Tim Duy's Fed Watch

Bernanke at Jackson Hole

A current acute awareness of forecast bias leaves me almost hesitant to comment on today's speech by Federal Reserve Chairman Ben Bernanke.

What is forecast bias?  Here I am thinking of the bias of Fed watchers struggling to interpret every bit of data and ever comment from policymakers in the context of their own views of the economy.  One version of such bias is thinking the Federal Reserve will do what you think they should do.  Because you view the economy as weak, you assume the Fed will do so as well, and react appropriately.  Such a bias, of course, will lead to an erroneous interpretation of the data and Fedspeak as it relates to monetary policy.

I fear falling into a variation of this bias.  For months, the flow of data and the Federal Reserve's own forecasts indicate the Fed will continue to fall short of both its employment and price stability mandates.  This has been confirmed by numerous Fed speakers including Bernanke himself.  Indeed, Bernanke has often stated disappointment with the pace of the recovery and, in particular, the costs of high levels of long-term unemployment.  He has also said that nontraditional policy tools continue to be effective, indicating that the Fed could do more to boost the recovery.

Yet such action has been fairly limited.  I tend to see the extension of Operation Twist as simply maintaining the status quo, not additional easing.  Expectations for another round of quantitative easing have been disappointed for the last three meetings.  The bar to additional action has simply been higher than many believed.

So now I ask myself if monetary inaction during 2012 leads me to place a "no action" bias in my own analysis.  Am I picking out what I want to hear, and ignoring what I don't?

Now, in all honesty, I haven't had a strong conviction on the last two meetings.  They seemed like relatively close calls.  On average, though, the Fed has moved gradually toward another round of quantitative easing, with seemingly only Bernanke holding back policymakers.

Has Bernanke finally flipped sides, reverting to the Bernanke that we thought we knew back when he was writing about Japan?  That is the question we ask as we take apart his Jackson Hole speech.  And what biases are we bringing to the table when we do that analysis?

My first take on the speech was that Bernanke largely rehashed what I think was general knowledge, although with a somewhat dovish spin that would indicate a higher probability of quantitative easing at the next meeting than I had previously believed.  No obvious signs, but certainly on the margin pointing to additional easing. And whenever I worry about my bias, I seek confirmation from the bond markets.  Right now, yields are down 4 to 5 bp, which is what I think would be the expected market reaction from a slightly more dovish Bernanke. So far so good.

Bernanke's speech is largely backward looking.  He examines the effects of nontraditional tools, both balance sheet tools and communication strategies, and concludes that both have been effective in easing financial conditions and boosting economic activity and employment.  This result should really come as no surprise; Bernanke had previously expressed confidence that nontraditional tools had positive policy impacts.  And he is not going to reverse course now and say that policy has been a failure.

More important is his subsequent cost/benefit analysis.  For months we have been able to surmise that Bernanke believed the costs of additional action outweighed the benefits. If this wasn't the case, he would have eased already.  Is Bernanke's analysis shifting?

 Bernanke lists four potential costs:  Impaired functioning of securities market, heightened inflation expectations, risks to financial stability from encouraging excessive leverage, and potential losses to the Fed's balances sheets.  He quickly dismisses every concern, leading one to conclude that another round of QE is a no-brainer as the benefits obviously exceed the costs.  He concludes the section with:

In sum, both the benefits and costs of nontraditional monetary policies are uncertain; in all likelihood, they will also vary over time, depending on factors such as the state of the economy and financial markets and the extent of prior Federal Reserve asset purchases. Moreover, nontraditional policies have potential costs that may be less relevant for traditional policies. For these reasons, the hurdle for using nontraditional policies should be higher than for traditional policies. At the same time, the costs of nontraditional policies, when considered carefully, appear manageable, implying that we should not rule out the further use of such policies if economic conditions warrant.

Now I hesitate - is this really a no-brainer?  Do "economic conditions warrant" additional action?  And notice that the cost/benefit analysis varies over time.  While the benefits clearly outweighed the costs during the height of the crisis, is that still true today?  

Bernanke then assess the current economy.  He is clearly not happy with the current state of affairs:

Notwithstanding these positive signs, the economic situation is obviously far from satisfactory.

Specifically, he identifies persistent high rates of unemployment, and dismisses a structural explanation.  Thus, with the problem being cyclical, we have a clear role for monetary policy.  This seems to be "warrant" additional action.  But what is the explanation for persistent high unemployment rates?

...First, although the housing sector has shown signs of improvement, housing activity remains at low levels and is contributing much less to the recovery than would normally be expected at this stage of the cycle.

Second, fiscal policy, at both the federal and state and local levels, has become an important headwind for the pace of economic growth...It is critical that fiscal policymakers put in place a credible plan that sets the federal budget on a sustainable trajectory in the medium and longer runs. However, policymakers should take care to avoid a sharp near-term fiscal contraction that could endanger the recovery.

Third, stresses in credit and financial markets continue to restrain the economy. Earlier in the recovery, limited credit availability was an important factor holding back growth, and tight borrowing conditions for some potential homebuyers and small businesses remain a problem today. More recently, however, a major source of financial strains has been uncertainty about developments in Europe...

Now I am concerned again, as Bernanke appears to be saying that the factors currently restraining the economy cannot be addressed by monetary policy.  So what are the benefits to additional nontraditional tools in the current environment?  Is he kicking the can back to Congress?  Indeed, he later says:

In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally: Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly cannot fine-tune economic outcomes.

This does not sound like he believes additional monetary policy would be particularly effective in the "present context."  But he follows with this:

As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.

So now I am thinking he has focused his comments almost exclusively on the employment portion of the mandate, not the price stability part (which they aren't hitting anyway, but that is a different story).  This alone should scream additional easing.  But is Bernanke really hinting at a bias toward additional easing, or is he simply trying to convince everyone that he really cares about unemployment even though he has not acted more aggressively to date?  He cares, but just can't do much about it?  Or is that just my internal bias speaking, the bias from months of the Fed seeming to say one thing while doing another?

Attempting to take my own bias into account, my takeaways are:

1. Bernanke gives a very clear defense of nontraditional monetary tools to date.  The benefits have clearly outweighed the costs.  His rapid dismissal of the potential costs leads one to believe that he is more inclined than not to additional action.  This is critical; he is the key to moving the middle ground to additional easing.

2. That said, the analysis is clearly backward looking.  Do current conditions imply the same cost/benefit analysis, which Bernanke clearly states varies over time?  

3. Bernanke express considerable concern about high levels of unemployment.  But he also seems to say that the factors preventing more rapid labor market improvement are beyond the scope of monetary policy.  This sounds like Bernanke is not confident that more monetary policy will be effective.

Taken together, Bernanke is attempting to be a man for all seasons, giving a spirited defense of the past that clears the way for additional action while explaining why such action might not be effective or taken in the future.  Felix Salmon sums it up with:

The overall tone here, then, is defensive: Bernanke’s on the back foot, trying to justify past and future actions against critics on all sides. And when an institution is in a defensive crouch, it’s not going to do anything bold. The Fed was bold in 2008-9, at the height of the financial crisis; those days are over now. And so, whether we like it or not, any real boost for the economy going forwards is not going to come from the Fed, and is going to end up having to come from Congress instead. I’m not holding my breath.

Yes, if Bernanke is leaving it up to Congress, we have some troubling days ahead.

Bottom Line:  On net, Bernanke's speech leads me to believe the odds of additional easing at the next FOMC meeting are somewhat higher (and above 50%) than I had previously believed.  His defense of nontraditional action to date and focus on unemployment point in that direction. This is the bandwagon the financial press will jump on.  Still, the backward looking nature of the speech and the obvious concern that the Fed has limited ability to offset the factors currently holding back more rapid improvement in labor markets, however, leave me wary that Bernanke remains hesitant to take additional action at this juncture.  This suggests to me that additional easing is not a no-brainer, but perhaps that is just my internal bias talking.

2012 Oregon Road Trip

Something to occupy your time while you wait for Federal Reserve Chairman Ben Bernanke to speak at Jackson Hole...

We are on the tail end of what is becoming the annual end of summer Oregon road trip.  This year we headed out east to the Wallowa Mountains, which, depending on the geologist you talk to, may or may not be considered a part of the Blue Mountains.  The Wallowa Mountains are formed from granite lifted by underlying magna, with the landscape later carved by glaciers.  The region differs greatly from the volcanic peaks of the Cascades that many typically associate with Oregon. Especially neat are rivers filled with granite pebbles:

Our first destination was the city of Joseph, notable for an industry cluster of three bronze foundries.  The main strip has what must be the most large bronze sculptures per capita of any city on the US:

 

I have a certain affinity for this type of region, dominated by cattle ranching and related agriculture (hay).  If the number of shiny, new F150s is any guide, the region must be coming off of some fat years.  After a night in a roadside motel (I couldn't bear the thought of setting up camp in the dark with two tired and hungry kids), we made our way to our anticipated campground at the Wallowa Lake State Park.

We spent one night.  It was not our kind of place.  To be sure, it was clean and well run.  But it was large, with no separation between camp sites.  For my wife and I, whose camping experience together amounts almost exclusively to wilderness trips backpacking throughout much of the Oregon Cascades and the Olympic National Park in Washington, this just wasn't going to work.  Luckily, because of tight reservations, we were forced to pack up the truck with the expectation of a new site within the same campground.  Thinking that the site would not be open, we took to the road to explore the region for a few hours.

We stumbled up the Lostine River, and found numerous Forest Service campgrounds.  No showers, but that isn't our camping style anyway.  We settled on the Shady Campground near the top of the road.  Large, well-separated, clean campsites next to the river.  Not having this change in mind, after we set up camp I had to head back down to the town of Lostine for a fresh supply of ice.  Not that I minded; I admit to enjoying trashing the overall gas mileage blowing up dust on gravel roads.  I realized at the end I had no cash and, as these things seem to go, it turned out the credit card machine at the general store (in continuous operation for more than 100 years) was down.  No problem, though.  The owner doesn't like to send people back up the river empty handed, so he agreed to send me a bill if I didn't pass by later in the week.  Yes, this still does happen in some part of the world.   So I told him my name was Paul Ryan and gave him a Wisconsin address.  No, of course not.  

The Wallowa Mountains contain the Eagle Cap Wilderness, an opportunity to get high (altitude) fast.  The Maxwell Lake trail begins at the Shady Campground:

After three miles of switchbacks alternating through forest and meadows, the trail shifts to a much steeper grade that carries you into a wonderful basin with vistas such as this: 

Maxwell Lake itself is at the bottom of a steep-sided basin:

 

The hike, according to the iPhone GPS:

And, honestly, we never thought we would make it, but our littlest hikers did a wonderful job:

They don't realize yet the doors this opens. 

We spent three nights on the Lostine before heading back west (after paying my tab in Lostine) through the Elkhorn Range and its old gold rush towns from the 1800s.  A travel find was the Clyde Holliday State Park, sitting right on Highway 26 west of John Day.  Thirty one campsites, well-separated, with showers, $22 a night.  Not a true camping experience, but a good stopping point.  As an added bonus, walking distance to a fishing pond.  I was skeptical - late in the season, the water level was low and the weed level was high.  But it was stocked annually, and I managed to pull five rainbow trout out of the murky water, throwing them all back to be tortured by the next fisherman.  

We continued west, stopping at the John Day Fossil Beds, first the Sheep Rock Unit: 

Great visitor center (National Park Service) detailing the extent of the fossils collected in the region.  Very rich beds in which the fossils of various flora and fauna are found together for a more complete picture of life in the past:

 

 You can watch the paleontologists work through a glass window:

We also stopped at the Painted Hills Unit:

Striking landscapes.  We continued on to meet friends staying at Sunriver, and are now on the last legs of the trip with a few days in the Crescent Lake area, back with a steady internet connection.  Now waiting for Bernanke like everyone else. 

Forest Fire

Looks like somewhere on the south side of the Strawberry Mountains, I think.

The Classics Never Go Out of Style

Wallowa Mountains

Dueling Fed Presidents

Blogging tonight from Joseph, Oregon, on my way for a few days of camping in the Wallowa Mountains. Hopefully I will be able to get some pictures up over the weekend, but I haven't had much luck with the Typepad ap on 3G service.

For those of us tracking the odds of QE3 in September, two regional Fed presidents - both non-voting participants - offered opposite views today.  Neither was terribly surprising.  Chicago Federal Reserve President Charles Evans reiterated his support for additional easing.  Via Reuters:

"The (July) employment data was a little better than expected," said Evans, one of the Fed's most dovish policymakers and who has led the most recent calls for active easing of monetary policy.

"It is still not nearly good enough," he added. "We need 300,000 to 400,000 (new jobs) a month to get to where we should be."...

...Evans reiterated that he thought current economic conditions already warranted action, adding that this was the third successive summer slowdown seen in the United States, and that as the Fed had acted to boost activity in the previous two downturns, there was every reason to be prepared to act this time.

Of course, Evans has been pushing this story for awhile, to no avail so far.  I think that had he been a voting member, he would have dissented at the last three FOMC meetings.  On the other side of the coin is St. Louis Federal Reserve President James Bullard.  Again, via Reuters:

"I do think that the minutes are a bit stale because we have some data since then that has been somewhat stronger," Bullard, who will be a voting member of the policy-setting committee next year, said in an interview.

This is similar to the concern I mentioned yesterday.  To what extent have the FOMC minutes been overtaken by events, particularly better US data?  Bullard further downplayed the tone of the minutes:

"The tone of the discussions, for me anyway, was 'gosh things are not as good as we thought and it if continues to decelerate here, we're going to have to do something'," he said.

Still, he believed the probability of another round of easing was less than had been reflected in the pricing seen in financial markets over the summer.

"Going along at this slow pace is not enough to justify gigantic action," he said. "I'd like to see...some deterioration or indication we're going to slide down further," in order to support additional easing.

Trouble is that we haven't decelerated further, at least according to recent data.  That said, sometimes we hear what we want to hear, and Bullard wants to hear things that don't sound like QE3 is imminent.  Indeed, he doesn't have high expectations for the economy to begin with:

"If we were to resume, which I think we will, 2 percent growth, maybe a bit stronger than that, unemployment ticks down ... that is not a great outcome, but to me that is a good enough outcome to keep us on hold," Bullard said.

That's a pretty low bar for growth, which is the same thing as a high bar for QE3. 

Bottom Line:  Two Fed presidents at opposite ends of the spectrum.  I tend to think that the middle ground will be pulled by recent data in the direction of Bullard, which is why I see QE3 as less of a slam-dunk than the minutes seemed to imply.  Evans pushed his usual agenda; I would expect nothing less from him.  He wanted more action before this summer's signs of slowing.  No reason to expect the most recent data would change his view.  

It's All About The Data

The minutes of the July 31 - August 1 FOMC meeting are out.  In my opinion, they reiterated the importance of the data flow in assessing the Fed's next move.

The money quote was:

Many members judged that additional monetary accommodation would likely be warranted fairly soon unless incoming information pointed to a substantial and sustainable strengthening in the pace of the economic recovery. 

At first blush, this can be taken to indicate that easing is imminent, as early as September, in direct contradiction to what I wrote yesterday.  The key, however, is how have conditions changed since the last meeting?  The next line in the FOMC minutes is:

Several members noted the benefits of accumulating further information that could help clarify the contours of the outlook for economic activity and inflation as well as the need for further policy action.

Recall that as we headed into this meeting, the data had turned particularly weak.  The pace of job growth had fallen dramatically from the start of the year, retail sales were flattening out, and GDP growth had slowed to 1.5%. This data combined with the downside risks from Europe raised genuine concerns that more easing was necessary.  But they held back, instead waiting to see how the data evolved.

Since then, the data have turned upward, much more consistent with the Fed's medium-term forecast.  The July employment report was stronger, retail sales picked up, and overall growth is looking stronger, with Goldman Sachs' GDP tracking estimate rising to 2.3% for the third quarter.  In addition, equity markets are on firmer ground as the crisis in Europe has at least temporarily receded. While certainly not exciting, the better tone of the data is palpable.  I think the better data influenced Atlanta Federal Reserve President Dennis Lockhart to shift his language away from his dovish July comments.  In short, I would argue that the data since the last FOMC meeting has in fact pointed toward an improvement in the pace of the recovery, which I think will pull the middle ground back from the brink of additional asset purchases.

That said, the doves can still make a pretty good case for additional easing, even given the improvement in the data flow.  But enough to pull Federal Reserve Chairman Ben Bernanke into their camp?  I would guess that the data would pull him away from additional asset purchases as the threat of imminent recession has dramatically faded into the background.  We will get a chance to hear his thoughts on recent data at Jackson Hole next week.  I don't think he will give an obvious clue; as a general rule, that isn't his style.  He will give us the data as he sees it and we will need to figure out what that means for policy.

I would also note that we have plenty of data to chew on between now and September 15th.  Notably, we will get another look at the employment situation.  Note the pattern of the last two years:

Start stop, start stop, but on average, not inconsistent with the Fed's forecast as interpreted by David Altig (my response to Altig here).   The April-June slowdown in job creation certainly gave the doves the upper-hand, pushing us closer to QE3.  A solid August number would give the hawks the upper-hand once again.

There was much discussion about possible additional tools.  Communications could change:

One of the policy options discussed was an extension of the period over which the Committee expected to maintain its target range for the federal funds rate at 0 to 1/4 percent. It was noted that such an extension might be particularly effective if done in conjunction with a statement indicating that a highly accommodative stance of monetary policy was likely to be maintained even as the recovery progressed. Given the uncertainty attending the economic outlook, a few participants questioned whether the conditionality of the forward guidance was sufficiently clear, and they suggested that the Committee should consider replacing the calendar date with guidance that was linked more directly to the economic factors that the Committee would consider in deciding to raise its target for the federal funds rate, or omit the forward guidance language entirely.

I like the idea of tying policy to macroeconomic outcomes rather than dates.  I think it would remove one source of uncertainty about policy.  There was generally support for additional asset purchases, including this:

Many participants indicated that any new purchase program should be sufficiently flexible to allow adjustments, as needed, in response to economic developments or to changes in the Committee's assessment of the efficacy and costs of the program.

I take this to mean that a new program would not be tied down by a specific date or amount, another policy shift I would like to see.  Other options were received less enthusiastically:

Some participants commented on other possible tools for adding policy accommodation, including a reduction in the interest rate paid on required and excess reserve balances. While a couple of participants favored such a reduction, several others raised concerns about possible adverse effects on money markets. It was noted that the ECB's recent cut in its deposit rate to zero provided an opportunity to learn more about the possible consequences for market functioning of such a move. In light of the Bank of England's Funding for Lending Scheme, a couple of participants expressed interest in exploring possible programs aimed at encouraging bank lending to households and firms, although the importance of institutional differences between the two countries was noted.

Bottom Line:  Lots of possibilities at this point.  If you were looking for additional asset purchases at the last FOMC meeting, you were not crazy.  There was obviously widespread concern about the mid-year slowdown and its implications for the stability of the Fed's forecasts.  Moreover, policymakers appear to have concluded that additional asset purchases could be effective.  If the data had continued to progress as it had since the July/August meeting, I would say that another round of QE was a slam-dunk. But the data has not progressed in the same direction; rather than falling short of expectations, it has tended toward upside surprises.  That of course could change over the next few weeks.  In short, we need to ask ourselves what will constitute a "substantial and sustainable strengthening."  If Lockhart is a guide, I am thinking we have seen such a shift already.  If so, I would expect that on the basis of current data the Fed would delay action until closer to the end of Operation Twist II and to see if Congress has come to any agreement on the fiscal situation in 2013.   If the change in the data has not reached the threshold of  "substantial and sustainable strengthening" then we would expect action.  It will be interesting to see if any of the doves back off on their dreary forecasts in the coming days; such shifts in tone would be telling.  Also note that there is a middle ground in the possibility of further changes to the communication strategy; something that could placate both the doves and the hawks until a clearer image of the path of the US economy emerges.   

Chances of QE3 Diminishing

I have made the case that neither the doves nor the hawks that are important for the course of monetary policy.  It is the center that is the key, and that center needs to be pulled in one direction or the other by Federal Reserve Chairman Ben Bernanke.   If the 2Q12 slowdown proved to be temporary, I doubt Bernanke is inclined to pursue more QE in the absence of clear financial market disruption.  And with that in mind, although economic performance continues to be no better than lackluster, recent data has dispelled the worst fears that we are heading into recession. This combined with stable financial markets argues against additional easing in September.  

If the center is the key, we need to see where the center is moving.  This should provide some insight into Bernanke's leanings as well. On July 13, Atlanta Federal Reserve President Dennis Lockhart said:

So, as one policymaker, here's my situation: my support for the current stance of policy rests on a forecast that sees a step-up of output and employment growth by year-end and into 2013. If the economy continues on the track indicated by the most recent incoming data and information, that forecast will become untenable, as will the policy premises underlying it. So, as I said at the outset, this is a challenging juncture for policymaking.

The data since that time has shifted Lockhart's views, with likely no small part of that change due to the employment report.  Today:

As of July, there are more than 4½ million fewer payroll jobs than in November of 2007. Most of these job losses were in the private sector. The share of unemployed workers who have been out of a job for more than 27 weeks has fluctuated between 40 and 50 percent over the entire course of the recovery.

I think this condition can be attributed, at least in part, to fundamental imbalances that have not yet been corrected, a situation that presents formidable challenges for monetary policymakers. There is a risk to monetary policy being employed too aggressively and without effect to address economic problems that can be resolved only by fiscal reforms that involve making tough choices about the allocation of public resources. Monetary policy can exert a powerful positive influence on an economy, but as Chairman Bernanke has pointed out, monetary policy is not a panacea.

It is not that Lockhart believes the economy is surging forward.  It is muddling along.  But muddling along at a rate that does not justify additional easing.  Nor is it clear that such easing would be effective as the remaining problems are beyond the scope of monetary policy.  The logic appears to be that employed by Bernanke - the benefits of addition easing at this point do not exceed the risks.  And while for the hawks those risks are inflation, for the middle ground I suspect the risks are to the functioning of financial markets.  And while we are on the topic of financial markets, from Bloomberg:

“Anytime you see the equity markets rise, I think what it tells you is there is more appetite for risk,” Lockhart told reporters after his speech. “And in the current context, I would interpret that to be some comment on more confidence that Europe will work through its problems without a major incident of some kind.”

Europe has stabilized, reducing one of the clear risks to the outlook.  Perhaps I have been too hard on ECB President Mario Draghi. Of course, I thought the same thing after the two rounds of LTRO, and that didn't stick.  Once bitten, twice shy.  But that can wait for a later post.  The upshot is that equity markets have been on a nonstop trip higher:

We are not seeing a repeat of last summer's weakness that prompted Operation Twist.  And while I don't have access to a Bloomberg terminal, Zero Hedge does, and noted this headline:

LOCKHART SAYS DISINFLATION, DEFLATION NOT NOW A CONCERN

 Back to the charts:

TIPS are not signaling an imminent decline in inflation expectations.  To be sure, this is at odd with the steady decline in inflation expectations as measured by the Cleveland Federal Reserve:

but that measure is not likely to weigh heavily in FOMC discussions. Policymakers are more likely to take their signals from financial markets.

The Reuters coverage of Lockhart's speech included this line:

Central bank officials gather in Jackson Hole, Wyoming, late next week for an annual conference on monetary policy. Many analysts believe Bernanke will use a speech there to lay out a third round of quantitative easing via bond buys, or QE3.

I find it very unlikely that Bernanke gives such direction on QE3.  I think the current economic and financial environment bears little resemblance to the famous Jackson Hole speech of 2010.  Given the change in the tenor of the data and the financial markets, it is hard for me to believe that his risk/benefit calculus is currently in favor of additional quantitative easing.  I think he might take action if he could find another tool that he thought would be more effective than additional quantitative easing, but I don't see such a tool on the horizon.  Maybe he will pull something out of his hat next week, but I doubt it.

Bottom Line:  Closely following the doves would lead one to conclude that QE3 was imminent.  This dovish chatter keeps the possibility of QE on the table.  But really this has been the case for months.  That should lead one to conclude that the bar to additional QE is high, very high.  The middle, led by Bernanke, is just not pulling in that direction.  Indeed, recent events seem to be pulling the middle away from additional QE.   Assuming the FOMC holds steady in September, I think we will be able to measure the conviction of the doves by any dissents.  If San Francisco Federal Reserve President, the most dovish voting FOMC member, does not dissent, he must not have a strong conviction that additional easing is necessary.  And if the doves lack such conviction, why should we expect it from the middle ground?

Self-Fulfilling Prophecies

Is the Federal Reserve doing enough?  Joe Gagnon says no:

For more than two years, the Fed has dragged its feet and resisted the obvious need for more aggressive action...

...A large majority of the committee projects [pdf] that inflation will be below target over the next two and a half years. If they assign any weight to their employment objective, they should be willing to accept inflation at least modestly above target in order to get a better outcome on employment.

Considering that more aggressive action has not been taken, monetary policymakers appear to disagree.  The willingness to accept the current state of affairs suggests that fear of the 1970's remains alive and well on Constitution Ave.  The risks of inflation simply outweigh the expected benefits of additional easing, at least from the point of view of Federal Reserve Chairman Ben Bernanke. Earlier this spring, Brad DeLong made an insightful observation about the real parallels with the 1970s:

In my view, there is an odd symmetry between the Federal Reserve of today and the Federal Reserve of the 1970s. The Federal Reserve of today does not take effective steps to reduce unemployment because it thinks any risk of sustained inflation above 2%/year is unacceptable. The Federal Reserve of the 1970s did not take effective steps to control inflation because it thought sustained unemployment above 7% was unacceptable. Since then, the Federal Reserve of the 1970s--Arthur Burns and G. William Miller--have been censured, condemned, scorned, and damned for their failure to understand the situation they were in and their proper objective function.

The Fed is really making the same mistake as they did in the 1970s.  Not so says David Altig, who does not see so much of a conflict between the Fed's objective and the actual outcomes:

That complaint is not really about the inflation part of the mandate, but the employment/growth part of it. But if you are willing to accept that employment growth remains on a pace of 150,000 jobs per month—and I see no clear evidence to the contrary—it is not at all obvious that the pace of the recovery is inconsistent with the FOMC's view of achieving its dual mandate...

...And I am certainly begging the important issues. Would the economy have achieved even the somewhat unspectacular pace of 2 percent GDP growth, 150,000 jobs per month, and average inflation near the long-run objective absent large-scale asset purchases ("QE2"), forward guidance (statements indicating that policy rates are expected to be exceptionally low through at least late 2014), and maturity extension programs ("Operation Twist")? Does "appropriate policy" imply that more must be done to achieve even the modest progress in the unemployment rate implied in my calculations above?

Mark Thoma replies:

It sounds as though the Fed has given up -- we've done all that we can, there's nothing more we can do, so we won't even try -- and we're not about to risk even the tiniest bit of inflation to find out if we are wrong...

Mark's idea that the Fed has "given up" is not sufficiently appreciated.  Altig's calculations make the important assumption that the labor force participation rate holds at 63.7%.  This effectively assumes that none of the decline in the labor force participation is cyclical.  Instead, it is all structural:

Should the Fed take the labor force participation rate as exogenous or endogenous?  If they take it  as exogenous, then policymakers have effectively "given up" on the recovery.  Any cyclical decline in the labor force participation rate becomes structural over time as skill loss increasingly excludes those displaced by the recession from reentering the labor force.  

This is similar to the debate over the current level of potential GDP.  Once policymakers started to believe (on the basis of an HP filter, of all things) that the economy is operating at potential, rather than well-below potential, then they would start behaving as if the economy was in fact at potential, setting policy and managing the economy along the suboptimal level.  This sends signals to economic agents about the expected growth in output (or nominal GDP), who adjust their behavior accordingly.  The cyclical declines becomes structural.  In other words, a shift in potential GDP becomes a self-fulfilling prophecy.

Should the Fed take all "structural variables" as exogenous?  For all the derision heaped upon former Federal Reserve Chairman Alan Greenspan, consider the long-gone 1990s.  Greenspan believed that accelerating productivity growth meant the economy could run at a higher growth rate than previously believed.  Suppose Greenspan had not reached this conclusion.  Would unemployment have fallen as low as it did?  More importantly, we told a story back then, and it went like this:  Low unemployment was forcing firms to reach deeper and deeper into the labor pool to the point where they had to start actively training new employees.  They no longer had the luxury of cherry-picking only the obviously skilled employees; they had to bring unskilled labor up to speed.  This process is human capital deepening, which should have a positive impact on potential GDP growth.  A benefit that would have been lost if Greenspan pulled the plug on economy sooner (the same holds true of the physical capital deepening of the time).

And did that process of capital deepening make any difference?  Running the economy red hot had the benefit of shifting the share of output in favor of labor during the 1990s:

Of course, inflation did accelerate to something closer to 2.5% over that period. Was that such a high price to pay to lift up those at the lower end of the socioeconomic ladder?  Maybe, just maybe, the Fed's newly minted 2% target is simply too low.  Maybe, just maybe, if we run the economy a little on the red side of hot the supply response will be stronger than the Fed believes - that the long-run path of the economy will prove to be just a little more endogenous than the Fed is willing to accept.  Maybe, just maybe, the Fed's obsession with disinflation (and  don't let the Fed fool you - they used the most recent recession to achieve another round of opportunistic disinflation) is contributing to stagnant to falling standards of living for much of the country.

Note that I am not suggesting the Fed should take all structural variables as endogenous, just that we don't necessarily have a complete understanding of what is endogenous. In essence, if the Fed bases policy on 63.7% labor force participation as an exogenous variable, ignoring any endogenous response, the economy will proceed on a path that is very well suboptimal.  But downward nominal wage rigidities and fear of inflation above 2% will prevent the Fed from exploring any other possibilities.  

Bottom Line:  Monetary policy might have a bigger impact on shaping the underlying growth rate of the economy than policymakers believe.  Some of what they think is exogenous may be at least in part endogenous.  Ultimately, within a certain margin, we will get the economy the Fed wants us to get.  And right now we are getting the economy that is defined by central bankers living in mortal fear of any inflation rate greater than 2%.  With the exception of a few policymakers, the cost of 2.5% inflation far exceeds the possibility of learning to what degree the underlying structure of the economy is exogenous or endogenous.  

I increasingly believe that the Fed made a massive policy error in defining their mandate as 2% inflation.  I think they believed it would give them more freedom to use new tools by solidifying inflation expectations.  Instead, the target has placed policymakers in a straitjacket.  It is Bernanke's cross of gold.

 

When You Only Have a Hammer

Soon after we learn that economists are pulling their support for Britain's Chancellor George Osborne, German Chancellor Angela Merkel is back in the news, pounding the table for more austerity.  Via Bloomberg:

German Chancellor Angela Merkel renewed her call for austerity as crucial to tackling financial turmoil in the euro area, praising Canada’s economic example as she returned to the crisis fight after her summer vacation.

Merkel, facing European pressure to ease bailout terms and allow shared debt, and from global partners to do more to stop contagion, used a visit to Canada as the stage for her first public comments in a month on the crisis. She hailed Canada’s budget discipline, promotion of economic growth and “not living on borrowed money” as models for the 17-nation euro region.

“This is also the right solution for Europe,” Merkel said at a reception in Ottawa late yesterday before talks with Prime Minister Stephen Harper, according to a transcript posted on the German government’s website. “I will report on our political will to overcome the euro crisis and on our determination in Europe to band together for a common currency.

The problem is, of course, that Canada is the wrong model.  Peter Coy of Bloomberg noted this earlier this year when he commented on why Canada was the wrong example for the United States.  The basic rational applies to Europe as well:

• In Canada, austerity helped lower interest rates. Rates are already super-low in the U.S., so there’s no room to improve.

• In Canada, austerity lowered the value of the Canadian dollar, which made Canadian goods more competitive on world markets. The U.S. is a relatively self-sufficient economy, so it would benefit less from a depreciation, even if one occurred.

• Canada benefited from growing demand for its products from the U.S. and China, which compensated for the chilling affect of deficit reduction. No countries today are eager to soak up more imports from the U.S.

• Canada is indeed an exception. An International Monetary Fund study looked at 172 fiscal policy changes in rich countries and found that on average, reducing the budget deficit by 1 percent of GDP reduced output by two-thirds of a percent and boosted the unemployment rate by one-third of a percent.

On the first point, I suspect the European policymakers are hoping that lower interest rates will solve all their problems.  To be sure, lower rates will help finance government debt.  But lower rates haven't sparked the much-anticipated rebound in the UK, and given the damage done to the European financial system, I would expect the same for Europe.

On the second point, the Merkel doesn't want to believe that currency depreciation has anything to do with a standard IMF rescue program.  But you can't just wish that problem away.  The Canadian Dollar in the 1990s"

The third point follows from the second.  Global trade is already in a slowdown, sapping demand for exports across the board.  The challenge is even worse in Europe, where your primary trading partners are also struggling.  Moreover, Canada has the benefit of being an oil producer, which has certainly been something of a positive this past decade.

The final point, that history is general does not support the idea of "austerity" booms, already has plenty of examples in Europe right now, examples that Merkel chooses to ignore.

In addition, I would add that Canada benefited from a central bank willing to support nominal GDP growth:

Let's look at the situation in Spain:

It isn't exactly easy to reduce your debt to GDP ratio when the denominator is flat to falling.  Simply put, being in the Euro ties Spain, Italy, etc. to the disastrous monetary policies of the European Central Bank.  But that is a story for another time.

Bottom Line:  Canada is not a model for Europe.  If it is a model, it tells us that currency depreciation relative to your major trading partners is an essential part of any austerity program.  Not exactly a model that Europe is willing to follow.