Tim Duy's Fed Watch

Japan Follow-Up

Some follow up to last week's piece on Japanese monetary policy:

First, I think there are some obvious implications for US policymakers:  The Federal Reserve has all but given fiscal policymakers the green light to accelerate debt issuance to support stimulus efforts.  Matthew O'Brien at the Atlantic points out that while the Fed is willing to tolerate inflation slightly as high as 2.5%, the Fed's forecast remains at 2.0% or below through 2015.  So the Fed is willing to tolerate higher inflation, but not willing - or able - to generate higher inflation.  The ball is thus passed to fiscal policymakers to do the job.  Fiscal policymakers, however, have fumbled the ball.  Badly.  Even while the Treasury can borrow for 10 years at well below 2%, Washington is prepared to drop an austerity bomb on the economy.  Austerity looks to be a done deal; it is only the level of austerity that is at issue.  

Second, a thread is making the rounds claiming that Japanese Prime Minister Shinzo Abe is all bark, no bite.  Joshua Wojnilower argues that Abe is a closet austerian, thus ultimately the actual stimulus enacted will be of the short-term, low-power variety.  Noah Smith is less diplomatic, pointing out that Abe's first time at the helm was something of a disaster because Abe fundamentally has a narrow focus:

I of course don't mean to imply that Abe's cultural conservatism makes him unlikely to experiment with monetary policy (unlike in America, in Japan "hard money" is less of a conservative sacred cow). Instead, what I mean is that Abe really just does not care very much at all about the economy. I mean, of course he wants Japan to be strong, and of course he doesn't want his party kicked out of power. But his overwhelming priority is erasing the legacy of World War 2, with the economy a distant, distant second.

This is why Abe allows himself to be surrounded by corrupt and incompetent people. He is entirely focused on his cultural conservative quest. The other day Abe called Obama "Bush". He just deeply, truly, does not care about stuff that does not involve boosting Japanese nationalism.

Smith has a theory:

So why is Abe making all this noise about revoking central bank independence, setting hard inflation targets, etc.? I have a hypothesis: He is talking down the yen.

There is a long history of Japanese policymakers talking down the Yen; who could ever forget former Finance Minister Eisuke Sakakibara, AKA Mr. Yen?  That said, if Abe wants a sustained depreciation, is is going to take something more than just talk. After all, look at what has been accomplished over the past ten years:

If the goal of all the talk was a weak Yen, policymakers have failed miserably.  And If Abe can't follow through with a real policy change, talking alone will continue to fail, and the recent decline in the Yen will prove ephemeral.  

This leads me to my third thought, that the level of intervention required to change the economic outcome is much, much higher than most anticipate.  You can't just dabble in monetization; you need to commit to it.  Case in point: Switzerland.  Floyd Norris, the author of the original NYT piece that prompted my initial post, seems to argue that raising inflation is not all that hard:

“At this point, moving to a 2 percent target would not be such a giant step,” said Kenneth Rogoff, a Harvard economist who has suggested inflation targeting in the United States as well as in Japan. “They have to pursue it vigorously until we have inflation expectations firmly higher. No one knows how much they would have to do to accomplish that.”

The Bank of Japan has in the past been hesitant to really try to establish that credibility...

To establish the credibility, the central bank would have to show a readiness to create credit at a rapid rate. It would probably also need to take steps to hold down the value of the yen, a move that would no doubt cause concern in the United States.

It is, however, very doable, as Switzerland has shown. When the euro zone debt crisis was at its worst, Switzerland became a safe haven for European investors worried that the euro might blow up. That drove up the value of the Swiss franc versus the euro and damaged Switzerland’s ability to compete. The Swiss government responded by announcing that the euro would not be allowed to fall below 1.2 Swiss francs. If necessary, the government would simply sell francs to meet any demand.

That has been necessary, and the Swiss have accumulated a huge portfolio of foreign currency. So, too, could the Japanese if they chose to announce that the dollar would henceforth be worth at least 100 yen, a level not seen since 2009.

Rogoff is correct; no one really knows what is necessary.  I don't think that 100 yen is a meaningful target; aside from a couple of energy-price induced spikes, Japan has not had meaningful inflation since the early 1990's.  The Yen has fluctuated between 80 and 160 during that time.  Shoot for 160 and it might be interesting.  And how does this relate to Switzerland?  Although Norris holds it out as an example, look at inflation in that economy:

And nominal GDP:

The Swiss National Bank appears to be struggling to stave off deflation and stabilize the path of nominal GDP. So how exactly is this a lesson in establishing inflation target credibility?  Despite all the efforts of the Swiss National Bank, their work still fall short.

Norris is certainly right on the political implications.  I think the extent of direct currency depreciation necessary to by itself meet a 2% inflation target in Japan would be unacceptable to Japan's trade partners.  Monetary policy to support domestic demand - monetization of deficit spending - would be much more tolerable, perhaps even welcome.

Bottom Line:  Economic policy in Japan is never boring.

Missing The Big Japan Story

The potential exists for groundbreaking changes in Japanese economic policy - and I sense that Western journalists, caught up in the current celebration of central bankers, are missing the bigger story.  In my opinion, a higher inflation target by the Bank of Japan is not particularly interesting.  After all, the Bank of Japan can't hit the current "goal" of 1 percent inflation.  I don't have much faith that renaming the "goal" a "target" and increasing it to 2 percent will be like waving a magic wand.  But something much more significant is afoot - the possibility of explicit cooperation, albeit perhaps forced cooperation, between fiscal and monetary authorities.  The loss of the Bank of Japan's independence to force the direct monetization of deficit spending is the real story.

Floyd Norris at the New York Times begins a recent article on Japanese monetary policy with a quote from then-Federal Reserve Governor Ben Bernanke:

...under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Norris continues:

Now we may find out if Mr. Bernanke was right. Japan appears to be ready to do whatever it takes to end its long run of falling prices. The Bank of Japan took limited action on Thursday, and more is expected in the new year.

Norris then proceeds with a generic review of Bernanke's point that monetary policymakers are not without tools even at the zero bound.  Norris includes mention of Bernanke's "helicopter drop" reference, but fails to put it in proper context.  The proper context is in terms of the cooperation between fiscal and monetary policy.  This is my central complaint; that reporters have a tendency to not carefully read this speech.

Notice that Bernanke does not say a "determined monetary authority."  He says a determined "government."  Bernanke clarifies this earlier in the speech:

Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

The problem, in my opinion, is that reporters tend to report this speech without explicitly (or even implicitly) defining the importance of fiscal policy.  And we know that Bernanke himself does not believe that monetary policy can stabilize the economy in any and all times.  From the most recent post-FOMC press conference:

For example, I hope it won’t happen but if the fiscal cliff occurs, as I’ve said many times, I don’t think the Federal Reserve has the tools to offset that event and, in that case, we obviously have to temper our expectations about what we can accomplish. 

What does this have to do with Japan?  Norris acknowledges the political pressure change on the Bank of Japan:

This week the Liberal Democratic Party, which had ruled Japan for nearly its entire postwar history until it was swept from power three years ago, won a landslide victory. Shinzo Abe, the prime minister from 2006 to 2007, will get another chance.

Mr. Abe devoted a decent part of his campaign to criticism of the Bank of Japan, the country’s central bank. He wants the bank to pursue inflation, and to effectively print money until it gets it. At one point during the campaign he spoke of a 3 percent inflation target, although he seems to have cut that back to 2 percent.

Fine, political pressure is interesting, but the inflation target is just one part of the plan, and I would argue not the most important part.  From another New York Times reporter, Hiroko Tabuchi:

In his campaign speeches, he [Abe] called on the bank to set an inflation target of 2 to 3 percent and to buy more bonds to finance government stimulus efforts, another facet of his growth strategy. He warned that he would push to amend laws regarding the central bank to allow the government a bigger say in setting monetary policy. [emphasis added]

The implications are clear. From the Financial Times:

Mr Shirakawa, the BoJ governor, has warned that “monetising” government debt could undermine confidence in Japan’s fiscal discipline, resulting in higher interest rates that would make it much harder to finance the deficit.  

What would Bernanke say about the impact of joint monetary and fiscal policy?  From his 2002 speech:

Each of the policy options I have discussed so far involves the Fed's acting on its own. In practice, the effectiveness of anti-deflation policy could be significantly enhanced by cooperation between the monetary and fiscal authorities. A broad-based tax cut, for example, accommodated by a program of open-market purchases to alleviate any tendency for interest rates to increase, would almost certainly be an effective stimulant to consumption and hence to prices...A money-financed tax cut is essentially equivalent to Milton Friedman's famous "helicopter drop" of money.

...Of course, in lieu of tax cuts or increases in transfers the government could increase spending on current goods and services or even acquire existing real or financial assets.

US monetary policy would have been much more effective if complemented by fiscal policy.  Same goes for Europe.  Abe appears to be poised to try something along that route:

In an appearance on Fuji TV on Sunday, Mr Abe, who this week is set to become Japan’s seventh prime minister in just more than six years, said a new approach was essential to defeating the deflation dogging the economy.

“It has to be different from the traditional methods – the traditional methods have not been able to defeat deflation for more than a decade. That’s no good,” he said.

And Abe is determined to make it happen - even if it requires stripping the central bank of its independence:

...Mr Abe has already made clear that Mr Shirakawa will be replaced when his current term as governor ends in April and that his successor will be a candidate more willing to push aggressive easing. “We want to have someone who supports our thinking,” he said on Sunday.

Or he will push for legal changes such that the Bank of Japan to once again falls under control of the fiscal authorities.

Japan might very well be heading toward the end-game of permanent zero interest rate policy:  Explicit monetizing of deficit spending.  That is the real story here - it goes far beyond just inflation targeting.

Bottom Line: Inflation targeting is not the whole story in Japanese monetary policy.  It is a facet of a much greater story.  A story of a modern central bank stripped of its independence.  Of a modern central bank forced to explicitly monetize deficit spending.  Ultimately, it is the story of the end game of the permanent zero interest rate policy.  

Christmas Eve

My eight-year old son is so smart, so sweet, and so completely believes, as least for one more year.  All on his own:

Solid Bounce in Industrial Production

Industrial production posted a solid gain in November, more than offsetting the Sandy-impacted October decline:

This means that what had been the best clear top in a recession indicator a lot less clear.  A solid blow to ECRI Co-Founder Lakshman Achuthan's claim that the US slipped into recession in the middle of the year. 

I noticed this quote from Bloomberg:

“There is this continued tug of war for manufacturing,” said Aneta Markowska, chief U.S. economist at Societe Generale in New York, who forecast a 1.2 percent gain in manufacturing output. “Consumer spending is still looking pretty good so that’s helping support production. On the other hand, business demand for things like capital equipment, machinery is pausing.”

That vexing consumer spending question again - pretty good, on shaky grounds, or a pillar of strength?  I would say the middle ground holds, as least on the basis of core retail spending in November:

Of course, on a year-over-year basis, the deceleration from the earlier this year remains evident:

It is worth remembering that at least one consumer sector that is an important element of manufacturing activity remains solid:

I have trouble imagining IP rolling over and heading downward in any meaningful fashion when auto sales are still on the upswing.  Moreover, improving residential construction activity will provide support to suppliers of related manufactured goods:

 

Not to say the economy is growing gangbusters, but I think that Markoswka is broadly correct.  The external sector and domestic business spending are a drag on some sectors of manufacturing, but other sectors are still growing.  The upshot is that the decline in core manufacturing orders has yet to manifest itself in a broad decline in industrial production:

Bottom Line: Weaker than we would like to see, but news of the economy's demise remains premature.

The Press Conference

We will be analyzing details of Federal Reserve Chairman Ben Bernanke's press conference for the rest of the week.  For now, I am going to pass on my first take.  

In my opinion, what struck me as most important was that Bernanke emphasized that the addition of thresholds was a change in the communication of the Fed's monetary policy, not a change in the policy itself.  Indeed, I think the enhanced communication strategy is an important improvement.  It increases transparency dramatically.  As Bernanke noted, it is clearly more flexible in that the expectations for a change in Fed policy will fluctuate with the flow of data.  In contrast, the Fed only changed the date when significant revisions in the economic forecast became evident.  That said, as the statement makes clear, the Fed believes the threshold criteria are consistent with the previous date-based guidance.  In this regard, policy is unchanged as the expected date of first rate hikes is unchanged.

Next, I think there will be a tendency to view the 50bp margin on inflation (the explicit statement that inflation might rise as high as 2.5% in the near term without an automatic review of the interest rate stance) as an indication the Fed is placing less weight on its inflation mandate.  In contrast, Bernanke emphasized that the application of the dual mandate had not changed.  If you believed the 2% inflation target was a hard ceiling, however, the margin of error looks like an easing of inflation concerns.  If you think that there was room for symmetric errors around the 2% target (as I think the Fed has made clear recently), then the Fed's new thresholds are within an acceptable error band.  Also, note the importance of long-run inflation expectations in the Fed's policy-making process.  If the Fed believes that there is a real risk to long-run expectations, I would expect tightening regardless of the unemployment rate.

Also, I thought it important that policy seems to be headed in the direction illustrated by Vice Chair Janet Yellen:

Along the optimal path, inflation approaches its long-run rate from above.  The threshold guidance is perfectly consistent with this picture. The long-run inflation objective has not changed.  All the Fed has done was make explicit what I thought Yellen already made fairly explicity - that marginal deviations from the long-run path would not automatically trigger a policy shift.  Obviously, though, if economic conditions change, so too will the optimal path.  That's the point of the thresholds - to communicate that no one path is set in stone.  Policy will evolve according to economic outcomes.

Finally, Bernanke does not view the conversion of Operation Twist to outright purchases as a more expansionary policy.  If you accept the position of St. Louis Federal Reserve President James Bullard, dollar-for-dollar, Operation Twist is a less effective stimulus.  Thus, policy became easier.  Bernanke, hoever, does not believe continued, outright long-term Treasury purchases of $25 billion/month is an easier policy. As such, the Fed arguably left policy completely unchanged today, altering only the communication of policy.

FOMC Projections

The FOMC projections, central tendency:

The GDP growth projections were only marginally softer.  Most notable was the decrease in the high end of the 2014 forecast.  The unemployment rate projection fell in the near term, necessitated by the decline this year.  But the 2014 projection was roughly the same.  Inflation expectations were marginally softer, and notice that, within the central tendency, there are no projections above 2%.  You need to move to the overall range to get an upper-bound projection of 2.2%, still within the Fed's now explicit margin of error of 50bp.  

Another point:  There is no indication here of a fundamental change regarding the rate of potential output growth or the natural rate of unemployment in the longer-run.  For now, the speed-limits remain the same.

The expected date of first tightening is still reported:

Most participants (13, instead of 12 like in September) expect the first tightening in 2015.  Notice that this is consistent with unemployment falling below 6.5% that year.  The Fed thinks that the unemployment rate will hit its threshold first.  Also note that this reinforces the point that the shift to thresholds is consistent with previous date-based guidance as the Fed said in the statement.  I suspect Federal Reserve Chairman Ben Bernanke will make that clear in the presser.

Finally, something I don't talk much about is the uncertainty about the pace of tightening:

 
While the central tendency is for a gradual increase in the fed funds rate, there are a few expecting a relatively shift policy shift.  Consistent with uncertainty about the exit strategy.

Press conference next.

More Bond Buying and Thresholds

The FOMC statement was released this morning.  Key points are that Operation Twist will be converted one-for-one to an outright purchase program and the long-debated issue of thresholds became a reality.  First thoughts:

On the current situation:

Information received since the Federal Open Market Committee met in October suggests that economic activity and employment have continued to expand at a moderate pace in recent months, apart from weather-related disruptions. Although the unemployment rate has declined somewhat since the summer, it remains elevated. Household spending has continued to advance, and the housing sector has shown further signs of improvement, but growth in business fixed investment has slowed. Inflation has been running somewhat below the Committee’s longer-run objective, apart from temporary variations that largely reflect fluctuations in energy prices. Longer-term inflation expectations have remained stable.

Slow and steady, taking into account Hurricane Sandy, with a special nod to weak investment numbers.  Inflation both low in near-term and longer-term inflation expectations remain anchored.  Nothing too surprising here as it seems broadly consistent with the tenor of recent speeches by Fed speakers.

Next, the outlook:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely will run at or below its 2 percent objective.

Slow and steady is not enough to generate the improvement in labor market the Fed believes is necessary within the context of the dual mandate.  They continue to see strains in global financial markets...although this seems odd, as it seems that financial markets have calmed considerably in recent months.  The FOMC reaffirms its commitment to long-term price stability.

Bond buying, key addition:

The Committee also will purchase longer-term Treasury securities after its program to extend the average maturity of its holdings of Treasury securities is completed at the end of the year, initially at a pace of $45 billion per month. 

I am not surprised, but I was cautious that the Fed would choose to pull the trigger on a complete conversion of Operation Twist to an outright purchase program.  I think the St. Louis Federal Reserve President James Bullard is right when he notes that this is a more dovish policy.  The Fed has more than doubled the pace of the balance sheet expansion, a much more stimulative stance - unless, of course, we are deep into the territory of diminishing marginal returns.

We all knew thresholds were coming, but in general did not expect it this meeting:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. The Committee views these thresholds as consistent with its earlier date-based guidance. In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent.

The expiration date of low-interest rate policy is replaced with economic thresholds, which I believe is a more appropriate communications strategy.  The baseline expectation is that as long as unemployment remains above 6.5%, the Fed will tolerate an inflation forecast as high as 2.5% in the near term, assuming that long-term expectations remain anchored, before considering to raise rates.  In other words, all bets are off if the Fed judges that long-term expectations are accelerating even if unemployment and near-term inflation forecasts remain within their respective bounds.  The Fed is also taking pains to explain that policy depends on more than just two variables, and may act on the basis of that additional information.  Also, the Fed does not believe the move to thresholds changes policy relative to the date-based guidance; it only changes the communications strategy.

Finally, a dissent:

Voting against the action was Jeffrey M. Lacker, who opposed the asset purchase program and the characterization of the conditions under which an exceptionally low range for the federal funds rate will be appropriate.

Not surprising in the least.

Bottom Line: The Fed delivered an early Christmas present to the economy by acting above expectations with not only a one-for-one conversion of Operation Twist to outright asset purchases, more than doubling the pace of balance sheet expansion, but also shifting the communications strategy to thresholds.  The latter ties policy explicitly to outcomes rather than dates, which I think is the appropriate direction for policy.

Gas Prices Falling

Gas prices continued to decline last week, falling to the bottom of the roughly $3.50-$4.00 range of the past two years:

Ever notice that when gas prices rise, Fed critics starting jumping up-and-down and screaming inflation, but never say a word about deflation when gas prices fall?

The Debt-Celing Gamble

Ezra Klein reports that the White House is drawing a line in the sand on the debt-ceiling, and they really, really mean it:

The Obama administration is utterly steadfast on this point: They will not suffer a repeat of 2011, when they conducted negotiations over whether the United States should default. If Republicans go over the cliff and try to open up talks for raising the debt ceiling, the White House will not hold a meeting, they will not return a phone call, they will not look at the e-mails. 

The Administration is looking to take the debt ceiling off the table forever.  This is good policy; that Congress should be able to pass laws authorizing spending but not authorizing the required debt is beyond ridiculous.  Also ridiculous - and irresponsible - is the willingness of the Republicans to use the debt ceiling to hold the economy hostage.  Ending this travesty should be a priority for the White House.  

Klein adds that the White House is ready for the fight now while their strength is up:

Boehner and the Republicans don’t want to give up the leverage of the debt ceiling forever, or for 10 years, or even, as John Engler, head of the Business Roundtable and a former Republican governor suggested, for five years. But the White House isn’t very interested in compromising on this issue, as they figure that if there needs to be a final showdown over the debt ceiling, it’s better to do it now, when they’re at peak strength, then delay it till 2014 or 2015, when their own vantage might have ebbed.

I would add another advantage.  Better - from a political point of view - to have a recession at the beginning of President Obama's second term that can be blamed entirely on the Republicans.  A recession in the first half of 2013 means that, most likely, the Democratic presidential nominee can run on the back of an improving economy by 2016.  Alternatively, they run the risk that this recovery, anemic as it is, gets long in the tooth by 2016.  Even worse would be that they agree to let the Republicans once again hold the economy hostage two years from now.  Politically, if I had to pick between a recession now or closer to the next election, I would pick now.  

Disappointing Trade Report

Today's international trade report confirms that sluggish global growth is taking a toll on the US economy.  Exports are now barely up compared to last year:

Calculated Risk notes the wider goods deficit with the Eurozone.  I would add that this is clearly on the back of weaker exports (imports are up slightly).  On the plus side, exports of services were up 4.3 percent, while goods exports were down slightly, a story consistent with the divergent ISM manufacturing and services surveys.

Also note the negative year-over-year growth around 1998, the time of the Asian Financial Crisis, which means that even a significant external shock does not necessarily induce a US recession. That said, the softer external sector does leave the economy more vulnerable to negative internal shocks. In the late 1990's, the US experienced a positive internal shock, mitigating the impact of the Asian Financial Crisis. In the near-term, such a positive shock does not look as likely this time around. 

I take little comfort from the import data:

Flat to negative numbers are typically consistent with recession as they reflect periods of negative domestic demand.  We can't write off the slightly negative reading as simply a reflection of falling oil imports (down $625 million); non-petroleum imports (down $792 million) also fell slightly compared to a year ago. Unless the pace of import-substitution is happening very quickly, this data seems like something of a red flag.  Something to be cautious of as we head into 2013.

Bottom Line:  While I do not believe the US economy is in recession by any stretch of the imagination, I am under no illusions about the lack of underlying momentum.  Slow and steady, in my opinion.  But slow also means more vulnerable; there was more room to absorb an external hit in the late 1990's than today.  Which again leaves me wary about the impact of tighter fiscal policy, and I am not alone.  I question the belief that the clarity-induced confidence of a deal will be sufficient to offset the impact of tighter policy. Just as the Federal Reserve has committed to asset purchases until labor markets are substantially and sustainably stronger, fiscal policymakers should commit to easy policy until those conditions are met as well.  Instead, we are poised for another austerity experiment.  For now, the plan is to squeeze through the choppy first part of 2013 to the restorative powers of improved private sector balance sheets at the end of 2013.  Hopefully we make it there relatively unscathed.