink, and prognosticators call for the apocalypse, someone backs down.  Why should this time be any different?  Honestly, it is tough to argue with that logic.  Expectations of imminent financial crisis have simply gone unmet, leaving markets relatively unphased by the most recent events in Greece.  Perhaps the ECB haas done enough to let Greece slide out of the Euro without much noise. 

It would be an interesting experiment to see unfold.  I am curious to see if the ECB has indeed done enough.  Not curious enough, however, to want to take such a risk.  The Boy Who Cried Wolf ultimately had a poor ending. 

 

Good News On Employment

With only a minimal drag from the government sector, the February employment report shined on the back of a solid gain in private sector hiring: 

The last couple of months look more like the optimistic numbers seen early in 2011 before the mid-year slowdown raised the specter of another recession.  As has been widely noted, there is little to complain about in this report.  To be sure, in many respects we are still deep in the hole.  Long-term unemployment remains a challenge:

Wage growth is meager: 

And the employment to population ratio remains sits a levels not seen since the early 1980s:

Still, as noted earlier, these issues should be alleviated if job growth is sustained.  And as a precursor to such improvements, the unemployment rate is falling, and at a reasonably quick pace:

What will this mean for the Fed?  As I discussed earlier, the unemployment rate looked to be the weak link in the Fed's most recent forecast of 8.2-8.5% by year end.  We are at 8.3% in January, and unless either waves of workers reenter the job market or the economy shifts gears dramatically soon, we will be easily below 8% in just a couple of months.  Under such a trajectory, I have to imagine that another round of QE, as well as the Fed's interest rate projection, are not sure bets at all.  

To be sure, one can argue the Fed should seize this opportunity to entrench the recovery with more easing.  After all, the employment to population ratio suggests plenty of slack in the labor market, as does minimal wage growth.  And unit labor labor costs are moving sideways as well:

We know that at least one policymaker, Chicago Federal Reserve President Charles Evans, would already be easing much more aggressively, but we also know that others, such as Philadelphia Federal Reserve President Charles Plosser thinks the current rate outlook is not consistent with an improving economic environment.  A couple of reports like this will find others in his camp as well.

I think it still premature to expect the Fed to dramatically shift forward their own expectations of a rate hike.  That said, since the recession ended, Federal Reserve officials have tended to shift expectations away from more easing and toward tightening every time the data shows a little life, only to have to backtrack six months later when hopes are dashed.  Assuming the Fed follows the same pattern, watch for a shift in tone from Fed officials.  

How This Gets Even Uglier

At this risk of beating a dead horse, I reiterate that I don't see how the European situation comes to a happy conclusion.  Conditions in Greece appear to be deteriorating rapidly.  Via Athens News, retail sales are in freefall:

Retail sales by volume fell 8.9 percent year-on-year in November after a 10.8 percent drop in October, statistics service data showed on Tuesday.

Households, burdened by austerity measures to plug deficits and rising unemployment, have cut back on spending.

Consumer confidence has also been hurt by a climb in the jobless rate to 17.7 percent in the third quarter.

Officially, hope springs eternal:

"Increasing unemployment and austerity are likely to continue weighing on disposable incomes and consumer demand in the first months of 2012. However, a positive conclusion of the PSI deal and the approval of the second bailout package could provide a kind of positive shock to business and consumer sentiment," he added.

Right, good luck with that, as the next agreement is only about tightening the screws even more.  How exactly will consumer confidence get a boost given an acceleration in wage cuts, a late holiday gift from the Troika.  An interview with the IMF's Poul Thomsen, via Kathimerini: 

Are you advocating wage cuts?

Let me begin by saying what I think we all agree on. Greece still has a large competitiveness gap. Closing this gap will require actions on many fronts, not only wages, but it is clear that wages for the economy as a whole are too large compared to Greece’s productivity. One could hope to magically raise productivity to levels that will justify the current wage level. We are trying, but there is a limit to this. Thus, part of the adjustment must come by more closely aligning productivity in individual enterprises with wages. Reforms to the wage setting mechanism, to the system for collective agreements could help in this regard. I think that most of us agree on what I have said so far. Where we need to be more convinced, is that such reforms can deliver results in the foreseeable future. If not, we believe that the government should consider more direct interventions for a temporary period, until reforms become effective. These could include limitations on the minimum wage and possibly the 13th and 14th salaries. We are still discussing this. It is too early to say. We need to better understand what kind of reforms the government has in mind.

Under conditions of never-ending austerity with no exchange rate release valve, what exactly is the half-life on any new plan to reduce Greece's debt to GDP ratio to 120% by 2020 (itself a questionable goal)?  3 months?  6 months?  Back to deteriorating conditions, via Kathimerini:

Archbishop Ieronymos, the head of the Church of Greece, has taken the rare step of writing to Prime Minister Lucas Papademos to express serious concerns about the effectiveness of the government’s fiscal policy and the effect it is having on Greek people.

In his letter, Ieronymos also raises doubts about the role of the European Commission, European Central Bank and International Monetary Fund – or troika – in the country and whether Greece should agree to further austerity measures to receive its next bailout, suggesting that they are “larger doses of a medicine that is proving deadly.”

Ieronymos expresses concern about the impact of the crisis, describing a rise in suicides, homelessness and unemployment and the desperate state that an increasing number of Greeks find themselves. He warned that this was creating a dangerous social situation.

“Greeks’ unprecedented patience is running out, fear is giving way to rage and the danger of a social explosion cannot be ignored any more, neither by those who give orders nor by those who execute their deadly recipes,” he wrote.

Meanwhile, Germany appears to have underestimated the possibility of resurgent nationalism in the periphery.  Via Athens News:

Twenty-eight MPs tabled a proposal in parliament on Thursday requesting a debate on the so-called occupation loan paid by the collaborationist government to Germany during the Second World War as well as the issues of reparations for victims of Nazi atrocities and looted treasures...

...The MPs stressed that the now united German state owes Greece, a Second World War victor, roughly 54bn euros before interest, underlining that Greece was the victim of unparalleled cruelty inflicted by the Nazi forces. 

The signatories stressed that Greece has been the subject of an obvious injustice because it is the only country to which Germany has not paid reparations.

Reopening the wounds the Euro was meant to close.

Call me a pessimist, but I can't help but conclude that unless Greece gets real relief more quickly, the cost of being in the Euro will outweigh the costs of leaving.  At this point, I am starting to wonder what was the bigger mistake - to allow Greece into the Euro in the first place, or to force them to stay?