Tim Duy's Fed Watch

If QE Causes Commodity Price Inflation...

If QE causes commodity price inflation, what caused commodity prices to rise before QE?  It never ceases to amaze me that critics of quantitative easing fail to remember that commodity prices were rising well before the Federal Reserve engaged in quantitative easing:

If anything, commodity prices have been moving generally sideways since the Fed began expanding its balance sheet:

And please don't say "commodity prices have surged since the beginning of 2009."  I think it is pretty obvious that virtually everyone would not want to return to the economic conditions of 2009 to achieve lower commodity prices.  The rebound of commodity prices was a natural consequence of expanding global activity; if QE is to blame, it must also be blamed for the economic rebound. Also, why have headline consumer prices grown more slowly since the Fed initiated quantitative easing?

What about the surging inflation expectations in the TIPS markets (not necessarily the best measures of inflation expectations, and the ones already falling anyway)?

At best, quantitative easing is keeping inflation expectations propped up, barely.  And once again, does anyone really want to return to the collapsing inflation expectations at the height of the recession?  And are expectations any higher than before quantitative easing?  No.  

Bottom Line:  If anything, inflation is lower, both for commodity prices and headline PCE, after quantitative easing.  So isn't it finally time to put to rest the myth that quantitative easing is causing runaway inflation?  Nothing to see here folks, move along.  

Is Low Inflation Always Good?

I was intrigued by something Scott Sumner wrote last week:

 I’d also point out that the US has experienced 3 major equity or residential real estate bubbles in periods of relatively low inflation and NGDP growth (1929, 2000, 2006) and zero major bubbles in periods with high inflation and NGDP growth (1968-81).  The 1987 stock market bubble was an intermediate case (which did zero harm, as NGDP continued growing after the bubble.)

I was further intrigued when I saw this chart from the IMF (h/t FT Alphaville):

This was from a chapter covering the history of all situation in which public debt rose above 100 percent of GDP.  See the gap in the timeline?  The relatively high inflation late 1960's and 1970's.  Another reason to at least think about the possibility that while high and variable inflation is not ideal, perhaps neither is very low inflation. 

Plosser Opposes the 1933-37 Expansion

Philadelphia Federal Reserve President Charles Plosser spoke yesterday, reiterating his opposition to QE and his expectation that it will have no impact on growth. I don't think any of that should have been a surprise.  What caught my attention was this:

Once the recovery takes off, long rates will begin to rise and banks will begin lending the large volume of excess reserves sitting in their accounts at the Fed. This loan growth can be quite rapid, as was true after the banking crisis in the 1930s, and there is some risk that the Fed will need to withdraw accommodation very aggressively in order to contain inflation. 

I am somewhat concerned that a Federal Reserve official would use loan growth in the 1930s as an example of what could go wrong with quantitative easing.  It should be seen as an example of what could go right.

Presumably, Plosser is talking about something like this graph:

This is a problem because...why?  The inflation, that's right:

Yes, there was inflation after 1933.  And no, this wasn't a bad thing.  The inflation, as well as the loan growth were part of the recovery.  They were features, not bugs, of easier policy.  And even by 1937, both the price level and loans were below pre-recession peaks. Yet, policy turned prematurely tighter, tipping the US economy back into recession and deflation.  

Bottom Line:  Fed hawks obsess with the issue of having to unwind quantitative easing when the economy improves.  We should be so lucky.  Shouldn't we wait until we see some hope that rates can sustain themselves above at least 3% before we worry about this?  Somehow the hawks fail to understand that policy is always reversed in the next pahse of the business cycle.   Simply put,  if we need to unwind quantitative easing, the policy was indeed effective.  Plosser takes the wrong lesson away from rapid loan growth in the 1930s.  The lesson is not that we should fear recovery.  The real lesson was to avoid premature tightening of policy.  

Why I Agonize About The Zero Bound

I increasingly agonize about the zero lower bound.  It's really no secret that I believe that the faster we normalize interest rates, the better.  Such a goal should appeal to those who believe current monetary policy is reckless.  To be sure, the Fed's forecast that the US economy will be stuck at the zero bound into 2015 does not leave me filled with confidence; the risks are all too high that the economy will experience a recession before then.  But I very much doubt the Fed can simply raise interest rates to normalize the yield curve.  That would simply invert the yield curve, and such inversion is a harbinger of recession.  As long as the economy is operating at sub-optimal levels, monetary policy will be constrained by the zero bound.  To lift the economy well clear of the lower bound, we need greater cooperation between fiscal and monetary authorities.  I suspect this will require making explicit what is often viewed as crazy but many would argue is already implicit in recent policy, the monetization of some fiscal spending.

Japan serves as a role model for the zero bound problem.  As Paul Krugman notes, fiscal policy has been effective in staving off the worst consequences of the Japanese financial crisis.  But the associated fiscal deficits appear never ending; the Japanese economy never gained enough strength to eliminate the dependency on fiscal stimulus, leading to what looks like an excessive build-up of government debt that now exceeds 200% of GDP. 

We frequently see concerns that a build-up of government debt will lead to a new Japanese financial crisis.  Peter Boone and Simon Johnson are the latest addition to that long line of thought.  On the surface, it might be easy to dismiss such concerns, as they have been regularly voiced over at least the past 12 years, so far proving to be incorrect.  Japanese interest rates have not skyrocketed, the crisis has not arrived.

That said, I would not bet against that crisis over the decade, and I think that the longer the economy is stuck at the zero lower bound, the more likely it becomes.  Boone and Simon note:

Japan’s taxpayers are already rebelling against small tax increases needed to limit escalating deficits. This leaves little room for hope that future taxpayers will accept the larger tax increases needed to repay debts.

Japan’s demographic decline will be hard to reverse...

...A crisis in Japan would most likely manifest as a collapse of confidence in the yen: At some point, Japanese citizens will decide that saving in any yen-­denominated asset is not worth the risk. Then interest rates will rise; the capital position of banks, insurance companies, and pension funds will worsen (because they all hold long-maturing bonds, which fall in value when rates rise); and fears of insolvency will surface.

The basic story is straightforward.  Japan has a fiscal problem, but cannot find the political will to fix it via tax increases or spending cuts.  I am not surprised.  It is too easy to claim that this is simply the outcome of a broken political system.  Fiscal austerity will be met with a recession, just as it has been elsewhere.  And with the economy operating at the zero bound, the Bank of Japan will have relatively few tools to counteract the recession (actually, no, but more on that later).  Fiscal austerity is easy to say, hard to do.

It is hard to believe, however, that the debt situation in Japan is sustainable indefinitely (see Noahpinion here).  At some point the Japanese will not be able to finance their deficit without deep budget cuts, hard default, or soft default in the form of outright monetizing of debt.

Austerity will prove to be ineffective; I don't think it will be politically possible.  Too many people starving in the streets.  Eventually, the hit will be taken by bondholders.  It is simply a question of whether they take that hit in the form of hard or soft default.

And herein lies the problem with the zero bound.  Japan has long moved past the point where their citizens can worry only about the lost income from low interest payments.  Now it is all about capital preservation, making it harder to implement either a hard or a soft debt default.  In effect, the outcome of being at the zero bound is an every increasingly large political class that has a lot to lose by anything that increases interest rates, inflation or a drop in confidence.  

Worse, that large political class makes it increasingly difficult to do what seems to be the best path, a gradual erosion of the real value of that debt through inflation.  The failure of generate inflation over a period of decades actually makes it more difficult politically to create that inflation as the capital losses would be borne more intensely by an ever increasing part of the population.  They are all taxpayers and bondholders.  They take the hit in taxes, spending, or capital position.  The longer they wait to take that hit, the bigger it will be.  

What I expect to happen is this:  The Bank of Japan will be forced into outright monetization at some point; a soft default in the form of higher inflation will occur.  And dramatically higher inflation, I fear.  Japan has not had inflation for two decades.  I suspect they will experience all that pent-up inflation in the scope of a couple of years.

In other words, you can take your inflation medicine a little bit at a time, or a whole bunch at once.  But a even a little bit at a time becomes increasingly more difficult politically as the debt load grows larger. 

Now, how does this apply to the US?  After all, the US does in fact have inflation, with prices projected to grow at something less than 2% annually.  But this argument assumes that 2% is the "right" inflation rate.  I would argue that it is not the right inflation rate if it is insufficient to lift the economy from the zero bound.  The Fed's own forecasts, and the fear of the fiscal cliff and the subsequent recession, says we are not yet there. 

I suspect the US needs higher inflation, just like Japan.  The commitment to ultra-low inflation seems to be a pendulum that has swung too far.  Policymakers need to take the danger of the zero-bound seriously.  And I think the Fed's forecast imply they are not taking it seriously.

Think we can't create inflation?  Think again.  Federal Reserve Chairman Ben Bernanke gave the answer:

There is no unique solution to the problem of continuing declines in Japanese prices; a variety of policies are worth trying, alone or in combination. However, one fairly direct and practical approach is explicit (though temporary) cooperation between the monetary and the fiscal authorities. Let me try to explain why I think this direction is promising and may succeed where monetary and fiscal policies applied separately have not...

...My thesis here is that cooperation between the monetary and fiscal authorities in Japan could help solve the problems that each policymaker faces on its own. Consider for example a tax cut for households and businesses that is explicitly coupled with incremental BOJ purchases of government debt--so that the tax cut is in effect financed by money creation. Moreover, assume that the Bank of Japan has made a commitment, by announcing a price-level target, to reflate the economy, so that much or all of the increase in the money stock is viewed as permanent....

...The health of the banking sector is irrelevant to this means of transmitting the expansionary effect of monetary policy, addressing the concern of BOJ officials about "broken" channels of monetary transmission. This approach also responds to the reservation of BOJ officials that the Bank "lacks the tools" to reach a price-level or inflation target.

Isn't it irresponsible to recommend a tax cut, given the poor state of Japanese public finances? To the contrary, from a fiscal perspective, the policy would almost certainly be stabilizing, in the sense of reducing the debt-to-GDP ratio. The BOJ's purchases would leave the nominal quantity of debt in the hands of the public unchanged, while nominal GDP would rise owing to increased nominal spending. Indeed, nothing would help reduce Japan's fiscal woes more than healthy growth in nominal GDP and hence in tax revenues.

Potential roles for monetary-fiscal cooperation are not limited to BOJ support of tax cuts. BOJ purchases of government debt could also support spending programs, to facilitate industrial restructuring, for example....

Lifting off the zero bound probably requires a high degree of cooperation between the fiscal and monetary authorities that may, gasp, require some outright monetization of government debt.  Such monetization is what Bernanke advocated for Japan, but this advice fell on deaf ears.  Because such cooperation is feared, it is essentially off the table.  For now.  But what I think will be the case is that instead of small amounts of cooperation now, we are setting the stage for large amounts in the future.  Debt reduction via inflation will come; the longer we wait, the more disruptive it will be.

Such thoughtful, careful, technocratic cooperation between monetary and fiscal authorities, however, is no where to be found.  In the US, Europe, and Japan, at best we have is monetary authorities trying to offset real and expected fiscal austerity.  That path, I fear, only leads us deeper into permanent zero bound territory.

Bottom Line:  2015 is too long to wait to emerge from the zero bound.  Policymakers need to make efforts to normalize the economic environment a priority.  That may require a level of fiscal and monetary cooperation that today seems to be unthinkable.  But if gets to the point where central banks are pulled kicking and screaming into such cooperation (the European Central Bank may be the first to explicitly monetize government spending; I suspect it will be the only way to keep Greece in the Euro and live up to Draghi's pledge that the Euro is permanent), then I think we will all wish we had engaged in such cooperation sooner than later. 

Excuses Not To Do More

Josh Lehner (via CR) reviews some of his earlier work on the Reinhart and Rogoff results and concludes:

...when the Great Recession is compared not to other U.S. cycles but to the Big 5 financial crises and the U.S. Great Depression (thanks to U.S. Treasury for adding that to the graph), the current cycle actually compares pretty favorably. This is likely due to the coordinated global response to the immediate crises in late 2008 and early 2009. While the initial path of both the global and U.S. economies in 2008 and 2009 effectively matched the early years of the Great Depression – or worse – the strong policy response employed by nearly all major economies – both monetary and fiscal – helped stop the economic free fall.

This is worth highlighting because of the eagerness of policymakers to embrace Reinhart and Rogoff as an excuse to avoid fiscal and monetary policy.  For instance, see St. Louis Federal Reserve President James Bullard in the Financial Times:

Some may argue that real output and employment in the US have not returned to the pre-crisis, bubble-induced path that seemed to prevail in the mid-2000s. Indeed, US employment is about 4.7m lower than at its peak in January 2008. But this is to be expected. Recoveries in the aftermath of financial crises tend to be especially protracted, as the work of Carmen Reinhart and Kenneth Rogoff has documented. 

Bullard sees Reinhart and Rogoff as an excuse to do nothing.  After all, why even try when history has proved the long-lasting impact of financial crises?  Bullard completely misses the alternative argument - that if financial crises are long-lasting, then the policy response needs to be more aggressive. As Lehner points out, aggressive policy response can mitigate the impact of the crisis.  Bullard should read Reinhart and Rogoff as a demand to do more, not an excuse to do less.

Indeed, Reinhart and Rogoff have said as much.  Via Ezra Klein:

...if you look at the leaked memo that the Obama administration was using when they constructed their stimulus, you’ll find, on page 10 and 11, a list of prominent economists the administration consulted as to the proper size for the stimulus package. And there, on page 11, is Rogoff, with a recommendation of “$1 trillion over two years” — which is actually larger than the American Recovery and Reinvestment Act. So if they’d been following Rogoff’s advice, the initial stimulus would have been even bigger — not nonexistent.

As for Reinhart, I asked her about this for a retrospective I did on the Obama administration’s economic policy. “The initial policy of monetary and fiscal stimulus really made a huge difference,” she told me. “I would tattoo that on my forehead. The output decline we had was peanuts compared to the output decline we would otherwise have had in a crisis like this. That isn’t fully appreciated.”

Bullard also argues against a higher inflation target:

To argue against monotonic convergence now would imply that when unemployment is above the natural rate, monetary policy should aim for inflation above the Fed’s 2 per cent target. On the face of it, this does not make sense: the US has experienced periods when both inflation and unemployment have been above desirable levels. In the 1970s this phenomenon was labelled stagflation. Monetary policy has been regarded as poor during that period.

Scott Sumner already identified the sad mistake Bullard makes here.  Essentially, Bullard has a limited sense of history - he knows of only two possible monetary equilibriums, one with 2% inflation and low unemployment, the other with infinite inflation and high unemployment.  What about the Great Recession?  Couldn't current monetary policy, with below target inflation and above target unemployment, also be regarded as poor?  And isn't that the situation we are in now, as Bullard himself admits?  

What does Rogoff have to say about the 2% inflation target?  From the FT last year:

If direct approaches to debt reduction are ruled out by political obstacles, there is still the option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 per cent for several years. Any inflation above 2 per cent may seem anathema to those who still remember the anti-inflation wars of the 1970s and 1980s, but a once-in-75-year crisis calls for outside-the-box measures.

And more recently:

...many (if not necessarily all) central banks will eventually figure out how to generate higher inflation expectations. They will be driven to tolerate higher inflation as a means of forcing investors into real assets, to accelerate deleveraging, and as a mechanism for facilitating downward adjustment in real wages and home prices.

Rogoff apparently does not take his research to imply that policymakers should give up.  And he explicitly identifies higher inflation targets as a potential tool.  Yet Bullard (like most of the Fed) is married to the 2% target without any consideration that the appropriate inflation target may vary across time and economies, and he essentially cites Rogoff as a reason to justify this position.  You can't do more, so why try?

Bottom Line:  Policy is effective even in the aftermath of a financial crisis.  Don't let policymakers fool you into believing otherwise. 

Update:  I notice some Twitter chatter of surprise that Rogoff was not completely opposed to fiscal stimulus (I thought everyone read Ezra Klein).  Some additional quotes from the FT would be helpful:

At the root of today’s credibility deficit is a failure to come to grips with the long, slow growth period that is typical of post-financial crisis recovery...By far the main problem is a huge overhang of debt that creates headwinds to faster normalisation of post-crisis growth – that is why post-financial crisis growth is typically very slow...It is far from clear that any huge temporary fiscal stimulus will rev up the engine enough to achieve self-sustaining growth...The most direct remedy, of course, would be to find expeditious approaches to cleaning up balance sheets whilst maintaining the integrity of the financial system...If direct approaches to debt reduction are ruled out by political obstacles, there is still the option of trying to achieve some modest deleveraging through moderate inflation of, say, 4 to 6 per cent for several years. 

I think the story here is that fiscal stimulus is only a temporary measure, not a long-run solution.  The long-run solution is dealing with the debt overhang, which can be addressed with more aggressive monetary policy.

Gramm and Taylor Don't Get It

As a general rule, I stay clear of the Wall Street Journal editorial pages.  I'll be honest - I just don't have the emotional energy for it anymore.  But Brad DeLong forced it on all of us this weekend, drawing attention to another anti-QE article, this time penned by Phil Gramm and John Taylor.

DeLong gets to the heart of the problem.  Gramm and Taylor don't seem to realize that the stock of Treasuries is the same regardless of who owns them.  What GT see as higher future interest rates would simply be higher current interest rates if the Fed was not temporarily substituting some cash for bonds.  DeLong summarizes:

So why are Taylor and Gramm arguing that returning interest rates in 2016 and after to what they would have been anyway is a cost to QE III? It's a zero. It's not a change. It simply does not compute.

Yet there is still room to build upon DeLong's critique.  GT get off to a bad start:

That kind of monetary expansion would normally be a harbinger of inflation. However, with banks holding excess reserves rather than lending them out—and with velocity (the rate at which money turns over generating national income) at a 50-year low and falling—the inflation rate has stayed close to the Fed's 2% target.

While the Fed considered its previous rounds of easing—QE1, QE2 and Operation Twist—the argument was consistently made that the cost of such actions was low because inflation was nowhere on the horizon. The same argument is now being made as the central bank contemplates QE3 during the Federal Open Market Committee meetings on Wednesday and Thursday.

Inflation is not, however, the only cost of these unconventional monetary interventions. 

Notice that they admit that inflation has remained under control, yet then proceed to claim that inflation is a cost of QE.  How can inflation be both under control and a cost?  It can't, of course; GT just can't admit that inflation is not a problem even after actually admitted that fact.  GT continue:

As investors try to predict the timing and effect of Fed policy on financial markets and the economy, monetary policy adds to the climate of economic uncertainty and stasis already caused by current fiscal policy. 

QE3 actually reduces the uncertainty about monetary policy.  Rather than defining QE by arbitrary amounts and end dates, we now have a steady flow of QE tied only to improving economics conditions in the context of price stability.  No more uncertainty that the Fed will pull policy support regardless of the state of the economy.  More:

Since September 2008, the Fed has acquired $1.16 trillion of government securities—in fiscal year 2011 (Oct. 1, 2010-Sept. 30, 2011), the central bank bought 77% of all the additional debt issued by the Treasury. Aside from the monetary impact of these debt purchases, the Fed allowed the federal government to borrow a trillion dollars without raising the external debt of the Treasury and without having to pay net interest on that portion of the debt, since the central bank rebated the interest payments to the Treasury.

So GT do not consider the Treasury debt held by the Fed as real debt because...why?  Apparently because all of the Fed's profit need to be returned to the Treasury at the end of the year.  That doesn't mean it isn't real debt, issued to cover deficit spending and issued without the expectation of outright monetiziation.  Moreover, private investors see the Fed's holdings as part of the aggregate Treasury debt and will set their price expectations accordingly.   GT continue:

When the Fed must, in Chairman Ben Bernanke's words, begin "removing liquidity," by selling bonds, the external debt of the federal government will rise and the Treasury will then have to pay interest on that debt to the public. Selling a trillion dollars of Treasury bonds on the market—at the same time the government is running trillion-dollar annual deficits—will drive up interest rates, crowd out private-sector borrowers and impede the recovery. 

This just makes my head hurt.  If the Fed needs to sell their portfolio into the market, this will be because interest rates are already rising.  Let's take this slowly:  Currently, interest rates are at very low levels.  If the economy improves, there will be upward pressure on interest rates.  Yes, interest rates will rise, and supposedly "impede the recovery."  Yes, this will have an impact on growth, but that is exactly what you might expect if the LM curve slopes upward (if the IS curve increases, both output and interest rates rise).  And yes, the Fed will likely follow rising long term interest rates by reversing the current situation.  

This should be absolutely, 100%, not a controversial subject because, surprise, surprise, the Fed reverses their policy stance in every expansion.  That is a feature of monetary policy, not a defect. 

Moreover, assuming the economy is operating near potential, the Fed would not be crowding out the private sector; they would only be controlling inflation.  Only the fiscal authority can crowd out the private sector by not engaging in counter-cyclical policy.  And if the fiscal authority does indeed not control deficit spending as needed, it would be the Fed's job to compensate to the best of their abilities.

GT continue:

In addition, Operation Twist, by shortening the average maturity date of externally held debt, will require the Treasury to borrow more money sooner when the economy recovers and interest rates start to rise. This too will drive up interest costs and the deficit.

The issue here, I think, is that the Fed is swapping out short-dated assets that they normally would have rolled over when the assets matured (assuming they wanted to hold the balance sheet constant).  Thus, the Treasury needs to increase its debt issuance to the public compensate in the near term.   But guess what? First, if the Fed didn't hold the debt in the first place, then the public would hold the debt with the same consequences for the Treasury at maturation.  Second, the US Treasury is wisely extending the maturity of its debt; see Jim Hamilton here.   Extending the maturity will help reduce the pressure to refinance short term debt and lock in low longer term interest rates.  Moreover, the Treasury has time time to implement these changes; interest rates are not skyrocketing overnight.  

GT make similar errors with mortgage rates:

The same problems will occur as the Fed begins to sell its holdings of mortgage-backed securities to reduce the monetary base. When the Fed bought these securities, it may have marginally reduced mortgage interest rates. Selling them during a real recovery will likely cause mortgage rates to rise.

Yes, once again in a real recovery mortgage rates will rise.  Just as in the past.  And guess what happens if they don't rise - then you might in fact get that inflation the authors so fear.  Again, rising rates are a feature, not a defect.  GT, inexplicably, continue:

Proponents of QE3 argue that while the Fed's balance sheet must be reduced at some future time, it has the tools to minimize the impact on interest rates by slowing down the pace of the sales. But the Fed's ability to act has already been compromised by its pledge to maintain low interest rates through 2014. Having to time open-market sales to minimize interest-rate increases will further limit the Fed's ability to preserve price stability.

Once again, with emphasis, it is not a commitment.  Believe me, many of us would like to see a commitment to be irresponsible.  This isn't it.  It is a conditional forecast; if economic activity exceeds current projections, the Fed will tighten policy sooner than currently anticipated. Finally:

The Fed could raise the interest rate that it pays banks on reserves they hold in lieu of reducing its balance sheet. Where would the money come from? It has to come out of the money the Fed is currently paying the Treasury, driving up the federal budget deficit. How will taxpayers feel about subsidizing banks not to lend them money?

Yes, the profits from monetary policy accrue to the US Treasury.  Yes, profits are currently unusually high.  Yes, if interest rates, and along with them policy, normalizes, then those profits will fall.  Will this drive up the budget deficit?  Consider the bigger picture.  If the economy is accelerates such that there is upward pressure on interest rates, then the deficit will be eased by the activation of automatic spending and revenue stabilizers.  In other words, we will have a choice - the Fed can hold the economy down now by withdrawing monetary stimulus, which will in turn widen the deficit, or foster stronger activity which will lower the deficit in the future.  The Fed's profits are of third or fourth or fifth order importance in this process.  

Bottom Line:  If the US economy was not operating at the zero bound, the Federal Reserve would react to improving economic conditions and tighten policy by selling Treasury securities in the process of targeting a higher Federal Funds rates.  John Taylor should know this.  Now, with quantitative easing, if economic conditions improve, the Fed will tighten policy by...yes, the same thing, selling Treasury securities.  In either case, the Fed will only do this if interest rates are already responding to stronger activity.  In this light, the Fed isn't really doing anything new.  I don't think you should fear the Fed having to withdraw the stimulus.  Indeed, I think you should really fear the opposite - that the economy does not lift off the zero bound before the next recession hits.  If that happens, we will all be wishing the Fed had done more, and sooner. 

 

Getting Lonely to be a Hawk

Minneapolis Federal Reserve President Narayana Kocherlakota today gave a speech that was something of a shocker.  But a little background first.  Kocherlakota has generally be viewed as a hawk, more so than his colleague St. Louis Federal Reserve President James Bullard.  See, for example, the Credit Suisse mapping of Fed policymakers. I referred to Kocherlakota as one of the "Three Stooges" among the voting members of the 2011 FOMC meetings in regards to his dissents.  So it came as something of a surprise today when he said:

The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.

At first blush, this sounds like a light version of Chicago Federal Reserve President Charles Evans' policy approach in which Evans would explicitly allow for an inflation rate as high as 3% as long as unemployment was above 7%.  With this sentence, Kocherlakota appears to have decisively moved from the hawkish column to the dovish.  Credit Suisse needs to update their charts, and the remaining hawks become even more marginalized.

Mark Thoma, however, argues that there is less here than meets the eye, noting that Kocherlakota shows no willingness to accept that inflation greater than 2% may be helpful.  Indeed, Kocherlakota seems focused on the Fed's 2% target, with the 2.25% simply allowing for some uncertainty of plus or minus 25bp around that target.  A true dove, in the classic definition (as I explain here), is a policymaker that seeks relatively higher inflation than his/her colleagues.  But by that definition, Evans is the only true dove.  The rest of the FOMC worships at the altar of their newly enshrined 2% target.  The hawks/doves divide is now about how one views the upside or downside inflation risks to the target rather than the target itself.

A further distinction can be made.  Hawks tend to view high upside risks to inflation because they believe structural factors limit the pace of growth.  Thus, more monetary policy can only show up in higher inflation.  Doves tend to view current challenges as largely cyclical.  With the economy operating well below trend, further monetary policy can be applied without stoking inflation.  

Now let's go back to our friend from Minneapolis.  Recall that last year, Kocherlakota believed that the Fed funds rate would need to rise in 2011:

These two elements—the increase in core PCE inflation and decline in labor market slack—imply that the target fed funds rate should be raised by at least a percentage point. However, there is a third effect that partially offsets the first two effects. The level of accommodation provided by the Fed’s holdings of long-term securities depends on how long people expect those holdings to last...By putting these three elements together, I arrive at my conclusion: If PCE core inflation rises to 1.5 percent over the course of 2011, the FOMC should raise the fed funds rate by around 50 basis points. 

Last year, Kocherlakota was citing 1.5% (core) inflation as a trigger for immediate action; now he sees 2.25% as a threshold that may call for tighter policy.  Thus, he exhibits a higher tolerance for inflation, which in and of itself makes him less hawkish in the classic sense than we saw last year.

In addition, last year Kocherlakota argued that monetary policy is incapable of achieving full employment in the near term.  In this presentation, he modifies an IS-LM model to define an output level "FEDMAX" that is below the full employment level of output.  That Kocherlakota would not have believed that the unemployment rate could be pushed to 5.5%, even in the context of price stability, before the Fed needed to tighten policy.  See also Robin Harding on this point.

So by my read, Kocherlakota has definitely come off the hawkish side of the FOMC.  He appears to be both more tolerant of inflation and putting less weight on concerns that structural factors could be limiting growth.

Bottom Line:  The ranks of Fed hawks grows even thinner, down to just four clear hawks (plus or minus Bullard) out of nineteen policymakers.  Barring an "sustainable and substantial" shift in the tone of the data, expect this Fed to keep their foot on the pedal for the foreseeable future.

Fisher Turns to Fear Mongering

Dallas Federal Reserve President Richard Fisher is quick to continue his fear mongering about inflation.  Via Bloomberg:

“I do not see an overall argument for letting inflation rise to levels where we might scare the market,” Fisher said on Bloomberg Radio’s “The Hays Advantage” with Kathleen Hays and Vonnie Quinn. “We have seen a sharp rise in inflation expectations. If you let this get out of hand, then I think we will have a market reaction.”

Let's go to the chart:

You really can't say that inflation expectations are surging beyond anything we have seen in the past six years.  Moreover, supporting inflation expectations was an expected outcome of Fed easing.  And financial markets seem to like it.  

Also, it is not clear that TIPS-derived expectations are the best measure (a point I don't make enough).  The Cleveland Federal Reserve works on teasing out inflation expectations, and on September 14th reported:

The Federal Reserve Bank of Cleveland reports that its latest estimate of 10-year expected inflation is 1.32 percent. In other words, the public currently expects the inflation rate to be less than 2 percent on average over the next decade.

Yes, near term expectations have gained but from a too-low 1.2% to 1.8%.  Moreover, this would be expected not just from anticipation of QE3, but from the rise in gas prices (and note that oil prices are now falling again). By this measure, the more important longer term expectations remain mired well below the Fed's 2% inflation target.  Let's at least agree to stop worrying about inflation until we get expectations back up to the Fed's target.

 Bottom Line:  Fisher stays true to form, clutching to his fears of inflation like a drowning man grabs onto a life preserver.  My guess is that he doesn't need to be marginalized by the doves; he does a fine job marginalizing himself.

Hawks Are Marginalized

There has been a lot of Fedspeak over the last few days as policymakers expand upon the shift to open-ended QE.  See Cardiff Garcia at FT Alphaville for an overview of some of the dovish talk, and see Pedro Da Costa at Reuters for some thoughts on the hawkish talk, described as a "vocal minority."  See also Reuters for an interview with St. Louis Federal Reserve President James Bullard, who claims that he would have voted against QE3:

"I would have voted against it based on the timing. I didn't feel like we had a good enough case to make a major move at this juncture," said Bullard, who has been viewed as a centrist on the spectrum of Fed officials, though in recent months he has sounded opinions that have sounded more hawkish as he has expressed doubts about the need for further stimulus.

Bullard does acknowledge his preference for open-ended QE, if he had believed it was needed:

Even so, Bullard said some of the contours of the plan, which has no set end date, were in keeping with how he thinks monetary policy should be conducted with interest rates already near zero. Leaving end dates off a bond buying program can make the policy "more effective," he said.

Bullard is also reported to have expressed support for dropping the dual mandate, although I am not seeing a direct quote.  Same for concerns about commodity prices:

He also voiced concern that QE3 could spill over into higher commodity prices, as happened with the previous rounds of Fed bond-buying, although he said the soft tone of the world economy would help curb price rises.

The reporter reaches the conclusion:

In discussing his views on more monetary stimulus, Bullard said, "We should take a little bit more (of a) wait-and-see posture." His comments, in an interview with Reuters Insider, highlight potential dissent on the Fed's policy committee next year when he will be a voting member.

Should we be concerned about this warning?  I would say no.  I think it is easy for Bullard to say that he would have dissented, but a lot harder to actually dissent if he was seated in the meeting.  Indeed, he gets the best of both worlds - he gets to display his hawkish credentials by saying he would voted against QE without the pressure of the actual vote.  Might he get more vocal next year?  Maybe.  I suspect his comments will be a function of which way the political winds are blowing.  All of his comments to Reuters - anti-QE, concerns about commodity prices, desire to dump the employment mandate - sound like attempts to position himself for a role in a Republican Administration.  The more he needs to position himself in that direction, the more hawkish he will appear.

And note that fundamentally, whatever Bullard (or other hawks) say is for the time largely irrelevant.  As a group, they were small to begin with, and by now have been intellectually marginalized.  Via Cardiff Garcia, Credit Suisse provides a summary chart of policymakers:

The hawks are all bark, no bite.  They are more than overwhelmed by dovish-leaning policymakers, even if Bullard joins Kansas City Federal Reserve President Esther George in hawkish dissent.  What remains important heading into 2013 (aside from the data, of course), is Federal Reserve Chairman Ben Bernanke.  He can pull the moderates where he wants to go.  And it obviously is not in a hawkish direction.  

Bottom Line:  Fed hawks are largely marginalized.  Their views have not and will not have a significant impact on policy making.  They will only appear to have an impact on policy if the data signals that a policy shift is needed.  Given the current set of policymakers on the Fed, the hawks will only have a voice if Bernanke is replaced with one of their own.  And that is when it would get interesting, as I am not sure that the moderates would follow a hawkish Chairman. 

Getting Off the Zero Bound

Weighing on my mind is the possibility that we do not lift off the zero bound - in other words, we don't normalize the economic environment - before the next recession hits.  When I say normalize the environment, I am thinking in the terms David Beckworth describes here.  Begin with the premise that interest rates are abnormally low.  I can't see how anyone can not come to that conclusion with ten year TIPS in negative territory:

 

Rather than seeing the Federal Reserve's action as the cause of the low interest rate environment, I tend to think it was the Federal Reserve's inaction.  If monetary policy was gaining traction, interest rates should rise, forcing the Fed to follow rates up.  Instead, Fed policy continues to follow interest rates down.

Looking at the Fed's extended guidance, they do not see the need to raise short term interest rates until mid-2015.  June 2015 would mark 90 months since the peak of the last business cycle in December 2007.  The average peak-to-peak cycle of the last three recessions 96 months, the average since 1945 is 66 months.  Now, I don't think you can say that the probability of recession in the next month is a factor of the time since the last recession.  But you can say that given past business cycle timing, it is perfectly reasonable to believe that the next recession will hit before we lift off the zero bound.  Moreover, it would be relatively uncommon for the peak-to-peak cycle to last more than 90 months.  Only 4 of the last 11 cycles have exceeded this length of time. 

So I am getting a little nervous that we will not lift off from the zero bound before the next recession hits. Or maybe the attempt to lift the economy off the zero bound is the trigger of that recession.  In either case, I am thinking it would be very bad to be still at the zero bound when that recession hits.  So I am wondering what is the equilibrium path that returns the US economy to a normal interest rate environment.  Furthermore, can the Fed push the economy to such a path by itself, or is fiscal cooperation required?  I don't have answers to these questions, but my suspicion is that the job would be easier with coordinated fiscal and monetary policies.