Tim Duy's Fed Watch

Interesting Anecdote

Looking at the Reuters report on the latest consumer confidence numbers, this caught my attention:

"The increase in the payroll tax has undoubtedly dampened consumers' spirits and it may take a while for confidence to rebound and consumers to recover from their initial paycheck shock," Lynn Franco, director of economic indicators at The Conference Board, said in a statement.

One of the more interesting anecdotes I picked up last week was from a businessman who said that after his firm issued the first paychecks of the year, virtually every employee came to the payroll office and asked why their paychecks were lower, evidently unaware that the payroll tax cut had expired.

If the expiration does come as a surprise to a large proportion of the workforce, perhaps consumer spending in the first quarter will be somewhat softer than current estimates.  Something to watch for.

Room For Upside in Tomorrow's ISM Report?

Calculated Risk has the run down on tomorrow's employment report, opting to bet on the high side of the forecast. Likewise, I am inclined to bet on the high side of the ISM forecast of 50.7, up from 50.5 the previous month.  A couple of things to keep in mind:

1.  Industrial production firmed in recent months:

 

Those that thought the mid-year slowdown in production bolstered their case for an imminent recession need to head back to the drawing board.

2. Core durable goods orders are stronger:

 

A significant portion of the sharp slowdown this year has been reversed.  Eventually, this will impact the ISM index.

 3. The Chicago PMI surprised on the upside, gaining sharply to 55.6 from 50.0 in December.

 4. The Markit PMI has tended to the strong side in recent months:

All in all, it looks like manufacturing is shaking off some of those mid-year doldrums.  Consequently, I would expect the ISM index to come in ahead of expectations.  

 

Unsurprisingly, the Fed Stands Pat

I fell off the grid a couple of weeks ago, as seems to happen each time the teaching schedule ramps up.  All those projects and papers seem like such a good idea until they show up on my desk needing to be graded.  Between that and travel up and down I5 from one end of the state to the other, blogging suffered, to say the least.

There, however, is nothing like a Fed meeting to prod me back to the keyboard.  Alas, the outcome of this meeting was not entirely unexpected.  Policy remains unchanged, with only minimal changes to the FOMC statement.   The Fed followed the path of all analysts not of the Zero Hedge variety and largely dismissed the unexpected decline in 4Q12 GDP:

Information received since the Federal Open Market Committee met in December suggests that growth in economic activity paused in recent months, in large part because of weather-related disruptions and other transitory factors.

"Transitory" = "don't panic." We can try to read something in the change of this sentence:

The Committee remains concerned that, without sufficient policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions.

to:

The Committee expects that, with appropriate policy accommodation, economic growth will proceed at a moderate pace and the unemployment rate will gradually decline toward levels the Committee judges consistent with its dual mandate.

It sounds a little more optimistic, as though they are more comfortable they have policy about right.  This, in turn, would suggest that no one at the FOMC is really thinking about accelerating the pace of asset purchases.  Of course, I don't think anyone was expecting that anyway.  

There was no indication of setting thresholds for the end of large scale asset purchases.  Such discussions are likely in their infancy; for now, all we know is that the end will come before the unemployment rate hits the 6.5% threshold.  7.25%, as suggested by Boston Federal Reserve President Eric Rosengren?  Or a sustained period of substantial nonfarm payroll growth, as suggested by Chicago Federal Reserve President Charles Evans?  Of course, these two thresholds may be effectively equivalent.  

Kansas City Fed President Esther George (was she invited to the bloggers conference?) revealed herself as a true hawk with her dissent.  To be sure, not entirely surprising.  Still, I had wanted a little more confirmation before I labeled her a "hawk" rather than just having "hawkish leanings."  I got it.  Her reason:

Voting against the action was Esther L. George, who was concerned that the continued high level of monetary accommodation increased the risks of future economic and financial imbalances and, over time, could cause an increase in long-term inflation expectations.

The potential imbalances reason seems like the primary reason for her dissent, and falls in-line with her recent speech.  Such views are not uncommon - see A. Gary Shilling in Bloomberg, for example:

In desperation, monetary policies have become highly experimental. Huge government deficits are limiting the possibility of additional fiscal stimulus so policy makers are moving toward competitive devaluations. Meanwhile, low interest rates have spawned distortions as well as zeal for yield, regardless of risks.

I can't say that I am completely immune to such fears.  Indeed, it is difficult to ignore the reality that the last two expansions were correlated with what I would argue were asset price bubbles.  Moreover, I am somewhat interested in learning if the Federal Reserve could in fact stoke the fires of another asset bubble.  But I think all of this speculation might be just a bit premature.  We have an increasingly better idea of what an asset bubble looks like, and I don't think we are quite there:

Yes, premature.  Another 25% of GDP and I will likely start getting a little more nervous.  Speaks to my concern that we are leaning a little too hard of monetary policy and not enough on fiscal policy.  But that train has left the station.

 Bottom Line:  Like the Fed, I think it best to discount the GDP data.  I didn't really think the economy was growing over 3 percent in the third quarter, and I don't below it was really shrinking in the fourth quarter.  The underlying rate of growth is somewhere in between.  More slow and steady for the time being.  Slow and steady, though, has been enough to push the unemployment rate lower.  As 6.5 percent comes closer - or if we see a handful of 200k+ nfp numbers - the Fed will begin easing back on the asset purchases.  But I have trouble see that until mid-year at the earliest.  For now, policy is on hold. 

Is There a Big Inflation Mystery in Greece?

Tyler Cowen confuses me:

The rates of price inflation in Greece have been running in the range of 0.8% to 2%...It’s funny how many people pretend to understand what is going on here.  If Greece were seeing a stronger bout of price deflation, the situation would be much clearer.

This seems to me to be a case of trying to find a problem where none exists.  Greece consumer prices excluding energy:

What part of the deflation is not clear?  Seems like any inflation is being driven by energy costs:

So what going on in the energy sector?  Stories like this:

Greeks cutting back on household expenses are turning from oil to wood to heat their homes, but in turn are filling the night air with potentially hazardous pollutants, health care officials have warned.

The coalition government, under pressure from the EU-IMF-ECB Troika to impose more austerity measures, has pushed the price of heating oil to about 1.50 euros per litre by raising the tax on heating oil by 40 percent. Besides being a revenue-raiser, the government said the tax was meant to deter people from putting the oil in their cars instead of more expensive diesel.

And:

Greece raised electricity prices for households by up to 15 percent this year to help state-controlled power company PPC cover costs for transmission rights, the government said on Sunday...

...They come after a 9.2 percent average increase in prices last year.

PPC is the dominant player in the Greek energy market, and the country's EU and IMF lenders are pressing the government to make room for private companies. The company's tariffs are regulated by the state.

The Troika is remaking the energy sector, with the consequence of rising prices in a way that looks like a sectoral supply shock that is very obviously distinct from the demand side disturbance.  What exactly is the big mystery here?

Money and Debt, Continued

Paul Krugman responds to Steve Randy Waldman, noting that perhaps they are having a failure to communicate.  I hope I can bridge that gap (I suppose we can't discount the risk that I make it wider).  

Krugman begins:

What Waldman is now saying is that in the future the Fed will manage monetary policy by varying the interest rate it pays on reserves rather than the size of the conventionally measured monetary base. That’s possible, although I don’t quite see why.

Correct, a key point in this discussion is that the Fed can manage policy by interest on reserves.  Indeed, as Waldman notes, now that they have this tool, they are not likely to give it up.  I would say that the issue of "I don't quite see why" is irrelevant.  The basis of Waldman's argument is that they can, not that they will.  This isn't an argument about existing institutional arrangements, but potential institutional arrangements.  Krugman continues:

But in his original post he argued that under such a regime “Cash and (short-term) government debt will continue to be near-perfect substitutes”.

Well, no — not if by “cash” you mean, or at least include, currency — which is the great bulk of the monetary base in normal times.

I don't think Waldman means "cash" as currency, but both currency and reserves.  Such that reserves and government debt are essentially the same (more on this later).  At least, I think this is what Waldman is driving at, but clarification is needed (I find myself getting sloppy on the term "cash," so I can't really throw stones).  Back to Krugman:

But this could come across as word games. I think the way to get at the substance is to ask the question that set this discussion off: what happens if the US government issues a trillion-dollar coin to pay its bills?...

...But what happens if and when the economy recovers, and market interest rates rise off the floor?

There are several possibilities:

1. The Treasury redeems the coin, which it does by borrowing a trillion dollars.

2. The coin stays at the Fed, but the Fed sterilizes any impact on the economy, either by (a) selling off assets or (b) raising the interest rate it pays on bank reserves

3. The Fed simply expands the monetary base to match the value of the coin, an expansion that mainly ends up in the form of currency, without taking offsetting measures to sterilize the effect.

What Waldman is saying is that he believes that the actual outcome would be 2(b). And I think he’s implying that there’s really no difference between 2(b) and 3.

I think that Waldman is saying the outcome could be 2(b), but that depends on the relationship between the Treasury and the Fed.  But I do not believe he is saying it will be the same as option 3 because, as Krugman notes:

Option 3 would be inflationary; on the other hand, it would not lead to any increase in government debt. 

and Waldman is looking for a noninflationary outcome.  Krugman continues:

Option 2(b) would not be inflationary — but it would affect the federal budget. Why? Because the Fed’s additional interest payments would reduce the amount it can remit to the Treasury.

I don't think that Waldman ever said that the Fed's use of the required reserve tool would be costless to the Treasury.  This is an important point - that cost is what prevents the platinum coin from being simple debt monetization.  The platinum coin is not a free lunch.  Krugman is on the right path when he continues:

In fact, the effects of option 2(b) would be identical, both for the economy and for the federal government’s cash flow, to option 1. Either way, the budget deficit would be enlarged by the payment of interest on $1 trillion of borrowing. In that sense, the Treasury will have redeemed the coin, for practical purposes, even if it never redeems the coin.

Compare this to what I said:

The Fed has a portfolio of bonds which is a indirect transfer from Treasury which in turns allows it to pay interest on reserves.  Lacking such a portfolio, the Fed would need to receive a direct transfer from the Treasury to pay interest on reserves.  Operationally, these are the same.  As long as both have the same objective function, it makes no difference if the Treasury's transfer goes through the middleman of a bond or just directly to the Fed.

As Krugman correctly notes, in this world the Treasury, not the Fed, is effectively paying the interest on reserves.  Thus, we really shouldn't consider the excess reserves as monetary base (with the connotation that these reserves are simply cash ready to be lent out), but as psuedo-government debt (and I thank Gavyn Davies for pointing this out to me, so I hope I got his meaning correct). 

In the old world, the banks held an asset called government debt that paid interest.  In the new world, they hold an an asset called excess reserves that pay interest.  And in both cases the entity paying the interest is the Treasury, either directly or indirectly.  Both cases are noninflationary, but one relies on pieces of metal with a number on them (platinum coins), while the other relies on pieces of paper with a number on them (government debt).  

Now, back to Krugman's  statement: "That’s possible, although I don’t quite see why."  Which is to say, why should we believe it would be institutionally possible to issue platinum coins rather than debt?  This gets to my point:

But what if the Treasury does not have the same objective function, does not want higher interest rates, and thus does not want to transfer the resources to the Fed?  What claim does the Fed have on the Treasury to force it to act?  

Somewhere in this space is why we have come to accept the importance of an independent central bank. 

I think if Krugman and Waldman have a failure to communicate, it is because the latter is not shackled to the current institutional structure.  Waldman is describing a system in which the relationship between the fiscal and monetary authorities is fundamentally different than that of the current system.  This is evident when Waldman says:

What used to be “monetary policy” is necessarily a joint venture of the central bank and the treasury.

My takeaway from Waldman is that under some institutional structures, there is little difference between platinum coins and government debt (or because we have debt we have a particular institutional structure?) In effect, the the zero-bound issue and platinum coin debate have forced us to think down paths that blur the lines between fiscal and monetary policy.  The longer we are in at the zero-bound, the more we will challenge the existing status-quo.

Alternatively, this can also be simply a misunderstanding on Krugman's part if he believes that Waldman is saying that we can use platinum coins to literally monetize deficit spending with neither budgetary nor inflationary implications.  I don't think Waldman is thinking this, and if he is, then I think he would be wrong.   

Perhaps this clears up this issue, at least a little bit.  Or perhaps not (see Stephen Williamson for another take).  In any case, I hope I have not mangled either author's thoughts too badly.

A Trap of My Own Making

Steve Waldman at interfluidity catches me in a trap of my own making.  Waldman focuses on this quote of mine:

Ultimately, I don't believe deficit spending should be directly monetized as I believe that Paul Krugman is correct - at some point in the future, the US economy will hopefully exit the zero bound, and at that point cash and government debt will not longer be perfect substitutes.

Waldman has two responses.  The first:

Consistent with the “Great Moderation” trend, the so-called “natural rate” of interest may be negative for the indefinite future, unless we do something to alter the underlying causes of that condition. We may be at the zero bound, perhaps with interludes of positiveness during “booms”, for a long time to come.

I suppose this is why I added the modifier "hopefully."  I am no stranger to concerns that the economy is locked on the zero bound for a long, long time.  

The second response is this:

What I am fairly sure won’t happen, even if interest rates are positive, is that “cash and government debt will no[] longer be perfect substitutes.” Cash and (short-term) government debt will continue to be near-perfect substitutes because, I expect, the Fed will continue to pay interest on reserves very close to the Federal Funds rate.

I call this a trap of my own making because I was headed in this direction:

If you follow Ip's analysis through to its logical conclusion, then why should the Treasury issue debt at all?  Why not just issue platinum coins? Could cash and government debt combine to serve the same functions together that they serve separately?  Consider the disruptiveness of that outcome to the status quo.

Compare to Waldman:

Printing money will always be exactly as inflationary as issuing short-term debt, because short-term government debt and reserves at the Fed will always be near-perfect substitutes. 

So, why did I back away from that direction?  Because it ended me up at the same place as Waldman:

What used to be “monetary policy” is necessarily a joint venture of the central bank and the treasury. Both agencies, now and for the indefinite future, emit interchangeable obligations that are in every relevant sense money.

A key part: "joint venture" disrupts the status quo.  The ability to pay reserves and the subsequent equivalency of debt and cash moves us one step closer to the elimination of monetary policy independence.  Coordination is necessary not only, as I have argued, conditionally, but always.  This works - by works I mean does not generate hyperinflation - so long as both share the same objective function, which I think they do at the zero bound (even if they pretend that don't have the same objective function).  But it is not evident that this will be the case away from the zero bound, which is why we place value on central bank independence.  

I think what I had in mind is this (and I admit that I am not wed to this, a little open-microphone now):  The Fed has a portfolio of bonds which is a indirect transfer from Treasury which in turns allows it to pay interest on reserves.  Lacking such a portfolio, the Fed would need to receive a direct transfer from the Treasury to pay interest on reserves.  Operationally, these are the same.  As long as both have the same objective function, it makes no difference if the Treasury's transfer goes through the middleman of a bond or just directly to the Fed.  But what if the Treasury does not have the same objective function, does not want higher interest rates, and thus does not want to transfer the resources to the Fed?  What claim does the Fed have on the Treasury to force it to act?  

Somewhere in this space is why we have come to accept the importance of an independent central bank.  Indeed, this is a concern should the Fed need to pay interest on reserves that exceed the interest earned on its bond portfolio.  Then the Fed would need to turn to the Treasury and say "Remember when we paid you $89 billion?  Well, we need some of that back now."  

Ultimately, though, I have to agree with Waldman when I allow for the two authorities to have the same objective function.  This is another way of saying that one side effect of the zero bound is the blurring of what many thought were sharp lines between fiscal and monetary authorities. 

On The Disruptiveness of the Platinum Coin

Apparently fiscal and monetary cooperation is alive and well - the US Treasury and the Federal Reserve conspired to kill the platnium coin idea.  In retrospect, we should have seen this coming.  As the debate continued, it became increasingly evident that the platinum coin threatened the conventional wisdom in very deep and profound ways.   It was a threat that could not be endured by Washington.

This realization hit me this morning, working on my last piece.  Begin with the effectiveness of monetary policy at the zero bound.  Or, more accurately, the lack of effectiveness as the Federal Reserve is swapping one zero-interest asset for another.  Rarely do we take this to its logical conclusion for fiscal policy:  If there is no difference between cash and Treasury bonds, why should we issue bonds at all?  Why not simply issue cash?  In other words, at the zero bound, what is the argument against monetizing deficit spending?

Indeed, the lack of any difference explains how Japan can sustain massive fiscal deficits year after year.  At the zero bound, cash and government debt are the same thing.  We would assume that as long as inflation was not a concern (which it wouldn't be at the zero bound), the fiscal authority could issue as much cash as it wants, so why couldn't it issue as many bonds as it wants?  After all, at the zero bound the two are equivalent.  Hence Japan continues to defy predictions of doom despite ongoing debt issuance.

Carrying the argument further, the illusion of a difference between cash and debt at the zero bound is counterproductive because it prevents the full application of fiscal policy.  Fears about the magnitude of the government debt prevent sufficient fiscal policy, but such fears are not rational if debt and cash are perfect substitutes. If cash and debt are the same, the fiscal authority should prefer to issue cash if debt concerns create a false barrier to fiscal policy.  Still, I would argue that this is best done in cooperation with the monetary authority.  Note that this is not really a new idea, as then Governor Ben Bernanke drew a similar conclusion with regards to Japan:

However, besides possibly inconsistent application of fiscal stimulus, another reason for weak fiscal effects in Japan may be the well-publicized size of the government debt...In addition to making policymakers more reluctant to use expansionary fiscal policies in the first place, Japan's large national debt may dilute the effect of fiscal policies in those instances when they are used....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.

And then we come to the platinum coin, which threatened to expose the illusion that cash and debt are different at the zero bound.  By extension, the platinum coin threatened to expose as folly any near-term deficit reduction plan.  If you could issue a coin to support near term spending without inflationary consequences, what exactly is the rational for tighter policy now?  There is none - but that would run directly contrary to the conventional wisdom among Very Serious People on both sides of the aisle that the debt needs to be addressed right now.  

And just think about what it would mean for the Fed if it became evident that, even if only temporarily at the zero bound, deficit spending could be monetized with no impact on inflation.  The lines between monetary and fiscal policy would blur further, threatening the existing state of affairs in Washington.  Monetary policymakers would face an increasingly hard time defending their need for independence as akin to an Eleventh Commandment.

Ultimately, I don't believe deficit spending should be directly monetized as I believe that Paul Krugman is correct - at some point in the future, the US economy will hopefully exit the zero bound, and at that point cash and government debt will not longer be perfect substitutes.  Note that Greg Ip disagreed with this point:

I disagree. The Fed does not have to sell its bonds, or the $1 trillion coin, to control inflation (though it may do so anyway). It only needs to retain control of interest rates, and that does not depend on the size of its balance sheet.

Ip argues that interest on reserves gives the Fed the power to control interest rates, and consequently the power to control inflation, regardless of the size of the balance sheet.  If you follow Ip's analysis through to its logical conclusion, then why should the Treasury issue debt at all?  Why not just issue platinum coins? Could cash and government debt combine to serve the same functions together that they serve separately?  Consider the disruptiveness of that outcome to the status quo.  

Bottom Line:  The platinum coin idea was ultimately doomed to failure because neither the Federal Reserve nor the Treasury could allow for even the remote possibility it might be successful.  Its success would not just alter the political dynamic by removing the the debt ceiling as a threat.  The success of a platinum coin would fundamentally alter the conventional wisdom about the proper separation of fiscal and monetary policy and the need to control the debt immediately.  

Safe Assets and the Coordination of Fiscal and Monetary Policy

Kansas City Federal Reserve Bank President Esther George considers the long-run consequences of Federal Reserve policy:

But, while I agree with keeping rates low to support the economic recovery, I also know that keeping interest rates near zero has its own set of consequences. Specifically, a prolonged period of zero interest rates may substantially increase the risks of future financial imbalances and hamper attainment of the FOMC’s 2 percent inflation goal in the future.

A long period of unusually low interest rates is changing investors’ behavior and is reshaping the products and the asset mix of financial institutions. Investors of all profiles are driven to reach for yield, which can create financial distortions if risk is masked or imperfectly measured, and can encourage risks to concentrate in unexpected corners of the economy and financial system...The push toward increased risk-taking is the intention of such policy, but the longer-term consequences are not well understood.

We must not ignore the possibility that the low-interest rate policy may be creating incentives that lead to future financial imbalances. Prices of assets such as bonds, agricultural land, and high-yield and leveraged loans are at historically high levels. A sharp correction in asset prices could be destabilizing and cause employment to swing away from its full-employment level and inflation to decline to uncomfortably low levels. Simply stated, financial stability is an essential component in achieving our longer-run goals for employment and stable growth in the economy and warrants our most serious attention.

Brad DeLong wonders:

The Fed's current Quantitative Easing ∞ program involves its buying risky bonds--thus diminishing the pool of risky assets that the private sector can hold. Esther George objects because… it does not make complete sense to me...Because there is less in the way of risky assets for the private sector to hold--and because that pushes prices of risky assets up and returns on risky assets down--QE ∞ actually makes private-sector portfolios riskier? Is that the argument?

I think DeLong is looking at a continuum of assets from safe to risky, where cash anchors the safe end of the continuum.  Right next to cash is the somewhat riskier Treasury security.  Thus by exchanging cash for Treasury securities, you by definition must be removing risk from the continuum, and thus the public's portfolio is now less riskier.

But, as he notes, this is obviously not how George views the situation.  And, note that George claims that the intention of Fed policy is in fact to push people into riskier portfolios, which implies that the Fed believes that they are in fact making the public's portfolio more, not less, risky.  This implies that DeLong's view is not just in opposition to George's, but to that of the majority of policymakers as well.

I think a way you can explain George's position if you consider Treasuries as less risky than cash.  At first, this sounds crazy, but if you assume there is no default risk (which I don't think there should be if you can print currency of the same denomination as the bond), then the Treasury bond may be perceived as a safer because it provides some return.  Assuming no default risk, for any given inflation rate, the Treasury bond will thus be a safer store of value.  If you viewed the world from this perspective, then the Fed is increasing riskiness of the public's portfolio.

This, however, is not how I think the Fed considers the situation.  I think the Fed tends to view the public's desired cash holdings as roughly constant (although the rise in deposits would call this into question).  If by QE the Fed swaps out some of the safe Treasury securities for cash, the public, not wanting to hold anymore cash, takes the cash and, by default, purchases riskier assets, and thus is left with holding a portfolio of riskier assets. George believes this disrupts the natural order of things by creating financial market distortions.   

In any event, I tend to take this in a different direction from here.  George appears to be saying that the Fed is eliminating (more accurately, removing) the safe assets that the public wants to hold.  Suppose that this is true.  Does this mean that the Fed should reverse policy to increase the proportion of safe assets in the public's hands?  Or does it mean that another agency - perhaps a fiscal authority, hint, hint - should take action to increase the proportion of safe assets in the public's hands?  

Once again, we come back to the issue of coordinating monetary and fiscal policy.  If the public has a strong demand for noncash safe assets, monetary policy has something of a secondary role by providing an accommodative environment by which the fiscal authority can issue those assets. If the proportion of safe to risky assets is not "correct", the the fiscal authority should have a role in correcting that imbalance.  In this world, then, it is not really the actions of the monetary authority that is creating the financial sector imbalances that concern George.  It is the lack of action by the fiscal authority that creates those imbalances.  George should be criticizing the fiscal authorities, not the monetary authority.

In other words, if a recession is the result of the public shifting to safe assets, the Fed is trying to respond by taking away the option of safe assets, leaving only risky assets.  Instead, the Fed should view their role creating an environment (making clear that default is not an option) that allows the fiscal authority to issue more safe assets.

All of this, however, suggests that fiscal policy has a much greater role in stabilizing economy activity than conventional wisdom would hold.  I suspect, however, that thinking along these lines is anathema to Federal Reserve officials who maintain that stabilization policy is the domain of monetary policy only.  But if in fact there needs to be greater cooperation, and instead we continue to rely solely on monetary policy, then we will continue to experience less-than-satisfactory economic outcomes which will eventually endanger the cherished independence of central banks.

In short, I don't think you can have a discussion about the influence of monetary policy on the riskiness of the public's portfolio without including some discussion about the role of the issuer of those safe assets, the fiscal authority.

More on Central Bank Independence

Central bank independence is a hot topic right now.  Two obvious themes are in play.  First, should central banks always be independent?  Second, are the supposed threats to independence widespread?

On the first topic, Izabella Kaminska offers this:

Nowadays, the idea of not having an independent central bank is seen as being a bit backward. One could even say that central bank independence is widely accepted as the optimum set-up for any country’s monetary system, a reflection of its developmental status.

“Independent central bank? Check.”

“This country must be civilised. ”

Yet, can we really be so absolute about the matter?

In Raiders of the QE surplus — a post that challenged the controversy regarding the UK Treasury’s so-called raid of Bank of England surpluses — David and myself proposed that central bank independence must not be treated so resolutely. We argued, in fact, that any central bank’s status should be determined by the economic context it finds itself in.

I tend to agree.  I don't recall there being an Eleventh Commandment to the effect of "Thou shalt always grant independence to the monetary authority."  Ultimately, the central bank serves the public, and the latter only grants independence if the former is adequately meeting the needs of the public.  In other words, central bank independence is ultimately tied to job performance.  

With this in mind, note this Reuters piece by Leika Kihara:

Abe had run his campaign with a relentless focus on economic policy and had called on the Bank of Japan (BOJ) to take drastic steps to end the nation's long bout of deflation, or else face a radical makeover at the hands of parliament.

The vote had become an unexpected referendum on the BOJ itself, and the bank had lost.

Senior officials concluded that to preserve the BOJ's scope to act in a future crisis, it needed to move quickly to show it recognized reality, according to people familiar with the hurried deliberations. Abe had won a mandate for more forceful monetary easing, and Japanese taxpayers were frustrated with an economy slipping back into its third recession in five years.

Kihara suggests that what many perceive as the loss of independence is the Bank of Japan's response to the will of the people:

"The LDP's win was just too big, and it won an election calling for a 2 percent inflation target. If that's the will of the people, the BOJ must respect that," said a source familiar with the central bank's thinking. "Otherwise, the BOJ could lose everything, including its independence."

The counterargument is that the Bank of Japan is fooling itself; a response to political pressure, by the fiscal authority or the electorate, is simply a loss of independence.  More accurate, in my opinion, is that the Bank of Japan is choosing the avenue of least restraint - either willingly acquiesce to political pressure and retain some modicum of self-respect, or suffer the humiliation of have their independence seized from them by legal decree.  Can't blame them for taking the first option. 

Gavyn Davies responds to charges that other central banks are losing their independence, coming to the opposite conclusion:

It seems to me that this is a very premature conclusion. While there is no denying that this is indeed the objective in Japan, the direct opposite seems to be happening in the rest of the developed world.

Davies' first point is:

First, it is argued that the central banks are now operating far outside the realms of traditional monetary policy, and have crossed the border into territory that has always been deemed to be clearly “political” in western democracies....I would point out that none of the recent actions of the central banks, including the 2008 bank rescues and the subsequent credit easing, have been contrary to the wishes of elected officials, such as the US Treasury secretary, the UK chancellor, or a clear majority in Congress. As a result, there are very few signs that the political process sees any urgent need to re-assert any control over central bankers in these areas. Obviously, this could change if central bankers were to become more hawkish in ways that could prove politically unpopular, but to date there is little sign of that happening either. 

Indeed, one can argue that, aside from the Bank of Japan, the last few years have strengthened the notion of an independent central bank (I made an argument to that effect here regarding the European Central Bank).  And notice were Davies ends up - in the current environment, the lose of independence is most likely to come from being excessively hawkish.  With inflation low, some elements of Congress might publicly lament about runaway monetary policy, but few would actually take the chance of derailing what recovery we have by undercutting the central bank in the pursuit of tighter policy.

Davies' second point:

The second reason given for the inevitability of political control over the central banks concerns the relationship between fiscal and monetary policy....politicians will “order” the central bank to expand the monetary base to finance the budget deficits. This will hold down the public debt ratio, and if it causes inflation to rise, that might be a welcome side effect....This has now happened in Japan, but it has taken a full two decades of failing economic activity to get there. And while the outcome in Japan will presumably have powerful effects on opinion elsewhere in the world, the current situation is a long way from fiscal dominance over the central bankers. 

Again, the key is "failing economic activity."  If central bankers can't or won't due their jobs, they will lose their independence, period.  Davies then points out something that is often missed:

In the US, for example, the Fed has, entirely voluntarily, announced an open-ended programme of bond purchases, which will be continued until unemployment falls substantially. Furthermore, the Fed chairman has hinted that he thinks that, for a while, fiscal policy should be more supportive of economic activity.

I made similar comments to Pedro DaCosta at Reuters, although I think more forcefully.  Congress and the President are remarkably tone deaf with regards to the message from the Federal Reserve, which is essentially "issue as much debt as you want; we won't stand in the way as long as inflation is under control."  Federal Reserve Chairman Ben Bernanke has opened the door to implicit cooperation, but fiscal authorities remain afraid to enter.

Which brings me to Greg Ip, who argues against the platinum coin because it would infringe upon the Fed's independence (and I thought I was going to make it through the year without writing something on the platnium coin).  How he gets there is interesting.  Ip first argues that the platinum coin and the subsequent (although not immediate) increase in the monetary base need not lead to an increase in inflation as long as the Fed has the ability to control interest rates:

...in 2008, Congress gave the Fed authority to pay interest on reserves.  Because banks should not lend reserves to each other for less than they can get from the Fed, this restores the Fed’s control over interest rates regardless of the size of its balance sheet, and thus over inflation...What this means is that while the platinum coin option expands the Fed’s balance sheet and, ultimately, the monetary base, it has no implications for inflation, even if the Treasury never buys back the coin.

So the platinum coin does not cause inflation because the Fed has a tool to control interest rates.  Ip continues:

But while the economic consequences for the Fed are benign, the political consequences are not. As I noted earlier, the Fed buys coins in response to demand from commercial banks (the process is explained here). Banks won’t want a $1 trillion platinum coin, so the Fed will only buy the coin if Treasury forces it to. The Treasury, in “depositing” its coin at the Fed, is in reality ordering the Fed to print money. And if Treasury doesn't take the coin back, the money stays printed. 

The economics may be the same as QE; as Mr Krugman notes, coins, like bonds, are liabilities of the central government. But the politics are utterly different. We have a central bank to separate fiscal from monetary policy. The Fed implements QE when it has decided that’s the best way to carry out its monetary policy objectives. Buying a coin solely to finance the deficit is monetizing the debt, precisely the sort of thing central bank independence was meant to prevent. How could any Federal Reserve chairman justify cooperating in such a scheme, in particular since the Fed would be taking the White House’s side in a fight with Congress over a matter of dubious legality?

Ip initially claims that the platinum coin does not cause inflation, which is good, but it is monetizing the debt, which is bad.  But how can both of these things be true?  I think there is a logical error here.  Because if, as Ip claims, the platinum coin does not lead to inflation, why should the Fed care about how government spending is financed?  In Ip's analysis, whether government spending is financed by debt or platinum coins is irrelevant.  Indeed, it is strongly irrelevant in Ip's analysis - he doesn't just say that there is no difference at the zero bound, he says there is always no difference (..."no implications for inflation") as long as the Fed can pay interest on reserves (..."regardless of the size of the balance sheet").

If the Fed has control over interest rates, and thus control over inflation, then how can the platinum coin infringe on the Fed's independence?  The Fed is not charged with stopping monetization.  It is charged with price stability.  We don't care about monetization itself; we care about monetization because it has the potential to generate hyperinflation, which Ip says we don't have to worry about because the Fed can control interest rates.  Thus there is no threat to Fed independence.  In short, no one is ordering the Fed to raise the inflation target; it remains free to conduct monetary policy with the objective of 2% inflation.

Furthermore, turn the situation on its head and say that what if push came to shove and the Administration was forced to choose between issuing the platinum coin or defaulting on the debt?  What would be the consequences of the Fed asserting its independence by not accepting the coin?  Financial chaos as the world's safest asset becomes unsafe leading to a massive deflationary shock?  For this the Fed would lay claim to its independence?  Indeed, this is exactly the sort of thing that gets a central bank stripped of its independence.  See Davies above.  Either retain its independence by willingly accepting the coin, or be complicit in triggering a global recession which, in the process, would cost it its independence eventually.  Ultimately, the Fed would have no choice to accept the coin.

Simply put, at some level lofty ideas about strict central bank independence are like those of moral hazard, largely talk around the water cooler.  When the economy is on the line, moral hazard concerns will pale in comparison to the need to saving the financial system, as too would the idea of independent central banks.  The old adage is true:  There are no atheists in foxholes.

Bottom Line:   The idea of central bank independence has always been more of an illusion than reality.  Ultimately, the monetary authority is a creation of the electorate.  It retains the illusion of independence so long as its actions are consistent with the conventional wisdom of the public.  At this point, only the Bank of Japan is threatened with such a loss of independence.  Otherwise, fears are as of yet unfounded.  

What's Good For the Goose...?

Via a tweet from Edward Harrison, Germany is preparing secret plans - not so secret anymore - to implement a wide-ranging austerity program after the elections.  From Spiegel:

The government in Berlin is living in a dual reality. Strategists in the center-right coaliton parties are planning to enhance benefits for families, pensioners and the long-term unemployed in a bid to woo voters in the upcoming elections.

 By contrast, due to the economic slowdown, experts in Schäuble's ministry are anticipating an entirely different scenario: The next government -- no matter who will be chancellor and which parties will be in power -- won't be able to boost spending. Instead, it will have to impose rigorous spending restraint.

According to the recommendations made by Schäuble's team...Germany will have to drastically increase taxes and make painful cuts in social services over the coming years.

These ideas don't fit with the current political climate in Germany...Schäuble nevertheless feels that his experts' forecasts are realistic. He has expressly approved their proposals and ordered them to continue to work on the cost-cutting program. At the same time, he has ordered strict secrecy to avoid any adverse effects on his party's campaigns for the upcoming state election in Lower Saxony in January and the general election in the fall of 2013.

Speigel describes Schäuble's plan as:

...nothing less than the most comprehensive austerity program in postwar German history.

But most amazing is the appeal to pro-cyclical fiscal policies:

The proposals from Schäuble's ministry serve to tighten a regulation that has only been enshrined in the German constitution for the past few years: the so-called debt brake, which calls for the German federal government to "maintain a nearly balanced budget" starting in 2016.

The government will still be able to take out loans to some extent. In 2016, for instance, it will be allowed to borrow some €10 billion. However, Schäuble and his staff say that Germany should not completely exhaust this scope for borrowing. They want a safety buffer...

 One of the examples that they cite is "a sharp economic downturn." If the economy collapses, as it did in the wake of the financial crisis in 2009, experience has shown that public coffers come under considerable pressure...

This can have a devastating impact on state finances. Following the most recent recession, government debt soared from 65 to nearly 83 percent of gross domestic product (GDP). Schäuble's experts say that the country cannot withstand another similar increase in public debt and conclude that it's time to take appropriate countermeasures.

Attempting to control, or even reduce, a fiscal deficit as an economy slips into recession is economic suicide, yet that appears to be the only path European policymakers know.  Indeed, part of the "need" for this austerity plan is the theory that what is good for the goose is good for the gander:

The paper by the Finance Ministry officials contains a further admission. The next finance minister will have to make up for what Schäuble has failed to accomplish. Merkel's most important minister forced half of Europe to submit to austerity measures while the Germans were spending money hand over fist at home.

In short, Germany looks set to further entrench the Continent's move toward an "austerity union," not a fiscal union, condemning the people of Europe to weak growth and high unemployment.  And, as a reminder, the path of interest rates in Germany:

Absolutely no reason to think that a massive austerity plan is necessary.  Completely opposite of the spike in rates that followed the 1990 reunification.  Then spending control was needed in the wake of increased expenses to combine the East and the West.  But interest rates are clearly indicating that completely opposite policies are now in order.  Apparently policymakers only listen to the signals of the currently nonexistent bond market vigilantes.

Bottom Line:  German plans for further austerity indicate that fiscal policy remains a downside risk for the European economy.