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January 22 2010

Bernanke's Reconfirmation Chances Fall

I didn't want to be right about this (video from 12/17/2009):

From Market Talk:

...It seems hard to believe that Congress would not approve the President’s choice for the Federal Reserve, but the uncertainty of it is hanging in the air, after the confirmation vote was delayed to next week. Some time next week. The Fed chairman’s term expires Sunday.

Let’s just say it wouldn’t exactly send the right message to the rest of the world, and the bond market especially, should Congress vote Bernanke out. You have to expect a good amount of this is just posturing, something Congress does better than any other group on the planet. But, you know, wars tend to start with a single, errant shot.

The latest spanner in the works came from Nevada’s Harry Reid, who said he’s still undecided about how to vote. Reid happens to be the Senate’s Democratic leader, so his voice carries some amount of water. The odds are still that he gets reappointed — a senior Senate Republican aide said it’s not an issue as at least four GOPers intend to vote for him — but even the fact that it’s being discussed just a week before his term ends should give you some indication of just how unsettled things are these days....

What a great time to give financial markets a big dose of uncertainty along with the potential shock of replacing the Fed chair.

Update: What happens if he is not reappointed before his term ends on 1/31/2010?:

The chairman and vice chairman of the FOMC are chosen separately from the main Board of Governors. At the first meeting of the year, the committee members vote for the two positions. The chairman of the Board is usually named chairman of the committee and the president of the New York Fed is traditionally the vice chairman. At next week’s meeting, the FOMC is expected to vote for Bernanke and William Dudley of the New York Fed to take those positions for 2010. Though Bernanke’s term as chairman of the Fed’s Board is up on Jan. 31, he retains his position as Fed governor and remains on the FOMC. As long as he stays on the Board of Governors, he can lead the rate-setting committee.

But things won’t be as stable at the Board of Governors. When Bernanke’s term expires on Jan. 31, Vice Chairman Donald Kohn is set to become acting chairman. Kohn remains in that position until Bernanke or another nominee is confirmed.

January 21 2010

John Taylor Interview

John Taylor answers a few of my questions in one part of an interview at Big Think (transcript and video of entire interview, video broken into parts). My biggest disagreement with his answers comes when he says it's time to start "letting interest rates rise appropriately and reducing the amount of quantitative easing," a theme that appears repeatedly in his answers to my questions and to those submitted by others. It's far too early for that, and if anything the Fed should be doing more to combat the slow recovery of labor markets. Where we agree the most is when he says the most important unresolved questions in monetary economics are about the connections between the financial sector and monetary policy. [As a lead-in, Dean Baker asks the first question below, and my questions follow. Questions were emailed in advance of the interview.]:

...Question: Would you advocate an aggressive strategy of quantitative easing?

John Taylor: Well, the question is; given that the Taylor Rule has large negative interest rates right now, would I want more quantitative easing? First of all, I don't think the Taylor Rule does show a large negative interest rates right now. That's kind of a myth. The Taylor Rule is pretty simple. It just says, the interest rate should equal 1 1/2 times the inflation rate, plus 1/2 time the GDP gap, plus 1. Well, if you plug in reasonable estimates for what inflation is and what the GDP gap is, I get a number that’s pretty close to zero. Not minus four, minus five, not numbers like that. So, in fact I would say the amount of quantitative easing could be reduced right now. I hope it is reduced in a gradual way. Some of the mortgage purchases I think could be slowed down and then actually reversed.

So, the question is a good one, and I'm glad it was asked because there is a lot I think, of misinformation out there about what the Taylor Rule says. The Taylor Rule is very simple, as I just mentioned. You can say it in a sentence and you plug in the numbers, you don't get minus five, minus six percent. You get something much closer to zero where the interest rate is now. Now, that of course has implications going down the road because it says, to the extent that real GDP picks up; I hope it does, or if inflation picks up; hope it doesn't. But if either of those occur, then you'd have to see interest rates starting to move above the zero to 25 basis point range. And if we don't then we're going to be back in the same kind of situation we were in 2002 through 2004, and that of course could begin to induce bubbles and we certainly don't want that to happen.

Question: Would quantitative easing speed the recovery?

John Taylor: No. I don't think quantitative easing at this point would effectively smooth the recovery. I think right now, based on historical experience, the interest rate is about where it is, it's not that we don't need a lot of quantitative easing. We've had some and I think the job of the Fed now is to bring it back. They're talking about doing that, which is good. But I think, for me, the most important thing now for policy to have a good recovery is to reduce this tremendous amount of uncertainty that exists with both monetary policy and fiscal policy and the uncertainty for monetary policy is, we don't know how rapidly the quantitative easing will be reversed. We don't know what's going to happen with interest rates. There is a lot of questions there. So I’d say, get back to the things that were working during the great moderation period, the '80's and '90's primarily, and that means letting interest rates rise appropriately and reducing the amount of quantitative easing; getting back to where it was through most of policy of the '80's and '90's.

Question: What is the most important unresolved question in monetary economics?

John Taylor: I think the most important unresolved question of monetary economics is the interaction between the financial sector and monetary policy. There's been lots of thinking about it over the years, some of it actually done here at Stanford, e.g. Gurley and Shaw. A lot of it done by Tobin at Yale, Ben Bernanke has done some of it. But I think the most promising part is the combination of the newest work on pricing of bonds and securities. A lot of it's done by [people who] combine that with monetary policy so that you have a sense of what's going to happen to longer term rates when the short rate is reduced. What's going to happen to credit flows and how much are credit flows going to impact the economy?

This crisis has been very clear in demonstrating that more work on the connection between the financial economics and monetary policy is needed. In fact, there's still a lot of questions out there in policy about whether the financial markets performed well, or not. It seems to me, if you look at them, they absorbed a tremendous shock from policies. It's effectively a panic induced by some ad hoc policy changes and they responded quickly and they responded in a way which has been smooth, as the markets themselves. The institutions, the financial institutions of course, have been in great difficulty, but the markets themselves have worked well.

So, to me, where we should focus our attention really is this connection between the financial markets, including the financial institutions and the monetary policy itself.

Question: How important is Fed independence?

John Taylor: I think we need to have both independence and accountability. They go together. It's not one or the other. So, in answer to the question, how important is Fed independence? I say it is very important, but it needs to be matched with accountability.

A lot of the concerns that you're seeing in the Congress, in the country about the Fed; the Ron Paul bill, I think that's a reaction to what looks like a very interventionist action by the Federal Reserve. Not a lot of descriptions of how it actually occurred, there's no reports on what's called a Section 13-3 Intervention. Section 13-3 of the Federal Reserve Act which allows for such actions, but there’s very little reporting on how it actually took place.

So, I think the best thing the Fed can do to get back some of its independence, and quite frankly, I think it's lost a little bit in this crisis. The best thing it can do is be very accountable about some of the interventions in Section 13-3, that's where most of the transparency concerns exist at this point, and then of course to emphasize that the policy that has worked most well was the policy of the '80's and '90's and when we got off track on that, things deteriorated.

I think that some recognition of interest rates being so low for so long in the '02 to '04 period by the leadership would be very important. It’s discussed in the Fed system, is discussed by other central banks, it's discussed quite widely, but some recognition of that seems to me would be important in terms of bringing back some of the independence that the Fed lost.

So, I think that independence, just to summarize, is really important, it's essential, we've seen evidence over time about how it is. But it has to be matched with a strong sense of accountability to the Congress and to the American people of what the Fed is actually doing. ...

January 20 2010

"Stimulus Too Small"

I agree with Brad DeLong:

Stimulus Too Small, by Brad DeLong, WSJ: Fourteen months ago, just after Barack Hussein Obama's election, most of us would have bet that the U.S. unemployment rate today would be something like 7.5%, that it would be heading down, and that the economy would be growing at about 4% per year. ... Well, we have been unlucky. Unemployment is ... not 7.5% but 10%. More important, perhaps, is that the expectation is for 3% real GDP growth in 2010.
That leaves us with two major questions: First, why has the outcome thus far been so much worse than what pretty much everyone expected in the late fall of 2008? And second, why is the forecast ... for growth so much slower than our previous experience with recovery from a deep recession in 1983-84?
I attribute the differences to four factors:
First, the financial collapse of late 2008 did much more damage than we realized... The shock now looks to have been about twice as great as the consensus in the fall of 2008 thought. ...
And that leads us to Factor No. 2. The Obama administration envisioned a $1 trillion short-term deficit-spending..., had the administration known how big the problem would turn out to be, it would have sought a $2 trillion stimulus. And what did we get once Congress got through with it? A $600 billion stimulus—about one-third of what we needed.
Making matters worse: The stimulus was not terribly well targeted. In an attempt to attract Republican votes, roughly two-fifths of it was tax cuts. Such temporary cuts are ineffective... (It also failed to win any extra votes.) Roughly two-fifths ... was infrastructure and other ... direct federal spending. But it is hard to boost federal spending quickly without wasting money, and those projects that are shovel-ready are not terribly labor intensive.
Meanwhile, the most-effective stimulus would have been aid to the states... But senators don't want to hand out money to governors; the governors then tend to run against the senators and take their jobs away.
This problem with both the quantity and quality of the stimulus is tied up with the third factor: that the Obama administration declared victory on fiscal policy with the American Recovery and Reinvestment Act ... and then went home.
There was no intensive lobbying for a bigger program,... no attempts to expand the stimulus programs... The background chatter is that trying for more deficit spending would have been fruitless, given the broken Senate...That background chatter is probably right. But ... there is still the Federal Reserve. And that's where the fourth factor comes in.
It is true that as far as normal monetary policy is concerned, the Federal Reserve was tapped out... But there is more in the way of extraordinary monetary policy that could have been attempted in 2009—including inflation-targeting announcements, the taking of additional risky assets out of the pool to be held by the private sector, larger operations on the long end of the yield curve.
And I must confess that what the Federal Reserve thought and did in 2009 remains largely a mystery to me.

January 19 2010

Bernanke Asks GAO to Audit the AIG Bailout

Ben Bernanke tries to overcome some of the Fed's negative publicity:

Bernanke Invites GAO to Audit AIG Bailout, by Sudeep Reddy: In a bid to soften congressional criticism, Federal Reserve Chairman Ben Bernanke on Monday invited the Government Accountability Office to audit the central bank’s involvement in the U.S. rescue of American International Group Inc. In a letter to Acting Comptroller General Gene Dodaro, Bernanke said the Fed would provide “all records and personnel necessary” for the auditing arm of Congress to review the rescue. ...
The invitation from Bernanke does not change existing policies about congressional reviews of the Fed. The GAO already has authority to review the central bank’s involvement in the AIG bailout, along with other company-specific rescues by the Fed and Treasury Department. ...

Most people won't realize Bernanke is asking for something the GAO could have done on its own (though perhaps with less cooperation), e.g. the LA Times does not even mention this, so the politics work in the Fed's favor. And it does send the message that the Fed doesn't think it has anything to hide.

January 15 2010

Fed Watch: It's Not About Interest Rates Yet

Tim Duy looks at the Fed's likely interest rate and balance sheet actions in the months ahead:

It's Not About Interest Rates Yet, by Tim Duy: Incoming data continue to support expectations that the Federal Reserve will hold rates at rock bottom levels for the foreseeable future - likely into 2011. But interest rates should not be the focus of policy analysts. The Fed will manipulate policy via the balance sheet long before they fall back to the interest rate tool. The question is whether or not the slow growth environment is sufficient to persuade the Fed to hold the balance sheet steady or even expand the balance sheet beyond current expectations. And there always remains the third option, favored by a minority of policymakers - withdraw the stimulus now that growth has reemerged. At this point, I suspect the Fed will stick with the hold steady option.

One of the key elements of the slow growth story was the inability and unwillingness of households to revert to past spending habits. The critical parts of the story are that savings rates would rise as household struggled to rebuild tattered balance sheets and that credits would become dearer. These stories are playing out in the data:



Yet the trend of consumer spending has undoubtedly been upward since June, as has been the trend of overall economic activity. Cyclically, the economy is on an upswing, surprising many who believed the apocalypse was at hand. But fears of a consumer apocalypse were always overblown; the change need only be moderate to have a large impact on the overall economic environment. It is not necessary that consumers crawl into their basements, curled into a fetal position hugging a bar of gold in one arm and a loaded shotgun in the other, to dramatically alter the role of households in the economy. Consider, for instance the path of retail sales excluding gasoline:


The November-December average monthly growth trend is 0.032% (note: log difference approximation), while the July-December trend is 0.03% and averages out the distortion caused by the "Cash for Clunkers" program. In either case, the spending trend is below the prerecession trend in sales growth. What are the takeaways from such an analysis?

  1. Underlying demand is rising. The resulting stability is helping stabilize the job market; the December decline in nonfarm payrolls was negligible in contrast to the 600k or 700k monthly losses at the height of the recession. This is not meant to imply that the unemployment picture is positive; just that it is significantly less bad.

  2. The pace of underlying demand during the recovery to date slowed compared to prerecession growth rates. This is the slow growth story evolving. Stronger retail spending is dependent on stronger job growth (but faster growth could entail a rise in energy costs, which would squeeze other spending). We are not there yet.

  3. Retail activity remains well below the trend expected in 2007, a forgotten piece of the puzzle, in my opinion. The capital infrastructure of the retailing sector was predicated on the expansion of spending along the red line. A lower path leaves the sector overcapitalized on a long term basis, suggesting that a rapid rebound in retail commercial real estate is very unlikely. Moreover, the spending that would have occurred absent the recession must now find another home.

One hope was that the consumer decline would be offset by improvements on the trade side of the equation, the rebalancing story. But no such luck yet. Improvement in real net exports has stalled as the rebound in global activity has stimulated US imports slightly more than US exports:


To be sure, trade is supporting improvement in some manufacturing industries. But net exports is the key for overall economic activity, and it looks like we need much stronger growth abroad to sustain overall net exports. But the news out of China this week was worrisome on this point:

Chinese authorities on Thursday took the latest in a series of steps to cool the country's supercharged economy amid worries over inflation, engineering a minor tightening of credit that unnerved global markets.

For the first time in nearly five months, the central bank edged up the interest rate on its three-month treasury bills by about 0.04 point, to 1.3684% from the 1.3280% yield that has prevailed since August.

It would be unfortunate if inflationary pressures abroad slowed US export growth. Some have logically speculated that tighter credit controls foreshadows an eventually appreciation of the yuan. I am hopeful yet skeptical; I can also see Chinese authorities attempt to use the external sector to compensate for waning domestic stimulus.

In short, the recent trade and retail sales data suggest what many expected: Absent inventory correction and federal stimulus, the underlying rate of growth is anemic at best (note that perhaps half of the anticipated 4.5-5% growth in Q4 is inventory related). In this case, the v-shaped recovery emerging in manufacturing is not sustainable for the broader economy. But the absence of these factors does not guarantee recession; I think an anemic recovery remains the most likely medium term outcome.

In such an environment, with a significant gap between capacity and demand combined with mostly downside risk to the pace of activity in the second half of this year, monetary policymakers should be wary about withdrawing stimulus. Yet not everyone is. Kansas City Fed President Thomas Hoenig sent up a hawkish signal last week:

Unfortunately, mixed data are a part of all recoveries. And, while there is considerable uncertainty about the outlook, the balance of evidence suggests that the recovery is gaining momentum. In these circumstances, I believe the process of returning policy to a more balanced weighing of short-run and longer-run economic and financial goals should occur sooner rather than later...

The group pushing for a near term withdrawal of stimulus is likely small (hopefully, a group of one). But an effort to shrink the balance sheet is not the immediate threat. Soon to come is the conclusion of the mortgage asset purchase program, an end that is likely to trigger a rise in mortgage rates. And Fed officials know it. Via Calculated Risk:

Eric S. Rosengren, president and chief executive of the Boston Fed, said in an interview at The Courant that he expects [mortgage] rates to rise when the [Fed MBS purchase] program ends — or before, as the end approaches…

"Actually, I've been surprised that we haven't seen more of a backing up already," Rosengren said. "You maybe would have thought you would have seen rates move up more quickly than they have, but nonetheless that is a concern."

...The mortgage rate increase of one-half to three-fourths of a percentage point from the end of the Fed program would happen regardless of any Fed action in interest rates, Rosengren said.

It seems the Fed knows they will be delivering a contractionary blow to the economy just by ceasing balance sheet expansion - indeed, everyone (except maybe your local realtor) knows the housing market is being held together by little more than bailing wire and duct tape. Hence why some policymakers are troubled by the impending exit. From the minutes:

The Committee emphasized that it would continue to evaluate the timing and overall amounts of its purchases of securities in light of the evolving economic outlook and conditions in financial markets. A few members noted that resource slack was expected to diminish only slowly and observed that it might become desirable at some point in the future to provide more policy stimulus by expanding the planned scale of the Committee's large-scale asset purchases and continuing them beyond the first quarter, especially if the outlook for economic growth were to weaken or if mortgage market functioning were to deteriorate. One member thought that the improvement in financial market conditions and the economic outlook suggested that the quantity of planned asset purchases could be scaled back, and that it might become appropriate to begin reducing the Federal Reserve's holdings of longer-term assets if the recovery gains strength over time.

This translates into the following: The Fed is not committing to an absolute end to asset purchases, but the bar to extending purchases is relatively high considering policymakers appear to be divided on the issue. A backup in mortgage yields is expected, and by itself will not be cause for alarm. Either financial distress or ongoing job losses are likely to persuade officials to return to asset purchases.

Critically, the focus is on asset purchases. From Bloomberg:

The Fed should retain flexibility by adopting a “state- contingent” policy that would allow for the adjustment of such purchases as new information becomes available, Bullard, who votes on monetary policy decisions this year, said today in prepared remarks for a speech in Shanghai. He said it was “disappointing” that markets focus more on interest rates instead of the Fed’s quantitative monetary policy.

U.S. central bankers switched last year to asset purchases and credit programs as the primary tools for monetary policy, including buying mortgages and government securities to reduce borrowing costs and stimulate growth. The Fed has expanded its balance sheet to $2.24 trillion at the end of 2009 from $858 billion at the start of 2007.

“Markets are still thinking of monetary policy strictly as changes in interest rates even though the Fed has been conducting successful policy this past year through quantitative easing,” Bullard said. “Markets should be focusing on quantitative monetary policy rather than interest rate policy.”

St. Louis Fed President James Bullard is delivering a pretty clear message. In his view, policy for the foreseeable future is about altering the rate of asset purchases, not interest rates. This will be a challenging new ocean for Fed Watchers to navigate. Will the Fed scale up asset purchase by $25 billion? $50 billion? Hold steady? Sell $25 billion back into the markets? Fun, fun, fun.

Bottom Line: The underlying pace of growth is in doubt. To be sure, manufacturing is getting a boost from inventory correction and pent up demand; the upward trend in industrial production, ISM, capacity utilization, and new order for nondefense, nonair capital goods all look solid. But households are financially hobbled, and net import growth remains lacking. All told, the net impact is to stem the pace of job losses and, if temporary help is an indication, set the stage for actual gains in nonfarm payrolls in the months ahead. But a rapid reversal of the dreary employment setting looks elusive, especially given the likelihood that growth slows as government stimulus wanes in the second half of 2010. Loose cannons like Hoenig aside, all of this should keep monetary policymakers on hold, not pushing to actively contract the Fed's balance. Further expansion of asset purchases is not out of the cards, as Bullard makes clear. But the bar to additional purchases looks high; the Fed will wait to see how actively evolves before taking that road.

"Inflation Targets and Financial Crises"

Andy Harless says that, in the future, the Fed should target a higher level of inflation to give it more room to maneuver in a crisis:

Inflation Targets and Financial Crises, by Andy Harless: There are basically four ways to deal with the possibility of severe financial crises. First, you can just cross your fingers, hope such crises don’t happen very often, and live with the consequences when they do. Second, you can publicly insure and regulate your economy heavily in an attempt to minimize the risk and severity of such crises. Third, you can have your central bank monitor the fragility of general financial conditions and “take away the punch bowl” when it thinks conditions are in danger of becoming too fragile. Fourth, you can have your central bank target an inflation rate that is high enough to give it a lot of room to respond to a crisis (or an incipient crisis) by cutting interest rates far below the inflation rate.
For most of the past 20 years, the first approach – supported by a liberal dose of optimism that was buttressed (in the US, anyhow) by the experience of several financial crises with only mild consequences – was in favor. It’s suddenly unpopular now that we have gone through a crisis with severe consequences.

The order of the day seems to be some combination of the second and third approaches. Congress wants to overhaul financial regulation, and the Fed is reconsidering its erstwhile rejection of the role of bubble-popper. I am by no means the world’s foremost opponent of government involvement in the economy, but I find myself rather uncomfortable with these approaches, for much the same reasons that such a minarchist might be.

Regulation is costly, and I am skeptical as to whether Congress is smart enough, or has the right motivation (or the right group dynamic), to produce a regulatory regime that will be successful in achieving the benefit (avoiding future severe financial crises) without imposing unduly large costs. Regulators are human, subject to blind spots, bouts of unwarranted optimism and pessimism, and the temptation to rationalize actions that benefit their own interests more than those of the public. Without denying that some aspects of our financial system have been under-regulated in recent years (particularly given the public’s direct financial interest via actual or implied insurance programs), I question whether regulatory reform will be a significant improvement. Some things that have been under-regulated will be regulated appropriately, no doubt, but some things that have been appropriately regulated will become over-regulated, and some things that have been under-regulated will remain so.

As to the punch bowl approach, my concerns are similar. Undoubtedly there have been times when the Fed – if it had seen that as part of its function – would have popped an incipient bubble and avoided a much larger pop in the future. But if the Fed considered itself to be in the bubble-popping business, it might well have popped some healthy expansions long before they began to pose severe systemic risk. In retrospect, we can all agree that the last phase of the 1990’s tech boom was “bubbly;” but overvaluation concerns were being raised long before it reached that phase. If Alan Greenspan had followed up immediately on his famous 1996 “irrational exuberance” remark by using monetary policy to beat down that exuberance, I dare say the cost to economic growth would not have merited the benefit to financial stability. And, as it happened, by the time things had gotten dangerously bubbly, a lot of his skepticism seemed to have disappeared. A bubble is mediated through the public consciousness and reaches its peak when normal skepticism has all but evaporated. Are central bankers somehow immune to that consciousness?

The only conservative approach to the possibility of financial crises – the only approach that minimizes the damage without relying on authorities to behave better or more presciently than they normally do behave – is the last of the four I mentioned: inflation. Of the four approaches, it’s probably the least popular right now, especially among those who consider themselves conservative. All alike, populists, traditionalists, and technocrats hold that inflation is bad, and that low inflation, once achieved (as it has been) is so precious that it must be not be risked, let alone intentionally tossed aside, for the sake of some imagined greater good. That attitude brings to my mind the perfectly cleaned and ordered living room in which nobody is allowed to sit, lest they mess it up again.

Low inflation does have its advantages, but economists have been hard pressed to come up with any bigwith full-time jobs, who, according to polls, suddenly hate those jobs, probably because they’re being asked to do the additional work of those whom their employers can no longer afford to keep on payroll, or because they feel their own job security in jeopardy), that should seem rather a severe disadvantage!

Among the most well-informed of the most vocal advocates of a low-inflation regime, the advantage cited most vociferously is stability. Only by maintaining low inflation rates, we are told, can central banks instill confidence in their policies. Even just raise the unofficial target from 2% to 3%, and all Hell will break loose, because….well, if 3%, then why not 4%? and if 4%, why not 5%? and if 5%, why not 10%? and so on. It’s a variation on the old “slippery slope” argument: not that we would actually slide down such a slope (since most sophisticated economists wouldn’t want to be caught making a standard slippery slope argument), but that it would be hard to give credible assurances to the contrary. The idea, I think, is that unless you can maintain something that looks reasonably close to true price stability (0% inflation), nobody will know what to expect. (2% is apparently considered close enough to zero – essentially the highest you can go and still be “close enough” to zero – and some argue that, once we have fully accounted for quality improvements, changes in consumer choices, and other such distorting factors, a measured 2% is more-or-less the same as a true 0%.).

Some would also argue that, whatever the ideal might be, an expectation of 2% inflation (actually just above or just below, depending on which price index you use) is what we have, what has crystallized over the past 10-15 years, and that it is therefore the only inflation rate about which we can have stable expectations going forward. It’s much easier to have confidence in a well-established existing regime than in a new regime that has only just been announced. Of course, this argument relies on the premise that markets do in fact still have confidence in the 2% regime – a premise for which supporters present as evidence the average results of long-range inflation expectation surveys. I do not find such averages very convincing. More people than usual expect deflation, and more people than usual (compared to the last 10 years) expect high inflation. And even those who expect canonical low-but-positive inflation – as the most likely single outcome – are more worried than usual that their expectations may be wrong in one direction or the other. Confidence – in low, stable, positive inflation – is not what I am hearing or seeing. Or feeling.

But this is one of those situations where you thank your adversary for bringing up the most important issue. “Stability” is what we all want. And it is precisely the pursuit of stability – in the long run – that leads me to advocate higher inflation targets. Let me, for the moment, concede, for the sake of argument, that higher inflation targets today might increase uncertainty, and that this increase in uncertainty might damage the recovery more than the expectation of higher product prices would help. Even so, the world does not end when this recovery is complete. (I do rather fear, however, that the world may end before the recovery is complete, only because the world must end eventually, and – in the light of Japan’s experience – there is no guarantee that the recovery will ever be complete.) Let’s suppose that the “stable inflation” medicine proves fully effective, the economy makes a complete recovery, and growth resumes a normal path --- for a while. What will happen next time there is a severe financial crisis?

Let’s distinguish between financial stability and economic stability. Financial instability often – but not always – leads to economic instability. I recall from 1987 (when I was in my first year of graduate school) a certain episode of financial instability in the equity markets. It didn’t last long, but it was huge news for a couple of weeks. It did not induce economic instability: in fact, it turned out to be almost a complete non-event economically. By contrast, instability in credit markets, over the past couple of years, has induced the worst economic crisis most living Americans can remember. The financial crisis itself has been a particularly severe one, and it would not have been possible to avoid some economic impact. But surely we could have gotten off with a much milder recession (and a more robust recovery than we are likely to experience) if the Fed had been able to pursue conventional monetary policy more aggressively.

But the Fed’s hands were tied. The Fed dropped its federal funds rate target by 5 percentage points in the year and a half following the onset of the financial crisis, and that was as far as conventional monetary policy could go. If the inflation target had started out at 4% instead of 2%, and the federal funds rate had started out at 7.25% instead of 5.25%, the Fed would have had a lot more ammunition. Moreover, the market would have known that the Fed had more ammunition, and investors would have been more confident in the Fed’s ability to minimize the economic impact of the financial crisis, and this would have made financial instruments less risky and thereby ameliorated the financial crisis itself.

You may therefore add my name to the list of those who blame past Fed policies for the severity of the recent crisis – but not because the Fed allowed a bubble to develop. Quite the contrary. The Fed eventually popped the previous bubble – the tech bubble – not because it was a bubble but because the economy was nearing the overheating stage, and the inflation rate risked eventually rising back to levels of a decade earlier. In my opinion, the Fed was wrong to pop that bubble. The Fed should have let the economy overheat, for a while, and let the inflation rate rise. (Higher future product prices might, in fact, have turned out to justify stock valuations that proved to be, in the retrospect of the path actually taken, unreasonable: a bubble is a slippery thing.)

I’m not saying that anyone at the Fed made a mistake. Indeed, Alan Greenspan handled that episode quite a bit better than I (and most others) expected, and quite possibly better than any of us would have under the same circumstances. I haven’t changed my opinion on that point: the Maestro conducted a near-perfect performance; all the instruments were in tune with one another, they entered precisely on the right beats, at just the right tempo, with just the right amount of “personal touch.” But the whole performance was in the wrong key.

In real life, I don’t have perfect pitch, and if I were listening to the performance in my metaphor, I might not notice anything wrong. But experience can be a substitute for ability. I’ve heard Beethoven’s Ninth Symphony performed in D minor enough times that, if I heard an orchestra perform it in E minor, I probably would notice that it sounded too high. I have been skeptical of the low inflation consensus all along, but I won’t fault those who were playing in the wrong key in 1995 or 2000 or 2005. But after 2008, we have the necessary experience. We’ve heard, first hand, how bad it sounds when the vocal soloist has to strain to reach notes that were easy for him to sing from the original score.

Admittedly, his voice is not nearly as strained as my metaphor, so I will say it in plain English. A number of economists have suggested higher inflation targets as a way to strengthen the recovery. Conventionalists counter that such targets, once implemented, will be difficult or impossible to replace once they have fulfilled their promise. But now, of all times, we should be aware of just why we should never want to replace them. Low inflation is what got us into this mess. And yet the consensus among policymakers seems stronger than ever: “Low inflation is awesome!” Dude, it’s lame.
advantage. The typical economic argument would be that the disadvantages of low inflation are even smaller than the advantages. But in the light of recent experience, that argument no longer holds much water: the big disadvantage of a low inflation regime is that, by putting a floor on interest rates that is not far below the inflation rate, it ties the hands of monetary policy when responding to a severe financial crisis. Surely, to the 17 percent of the today’s broadly defined US labor force who are wishing vainly for full-time employment (not to mention the apparent majority of Americans

Should the Fed Have a Large Role in Bank Regulation?

I know you are tired of hearing me make this point, and that many of you disagree, but maybe you'll be convinced by Paul Volcker? Should the fire code designers, inspectors, and enforcers be part of the fire department, or housed in a separate, independent agency? Does, for example, the knowledge inspectors gain about the risks of fire in various buildings along with knowledge about the nature of those risks (e.g. of spreading to particular adjacent buildings) help firefighters plan a more effective response if a fire does break out? Conversely, does the knowledge that firefighters have help the inspectors to know what to regulate and what to look for during inspections? Are there economies of scale from consolidation, e.g. if we want experts on how fires spread from building to building present among both inspectors and firefighters, is it most efficient and effective to concentrate this expertise in a single agency?:

Volcker Stands Up for Fed Role in Financial Oversight, Reuters: The Federal Reserve must have a “strong voice and authority” on regulatory matters, Paul Volcker ... said on Thursday. Mr. Volcker, a former Federal Reserve chairman, told a lunch meeting at the Economic Club of New York that he had been “particularly disturbed” by proposals to strip the Fed of its supervisory and regulatory responsibilities. “What seems to me beyond dispute, given recent events, is that monetary policy and the structure and condition of the banking and financial system are irretrievably intertwined,” said Mr. Volcker...

What are the actual arguments for this?:

The Public Policy Case for a Role for the Federal Reserve in Bank Supervision and Regulation, by Ben Bernanke: Like many other central banks around the world, the Federal Reserve participates with other agencies in supervising and regulating the banking system. The Federal Reserve’s involvement in supervision and regulation confers two broad sets of benefits to the country.
First, the financial crisis has made clear that an effective framework for financial supervision and regulation must address both safety-and-soundness risks at individual institutions and macroprudential risks--that is, risks to the financial system as a whole. All individual financial institutions that are so large and interconnected that their failure could threaten the functioning of the financial system must be subject to strong consolidated supervision. Both effective consolidated supervision and addressing macroprudential risks require a deep expertise in the areas of macroeconomic forecasting, financial markets, and payments systems. As a result of its central banking responsibilities, the Federal Reserve possesses expertise in those areas that is unmatched in government and that would be difficult and costly for another agency to replicate.
Second, the Federal Reserve’s participation in the oversight of the banking system significantly improves its ability to carry out its central banking functions. Most importantly, the Federal Reserve’s ability to effectively address actual and potential financial crises depends critically on the information, expertise, and powers that it gains by virtue of being both a bank supervisor and a central bank. In addition, supervisory information and expertise significantly enhance the safety and soundness of the credit the Federal Reserve provides to depository institutions by allowing the Federal Reserve to independently evaluate the financial condition of institutions that want to borrow from the discount window as well as the quality and value of the collateral pledged by such institutions. Finally, its supervisory activities provide the Federal Reserve information about the current state of the economy and the financial system that, particularly during periods of financial crisis, is valuable in aiding the Federal Reserve to determine the appropriate stance of monetary policy. These benefits of the Federal Reserve’s supervisory role proved particularly important during the financial crisis that emerged in 2007.

See the link above (beginning on page 2) for more on "(1) how the expertise and information that the Federal Reserve develops in the making of monetary policy enable it to make a unique contribution to an effective regulatory regime, especially in the context of a more systemic approach to consolidated oversight; and (2) how active involvement in supervising the nation's banking system allows the Federal Reserve to better perform its critical functions as a central bank."

Yes, the Fed made mistakes in its duties as a regulator, there's no denying that. But we need to understand the institutional and other failures that caused the breakdown in oversight and fix them. If we ask tough questions and insist that the Fed take action in response to the problems that are uncovered, oversight can be improved without moving the authority outside of the Fed. Simply moving the existing problems to an outside agency -- and losing the important complements between policy and regulation -- is not the answer.

January 12 2010

January 08 2010

Hawkish Talk from the Fed

We're beginning to hear hawkish talk from some members of the Federal Reserve:

The 2010 Outlook and the Path Back to Stability, by Thomas M. Hoenig, President, Federal Reserve Bank of Kansas City: ...Policy Challenges Ahead As I have indicated, a key contributor to the economic recovery is the extraordinary fiscal and monetary stimulus provided by governments and central banks around the world. In the U.S., we have seen the largest fiscal stimulus in history...
While these policy actions have been instrumental in helping to stabilize the economy and financial system, they must be unwound in a deliberate fashion as conditions improve. Otherwise, we risk undermining the very economic performance we hope to achieve. In the case of fiscal policy, the ballooning federal deficit must be controlled and reduced. ...
As the private sector recovers, increasing demand to finance both public and private debt will likely place upward pressure on interest rates. Eventually, there will be pressure put on the Federal Reserve to keep interest rates artificially low as a means of providing the financing. The dire consequences of such action are well documented in history: In its worst cases, it is a recipe for hyperinflation.
Addressing the deficit will be made all the more complicated by the fact that many of the stimulus programs are scheduled to wind down in 2011 at the very time the Bush administration tax cuts are also scheduled to expire. It will be an extremely abrupt shift in fiscal policy from stimulus to restraint that will cause the economy to weaken. Addressing the deficit under these types of circumstances will be controversial and desperately unpopular. ...
In the case of monetary policy, the challenges are no less daunting. The Federal Reserve must curtail its emergency credit and financial market support programs, raise the federal funds rate target from zero back to a more normal level, probably between 3.5 and 4.5 percent, and restore its balance sheet to pre-crisis size and configuration. ... However, normalizing monetary policy and the Federal Reserve’s balance sheet will be a ... contentious undertaking, and there are differing views regarding when this process should begin, how fast it should proceed, and what form it should take.
One view is that the Federal Reserve should delay interest rate normalization until there is more certainty that the economy and financial markets have completely recovered from this crisis. At that time, the accommodation can begin to be removed. Those who hold this view believe that high unemployment and low inflationary pressures due to excess capacity create considerable economic downside risks if the Federal Reserve removes stimulus. Their biggest fear is of the “double-dip” recession. In their minds, these immediate risks continue to outweigh concerns about long-term economic performance.
This is an appealing argument. The recovery is in its early stage, and weak data continue to emerge in some reports. State and local governments remain under severe fiscal pressures despite considerable federal assistance. Business investment spending for nonresidential construction and equipment remains weak. Additionally, those parts of the country heavily exposed to the subprime lending bust and to the auto industry remain depressed. Also, there is no denying the fact that despite improvements, labor markets and parts of our financial system remain under stress. Thus, while the economic and financial recovery is gaining traction, risks and uncertainty remain major deterrents to removing the stimulus.
Unfortunately, mixed data are a part of all recoveries. And, while there is considerable uncertainty about the outlook, the balance of evidence suggests that the recovery is gaining momentum. In these circumstances, I believe the process of returning policy to a more balanced weighing of short-run and longer-run economic and financial goals should occur sooner rather than later. ...
As I have already said today, experience has shown that, despite good intentions, maintaining excessively low interest rates for a lengthy period runs the risk of creating new kinds of asset misallocations, more volatile and higher long-run inflation, and more unemployment — not today, perhaps, but in the medium- and longer-run. ...
Low rates also interfere with the economy’s ability to allocate resources and distort longer-term saving and investment decisions. Artificially low rates discourage saving and subsidize borrowers at the expense of savers. Over the past decade, we channeled too many resources into residential construction and financial activities. During this period, real interest rates—nominal rates adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence. Low interest rates contributed to excesses. It would be a serious mistake to attempt to grow our way out of the current crisis by sowing the seeds for the next crisis. ...

I should note that St. Louis Fed president James Bullard, though generally hawkish, sent a different message when he talked today:

St. Louis Fed chief James Bullard said the U.S. jobless rate will start to fall soon and played down price pressures facing the United States in the near term, saying that the Fed's moves to pump liquidity into the economy were not an inflationary concern.

As noted above, there are two risks, one is high unemployment and the other is high inflation. However, the costs associated with high unemployment are larger than the costs of high inflation (Hoenig' mention of hyperinflation is merely to scare people, that's not going to happen). So preventing high unemployment should be the primary concern of policymakers. The Fed should not be in any hurry to tighten monetary policy, and if anything, it should drag its feet.

[Here's a bit more on the relationship between unemployment and the Fed's target interest rate in the aftermath of recessions. One more note. While I haven't been strongly in favor of further aggressive quantitative easing from the Fed due to pessimism that such policies would work (though I haven't strongly opposed such action either), that is different from being worried that the present policy will cause inflation problems. I don't think it will and I certainly don't think that the economy is anywhere near the point where we need to start worrying about tightening policy. Finally, I wonder what the correlation is between being hawkish about inflation and being hawkish about the deficit. I'd guess it's relatively high.]

January 07 2010

Interview with Raghuram Rajan

If you are unfamiliar with Raghuram Rajan, this is from the introduction to an interview of him conducted by Ron Feldman of the Minneapolis Fed:
In August 2005 at the Kansas City Fed’s annual symposium in Jackson Hole, Wyo., Raghuram Rajan presented a paper filled with caution. Answering the question “Has Financial Development Made the World Riskier?” the University of Chicago economist observed that financial innovation had delivered unquestioned benefits, but also had produced undeniable risks.
“It is possible these developments may create … a greater (albeit still small) probability of a catastrophic meltdown,” he told the assembled central bankers and academics. “If we want to avoid large adverse consequences, even when they are small probability, we might want to take precautions.”
It was a discordant note at a forum celebrating Alan Greenspan’s tenure as Fed chairman; many deemed his conclusions “misguided.” But history, of course, proved that Rajan’s analysis was dead on. ...

Here is a blunt assessment of the Jackson Hole episode.

Here are a few sections from the (much longer) interview:

... Doubts about Diminishing Risk
[Ron] Feldman: In a prominent Jackson Hole paper,2 you talked about some of the technologies of banking that people thought were going to distribute risk widely and therefore diversify it, making the financial system and financial institutions less risky. It was less clear to you that risk reduction was actually occurring. Could you talk about how you came to that view and how important you think that was in the current crisis?
[Raghuram] Rajan: One of the things I was asked to do was to look at the development of the financial sector, and I have great admiration for some of the things that have happened. There have been good things in the financial sector which have helped us. But to some extent there was a feeling that when you distribute risk, you’ve reduced the risk of the banking system.
My thought was, what business are the banks in? They’re not in the business of being plain-vanilla entities, because they can’t make any money that way. They are in the business of managing and warehousing risk. So if it becomes easier to lay off a certain kind of risk, the bank better be taking other kinds of risk if it wants to be profitable. And if the vanilla risk is going off your books, presumably the risks that you’re taking on are a little more complex, a little harder to manage.
That was the logic which led me to argue ... that distance-to-default measures didn’t look like they were coming down despite all this talk about securitization and shifting risk off bank books. That struck me as consistent with my view that maybe the risks that banks were taking on were more complicated. Whether they were excessive or not, I couldn’t tell.
Also, as I saw the mood, I became worried. Having studied past financial crises, I knew that it’s at the point when people say, “There’s no problem,” that in fact all the problems are building up. So that was just another indicator that we should be worried.
I should add that while I thought we could have a crisis, I never thought that we’d come to the current pass. However, I did argue that it could be a liquidity crisis..., and even though banks in the past had been the safe haven, they could be at the center of this problem.
So, one strand of my argument was based on the business of banks, but the second strand was to think about the incentive structure of the financial system and say that while we have moved to a compensation structure that penalized obvious risk, risk that you could see and measure, that may have made employees focus on risks that could not be measured. An example of that is “tail risk,” because you can’t measure it until it shows up, and it shows up very infrequently. So part of the reason I was worried was that people were taking more tail risk; an insurance company writing credit default swaps was just one example of that.
It didn’t require genius at that point to look around and say the insurance companies were writing these credit default swaps as if there was no chance on earth that they would ever be asked to pay up, so they were really taking on tail risk without any thought for the future. AIG should not have been such a surprise to the Fed.
Feldman: Ex post it was clear to everyone that the incentives were aligned so that firms were taking on risk that people didn’t understand, but at the time there was push-back to what you were saying. ...
Rajan: There were two reasons for the push-back. One was just the venue. This conference was almost a Festschrift [farewell tribute] to Greenspan, and it seemed to some—though it wasn’t intended as such—that I was raining on the parade. This was his farewell, and I was talking about problems that had arisen during his tenure.
But the bigger issue was the collective sense that the private sector could take care of itself, and if not, the Fed would be able to clean up. We had been through two downturns: the 1998 emerging market crisis and the 2000-2001 dot-com bust, and we had understood the tools that were required. In 1998, it was a short reduction in interest rates, not a dramatic one. In 2000-2001, it was a dramatic reduction. And these “successes” led to a feeling that “the Fed can take care of it.”
You know the argument: Typically, the private sector will have the right incentives. Why would they blow themselves up? Regulators aren’t that capable: They’re less well-paid and less informed than the private sector, so what can they do? And finally, if worse comes to worst, the Fed will pick up the pieces.
I think there are three things wrong with this argument, one for each of those elements. Private sector—yes, it can take care of itself, but its incentives may not be in the public interest; may not even be in the corporate interest if corporate governance is problematic. So the trader could fail the corporation, could also fail society. That’s one problem.
Second, the public sector has different incentives from the private sector, and that’s a strength of the public sector. When we’re talking about regulators, because they’re not motivated in the same way as the private sector, they can stand back and say, “Well, I don’t fully understand the risks you’re taking, but you are taking lots of risk—stop.” So I think we’ve made too little of the incentive structure of regulators which should be different, can be different, which gives them a role in this, rather than saying they’re incompetent and they can’t do it. I think they can.
But the third aspect was that I think we overestimated the ability of monetary policy to pull us out of a serious credit problem. The previous problems we had dealt with in the U.S. were not credit problems. They were standard, plain-vanilla recessions. The bank system was still active, so monetary policy wasn’t pushing on a string: The Fed brought down interest rates, and things did come back up.
When credit problems arose—and real estate was central to credit problems because of the real estate securities which ended up on bank balance sheets—then the banks were incapable of being part of the transmission process, and now monetary policy lost a lot of traction, so it wasn’t simply a matter of cutting interest rates and seeing everything come back.
Feldman: People might have thought after the banking crisis of the 1980s and early 1990s—which did not have the same macroeconomic effect as this crisis—that they could respond effectively.
Rajan: Exactly. I guess we didn’t see anything as big, as deep in the recent past. And there was a certain amount of hubris that we could deal with this.
Why was the Crisis so Severe?
Feldman: Why do you think this financial crisis was more severe? There are lots of potential explanations. Some observers point to the failure of credit rating agencies; others point to flawed incentives in compensation and to the creation of new financial products as examples. If you had to list the two or three things that you think really underlie why there was so much risk-taking, why more risk-taking than people thought, what’s the deep answer for that?
Rajan: You can go right to the meta-political level, but let me leave that aside for now. If you hone down on the banking sector itself, I think it was a situation where it was extremely competitive. Every bank was looking for the edge. And the typical place to find the edge is in places where there are implicit guarantees. ...

I think the most damaging statement the Fed could have made was the famous Greenspan doctrine: “We can’t stop the bubble on the way up, but we can pick up the pieces on the way down.” That to my mind made the situation completely asymmetric. It said: “Nobody is going to stop you as asset prices are being inflated. But a crash is going to affect all of you, so we’ll be in there. By no means go and do something foolish on your own, because we’re not going to help you then. But if you do something foolish collectively, the Fed will bail you out.”...

People were acting as if liquidity would be plentiful all the time. And my sense of what the Fed does, in part, by reducing interest rates considerably is help liquidity, and so there was a sense that, well, we can take all the liquidity risk we want, and it won’t be a problem. Of course, it turned out that not just interest rates mattered; the quantity of available liquidity or credit also mattered at this point. And that was the danger. ...

Corruption, Ideology, Hubris, or Incompetence?
Feldman: One thing you haven’t mentioned as a proximate cause is issues around “crony capitalism.” Some seem to argue that banks were allowed to grow large and complex because they were run by friends or colleagues of people who were in power. And for similar reasons, these firms got bailed out—because they had colleagues and friends in “high places.” Given that you’ve thought a lot about that in your own writing, given that you were at the IMF [International Monetary Fund] where you had the ability to look across countries where it is an issue, how important would you say crony capitalism is in the U.S. context in the current crisis?
Rajan: Let me put it this way. There is always some amount of regulatory capture. The people the regulators interact with are people they get to know. They see the world from their perspective, and, you know, they want to make sure they’re in their good books. And so it’s not surprising that across the world, you have a certain amount of the regulators acting in the interest of, and fighting for, the regulated.
Beyond that: Is there naked corruption, or less naked corruption? “If you do my work for me as a regulator, then you can come and join me as a senior official in my firm, and I’ll pay you back at that point.” I’m sure there were stray instances of that, but that to my mind, wouldn’t be the number one reason for this crisis.
I think I would put more weight on a sense of market infallibility which pervaded the economics profession, not just regulators. ... I think across the field of economics, we stopped worrying about the details in industrial countries because we said, by and large, things get taken care of. Yes, there is the occasional corporate fraud or misaligned incentives, but those are aberrations rather than a systemic problem. So I think this view, that you couldn’t have a large systemic problem, this was the problem.
Overlaid on this was the view that regulation was less and less important. We put excessive weight on the private sector getting it right on their own without understanding that the private sector can also break down—the board may not know what management is doing, management may not know what the traders are doing, so that process can break down. But even if everybody is working in the interests of the corporation, the corporation may not be acting in the interests of the system. We’ve seen all these things happen. So the regulatory system had a role to play, and it did not play that as much as it should have. ...
I’m positive that there were situations that we will discover in hindsight where excessive influence was used. There’s cronyism. In a crisis like this, it’s hard to escape it. But I’m less convinced that systematic cronyism was the reason for this. I think ideology was part of the reason we went wrong, as also was the hubris built up over decades of fairly strong growth and deregulation. ...
I guess I’m paraphrasing Churchill, but my tendency is not to attribute to malevolence what can be more easily attributed to incompetence. I think there are a fair number of situations where things didn’t work out as advertised.
Feldman: But you’re talking about more than incompetence, right? You’re talking about the incentive structures within firms that would lead people to act as if they were incompetent.
Rajan: I’d even go one step further and say you don’t have to offer an explanation that relies on evil people or corrupt people. The entire crisis can be explained in terms of people who were doing the right things for their own organizations. You can even argue that it was not that they were misdirected by their own distorted compensation structures; they thought they were doing the right thing for their organization. But when you added it all up, it didn’t add up to doing good for society. And that’s where we have the problems. ...
The Economics Profession
Feldman: We just talked about the economics profession and what has worked well or hasn’t worked well. There’s been a lot of discussion about saltwater and freshwater schools in economics recently.4 I think you have an interesting background to talk about that since you’re at the [freshwater] University of Chicago business school and you’ve done a lot of work about financial systems, but you got your Ph.D. at [saltwater] MIT. Do you have a view about what the economics profession didn’t do well? And what the economics profession ought to be focused on going forward?
Rajan: I have a take on this, yes. But first, one has to remember that the saltwater economists, so to speak, were crowing victory in 1969. You see quotes from Paul Samuelson and Bob Solow [at MIT] saying essentially that the business cycle is dead; we have learned how to deal with it. And we know what happened after that.
I think there is a problem with economics when it thinks it has solved all the traditional problems. That’s when economics slaps you in the face and says, “Not so fast!” The reason rational expectations in macroeconomics and efficient markets in finance are under attack now is not so much because people can tie specific failings to these theories but because they’re the dominant part of the economics or finance profession right now. So I think debate has gone a little off track, in the sense of saying, “You were responsible.”
Would any of the neo-Keynesians have done any better? There were many of them in the Clinton administration where some of this stuff built up. Would anybody pin all this on the Bush administration only? No, it’s a systemic problem. So, I think the debate about “economics is to blame.” well, yes, it is to blame to the extent that it didn’t pick up on some of what happened. But this crisis is problematic for all broad areas of macroeconomics or even of finance.
It is clear that there are many areas of economics that have studied the problems we saw in this crisis. For example, the banking and corporate finance guys have looked at agency problems, looked at banking crises, etc. The behavioral theorists have inefficient markets and irrational markets. So, again, the profession as a whole, I don’t think, deserves blame. It has been studying some of these things.
The central question is why certain areas of economics, particularly macroeconomics, abstracted from the plumbing, which turned out to be the problem here. My sense is that that abstraction was not unwarranted given the experience of the last 25 to 30 years. You didn’t have to look at the plumbing. You didn’t have to look at credit. Monetary economists thought credit growth was not an issue that they should be thinking about. Interest rates and inflation were basically what they should be focusing on. The details of exactly how the transmission took place were well established, and we thought they would not get interrupted. Well, we’ve discovered they can get interrupted.
The natural reaction is now to write models which have the details of the plumbing, and you see more of that happening. So I think what the macroeconomists did was not because they were in the pay of the financial sector or consultants of whatever [laughter], as some have said. But I think it was that that was a useful abstraction given what we knew, and it’s no longer an abstraction that we can ever undertake now. ...

January 06 2010

Unemployment, Vacancies, and Inflation Since 1951: The Movie

(Rated E: For economics audiences only)

This is from Roger Farmer's "Farewell to the natural rate: Why unemployment persists." He argues that "the relationship between unemployment and inflation is more complicated than that suggested by simple new-Keynesian models that incorporate a “natural rate” of unemployment." Why is this important?:

...In two forthcoming books,... I provide a theory that explains these data. I argue that there is no natural rate of unemployment and that the economy can come to rest in a stationary equilibrium at any point on the Beveridge curve. Which equilibrium persists, is decided by the confidence of households and firms that pins down asset values as reflected in housing wealth and the value of the stock market.

When households feel wealthy, that belief is self-fulfilling. Consumers spend a lot, firms hire workers, and the economy comes to rest at a point on the Beveridge curve with low unemployment and high vacancies. When the values of houses, factories, and machines fall, households spend less, firms lay off workers, and the economy comes to rest at a point on the Beveridge curve with high unemployment and low vacancies. Both situations – and anything in between – are zero-profit equilibria. ...

Policy implications

Most policymakers subscribe to the theory of the existence of a natural rate of unemployment. The data suggest that this theory is unconfirmed at best. To make the theory consistent with data, one must posit that the natural rate changes between recessions in unpredictable ways. This version of natural rate theory is difficult or impossible to refute. It is religion, not science.

For more than fifty years policy makers have been trying to hit two targets, unemployment and inflation, with one instrument, the interest rate. Recently, central bankers have discovered a second instrument – quantitative easing. I believe that quantitative easing works by influencing the value of real assets as reflected in housing wealth and the stock market and that it was successfully deployed by central banks in 2009 to maintain aggregate demand. In my two forthcoming books, I argue that quantitative easing should permanently enter the lexicon of central banking as a second instrument of monetary policy and that it will prove to be a more effective and flexible tool than fiscal policy for restoring and maintaining full employment.

I seem to be the only skeptic about the ability of quantitative easing to have a substantial impact on unemployment.

January 05 2010

Fed Watch: Out of the Gate with a Bang

Tim Duy:
Out of the Gate with a Bang, by Tim Duy: If you were looking for a final, cataclysmic collapse of the US economy, you remain disappointed. To be sure, the fallout from the financial crisis is severe, with the palpable wreckage evident in the bottom line, a rate of underemployment at 17.2%. Yet even the most diehard pessimist could not fail to recognize the numerous signs of a cyclical turning point in the second half of 2009. And those signs continued into the new year with today's ISM release. The bulls had reason to run with these numbers; the near term outlook appears baked in the cake. Yet the near term is not an interesting question, in my opinion. The interesting question is what will emerge in the second half of the year. Is the first half a head fake? And, more importantly, where will incoming data lead policymakers, particularly at the Fed? My expectation remains that the Fed will wait until the medium term uncertainty is lifted before raising interest rates, which would be well into the back half of this year if not into 2011. But that might not be the ball to watch; policymakers probably worry about the size of the balance sheet more than the level of interest rates. The near term risk is that stronger than expected growth in the first half would tempt the Fed to withdraw that liquidity before the recovery became fully entrenched.
The ISM manufacturing numbers for December stoked a fire on Wall Street Monday morning, with the better than expected headline number bolstered by strong gains in new orders, the lifeblood of future factory production. Moreover, the employment numbers moved higher, which, coupled with steady declines in initial unemployment claims, points toward actual - gasp - job growth as early as the first quarter. Industrial production gained a solid 0.8% in November, returning to something resembling a "V" shaped recovery in the making after a flat reading in October. Similarly, core manufacturing orders continued their upward trend that same month. Inventory to sales ratios continue to fall, arguing for continued restocking support. And consumer spending continues to edge forward despite declining consumer credit and rising saving rates, a dynamic that will be increasingly supported by firming job markets. What's not to like? No wonder then that Treasury markets have sold off modestly, the 10 year bond heading toward the 4% mark.
Indeed, using the typical post war recession as a guide, one would think the pessimists would by now have folded their cards, leaving that smoky back room of despair for the clear air and bright sunshine that mark the beginning of a new day. But alas, the fear remains that there is no longer such a thing as a "typical" post war recession. The recovery appears inexorably linked to a host of stimulus measures that reach into virtually every strand of the fabric that is the US economy. And therein lies the uncertainty - few are confident that the economy can stand on its own. And the hypothesis that it can has not been tested. The Fed continues to expand its holding of mortgage securities, still looking toward March as the end date for that program. The positive growth impulse from fiscal stimulus will continue through the first half of this year. Support for housing comes via many channels - and despite rising existing home sales and price stabilization, no one believes the housing market remains anything but broken. Moreover, it is difficult to forget that solid US growth of the past decade and earlier was dependent on asset bubbles to fuel consumer spending. No such convenient asset bubble is on the horizon at the moment.
Where does the economy stand when the support for housing is withdrawn, when fiscal stimulus runs its course, when the inventory correction process is complete?
The most dire predictions point to the possibility of a double dip recession
Nobel Prize-winning economist Paul Krugman said he sees about a one-third chance the U.S. economy will slide into a recession during the second half of the year as fiscal and monetary stimulus fade.
“It is not a low probability event, 30 to 40 percent chance,” Krugman said today in an interview in Atlanta, where he was attending an economics conference. “The chance that we will have growth slowing enough that unemployment ticks up again I would say is better than even.”
But as Krugman notes, even a slowing in the rate of growth would be sufficient to derail any nascent recovery in the job market pushing the unemployment rate higher. And the outlook for unemployment was not particularly optimistic to begin with, especially if a job market revival draws discouraged workers back to the job lines.
Simply put, despite an improving economy, the enormous uncertainty surrounding the path of growth in the second half of this year coupled with still high unemployment forecasts, look likely to keep policymakers on hold through at least the first half of this year. Recent Fedspeak has not been particularly optimistic at all, tending to favor stories of drags on the economy. See Federal Reserve Governor Elizabeth Duke via Calculated Risk. See also Federal Reserve Vice Chairman Donald Kohn:
Lingering credit constraints are a key reason why I expect the strengthening in economic activity to be gradual and the drop in the unemployment rate to be slow. Even as the impetus from fiscal policy and the inventory cycle wanes later in 2010, however, private final demand should be bolstered by further improvements in securities markets and the gradual pickup in credit availability from banks. In addition, spending on houses, consumer durables, and business capital equipment should rebound from what appear to be exceptionally low levels. We have already seen some hints of this increase in private demand in recent months. But, understandably, households and businesses and bank lenders remain very cautious, and the odds are that the pickup in spending will not be very sharp.
And finally, note that in Federal Reserve Chairman Ben Bernanke's most recent speech, he explicitly relies on the Taylor rule as evidence that the Fed Funds rate was not too low during the run-up to the housing boom. That same rule posits that the Fed Funds rate should hold at zero. Indeed, Paul Krugman notes that Taylor rules coupled with the Fed's forecast point to negative interest rates through 2012, a point that Bernanke ignores, clearly not wanting any criticism that he needs to more rather than less, by imposing the zero bound on his charts. Still, the point is clear; to the extent that the Fed's forecast is not changing, there seems to be no need to back off the zero interest rate policy any time soon.
But what about the balance sheet expansion? Recall St. Louis Federal Reserve President James Bullard from November:
In an interview posted on the newspaper's website on Sunday, St. Louis Federal Reserve Bank President James Bullard said he would not favor tightening monetary policy before recovery was well-established.
"You are going to need to have jobs growth and you are going to need to have unemployment declining," said Bullard, who moves into a voting seat on the Fed's rate-setting panel next year.
...Bullard said that tightening monetary policy "does not have to involve as its first step moving the federal funds rate off zero". Instead, he favored at that point selling back assets the Fed had acquired, the Financial Times said.
Many Fed officials have said asset sales could disrupt financial markets and push up long-term interest rates. But Bullard said that with proper planning, asset sales did not need to be disruptive.
Suppose that the combined effects of inventory correction and federal stimulus are sufficient to pop the nonfarm payrolls numbers, a possibility enhanced if firms cut employees a little too aggressively in 2009. This is likely not enough to spook the FOMC into hiking rates, but could be sufficient to test the waters on liquidity withdrawal. Would they spook that easily? Note Kohn's words of caution:
Third, because monetary policy typically acts with long lags on the economy and price level, the choice of when and how to exit will depend on forecasts. We will need to begin withdrawing extraordinary monetary stimulus well before the economy returns to high levels of resource utilization. The FOMC has been clear that its expectations for the stance of monetary policy depend on economic conditions, including resource utilization, inflation, and inflation expectations. Accordingly, the judgment as to when to begin initiating steps to withdraw stimulus will depend on the outlook for these variables.
Finally, it is well to remember that we are still in uncharted waters. We do not have any recent experience with financial disruptions of the breadth, persistence, and consequences of those that we have experienced over the past several years. And we have no experience with most of the sorts of actions the Federal Reserve has taken to counter the shock. The calibration of our exit from these policies is complicated by a paucity of evidence on how unconventional policies work. We will need to be flexible and adjust as we gain experience.
While Kohn is warning that the Fed would need to move quickly to get ahead of a turning economy, a pop in payrolls might not be sufficient to force near term action. The addition of rising inflation expectations, however, could be the final straw. Although actual core inflation was flat in November while the unemployment rate suggests resource slack for years to come, the 10 year Treasury TIPS breakeven has widened to a pre-crisis level of 239bp. But the general public appears to hold low inflation expectations. Will those shift dramatically? Again, given high unemployment, this looks unlikely. But what would surely cause expectations to shift is a steady rise in energy costs. Oil has moved back through the $81 dollar mark (on the back of ease Fed policy again?), and Calculated Risk notes that this may already be impact driving habits. Last time inflation expectations spiked on oil, the Fed looked through the gains, eyes firmly focused on the evolving financial crisis. But this time the balance sheet would be much bigger, a fact that would stick out like a sore thumb at an FOMC meeting.
The risk of course is that if the Fed is pushed into a premature withdrawal, financial anarchy would ensue. Indeed, via naked capitalism, some are already looking for that outcome on the back of the stabilization of the Fed's balance sheet in the latter half of 2009. Of course, risks are not all US centered. China plays a role as well. From Bloomberg:
Chinese central bank Governor Zhou Xiaochuan reiterated government warnings that investment in industries with excess capacity and in redundant infrastructure projects could threaten banks’ loan quality.
The People’s Bank of China will guide credit, seeking to avoid volatility in lending, Zhou said in an interview dated yesterday on the Web site of China Finance, a central bank publication. Investment in duplicated projects or industries with overcapacity could “pose a risk to the quality of banks’ loans,” Zhou said.
China’s policy makers are seeking to contain risks from an unprecedented credit boom, in which banks extended 9.21 trillion yuan ($1.3 trillion) of new loans in the first 11 months of 2009. Liu Mingkang, chairman of the China Banking Regulatory Commission, said yesterday that lenders have “more than” enough capital, while also cautioning that asset bubbles may emerge in the world’s third-biggest economy.
“The credit boom last year to cope with the financial crisis has brought side effects, including housing bubbles in some cities and overcapacity in manufacturing,” said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. “These are risks that China will need to guard against this year.”
Jim Hamilton adds his concerns about Chinese inflation he sees evidence in rising garlic prices:
Specifically, I'm wondering if the pent-up inflationary pressure takes the form of inducing consumers and businesses in China to try to acquire any hard assets they can, with the result that rather than overall inflation we see remarkable increases in the relative prices of such items.
The concern, of course, is that the next negative demand shock does not have to originate in the US, fears of a Fed overreaction aside. Tighter credit in China to stem inflation could be sufficient to once again push the global economy to the brink.
Bottom Line: The economy is gathering steam. Can't deny it. But the clear path to sustained recovery remains clouded by government stimulus, both in the US and abroad. Few policymakers are confident that economic activity can stand on its own as stimulus fades, leaving the Fed disinclined to rush for the exits given existing forecasts. Indeed, there is reason to believe based on Taylor Rules that interest rates should be held at the zero bound through 2010 and beyond. But policy mistakes happen. And FOMC worries about the timing of withdrawal could be the basis for such a mistake if near term activity accelerates rapidly and inflation expectations gain. The focus on the Fed may be misplaced; the FOMC is not the only policymaker that might upset the apple cart. The next negative shock might come from abroad.

January 04 2010

Paul Krugman: That 1937 Feeling

There's a pretty good chance that the next few economic reports will make it appear that the economy is improving, but those reports may not be as positive as they seem on the surface. Will policymakers "misinterpret the news and repeat the mistakes of 1937?":

That 1937 Feeling, by Paul Krugman, Commentary, NY Times: Here’s what’s coming in economic news: The next employment report could show the economy adding jobs for the first time in two years. The next G.D.P. report is likely to show solid growth in late 2009. There will be lots of bullish commentary — and the calls we’re already hearing for an end to stimulus, for reversing the steps the government and the Federal Reserve took to prop up the economy, will grow even louder.
But if those calls are heeded, we’ll be repeating the great mistake of 1937, when the Fed and the Roosevelt administration decided that the Great Depression was over, that it was time for the economy to throw away its crutches. Spending was cut back, monetary policy was tightened — and the economy promptly plunged back into the depths. ...
As you read the economic news, it will be important to remember, first of all, that blips — occasional good numbers, signifying nothing — are common even when the economy is ... in a prolonged slump. ...
Such blips are often ... statistical illusions. But ... they’re usually caused by an “inventory bounce.” When the economy slumps, companies typically find themselves with ... excess inventories, [and] they slash production; once the excess has been disposed of, they raise production again, which shows up as a burst of growth in G.D.P. Unfortunately, growth caused by an inventory bounce is a one-shot affair unless underlying sources of demand, such as consumer spending and long-term investment, pick up.
Which brings us to the still grim fundamentals of the economic situation. During the good years of the last decade,... growth was driven by a housing boom and a consumer spending surge. Neither is coming back. ...
What’s left? A boom in business investment would be really helpful... But it’s hard to see where such a boom would come from: industry is awash in excess capacity, and commercial rents are plunging in the face of a huge oversupply of office space.
Can exports come to the rescue? For a while, a falling U.S. trade deficit helped cushion the economic slump. But the deficit is widening again, in part because China and other surplus countries are refusing to let their currencies adjust.
So the odds are that any good economic news ... will be a blip, not an indication that we’re on our way to sustained recovery. But will policy makers misinterpret the news and repeat the mistakes of 1937? Actually, they already are.
The Obama fiscal stimulus plan is expected to have its peak effect ... around the middle of this year, then start fading out. That’s far too early: why withdraw support in the face of continuing mass unemployment? Congress should have enacted a second round of stimulus months ago... But nothing was done — and the illusory good numbers we’re about to see will probably head off any further possibility of action.
Meanwhile, all the talk at the Fed is about the need for an “exit strategy” from its efforts to support the economy. One of those efforts, purchases of long-term U.S. government debt, has already come to an end. It’s widely expected that another, purchases of mortgage-backed securities, will end in a few months. This amounts to a monetary tightening, even if the Fed doesn’t raise interest rates directly — and there’s a lot of pressure on Mr. Bernanke to do that too.
Will the Fed realize, before it’s too late, that the job of fighting the slump isn’t finished? Will Congress do the same? If they don’t, 2010 will be a year that began in false economic hope and ended in grief.

December 30 2009

Will Economists Ever Learn?

Will the crisis teach economists not to be overconfident about their abilities?

My answer is here.

December 29 2009

Fed Watch: Why Christmas Eve?

Tim Duy:

Why Christmas Eve?, by Tim Duy: One would think that policymakers would treat the day before Christmas as sacrosanct, if not for the sake of their employees, but to avoid the endless conspiracy theories that naturally arise when you partake in activities that look like they are intended to fly under the radar. Has US Treasury Secretary Timothy Geithner learned nothing in his long tenure serving Goldman Sachs the people of the United States of America? Ignoring the wisdom of the ages, Geithner made what appears to be unlimited funds available to Freddie Mac and Fannie Mae on the day when most of the nation is more concerned about getting presents under the tree (myself personally content that I can squeeze yet another year of magic under the Santa Claus myth) than the policy machinations of Washington.
But do we really care? Is this really a new news, or just a matter of questionable timing? Would the same announcement today have raised the ire of the blogoshpere?
To get at this issue, we should back up to a New York Times article a few weeks back (hat tip to Dean Baker):
Fannie Mae and Freddie Mac, which buy and resell mortgages, have used $112 billion — including $15 billion for Fannie in November — of a total $400 billion pledge from the Treasury. Now, according to people close to the talks, officials are discussing the possibility of increasing that commitment, possibly to $400 billion for each company, by year-end, after which the Treasury would need Congressional approval to extend it. Company and government officials declined to comment.
Apparently this little item was lost in the Christmas rush - seriously, could this even compare to the endless fascination with the status of holiday sales? The point is that hanging in the background was the likelihood that Mae and Mac were expecting some very, very bad fourth quarter numbers. Indeed, despite the massive efforts to support the housing market, Fannie Mae reported today that serious delinquencies continue to climb at an alarming rate. So, at second glance, Treasury's Christmas Eve announcement looks somewhat less disconcerting. The timing questionable, but the outcome expected. But why the essentially unlimited access to funds? I think this is pretty straightforward - Geithner simply lifted illusion (delusion?) that the GSEs were anything less than backed by the full faith and credit of the Uncle Sam. Seriously, at this juncture who believes that GSE debt is any different than Treasury debt? Or that the US will not pump in any amount of dollars necessary to keep the GSEs afloat?
That said, the Treasury's press release was bereft of explanatory information, giving rise to a host of theories as chronicled by Calculated Risk. In my mind, the most appealing of these explanations (other than that stated above) is the supposed intention to use the GSEs to absorb dysfunctional mortgages in an effort to revive floundering modification programs. Why? Because, as structured, modifications just simply don’t work in aggregate. I have thought this from day one of the modification story. And, frankly, I don’t think I am particularly insightful on this point. Seems obvious. Suppose homeowner A is underwater on a mortgage costing $4,000 a month for a property that now has a rental equivalent of $2,000. How exactly does it help that homeowner to "modify" their mortgage to $3,000 a month? They are still underwater, and they will likely have to sacrifice any potential gains (10-20 years down the road!). The modification leaves you with the choice of being a virtual renter for $3,000 a month or an actual renter for $2,000 a month. Moreover, what truly is better for the economy? To free up $2,000 in the household's monthly budget via a balance sheet restructuring, or to weigh down the household balance sheet with an impossible debt burden?
The Wall Street Journal recently printed a front page article on this topic that I thought was spot on:
Analysts at Deutsche Bank Securities expect 21 million U.S. households to end up owing more on their mortgages than their homes are worth by the end of 2010. If one in five of those households defaults, the losses to banks and investors could exceed $400 billion. As a proportion of the economy, that's roughly equivalent to the losses suffered in the savings-and-loan debacle of the late 1980s and early 1990s.
The flip side of those losses, though, is massive debt relief that can help offset the pain of rising unemployment and put cash in consumers' pockets.
For the 4.8 million U.S. households that data provider LPS Applied Analytics estimates haven't paid their mortgages in at least three months, the added cash flow could amount to about $5 billion a month -- an injection that in the long term could be worth more than the tax breaks in the Obama administration's economic-stimulus package.
"It's a stealth stimulus," says Christopher Thornberg of Beacon Economics, a consulting firm specializing in real estate and the California economy. "The quicker these people shed their debts, the faster the economy is going to heal and move forward again."
As the stigma of abandoning a mortgage wanes, the Obama administration could face an uphill battle in its effort to keep people in their homes by pressuring banks to cut their mortgage payments. Some analysts argue that's not always the right approach, particularly if it prevents people from shedding onerous debts and starting afresh.
"The effect of these programs is often to lead homeowners to make decisions that are not in their economic best interests," says Brent White, a law professor at the University of Arizona who has studied mortgage defaults.
The sorry truth is that many households underwater on their mortgages are likely better off defaulting (this is not a suggestion to strategically default; consult your attorney when contemplating that option), and so likely is the economy as a whole, accepting a modification that does not involve a significant principle reduction. The only people who do not recognize this are, sadly, policymakers, who have trouble comprehending the possibility of a bubble that led to prices far above ability to pay. Such a delusion extended to the highest levels of the Fed. Arguably, the push for modifications is simply more evidence that Washington is more concerned with the interests of Wall Street than Main Street.
That is why the Treasury's blanket coverage of the GSEs leads to speculation that the Administration intends to more aggressively use their portfolios to push for principle reductions. Such reductions, obviously, actually help households, but at a cost to the taxpayers that leaves mortgage asset holders nearly whole. Such reductions would also wipe away any remaining delusion that the trouble in housing is a liquidity issue rather than a insolvency issue. To be sure, I would indeed not be surprised to see an enhanced modification effort via the GSEs that pushes greater costs onto the taxpayer, especially with respect to the mortgages still held by Mae and Mac. But to dig deeper into the issue, I think the GSEs would need to aggressively purchase privately held mortgages with the potential for liquidation. And here this paragraph in the Treasury release sticks out:
Treasury remains committed to the principle of reducing the retained portfolios. To meet this goal, Treasury does not expect Fannie Mae and Freddie Mac to be active buyers to increase the size of their retained mortgage portfolios, but neither is it expected that active selling will be necessary to meet the required targets. FHFA will continue to monitor and oversee the retained portfolio activities in a manner consistent with the FHFA's responsibility as conservator and the requirements of the PSPAs.
So Mae and Mac are not required to sell part of their portfolio into a declining market (which would exacerbate the loss to taxpayers), but nor would they be expected or really allowed to expand their portfolio to ease the process of modifications on the back of the taxpayer. Moreover, even an effort to expand modifications does not appear to be within the FHFA's conservator responsibilities. Which would, if I am reading this right, suggest that while there are plenty of reasons to believe that the modification program is fundamentally a failure, Treasury's Christmas Eve announcement is not a backdoor effort to expand the socialization of mortgage losses. Yet.
In short, there are plenty of ulterior motives for Treasury's expansion of the Mae and Mac bailouts. My favorite is the desire to expand the ability of the GSEs to absorb principle reductions for housing modifications. But the simplest explanation is likely the correct one - the financial damage to the GSEs continues virtually unabated, and the Treasury simply needs to make explicit what was implicit: Mae and Mac are backed by the US government's full faith and credit, regardless of the level of losses in those institutions. I don't think this is really an expansion of the bailout; more just a confirmation of my prior beliefs.

December 24 2009

Unemployment and Excess Capacity


The excess capacity series is defined as 100 - capacity utilization rate.
The unemployment series is the civilian unemployment rate.

The excess capacity series (red line) peaked in June of this year, and has been moving downward ever since. If the pattern in the two most recent recessions holds, those in 1990-91 and 2001, the peak in the unemployment rate will come between 16 and 19 months after the peak in excess capacity, i.e. around a year from today (though prior to 1990 the peaks were coincident).

The most recent data on the unemployment rate showed a downward tick from 10.2 percent to 10.0 percent, so perhaps unemployment has already peaked and the lag will be shorter this time. But perhaps not. As an inspection of the unemployment series in the graph shows, the unemployment rate bounces around even when it is trending upward or downward. So it's hard to tell from one month's data whether the downward tick in the unemployment rate is temporary and unemployment still has a ways to go before peaking (as in the last two recessions), or a sign that a turning point has been reached and things are getting better (which would represent a reversion to the more coincident movement in the two series observed before 1990).

Note, however, that in the 2001 recession, unemployment fell briefly just after excess capacity peaked, but then resumed its upward movement for several more months before reaching a turning point 19 months after the turning point in excess capacity. Thus, while the recent downward tick in the unemployment rate is good news, certainly better than an uptick, we should be prepared for the possibility that the pattern in the last recession might repeat itself and unemployment will head back upward for several more months before it reaches its peak. I hope that doesn't happen, the sooner unemployment returns to normal the better, but we need to be better prepared than we are for the very real possibility that unemployment will continue to trend upward. I'd like to see more done on both the monetary and fiscal policy fronts as a preemptive measure, we can always ease off if things turn our better than expected, but at the very least we need to resist calls from the deficit and inflation hawks to begin pulling back and continue the programs that are already in place.

[Question: What happened from mid 1997 through the beginning of 1999 that caused the two series to move in opposite directions and separate?]

December 22 2009

Conducting Monetary Policy when Interest Rates Are Near Zero: Will it Work?

I have been more skeptical than most about the ability of quantitative easing to stimulate output and employment, so I thought I'd counter that with this explanation of how QE works, what might go wrong, and some of the evidence in its favor.

[My doubts come on two fronts. The first is the ability of QE to affect long-term real rates, and the evidence is somewhat favorable on this point, though not 100 percent compelling. It does seem that the Fed can lower long-term real rates, mortgage rates in particular, though why we want to stimulate investment in new housing in the aftermath of an housing bubble is a question we might want to ask.

My second objection is related to this - even if we do lower long-run real mortgage rates, will that stimulate new investment in housing given the inventory problem that already exists, and given the condition of the economy? I'm doubtful, and that doubt extends generally. The mechanism described below relies upon lower real interest rates stimulating new investment, but even if long-term rates fall across the board, will firms be inclined to go out and buy new factories and equipment when so much of what they have is sitting idle? 

Fiscal policy can put these resources to work directly, but monetary policy must induce firms to invest (or induce households to purchase housing and durables), and in a recession that may be hard to do. That's why I've emphasized fiscal policy, and that is what my objection is mostly about. The focus on the Fed has made it appear that monetary rather than fiscal policy is our best bet at this point. Monetary policy might be able to help for the reasons explained below, so I have no objection to trying, but fiscal policy needs to take the lead.

I should acknowledge that it may not be politically possible at this point to do more on the fiscal policy front, and the 3.5 percent growth rate for third quarter GDP that turned out to be a false signal didn't help at all (note, however, that the Fed is equally unlikely to respond to calls for it to do more). But there did seem to be momentum building toward providing more help through fiscal policy -- there was even a jobs summit -- however the talk about fiscal policy suddenly ended as people turned their guns on the Fed. While that may have been needed to get the Fed thinking harder about what more it can do, we should have also kept up the pressure on fiscal authorities. That fiscal authorities have been let off the hook is disappointing]:

Conducting Monetary Policy when Interest Rates Are Near Zero, by Charles T. Carlstrom and Andrea Pescatori, Economic Commentary, FRB Cleveland: This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes how monetary policy might be conducted in such a situation. We argue that avoiding expectations of deflation is key and that the monetary authority needs to demonstrate an unequivocal commitment to preventing deflation. We also argue that price-level targeting might be a good device for communicating such a commitment.
While business cycles are inevitable, there is quite broad agreement among economists and policymakers that monetary policy can and should be used to damp fluctuations in economic activity. But some fluctuations can occur in an unusual economic environment in which the traditional tools of monetary policy become useless. When short-term interest rates are at or near zero, for example, monetary policy cannot be implemented in the usual way—by adjusting these short-term interest rates. If policymakers want to lower rates in such an environment, they must look for alternative ways of conducting policy. With the federal funds rate hovering just above zero since December 2008, the current U.S. economic situation is a case in point. To conduct monetary policy under these conditions, the Federal Reserve has had to turn to a new strategy and new tools.
Some economists have pointed to another problem that an environment of near-zero interest rates could pose for monetary policy. They suggest that the inability to lower interest rates could allow a sudden and unexpected fall in the demand for goods and services to push the economy into a deflationary spiral, a situation in which falling prices and falling output feed upon each other. The fear is that a negative demand shock that pushes down prices (in short, a deflationary shock) could further decrease output, thereby accentuating the deflationary process. This additional deflation will then lead to further output decline. Paul Krugman, the economist and New York Times columnist, has dubbed this downward spiral a “black hole,” from where there is no return.1
This Economic Commentary explains the concerns that are associated with the combination of deflation, low economic activity, and zero nominal interest rates and describes some of the ways in which monetary policy might be conducted in this situation. We conclude by emphasizing that to be effective in an environment of zero short-term nominal interest rates, monetary policy needs to be unequivocally committed to avoiding expectations of deflation. We also argue that price-level targeting might be a good device for communicating such a commitment. While this policy prescription follows from the assumption that the zero interest rate bound is a consequence of a negative demand shock hitting the economy, it is worth stressing that falling prices can also be the consequence of a supply shock, namely particularly high productivity growth (not a bad thing!). This would clearly call for different policy actions than the ones described here.
Zero Interest Rates and the Black Hole
The special problem deflation might pose in times of near-zero nominal interest rates has to do with what could happen to real interest rates in such an environment and the effect that they could have on economic activity.
Consider, for example, a firm that decides to borrow money at a stated, or nominal, interest rate of 7 percent. If prices, including the firm’s product price, are expected to grow at 2 percent per year, then the real cost of borrowing for the firm (the real interest rate) is 5 percent per year. In principle, the real rate should be determined only by the saving and investment decisions of market participants, plus adjustments for risks, not monetary policy. In fact, a permanent change in expected inflation, say from 2 percent to 1 percent, will change only the nominal rate (in this case from 7 percent to 6 percent) and leave the real rate unchanged.
However, inflation expectations do not change instantaneously. Because they adjust over time, a policy move that decreases the nominal interest rate will also, in the short run, temporarily decrease the real rate. The decrease in the real rate will increase the willingness of banks to lend and firms to borrow. This extra lending will then temporarily stimulate output. In this scenario, a central bank could easily counteract a deflationary shock that reduces prices and expected inflation (which could potentially raise the real rate temporarily and depress the economy) by lowering the real rate, or equivalently, by lowering the nominal rate by an amount greater than the fall in prices.
But if a deflationary shock occurs when nominal rates are already at or close to zero, policymakers cannot counteract the shock by further lowering the nominal interest rate. Even if long-term inflation is well moored, the deflationary shock may still lower short-term inflation expectations and therefore increase the real interest rate. The increase in the real rate may further depress investment, consumption, and aggregate demand, causing prices to fall further. This second bout of deflation will increase the real rate again and exacerbate the decline in output and the original deflationary shock.
It is important to stress that the extreme version of this scenario—the black hole Krugman refers to—is unlikely to occur, partly because firms anticipating a drop in demand will eventually cut production enough to stop excess supply. Nevertheless, our inability to offset a deflationary shock could conceivably prolong a period of deflation and falling output.
Will Quantitative Easing Work?
Many argue that reserve targeting (or quantitative easing when it is done in a zero-interest-rate environment), can still stimulate the economy when short-term interest rates are zero. But if quantitative easing is implemented through the purchase of short-term securities, this policy is almost certainly doomed to failure. Since banks’ cash reserves and short-term securities are perfect substitutes when nominal interest rates are at zero, banks have no incentive to lend the money out.
They are likely to simply substitute the cash they receive from the central bank for the securities they were holding in reserves. Therefore, the supply of money in circulation (that is, one common and useful definition of it, M1, which is currency held by the public plus demand and other checkable deposits) is not affected. To affect M1, banks need to lend the cash out to the private sector, which in turn will redeposit part of this cash into checking accounts, thereby increasing money in circulation. Because open market operations will not increase the money supply when short-term interest rates are zero, they can’t be used to increase either real economic activity or prices.
But this reasoning applies to the purchase of short-term government securities. In March 2009, the Federal Reserve embarked on a program of quantitative easing by purchasing longer-term securities to stimulate the economy. Unlike short-term securities, these still had a positive rate of interest. The longer-term securities included agency mortgage-backed securities, agency debt, and longer-term government securities.
The idea behind buying longer-term government securities is that doing so will drive up their demand and therefore the price of these securities. This will decrease their yield and therefore lower long-term interest rates. Lower long-term interest rates will end up stimulating investment and the economy. The assumption underlying this approach is that banks will not simply sit on the cash they receive from the Fed in exchange for the long-term securities, and the supply of money in circulation will actually rise in consequence. That is, banks cannot view long-term and short-term government securities as perfect substitutes. Otherwise, they will not attempt to buy other long-term securities or loan out this extra cash.
While evidence suggests that longer-term interest rates fell with the announcement that the Fed would purchase long-term securities, the challenge for this policy is to have a large and lasting impact. That impact rests on a couple of assumptions, one of which is that the markets for short- and long-term bonds are segmented from each other; that is, short-term and long-term securities are not good substitutes for one another. With segmented markets, the supply and demand schedules for loanable funds in each market are separate.
But even if markets are segmented, over time, traders will be “tempted out of their preferred market segment” by the lure of higher expected returns. By decreasing long-term rates, the risk-adjusted return for short-term treasuries increases. Long-term interest rates will start to increase as investors substitute away from long-term securities to short-term securities, or equivalently, zero-interest-earning excess reserves. The extra money pumped into the system by long-term security purchases may quickly wind up back in banks’ reserve accounts.
Another way to think about this is that eventually long-term interest rates are eventually determined by market fundamentals, namely long-term inflation expectations in conjunction with expected long-term economic growth. Long-run growth is driven by nonmonetary factors.
Even while purchases of long-term treasuries may be affecting long-term interest rates, it is not easy to assess the size of the purchase that is required to affect yields in the desired manner or the timing of those effects.
In terms of sheer numbers, quantitative easing was dominated by purchases of mortgage backed securities (MBS) and not long-term government securities after interest rates effectively hit zero. The idea behind purchasing MBS is that the real impact of the operation will be much larger. This is because MBS are nowhere near as closely substitutable with short-term securities as government-issued long-term securities are, which implies that the market segmentation between short-term government securities and private MBS will persist for a much longer period of time. The evidence does suggest that these purchases have been successful in lowering mortgage rates.
Communication as a Policy Tool
As we have seen, when short-term rates are zero, monetary policymakers must look beyond standard tools to influence inflation and output. But they have another tool not yet mentioned. The FOMC can communicate, usually through speeches and its policy statements, information that is meant to influence expectations about future changes in the federal funds rate. Expectations of future monetary policy can increase future money growth and hence expected inflation. Increased inflationary expectations will lower real interest rates. This is one way of understanding the FOMC’s current language that there are likely to be “exceptionally low levels of the federal funds rate for an extended period.”
We have discussed the importance of expected inflation in counteracting a deflationary spiral. If interest rates are at zero, increases in expected inflation will decrease today’s real interest rate, stimulating both the real economy and prices. Using communication to boost future inflation expectations in this environment requires policymakers to promise that they will “err” on the side of keeping interest rates low even after the economy starts to recover. In essence, this future inflation will stimulate the economy today and actually increase money today.
Perhaps the best way for the central bank to communicate that it plans to deliver on its promise to “err” on the side of future inflation whenever deflationary shocks hit is to develop a simple rule that the public can easily monitor to see whether the central bank is fulfilling its promise. One simple rule is a price-level target. With a price-level target, the central bank commits to sticking to a given path for the level of prices over some horizon. If prices start rising faster than a prespecified rate, policymakers must lower inflation in the future to get the price level back to the target. Similarly, if there is a deflationary shock, the central bank must inflate in the future because it has to bring the price level back up (see figure 1).

Figure 1. Inflation and Price-Level Responses to Different Targeting Regimes

Instead of a price-level target, many central banks around the world have adopted inflation targeting, where inflation over a period of around two years is on average kept constant. A credible inflation target will anchor inflation expectations over the specified horizon, which, by definition, is enough to avoid expected deflations and increases in the real rate.
However, there is an important difference between an inflation target and a price-level target. An inflation target “lets bygones be bygones,” while a price-level target corrects for past misses. If prices fall on a year-over-year basis, a price-level target requires the central bank to reinflate prices until they are back to the target. An inflation target requires only that the rate of inflation be returned to its target rate from the present onward.
A price-level target is essentially a promise that a deflationary shock today will increase inflation in the future and thus expected inflation today. This promise of future inflation will lower real interest rates even when short-term nominal rates are zero. Long-term inflation is still pinned down as it is with an inflation target. One of the rare positive elements of the recent period of turmoil has been the stability of any measure of inflation expectations (survey or market-based), especially at medium and long horizons. It is an open question whether a central bank targeting the price level would have the same credibility, so that long-term inflation expectations remained well-anchored.
One drawback of a price-level target is that it necessitates stimulating the economy whenever prices fall—no matter what the cause. For example, an expansion driven by a positive supply shock would naturally put downward pressure on prices and upward pressure on the real rate, but few economists believe that monetary policy accommodation is helpful in such a situation. An inflation target can potentially be changed, to respond to unusual economic conditions,but a price-level target has the advantage of responding according to a very simple and easy-to-understand rule.
Avoiding the Zero Lower Bound
Going forward, it is important to try and minimize the chances that short-term interest rates will hit zero in the future. One way of doing this is for the Fed to increase its implicit long-term inflation target. Instead of the 1.5 percent–2 percent range for long-term inflation that most market participants currently expect the Fed to pursue, John Williams of the San Francisco Fed argues that the Fed’s long-term inflation target may have to be increased to the 2 percent–4 percent range. This will increase the long-term federal funds rate, thereby giving the Fed extra “ammunition” before the zero lower bound sets in.
But instead of a higher long-term inflation target, a price-level target is another way to mitigate the chances that a zero lower interest rate bound will be hit in the future. (Recall that a price-level target still implies a given long-term inflation rate.) If the economy is hit by a major deflationary shock when nominal rates are close to zero, a price-level target has a clear advantage over an inflation target. If monetary policy aims at stabilizing prices, policymakers must create future short- to medium-term inflation to correct for past misses. The future inflation promised by a price-level target will increase expected inflation over the short- to medium-term and therefore increase nominal rates, helping to insure that the zero lower bound for interest rates is never reached.
Undeniably, the zero bound produces problems for monetary policy, but these problems are not insurmountable. Communicating future monetary policy is the best way for monetary policymakers to increase inflation expectations when short-term interest rates are constrained by a zero lower bound. Furthermore, a price-level target is something that can potentially be used to enhance this communication. An appropriate price-level target can also reduce the likelihood of ever hitting the zero bound to begin with.
1. Although we focus on deflation, we recognize that some people are concerned about inflation risk in the economy as well. Our focus on deflation is not intended to express a view on the likelihood of one outcome as being greater than another.
Recommended Readings
“Japanese Monetary Policy: A Case of Self-Induced Paralysis?” by Ben Bernanke. 2000. In Japan’s Financial Crisis and its Parallels to U.S. Experience, Institute for International Economics, special report no. 13, edited by R. Mikitani and A. Posen.
“It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap,” by Paul Krugman. 1998. Brookings Papers on Economic Activity, vol. 2, edited by W. Brainard and G. Perry.
“Crisis in Prices,” by Paul Krugman, 2002. New York Times.
“Heeding Daedalus: Optimal Inflation and the Zero Lower Bound,” by John C. Williams. 2009. Forthcoming in Brookings Papers on Economic Activity.
“The Zero Bound on Interest Rates and Optimal Monetary Policy,” by Gauti Eggertsson and Michael Woodford. 2003. Brookings Papers on Economic Activity, vol. 1, edited by W. Brain.

December 21 2009

December 18 2009

The Fed Can Help, But Fiscal Policy Is The Key To Job Creation

At CBS MoneyWatch, why I haven't joined the loud calls for the Fed to engage in quantitative easing as a means of creating jobs:

The Fed Can Help, But Fiscal Policy Is The Key To Job Creation, by Mark Thoma: There are many people currently criticizing the Fed for worrying too much about inflation and not enough about employment. They want the Fed to use quantitative easing - the purchase of financial assets when interest rates are already at zero - as a means of stimulating the economy and creating jobs. I think it's a mistake ...[...continue reading...]...

December 17 2009

Ben Bernanke's Final Exam

Ben Bernanke answers some questions:

Sen. Vitter Presents End-of-Term Exam For Bernanke, by Sudeep Reddy, WSJ: Earlier this month, Real Time Economics presented questions from several economists for the confirmation hearing of Federal Reserve Chairman Ben Bernanke.  Many of the questions were addressed at the hearing, though not always directly. Sen. David Vitter (R., La.) submitted them in writing and received the  responses from Bernanke, along with his own other questions.  We offer them here.
The Wall Street Journal reported on some questions that different economists felt that you should answer. Let me borrow from some of those and I will credit them with their questions accordingly:
A. Anil Kashyap, University of Chicago Booth Graduate School of Business: With the unemployment rate hovering around 10%, the public seems outraged at the combination of three things: a) substantial TARP support to keep some firms alive, b) allowing these firms to pay back the TARP money quickly, c) no constraints on pay or other behavior once the money was repaid. Was it a mistake to allow b) and/or c)?
TARP capital purchase program investments were always intended to be limited in duration. Indeed, the step-up in the dividend rate over time and the reduction in TARP warrants following certain private equity raises were designed to encourage TARP recipients to replace TARP funds with private equity as soon as practical. As market conditions have improved, some institutions have been able to access new sources of capital sooner than was originally anticipated and have demonstrated through stress testing that they possess resources sufficient to maintain sound capital positions over future quarters. In light of their ability to raise private capital and meet other supervisory expectations, some companies have been allowed to repay or replace their TARP obligations. No targeted constraints have been placed on companies that have repaid TARP investments. However, these companies remain subject to the full range of supervisory requirements and rules. The Federal Reserve has taken steps to address compensation practices across all firms that we supervise, not just TARP recipients. Moreover, in response to the recent crisis, supervisors have undertaken a comprehensive review of prudential standards that will likely result in more stringent requirements for capital, liquidity, and risk management for all financial institutions, including those that participated in the TARP programs.
B. Mark Thoma, University of Oregon and blogger: What is the single, most important cause of the crisis and what s being done to prevent its reoccurrence? The proposed regulatory structure seems to take as given that large, potentially systemically important firms will exist, hence, the call for ready, on the shelf plans for the dissolution of such firms and for the authority to dissolve them. Why are large firms necessary? Would breaking them up reduce risk?
The principal cause of the financial crisis and economic slowdown was the collapse of the global credit boom and the ensuing problems at financial institutions, triggered by the end of the housing expansion in the United States and other countries. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn.
This crisis did not begin with depositor runs on banks, but with investor runs on firms that financed their holdings of securities in the wholesale money markets. Much of this occurred outside of the supervisory framework currently established. An effective agenda for containing systemic risk thus requires elimination of gaps in the regulatory structure, a focus on macroprudential risks, and adjustments by all our financial regulatory agencies.
Supervisors in the United States and abroad are now actively reviewing prudential standards and supervisory approaches to incorporate the lessons of the crisis. For our part, the Federal Reserve is participating in a range of joint efforts to ensure that large, systemically critical financial institutions hold more and higher-quality capital, improve their risk-management practices, have more robust liquidity management, employ compensation structures that provide appropriate performance and risk-taking incentives, and deal fairly with consumers. On the supervisory front, we are taking steps to strengthen oversight and enforcement, particularly at the firm-wide level, and we are augmenting our traditional microprudential, or firm-specific, methods of oversight with a more macroprudential, or system-wide, approach that should help us better anticipate and mitigate broader threats to financial stability.
Although regulators can do a great deal on their own to improve financial regulation and oversight, the Congress also must act to address the extremely serious problem posed by firms perceived as “too big to fail.” Legislative action is needed to create new mechanisms for oversight of the financial system as a whole. Two important elements would be to subject all systemically important financial firms to effective consolidated supervision and to establish procedures for winding down a failing, systemically critical institution to avoid seriously damaging the financial system and the economy.
Some observers have suggested that existing large firms should be split up into smaller, not-toobig- to-fail entities in order to reduce risk. While this idea may be worth considering, policymakers should also consider that size may, in some cases, confer genuine economic benefits. For example, large firms may be better able to meet the needs of global customers. Moreover, size alone is not a sufficient indicator of systemic risk and, as history shows, smaller firms can also be involved in systemic crises. Two other important indicators of systemic risk, aside from size, are the degree to which a firm is interconnected with other financial firms and markets, and the degree to which a firm provides critical financial services. An alternative to limiting size in order to reduce risk would be to implement a more effective system of macroprudential regulation. One hallmark of such a system would be comprehensive and vigorous consolidated supervision of all systemically important financial firms. Under such a system, supervisors could, for example, prohibit firms from engaging in certain activities when those firms lack the managerial capacity and risk controls to engage in such activities safely. Congress has an important role to play in the creation of a more robust system of financial regulation, by establishing a process that would allow a failing, systemically important non-bank financial institution to be wound down in an orderly fashion, without jeopardizing financial stability. Such a resolution process would be the logical complement to the process already available to the FDIC for the resolution of banks.
C. Simon Johnson, Massachusetts Institute of Technology and blogger: Andrew Haldane, head of financial stability at the Bank of England, argues that the relationship between the banking system and the government (in the U.K. and the U.S.) creates a “doom loop” in which there are repeated boom-bust-bailout cycles that tend to get cost the taxpayer more and pose greater threat to the macro economy over time. What can be done to break this loop?
The “doom loop” that Andrew Haldane describes is a consequence of the problem of moral hazard in which the existence of explicit government backstops (such as deposit insurance or liquidity facilities) or of presumed government support leads firms to take on more risk or rely on less robust funding than they would otherwise. A new regulatory structure should address this problem. In particular, a stronger financial regulatory structure would include: a consolidated supervisory framework for all financial institutions that may pose significant risk to the financial system; consideration in this framework of the risks that an entity may pose, either through its own actions or through interactions with other firms or markets, to the broader financial system; a systemic risk oversight council to identify, and coordinate responses to, emerging risks to financial stability; and a new special resolution process that would allow the government to wind down in an orderly way a failing systemically important nonbank financial institution (the disorderly failure of which would otherwise threaten the entire financial system), while also imposing losses on the firm’s shareholders and creditors. The imposition of losses would reduce the costs to taxpayers should a failure occur.
D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.