Tim Duy's Fed Watch

Europe Overnight

European policymakers are trying to sway the vote in Greece.  From the Financial Times:

Senior European leaders are attempting to turn Greece’s repeat national election next month into a referendum on the country’s membership of the euro, a high-stakes political gamble that officials believe can win back voters disillusioned by the tough bailout conditions but eager to stay in the single currency.

José Manuel Barroso, president of the European Commission, made the choice clear on Wednesday, telling Greek voters the €174bn rescue programme would not be changed and that remaining in the eurozone was now in their hands...

...“The next election is going to be a sort of referendum election,” said one eurozone finance minister. “We are going to convey very clearly to the Greek people that if there is no stable government to implement the conditions of the programme then we are going to have difficulties and are going to have to adopt plan B.”

I thought the last election was supposed to be a referendum on Greece's commitment to the Euro.  European policymakers fail to understand that they have provided the Greek people no way out - they are damned if they do, damned if they don't.  Even if the Greeks overwhelming want to remain in the Euro, the austerity program guarantees ongoing recession, and the Greek people are being asked to commit to a program that is effectively already overtaken by events.  The deteriorating fiscal situation seems to guarantee a new program will be necessary in the months if not weeks ahead.  Would the rest of Europe agree to another bailout, regardless of whatever new conditions were required to get another deal done?  If the rest of Europe really wants Greece to stay in the Euro, I think it can only work with a program of bilateral transfers to Greece in exchange for radical, rapid restructuring of the economy.  Carrot, meet stick.

The rest of Europe might not think this is fair, but let's be honest - ultimately, it wasn't fair to bring Greece into the Euro in the first place.

On the issue of internal fiscal transfers, British Prime Minister David Cameron is joining the chorus of policymakers calling on Continental leaders to understand the extent of their problem:

“Either Europe has a committed, stable, successful eurozone with an effective firewall, well-capitalised and regulated banks, a system of fiscal burden sharing and supportive monetary policy across the eurozone or we are in uncharted territory which carries huge risks for everyone.”

That pretty much summarizes the situation.  The institutional structure, the fiscal plumbing, simply isn't present in the Eurozone to adequately adjust for asymmetric shocks.  End of story.  Either get that structure in place or accept that the project is a failure.  Can Europe make such a transition fast enough?  Yes - with German leadership to offer a mix bilateral transfers, Eurobonds, and ECB commitment to stand as lender of last resort to all the region as a whole.  Economically possible and politically possible, however, are two different things.

Finally, the ECB has reverted to its usual helpful self.  From Bloomberg:

The European Central Bank is conducting a comprehensive review of all its policy tools and has no immediate plans to increase stimulus even as market tensions mount, two euro-area officials said.

The review, mandated by the central bank’s six-member Executive Board, intends to assess the effectiveness of its measures, including the bond-buying program and long-term refinancing operations, and is scheduled to be completed in June or July, said the officials, who spoke on condition of anonymity because the deliberations are private. A third official said the ECB may not consider taking any further policy action until July, and that the bank sees current market tensions as a way of focusing politicians’ minds on reform efforts.

Way to stay ahead of the central banking curve!  Maybe if ECB members just close their eyes, tap their heels together, and softly whisper "there's no place like home," the crisis will come to a sudden end.  

Hey, it works in the movies.

Don't Let the Data Get in the Way of Your Story

St. Louis Federal Reserve President James Bullard:

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

Ten-year inflation expectations via the Cleveland Federal Reserve:

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

FOMC Minutes

The FOMC minutes are released tomorrow.  Calculated Risk gives us the Goldman Sachs preview:

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

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

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

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

Questionable Assumptions

From the Financial Times:

Ms Merkel defended her belief that the common currency was “not just a monetary project, but a political project”. It meant that the member states of the eurozone shared a common responsibility. “People who have a common currency will never fight a war against each other,” she said.

Isn't this just plain wrong?  When people with a common currency fight a war, we call it a civil war.  Not exactly without historical precedent.    

Failure to Communicate

Yet another amazing quote from the same Wall Street Journal article:

Greece's renewed turmoil is putting Europe's leaders in a difficult position. Many hoped that the Greek election would result in a national consensus to push forward with the deep spending cuts Greece's previous governments committed to as a condition of the rescues. Instead, voters used the ballot to express deep dissatisfaction with the measures.

Really?  Did European policymakers really believe that the Greek people would never grow tired of the endless austerity?  If so, this is simply sad, because virtually everyone else in the rest of world saw that the Greek people were being pushed over the edge.  

Central Bank FAIL - ECB Edition

From the Wall Street Journal:

The steady outflow of deposits from Greek banks hasn't yet turned into a full-blown bank run, and the European Central Bank has nearly limitless capacity to provide banks with additional liquidity. But economists have long warned that a run on banks could develop if the population fears Greece's departure from the euro is imminent and that their savings would evaporate. A bank run could trigger the euro exit if it reaches a scale that forces Greek authorities to freeze bank accounts and print their own currency to keep the financial system alive.

What is more, if Greece fails to comply with the conditions of its bailouts, the ECB would likely cut off the liquidity support for its banks, a move that could cause the banking system's collapse.

It is simply unbelievable that at this point in history, more than 100 years after Bagehot's Lomberd Street, that we could consider that the European Central Bank will not only fail in its role as lender of last resort for the fiscal authority, but also fail in its role as lender of last resort to the banking system.  Yet here we are.

 

Greece is Running Out of Time

I have repeatedly described myself as a Euroskeptic.  The current combination of politics and economics looks likely to at worst doom the Euro to failure, at best to commit the Continent to a deep and long-lasting recession.  Moreover, the pace of deterioration in Greece, combined with an economic structure that seems completely at odds with much of the rest of Europe, seems to make a Grexit all but impossible.

That said, I am horrified at the ongoing willingness of European policymakers to still be playing chicken at this point.  I assumed that my skepticism would ultimately be proved wrong as the European Central Bank would ultimately cave and effectively monetize national debt across the Eurozone, and that Germany would come to this conclusion as necessary to save the single currency that they have long-championed.  That ultimately, the Eurozone would step up and take greater responsibility for this mess, understanding that while the Greeks have mismanaged their economy, they should never have been admitted to the Eurozone in the first place.  

Instead, Europe situation is now akin to two or three trains running full-speed at one another, and by the time someone finally pulls on the brakes, it will be too late.  By the time key actors step into action, irreparable damage will have been done

Consider that one of those trains, Greece, has no driver, nor will it until June 17 when fresh elections are held.  Combine that with a deteriorating fiscal situation - believe it or not, it actually continues to get worse.  From Bloomberg:

The level of funds in Greece’s state coffers has fallen below 1.5 billion euros ($1.9 billion), Imerisia reported, citing “reliable information.”

If the state doesn’t receive predicted revenue for the rest of this month, it will find it difficult to pay for social services, pensions and public-sector wages, the newspaper said.

This was confirmed by the outgoing leader:

Greece's outgoing Prime Minister Lucas Papademos has warned the country's political leaders the government may have difficulty in meeting its cash obligations as of the start of June, a Greek newspaper reported Monday.

In a note Papademos sent to Greek President Karolos Papoulias and discussed in Sunday's meetings between the president and party leaders on forming a coalition government, the prime minister said it is likely Greece will have significant difficulties in covering its cash payments in June, according to newspaper Ta Nea, citing unnamed sources from Papoulias' office

Now, further consider one of the proximate causes of the new fiscal shortfall:

Greece' s budget revenues have reportedly dropped by 10.2% in April compared to the same month in 2011, as daily Kathimerini reports quoting provisional figures the Finance Ministry is studying. The election period did nothing to help state receipts as the tax collection and monitoring mechanism traditionally relaxes ahead of polls, and did so again this year despite the crisis. 

It has been said before, but is worth saying again - how did this economy pass the bar to Euro membership in the first place?  If officially sanctioned tax avoidance remains in effect, and we have another month until the new elections, I can't imagine that the fiscal picture is going to do anything but go from bad to worse. Or from worse to as worse as it can get.

Given the deteriorating fiscal position, Greece will eventually need a larger bailout if it is to stay in the Euro.  Simply put, if they can't pay their bills with Euros, they will need to issue their own currency.  Deep in a piece on the failed efforts to collect property taxes via electricity bills, the FT brings us this from a "friendly trader":

When we talk about Greece “running out of money” in coming weeks/months, the combination of dire recession, plus non compliance in Revenue collection will speed the day that Civil Servants and suppliers are paid in IOU’s or “New Drachma” in the absence of any funding from the EU/IMF…

Once IOU's start circulating, the clock will start ticking.  Either they get replaced soon with actual Euros, or they start trading as currency.  In other words, time is growing very, very short to find a solution that keeps Greece in the Eurozone.  

Meanwhile, is the final run on Greece's banks underway?  From the Wall Street Journal:

Greek depositors withdrew €700 million ($898 million) from local banks Monday, the country's president said, as he warned that the situation facing Greece's lenders was very difficult.

In a transcript of remarks by President Karolos Papoulias to Greek political leaders that was released Tuesday, Mr. Papoulias said that withdrawals plus buy orders received by Greek banks for German bunds totalled some 800 million.

A bank run in the absence of a functioning government.  Is there anyone ready to push the button on a bank holiday with capital controls?  Or is this about to devolve into a free-for-all flight of capital?

Meanwhile, Germany and France are holding to the official line.  From the FT:

“We want Greece to stay in the euro,” Ms Merkel said. “We know that the majority of people in Greece see that.”

The Greek government had also agreed on a rescue programme with the IMF and the EU after lengthy negotiations, she said. “I believe that memorandum must be respected.”

This ignores the small point that the last bailout was certain to fail from the start.  The message remains that no one but Greece is making the decision to leave the Euro:

“We have to respect that there will be new elections in Greece,” she added. “We will make it clear that we want Greece to remain in the eurozone, and that is what the citizens are voting on.”

But out comes the unspecified carrot:

That meant fulfilling the commitments in the EU and IMF programme, she said, but added: “We will also give proposals to Greece to encourage growth.”

Mr Hollande went further, saying that “I hope that we can say to the Greeks that Europe is ready to add measures to help growth and support economic activity, so that there is a return to growth in Greece.”More carrot with stick would have been helpful two years ago.  Now it is looking like too little, too late.  And what kind of measures are these?  Direct bilateral transfers from Germany, which would be helpful?  Or more loans to add to those that Greece can not already afford?

In other news, in the wake of its two LTRO operations, the ECB is back to neglecting its role as lender of last resort.  As a consequence, Spanish yields are now solidly back above 6%, with Italian yields in close pursuit.  Apparently, investors are not convinced that the supposed firewalls are sufficient to control contagion.  European policymakers have fallen short of the mark.  Again.

Bottom Line:  I don't see how European policymakers can be anything but terrified that this whole experiment is unraveling at a frightening pace.  Yet they keep barreling ahead on this disastrous path, ensuring that things continue to get worse before they get better.

Too Big To Fail Lives On

JP Morgan is in the news tonight:

“This portfolio has proven to be riskier, more volatile and less effective as an economic hedge than the firm previously believed,” the New York-based company said today in a quarterly securities filing. 

Stock down 6% after hours, not good news on top of the instability emanating from Europe.  Calls for the Fed to ease further with QE3 will be amplified, as will volatility as market participants react to every headline and rumour.  This summer looks to be a lot more interesting with each passing day.

Hopeful Signs From Europe?

While I suspect this is a case of too little, too late, it is increasingly evident that European policymakers on some level realize the errors of their ways.  From the Wall Street Journal:

Euro-zone governments are expected to give Spain more leeway to meet its budget-deficit target next year, according to officials involved in the discussions, in a sign they intend to shift away from rigid enforcement of the currency bloc's budget rules.

Austerity will still be the guiding principle of European fiscal policies. But the likely Spanish move suggests the rules will be adjusted in some cases to account for the fact that when economies go into recession, their budget deficits usually rise.

Officials said the flexibility is unlikely to stop with Spain's politically sensitive deficit target. Among other countries that may take advantage of the rules in the future is France, which would have to pass large cuts to achieve its current deficit target for next year—a task likely to clash with the pledges of Socialist President-elect François Hollande to spur economic growth.

It is not clear that this shift gives struggling nations enough room, but it is a step in the right direction that policymakers now recognize that austerity programs have been self-defeating.  Likewise, perhaps even the Bundesbank is coming around to the realities of European adjustment.  From the FT:

The Bundesbank, the most hawkish of central banks, has signalled it would accept higher inflation in Germany as part of an economic rebalancing in the eurozone that would boost the international competitiveness of countries worst-hit by the region’s debt crisis.

A future German inflation rate above the eurozone average could be part of a natural adjustment process as crisis-hit countries pulled themselves out of recession, the Bundesbank argued in evidence to German parliamentarians submitted on Wednesday.

That said, I wouldn't get too eager that the Bundesbank is eager to rush into more easing:

“In this scenario, Germany could in the future have an inflation rate somewhat above the average within the European monetary union, although monetary policy will have to ensure that inflation overall in the Emu is consistent with the goal of price stability and that inflation expectations remain firmly anchored,” the bank said.

They are not talking about easing overall policy, just acknowledging that even in the context of a maintained inflation target, Germany will experience inflation in excess of that target.  

All in all, though, positive developments, at least at the margin.  My concern is that all the recent talk about "growth compacts" and such will yield more headlines than positive outcomes, and as a consequence policymakers will begin to believe that the original path of austerity was in fact the only path to follow.

On Negative Interest Rates

Scott Sumner writes:

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

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

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

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

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

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

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

 

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

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

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

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

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

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