Fed Talks Thresholds, Operation Twist

Economists are predicting what the Federal Reserve will tackle at is next Open Market Committee (FOMC) meeting and the two first guesses include policy guideline discussions and a look at Operation Twist. On the first topic, many Fed execs want to make clear that unemployment cannot be the only beacon for determining threshold levels. Regarding Operation Twist, or how the Fed will hand large-scale asset purchases, many economists feel that the move to an outright asset purchase program signifies an easing of current policy, although a final determination must involve the outcome of the fiscal cliff. For more on this continue reading the following article from Economist’s View. 

Tim Duy:

Monetary Policy to Become Easier Next Week?, by Tim Duy: There are two important issues to be discussed at next week's FOMC meeting. One is the issue of specific thresholds as future policy guides. The second is the replacement for Operation Twist. Clearly, support is building for specific thresholds, and I believe policymakers will work out the details within the next meeting or two. Also, I think the general sense is that the Fed will continue to purchase long-term Treasuries after Operation Twist is complete. But will they continue to purchase the full $45 billion a month? That seems like it should be an open question, but it looks like momentum is building in that direction.
St. Louis Federal Reserve President James Bullard offered his thoughts on both these topics yesterday. On the first point, he offers support for replacing the forward guidance with a set of thresholds. I don't find this to be surprising. Bullard has never been a huge fan of the time commitment implied in the current statement. Not only does it send a pessimistic signal about the economy, in theory it should respond more flexibly to evolving economic events. But in practice, the Fed is only willing to alter the date in the event of a substantial shift in the economic outlook.
Bullard cites the 6.5/2.5 unemployment/inflation thresholds recently described by Chicago Federal Reserve President Charles Evans. I am not sure that Bullard specifically endorses these figures, but he may sense the political wind is blowing in that direction. He nicely describes six challenges to a threshold regime:

1. The Fed needs to make clear that in the long-run the Fed cannot target unemployment.
2. He believes the threshold should be on actual outcomes, not forecasts.
3. The Fed needs to communicate that policy is about more than just two variables. For example, he suggests the possibility of raising interest rates to limit asset price bubbles.
4. Unemployment is not the only measure of the labor market. The Fed takes a broader view of labor markets into consideration.
5. Unemployment can remain high, such as in Europe (I think this is really just a restatement of point one).
6. Beware that thresholds will be viewed as triggers, which they are not.

I think these are valid concerns the Fed needs to address as the communication strategy evolves. Bullard then shifts gears to Operation Twist. Currently, large scale asset purchases come in two flavors. One is $40 billion a month in outright mortgage purchases (QE3), the other a monthly swap of $45 billion in short-term Treasuries for an equal amount of long-term Treasuries (Operation Twist). The former is open-ended, the latter concludes this month. Should it be fully converted to an outright asset purchase program? San Francisco Federal Reserve President John Williams gave his opinion last month:

Meeting with reporters following a speech at the University of San Francisco, MNI asked Williams whether he thinks the FOMC should replace the Operation Twist Treasury purchases dollar for dollar upon their expiration Dec. 31. He answered strongly in the affirmative.
"My view is based on the expectation that we won't see substantial improvement in the labor market" for awhile, Williams said, adding that therefore "my view is that we should continue with purchases of long-term Treasuries after December into next year."
Williams said he favors "just purely buying long-term Treasuries at the rate we're buying."
Asked to clarify, Williams said he favors buying MBS and Treasuries "at the same rate we're doing now" -- $85 billion per month.

Boston Federal Reserve President Eric Rosengren agreed yesterday. Operation Twist changes the composition of the balance sheet, not its size. If the Fed converts to an outright asset purchase program, they will more than double the pace of net purchases. In my opinion, this appears to be a substantial easing of policy. Bullard feels similarly:

...on balance I think it is reasonable to think that an outright purchase program has more impact on inflation and inflation expectations than a twist program....
...Replacing the expiring twist program one-for-one with outright purchases of longer-dated Treasuries is likely more dovish than current policy.

I think that is correct; the conversion of Operation Twist should be considered a more aggressive policy. Yet inflation expectations (with the usual caveats about TIPS based expectations) continue to wane:

Perhaps financial market participants do not expect the Fed to commit to the full $85 billion in purchases. But this does not seem to be the case. There has been more than enough Fedspeak to suggest that additional easing is coming. Which leads me again to wonder if monetary policy is now at full throttle? $40, $50, or $85 billion a month. Does it make a difference? Or is the expectation of additional easing simply offsetting expectations of tighter fiscal policy?

Bottom Line: The Fed is gearing up to convert Operation Twist to an outright purchase program. A complete conversion should be considered a more aggressive policy stance. If the Fed wants to hold policy constant, then we would expect a less than one-for-one conversion. There are reasons to expect the Fed would go the full monty. Notably, the fiscal cliff drama already appears to be affecting the economy, even though it is more risk than reality. But why are inflation expectations sliding? And what does that imply about the effectiveness of additional easing at this juncture? Important but as of yet unanswered questions.

 This post was republished with permission from The Economist's View.

Fed Battles Inflation

Quantitative easing (QE) has been the weapon of choice of the Federal Reserve and its chairman, Ben Bernanke, to stave off another recession, maintain stable prices and keep interest rates low. The method of flushing the market with currency seems to work in the short term, and some economists argue it can work in the long term, but many people are worried inflation has to come sooner or later, and relying on artificial money generation must be a ticking economic time bomb. Bernanke disagrees (although at this point it’s hard to say whether he has a choice), noting that inflation has been kept at bay for years using (QE). Naysayers argue only time will tell and that QE is too new to predict its consequences, but for now the Fed is willing to take the risk. For more on this continue reading the following article from Economist’s View.

David Altig of the Federal Reserve Bank of Atlanta argues that the Fed's quantitative easing and twist polices were necessary to preserve price stability (Dave will be in Portland, Oregon on Thursday along with Bruce Bartlett and others at the annual Oregon Economic Forum (scroll down) that Tim Duy puts on, and I am disappointed I can't be there this year -- I'm headed to the St. Louis Fed today for a conference):

Supporting Price Stability, by David Altig: All of the five questions that Chairman Ben Bernanke addressed in his October 1 speech to the Economic Club of Indiana rank high on the list of most frequently asked questions I encounter in my own travels about the Southeast. But if I had to choose a number one question, on the scale of intensity if not frequency, it would probably be this one: "What is the risk that the Fed's accommodative monetary policy will lead to inflation?"
The Chairman gave a fine answer, of course, and I hope it is especially noted that Mr. Bernanke was not dismissive that risks do exist:

"I'm confident that we have the necessary tools to withdraw policy accommodation when needed, and that we can do so in a way that allows us to shrink our balance sheet in a deliberate and orderly way. ...
"Of course, having effective tools is one thing; using them in a timely way, neither too early nor too late, is another. Determining precisely the right time to 'take away the punch bowl' is always a challenge for central bankers, but that is true whether they are using traditional or nontraditional policy tools. I can assure you that my colleagues and I will carefully consider how best to foster both of our mandated objectives, maximum employment and price stability, when the time comes to make these decisions."

While the world waits for "take away the punch bowl" time to arrive, here is another question that I think worthy of consideration: "Looking back over the past several years, what is the risk that the Fed's price stability mandate would have been compromised absent accommodative monetary policy?"
As the Chairman noted in his speech, it isn't easy to take the evidence at hand and argue any inconsistency between the Federal Open Market Committee's (FOMC) policy actions and its price stability mandate:

"I will start by pointing out that the Federal Reserve's price stability record is excellent, and we are fully committed to maintaining it. Inflation has averaged close to 2 percent per year for several decades, and that's about where it is today. In particular, the low interest rate policies the Fed has been following for about five years now have not led to increased inflation. Moreover, according to a variety of measures, the public's expectations of inflation over the long run remain quite stable within the range that they have been for many years."

To the question I posed earlier, I am tempted to take those observations one step further. Without the policy steps taken by the FOMC over the past several years, the "excellent" price stability record would indeed have been compromised.
Consider the so-called five-year/five-year-forward breakeven inflation rate, a closely monitored market-based measure of longer-term inflation expectations. If you are not completely familiar with this statistic—and you can skip this paragraph if you are—think about buying a Treasury security five years from now that will mature five years after you buy it. When you make such a purchase, you are going to care about the rate of inflation that prevails between a period that spans from five years from today (when you buy the security) through 10 years from today (when the asset matures and pays off). By comparing the difference between the yield on a Treasury security that provides some insurance against inflation and one that does not, we can estimate what the people buying these securities believe about future inflation. The reason is that, if the two securities are otherwise similar, you would only buy the security that does not provide inflation insurance if the interest rate you get is high enough relative to inflation-protected security to compensate you for the inflation that you expect over the five years that you hold the asset. In other words, the difference in the interest rates across an inflation-protected Treasury and a plain-vanilla Treasury that does not provide protection should mainly reflect the market's expected rate of inflation.
When you look at a chart of these market-based inflation expectations along with the general timing of the FOMC's policy actions, from the first large-scale asset purchase in 2008–2009 (QE1) to the second asset purchase program (QE2) in 2010 to the maturity extension program (Operation Twist) in 2011, the relationship between monetary policy and inflation expectations is pretty clear:

Enlarge

In each case, policy actions were generally taken in periods when the momentum of inflation expectations was discernibly downward. A simple-minded conclusion is that FOMC actions have been consistent with holding the bottom on inflation expectations. A bolder conclusion would be that as inflation expectations go, so eventually goes inflation and, had these monetary policy actions not been taken, the Fed's price stability objectives would have been jeopardized.

Statements like this do not come without caveats. A perfectly clean measure of inflation expectations requires that Treasuries that do and do not carry inflation protection really are otherwise identical. If that is not the case, differences in rates on the two types of assets can be driven by changes in things like market liquidity, and not changes in inflation expectations. Calculations of five-year/five-year-forward breakeven rates attempt to control for some of these non-inflation differences, but certainly only do so imperfectly.

Perhaps more pertinent to the current policy discussion, inflation expectations have, in fact, moved up following the latest policy action—which I guess people are destined to call QE3. But unlike the periods around QE1, QE2, and Twist, QE3 was not preceded by a period of generally falling longer-term breakeven inflation rates. So this time around there will be another, and perhaps more challenging, chance to test the proposition that monetary accommodation is consistent with price stability. As for previous actions, however, I'm pretty comfortable arguing the case that the price stability mandate was not only consistent with accommodation, it actually required it.

 This blog post was republished with permission from Economist's View.

Bernanke Bluster Boosts Precious Metals

Federal Reserve Chief Ben Bernanke recently announced a plan for more central bank money printing and experts believe it means the course will be set for much of the same as the year progresses. The news of more money in circulation acted to boost values of precious metals, and gold and silver shot to levels not seen in 10 months. The jump pushed gold to $1,669.70 an ounce and silver to $30.78 an ounce, but experts say this is not so impressive when viewed in context of cyclical lows and economic forces that have pushed precious metals prices down from previous heights. For more on this continue reading the following article from Iacono Research. 

Following an impressive technical breakout the week prior that constituted the biggest combined jump in gold and silver prices in ten months, precious metals moved sharply higher again last week, capped by a late-week surge spurred by heightened expectations of more central bank money printing after Fed Chief Ben Bernanke defended previous easy money policies, what many viewed as paving the way for more of the same.

After surging nearly $40 an ounce on Friday, the gold price ended at a five-month high while posting its biggest monthly gain since January, and silver jumped more than $1.00 an ounce after the Fed Chairman spoke, rising to its loftiest level in four months.

For the week, the gold price rose 1.3 percent, from $1,669.70 an ounce to $1,691.30, and silver rose 3.1 percent, from $30.78 an ounce to $31.74. Spot gold is now up 7.8 percent for the year, down 12.0 percent from its 2011 high, and silver is up 13.9 percent in 2012, down 35.6 percent from its peak last year.

The recent move higher for the gold price appears far less impressive when viewed in the context of recent corrections as shown below and, importantly, the current recovery now appears to be “on track” with the last two major cyclical upturns that followed moves down that began in 2006 and 2008.

[To continue reading this article, please visit Seeking Alpha.]

No Fed Plan for QE3, Experts Say

The economy is “muddling along” according market observers, and experts say this state of affairs is not enough to force the Federal Reserve to initiate yet another round of quantitative easing in September. The latest Federal Open Market Committee meeting minutes indicate the Fed is closer to action, but more critics are starting to believe that action is going to be muted. Many think a prediction can be found by looking at what way centrists are leaning because it could go either, especially considering the persistent high rate of unemployment. For more on this continue reading the following article from Economist’s View. 

Tim Duy:

Chances of QE3 Diminishing, by Tim Duy: I have made the case that neither the doves nor the hawks that are important for the course of monetary policy. It is the center that is the key, and that center needs to be pulled in one direction or the other by Federal Reserve Chairman Ben Bernanke. If the 2Q12 slowdown proved to be temporary, I doubt Bernanke is inclined to pursue more QE in the absence of clear financial market disruption. And with that in mind, although economic performance continues to be no better than lackluster, recent data has dispelled the worst fears that we are heading into recession. This combined with stable financial markets argues against additional easing in September.
If the center is the key, we need to see where the center is moving. This should provide some insight into Bernanke's leanings as well. On July 13, Atlanta Federal Reserve President Dennis Lockhart said:

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

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

As of July, there are more than 4½ million fewer payroll jobs than in November of 2007. Most of these job losses were in the private sector. The share of unemployed workers who have been out of a job for more than 27 weeks has fluctuated between 40 and 50 percent over the entire course of the recovery.
I think this condition can be attributed, at least in part, to fundamental imbalances that have not yet been corrected, a situation that presents formidable challenges for monetary policymakers. There is a risk to monetary policy being employed too aggressively and without effect to address economic problems that can be resolved only by fiscal reforms that involve making tough choices about the allocation of public resources. Monetary policy can exert a powerful positive influence on an economy, but as Chairman Bernanke has pointed out, monetary policy is not a panacea.

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

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

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

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

LOCKHART SAYS DISINFLATION, DEFLATION NOT NOW A CONCERN

Back to the charts:

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

but that measure is not likely to weigh heavily in FOMC discussions. Policymakers are more likely to take their signals from financial markets.
The Reuters coverage of Lockhart's speech included this line:

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

I find it very unlikely that Bernanke gives such direction on QE3. I think the current economic and financial environment bears little resemblance to the famous Jackson Hole speech of 2010. Given the change in the tenor of the data and the financial markets, it is hard for me to believe that his risk/benefit calculus is currently in favor of additional quantitative easing. I think he might take action if he could find another tool that he thought would be more effective than additional quantitative easing, but I don't see such a tool on the horizon. Maybe he will pull something out of his hat next week, but I doubt it.
Bottom Line: Closely following the doves would lead one to conclude that QE3 was imminent. This dovish chatter keeps the possibility of QE on the table. But really this has been the case for months. That should lead one to conclude that the bar to additional QE is high, very high. The middle, led by Bernanke, is just not pulling in that direction. Indeed, recent events seem to be pulling the middle away from additional QE. Assuming the FOMC holds steady in September, I think we will be able to measure the conviction of the doves by any dissents. If San Francisco Federal Reserve President, the most dovish voting FOMC member, does not dissent, he must not have a strong conviction that additional easing is necessary. And if the doves lack such conviction, why should we expect it from the middle ground?

 This blog post was republished with permission from Economist's View.

Election-Year Politics Pin Down Fed

Political gridlock has been the order of the day while the U.S. attempts to crawl out of an economic slump, but intensified obstructionism during the run up to the election has made progress even harder. Officials at regional Federal Reserve branches have been feeling the pinch and some have appealed to their colleagues in Washington to set aside political differences and enact policy to jolt the economy. It has become apparent to many that the Fed is standing fast until after the election and many find this behavior unacceptable given the state of the U.S. market. For more on this continue reading the following article from Economist’s View. 

Tim Duy:

Is the Election Holding Back the Fed?, by Tm Duy: Boston Federal Reserve President Eric Rosengren is stepping up his call for additional policy action at the next meeting. Via the Boston Globe:

Eric Rosengren, the head of the Federal Reserve Bank of Boston, is issuing an unusual public plea to his colleagues in Washington, urging the nation’s central bankers to ignore election-year pressures and do more to jump-start the muddling economy.
Less than a week after Federal Reserve policy makers elected not to take new steps to stimulate the economy, Rosengren in an interview added his voice to a handful of dissenters, saying the central bank has to act at its next meeting in September to revitalize the economy. The Fed should not worry, he said, if the move is seen as influencing the presidential election.
“We don’t get to pick the timing of a global slowdown,” Rosengren said. “If there’s a slowdown and you have an independent central bank, the appropriate response is to act. I think that’s exactly what we should do.”

I have to admit that I was caught off-guard by the direct reference to the presidential election. I have seen speculation that the Fed is avoiding action until after the election, and this seems almost like an admission of such hesitation. Is this comment directed at the public, or at his colleagues? My response:

Some Fed specialists said the remarks from Rosengren are unusually pointed in a world where even the simplest statements are carefully worded. Tim Duy, an economics professor at the University of Oregon who writes a column called Fedwatch on the website Economist’s View, said he was struck, in particular, by Rosengren’s publicly urging the central bank to ignore the political situation.
“That would be fine to say internally. But to say that externally, to pull back the curtain and say, ‘They’re doing this for the election,’ I think is a shift and reflects his level of frustration,” Duy said.

Rosengren then goes further and calls for very aggressive policy:

Rosengren said the economy is just “treading water” and among the actions the Fed committee should consider is a repeat of what the central bank did during the recession when it spent trillions of dollars buying securities. The bond-buying program was controversial, and critics complained it did not help much. But Rosengren said anything more modest than that would probably not be enough. “It would be hard to come up with a program with a big enough impact” without big purchases of securities, he said....
...“Facing a world that’s going to be treading water, monetary policy shouldn’t just stand there and watch it happen,” Rosengren said. “We should start talking about more aggressive policy to make sure we get the kind of growth that’s consistent with improvement in the labor markets.”

Rosengren has been moving in this direction for a few months, but these sound like very pointed remarks, the remarks of someone who is very frustrated with the current stance of policy. Interestingly, such level of frustration could also be indicative of the strength of opposition to additional quantitative easing within the FOMC. Indeed, I have long-hypothesized that Federal Reserve Chairman Ben Bernanke could move the middle ground of the FOMC to the doves if he desired, and the fact that he hasn't done so reveals his preference for inaction. Consequently, the bar to further easing has been higher than believed. That continued inaction in the face of ongoing lackluster economic growth and the persistent failure to meet not just one but both parts of the dual mandate could finally be trying the patience of the FOMC doves.
Bottom Line: Who is Rosengren talking to here? It doesn't sound like he is making a case to the public when he says "[w]e should start talking about more aggressive policy." It sounds like he is making a case to the rest of the FOMC. Same with his comments on the election. At a minimum, he is another voice for aggressive easing. But such comments sound like he is frustrated with the path of policy, which would signal the strength of the resistance to further easing. Overcoming that resistance is critical to clearing the path to that easing.
Now we await Bernanke's comments, to see if he gives any ground.

 This blog post was republished with permission from Economist's View.

Krugman Criticizes Ron Paul

Economist Paul Krugman, no lightweight when it comes to fiscal knowledge, recently debated sometime Republican presidential candidate Ron Paul on the issue of his Paul’s prediction of runaway inflation, and criticized the politician’s vague references to ancient history by way of response. Krugman contends that it is no accident that politician’s cite murky historical anecdotes as a way to establish credibility for positions on current affairs, despite having a century’s worth of well-documented knowledge from which to draw – if only it supported the desired conclusion. For more on this continue reading the following article from Economist’s View.

Paul Krugman comments:

Don’t Know Much About (Ancient) History: The things I do for book sales. I debated, sort of, Ron Paul on Bloomberg.Video here. I thought we might have a discussion of why the runaway inflation he and his allies keep predicting keeps not happening. But no, he insisted (if I understood him correctly) that currency debasement and price controls destroyed the Roman Empire. I responded that I am not a defender of the economic policies of the Emperor Diocletian.

Actually, though, appeals to what supposedly happened somewhere in the distant past are quite common on the goldbug side of economics. And it’s kind of telling.

I mean, history is essential to economic analysis. You really do want to know, say, about the failure of Argentina’s convertibility law, of the effects of Chancellor Brüning’s dedication to the gold standard, and many other episodes.

Somehow, though, people like Ron Paul don’t like to talk about events of the past century, for which we have reasonably good data; they like to talk about events in the dim mists of history, where we don’t really know what happened. And I think that’s no accident. Partly it’s the attempt of the autodidact to show off his esoteric knowledge; but it’s also the fact that because we don’t really know what happened — what really did go down during the Diocletian era? — you can project what you think should have happened onto the sketchy record, then claim vindication for whatever you want to believe.

It’s funny, in a way — except that this sort of thinking dominates one of our two main political parties.

This blog post was republished with permission from Economist's View.

Stocks Up, Consumer Sentiment Down

Rising gas prices are having a negative impact on U.S. consumer sentiment, although projections suggest the feeling is temporary according to the Reuters/University of Michigan consumer sentiment index. The Energy Department noted prices edged up another $0.04 in the past week, keeping more money in the pump and leaving consumers with less to spend elsewhere. Meanwhile, improvements in the stock market have some wondering about inflation, including Federal Reserve chairman Ben Bernanke, despite gains being propped up by a strengthening labor market. For more on this continue reading the following article from Tim Iacono.

The Reuters/University of Michigan consumer sentiment index dipped from 75.3 in February to 74.3 in the first of two readings for March in a sign that rising gas prices may now be having in an impact on the mood of the consumer.

Based in large part on a recently improving labor market, the current conditions component remains firm, up from 83.0 to 84.2, however, the expectations component more than offset that gain, down from 70.3 to 68.0.

It’s a good think that equity markets don’t have a gas tank to fill every week or they too might think about pulling back but, so far, they show little sign of doing so, though that could soon change given that inflation expectations show signs of stirring to life.

Survey respondents ratcheted up their one-year outlook on consumer prices from an increase of 3.3 percent to 4.0 percent in a delayed reaction to rising pump prices that the Energy Department said gained another 4 cents over the last week, rising to a national average of $3.83 per gallon.

Five-year inflation expectations (the measure watched more closely by Fed economists) rose just one-tenth to 3.0 percent, indicating that, like Fed Chief Ben Bernanke, most Americans see rising gas prices as being temporary, a belief that, unlike Bernanke’s, could prove to be temporary itself.

This blog post was republished with permission from Tim Iacono.

Fed Finally Getting Real?

Macroeconomist Mark Thoma is wondering whether Federal Reserve Chairman Ben Bernanke is finally coming to terms with the Fed’s role in the national economic crisis based on recent comments Bernanke made before the House Committee on Financial Services that did not mirror the Chairman’s typical rose-colored pronouncements. As he related in a recent CBS News commentary, Thoma has been given hope by Bernanke’s sterner disposition that the Fed will continue to support the U.S. economy during the tender stages of its recovery, rather than resort to austerity before any improvements have a chance to take root. For more on this continue reading the following article from Economist’s View.

I have been pretty critical of the Fed throughout the crisis. I still don't think policy is aggressive enough, and the Fed has been behind the developments in the economy due to its propensity to see green shoots that aren't actually there. But at least it's leaning in the right direction:
Has the Fed Learned Its Lesson?, Mark, Thoma, CBS News: COMMENTARY Federal Reserve Chairman Ben Bernanke seems to have learned an important lesson. In his appearance before House Committee on Financial Services, Chairman Bernanke said the monetary policy committee does "not anticipate further substantial declines in the unemployment rate over the course of this year. Looking beyond this year, FOMC participants expect the unemployment rate to continue to edge down only slowly toward levels consistent with the Committee's statutory mandate." In addition, "participants agreed that strains in global financial markets posed significant downside risks to the economic outlook." There were other cautionary statements as well.

That is quite a change from Bernanke's pronouncement that the Fed was seeing "green shoots" in the economy back in 2009, and similar optimistic statements about the prospects for recovery many times after that. Time and again, however, the green shoots withered and policy ended up in catch up mode rather than out in front of the economy as it ought to be. Policymakers were consistently behind.

I don't think either monetary or fiscal policymakers have been aggressive enough throughout the crisis, and I have also worried that policymakers in Congress and at the Fed would withdraw support for the economy too soon and harm the recovery. There's little chance that policy will march the aggressiveness I believe is called for, especially this late in the game, and I'm still very worried about Congress turning to budget balancing before the economy is ready to handle it. Premature austerity could damage our recovery prospects.

But I'm becoming less concerned that the Fed will withdraw support too soon. It has committed to keeping interest rates low through the end of 2014, an extension of an earlier commitment through mid 2013. However, the commitment has wiggle room, and there are voices on the Fed who are calling for interest rate increases now. But as Chairman Bernanke made clear today, the Fed as a whole remains cautious and monetary policymakers as a whole are not ready to conclude our troubles are over. I think that's exactly the right stance to take -- hope for the best, but prepare for the worst. In the past the Fed let its hopes interfere with its preparation, but this time does indeed appear to be different.

This article was republished with permission from Economist's View.

Fed Economists Laugh It Off

A new graph is making its way around the Internet that charts the amount of laughter recorded by Federal Open Market Committee (FOMC) stenographers during meetings between 2001 and 2006 – during the ramp-up to the recession. The graph shows that committee members had increasingly more fun as the years passed, and suggests they could have been doing more to keep an eye on the growing housing bubble that would soon burst. The FOMC is expected to announce a new initiative regarding interest-rate projections and future impact, and many are wondering how many will be laughing. For more on this continue reading the following article from Tim Iacono.

The Federal Reserve transcripts from 2006 released ten days ago continue to reverberate around the internet as the central bank has become a laughing stock for being so unaware of the U.S. housing bubble that was inflating to dangerous levels throughout the year.

Dean Baker’s Alan Greenspan’s ship of fools from last week is well worth reading if for no other reason than to learn what former Fed governor Frederic Mishkin was thinking late that year and I recently came across this item at The Daily Staghunt blog that charted how much laughter appeared in the transcripts over the years.

While Fed economists are purportedly a funny lot, it does look pretty bad to see increasing joviality at a time when they could have been doing something about the housing bubble.

The FOMC (Federal Open Market Committee) meets this week and they are expected to announce of a new communication initiative with two key features – expanded interest-rate projections and an explanation of their objectives for inflation and employment. Fed Chairman Ben Bernanke will surely discuss these in detail in the press conference after the meeting and, though normally keen on audience engagement, he’ll probably be hoping that he’s not asked about the 2006 transcripts.

If we’re really lucky, someone will ask him about this chart.

This blog post was republished with permission from Tim Iacono.

Fed Backs Conversion of Foreclosures into Rentals

The Federal Reserve’s latest report on the U.S. housing market indicates its advocacy for the bundling and selling of government-owned foreclosed homes to investors who can then convert the homes into rental properties. The report notes that the market is not expected to improve and that interest in rentals will continue to increase, thereby opening the door to a government investment opportunity. Some critics believe, however, that the ulterior motive here is to neutralize an area (rental costs) that accounts the for the Fed’s “core” inflation rate by placing more rentals on the market, thereby providing more room to print money in the event of a new fiscal emergency. For more on this continue reading the following article from Tim Iacono.

The Federal Reserve’s new white paper about the U.S. housing market released just yesterday – The U.S. Housing Market: Current Conditions and Policy Considerations (.pdf) – contains the following paragraph and a good deal of supporting rationale for their recommendation to sell GSE-owned foreclosed properties in bulk to investors so that they can be converted in bulk into rentals.

The price signals in the owner-occupied and rental housing markets–that is, the decline in house prices and the rise in rents–suggest that it might be appropriate in some cases to redeploy foreclosed homes as rental properties. In addition, the forces behind the decline in the homeownership rate, such as tight credit conditions, are unlikely to unwind significantly in the immediate future, indicating a longer-term need for an expanded stock of rental housing.

While, on the surface, this makes a good deal of sense after the nation painfully learned a few years ago that home ownership wasn’t what it was cracked up to be and, ever since, home prices have been falling while demand for rental properties has grown, a massive conversion of REO properties into rental properties would also have the convenient side effect of helping the Fed keep inflation low, giving it more leeway to print up another trillion dollars or so for the greater good, should the need arise.

How so?

Recall that, part of the reason that the housing bubble grew so big was that the inflation statistics include rental prices as a proxy for the cost of home ownership, a change that was made all the way back in 1983 and that forever changed how inflation is reported and how high home prices could rise (see this Seeking Alpha article on the subject from a few years back that still ranks quite high on a search of “owners’ equivalent rent”).

After years of being subdued because everyone wanted to own a home (and nearly did), lately, rents have been rising – up about 2 percent over the last year – and, since rents account for 40 percent of the Fed’s “core” inflation rate, you can see why lower rental prices might be in the central bank’s interest.

This blog post was republished with permission from Tim Iacono.

Fed Fends Off Negative Interest

Some economists wonder why the Federal Reserve does not lower its current interest rate on reserve holdings from 0.25% to zero, thereby possibly encouraging banks to ease lending restrictions rather than hold on to currency. One answer is that the Fed fears interest slipping into negative territory, which could eliminate banks’ incentive to borrow funds from various markets and keep interest positive. Negative interest, which incentivizes dumping cash now that won’t be worth as much in the future, could cause disruptions in treasury auctions, money market mutual funds and federal funds that are not designed to weather negative interest. For more on this continue reading the following article from Economist’s View.

I've been wondering why the Fed hasn't lowered the interest it pays on bank reserves from its current value of .25 percent to zero. It probably wouldn't do much, but it would slightly lower the incentive for banks to hold cash rather than loaning it out, and more loans would help to spur the economy, so why not give it a try? In addition, unlike some other policies the Fed might pursue, this would be easily reversible, and it would help to convince critics that the Fed is trying everything it can think of.

Though it's buried deep within the post, the NY Fed explains the FOMC's reluctance to pursue this option. The argument is that it's possible for some interest rates to go slightly negative, and if they do it will cause various problems the Fed would rather avoid (see below). Since banks can borrow from anyone charging less than the rate they earn on reserves and arbitrage the difference away, paying interest on reserves puts a floor on interest rates. Here's the full argument:

Why Is There a “Zero Lower Bound” on Interest Rates?, by Todd Keister, Liberty Street: Economists often talk about nominal interest rates having a “zero lower bound,” meaning they should not be expected to fall below zero. While there have been episodes—both historical and recent—in which some market interest rates became negative, these episodes have been fairly isolated. In this post, I explain why negative interest rates are possible in principle, but rare in practice. Financial markets are generally designed to operate under positive interest rates, and might experience significant disruptions if rates became negative. To avoid such disruptions, policymakers tend to keep short-term interest rates above zero even when trying to loosen monetary policy in other dimensions. These policy choices are the source of the zero lower bound.

The standard description of the zero lower bound begins with the observation that the nominal interest rate offered by currency is always zero: If I hold on to a dollar bill, I’ll still have one dollar tomorrow, next week, or next year. If I invest money at an interest rate of -2 percent, in contrast, one dollar of saving today would become only ninety-eight cents a year from now. Because everyone has the option to hold currency, the argument goes, no one would be willing to hold some other asset or investment that offers a negative interest rate.

This argument is only part of the story, however. Safeguarding and transacting with large quantities of currency is costly. One only needs to imagine the risk and hassle of making all transactions in cash—paying the rent or mortgage, utility bills, etc.—to appreciate the safety and convenience of a checking account. Many individuals would likely be willing to keep funds in deposit accounts even if these accounts pay a negative interest rate or charge maintenance fees that make their effective interest rate negative.

Large institutional investors are in a similar situation. They use a variety of short-term investments, such as lending funds in the “repo” (repurchase agreement) market and holding short-term Treasury bills, in much the same way individuals use checking accounts. These investments will remain attractive to large investors even at negative interest rates because of the security and convenience they offer relative to dealing in currency. Some repo rates did in fact become negative in 2003 (see this New York Fed study) and again more recently (see Bloomberg). Interest rates in the secondary market for Treasury bills have also been slightly negative recently (see Businessweek).

In other words, market interest rates can move somewhat below zero without triggering a massive switch into currency. Nevertheless, central banks typically maintain positive short-term interest rates even while using less conventional tools (such as large-scale asset purchases) to provide additional monetary stimulus.

The Federal Reserve, for example, currently pays an interest rate of 0.25 percent on the reserve balances that banks hold on deposit at the Fed. The ability to earn this interest gives banks an incentive to borrow funds in a range of markets (including the interbank market and the repo market) and thus has the effect of keeping market interest rates positive most of the time. The Federal Open Market Committee (FOMC) discussed the idea of reducing the interest on reserves (IOR) rate at its September meeting, but no action was taken. Reducing this rate would tend to lower short-term market interest rates and might push some rates below zero. The minutes from the meeting report that “many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict.”

Similarly, the Monetary Policy Committee (MPC) of the Bank of England discussed the possibility of lowering the official Bank Rate below 0.5 percent at its September meeting, but decided against doing so. The MPC had previously expressed concern that “a sustained period of very low interest rates would impair the functioning of money markets.”

Some examples of areas where disruptions could potentially arise in U.S. financial markets are:

• Money market mutual funds: Money market funds operate under rules that make it difficult for them to pay negative interest rates to their investors, either directly or by assessing fees. Many of these funds would likely close down if the interest rates they earn on their assets were to fall to zero or below, possibly disrupting the flow of credit to some borrowers.
• Treasury auctions: The auction process for new U.S. Treasury securities does not currently permit participants to submit bids associated with negative interest rates. If market interest rates become negative, new Treasury securities would be issued with a zero interest rate—effectively a below-market price—and bids would be rationed if demand exceeds supply. Such rationing, which has occurred in recent auctions, would generate an incentive for auction participants to bid for more than their true demand, leading to even more rationing. This situation could generate market volatility, as unexpected changes in the amount of rationing in each auction could leave some investors holding either many more or many fewer securities than they desire.
• Federal funds: A decrease in the IOR rate would also likely affect the federal funds market, where banks and certain other institutions lend funds to each other overnight. A lower IOR rate would give banks less incentive to borrow in this market, which would likely decrease the amount of activity. When less activity takes place, the market interest rate will be influenced more by idiosyncratic factors, making it a less reliable indicator of current conditions. This decoupling of the federal funds rate from financial conditions could complicate communications for the FOMC, which operates monetary policy in part by setting a target for this rate.

These examples demonstrate that many current institutional arrangements were not designed with near-zero or negative interest rates in mind. In principle, these arrangements—such as the rules governing mutual funds and Treasury auctions—could be changed. The implementation of a “fails charge” in 2009 for the settlement of Treasury securities (see this New York Fed study) is one example of an institutional adaptation that allows markets to function better at very low interest rates. (A similar charge is scheduled to take effect in some mortgage-related markets in February 2012.) In practice, however, such changes may take significant time to implement and could simply move disruptions to other markets.

Given the markets’ limited experience with very low interest rates, it is difficult to predict with any degree of certainty how they will react to them. If the types of disruptions described above turn out to be significant, taking steps to lower short-term interest rates could actually make financial conditions tighter rather than looser and thus hinder the economic recovery. To avoid this outcome, policymakers tend to choose policies that keep market interest rates positive. In other words, the potential for negative interest rates to disrupt financial markets limits the extent to which policymakers can stimulate economic activity by lowering interest rates. This limit is known as the zero lower bound.

This article was republished with permission from Economist's View.

Fed Oblivious to Market Reality, Says Critic

Market observer Tim Iacono opines on the meeting minutes released for September’s Federal Open Market Committee, wherein members concluded home prices in the U.S. were not falling and that consumer spending looked healthy. Iacono pulls directly from the minutes to discuss where these ideas may have originated for committee members, and recalls the last time the Federal Reserve was caught unawares by the bursting housing and credit bubbles in 2006. For more on this continue reading the following article from Tim Iacono.

[It's not surprising to read about how ill-prepared the Federal Reserve was back in late-2006 for the aftermath of the bursting of the housing and credit bubbles that, by that time, wasn't much they could do about even if they wanted to. In this item from October 12th, 2006, the Fed meeting minutes noted that "considerable uncertainty was expressed regarding the ultimate extent of the downturn in the housing sector" as central bank policy makers were the proverbial lambs being led to slaughter (along with millions of homeowners).]

ooo

Yesterday’s release of the Minutes of the Federal Open Market Committee from last month’s Fed policy meeting showed continuing concern over rising prices, members indicating a “substantial risk” that inflation may not decline with a slowing economy.

Members were also concerned about housing, though apparently they’re falling a little behind in their reading.

In their discussion of major sectors of the economy, meeting participants focused especially on developments in the housing market. Although the situation varied somewhat across the nation, housing activity was continuing to contract in most regions. Home sales had slowed considerably, and anecdotal reports suggested that more buyers were canceling contracts for purchases. Participants noted that inventories of unsold homes had climbed sharply in many areas and that builders were taking a number of measures to reduce inventories. Both permits for new construction and housing starts had declined significantly. Available measures of home prices suggested that appreciation had slowed considerably but prices in most areas were not falling, although some sellers were reported to be providing various inducements to potential purchasers that reduced effective prices.

Apparently they haven’t seen last month’s report from the National Association of Realtors where both new and existing home prices have fallen from year ago levels – it was in many of the papers. It’s plain to see in the chart from Northern Trust.

If they’re waiting for the third quarter report from the OFHEO (Office of Federal Housing Enterprise Oversight), they’ll have to wait another two months. The December report will include a highly anticipated data set as it reflects resale prices of existing homes as well as assessed values for refinancings. This report is generally deemed the most reliable measure of home prices and the December publication could be a doozy.

No one seemed overly concerned about consumer spending – the lynchpin of our modern economy. Maybe they should be. The buoyant effects of increasing household wealth due to rising home prices may be short-lived – not likely to be offset by more jobs and higher wages anytime soon.

In fact, you have to wonder what they’re referring to in the first bold, italicized passage below. Lackluster job creation and a fraction of a percent gain in real wages can’t be driving consumer spending – it’s still all about home equity and easy credit.

Thus far, the drop in housing market activity appeared not to have spilled over significantly to other sectors of the economy. Indeed, consumer expenditures appeared to have been expanding moderately over the previous few months, buoyed by increases in employment, personal income, and household wealth. Contacts in some Districts reported that retail sales had picked up a little most recently. Meeting participants noted that consumer spending going forward would be supported by the higher levels of personal income indicated by recent revisions to the national income and product accounts, by further gains in employment, and by the decline in consumer energy prices over recent months. However, considerable uncertainty was expressed regarding the ultimate extent of the downturn in the housing sector and the degree to which the slowing in housing activity and the deceleration in home prices would affect consumption and other expenditures going forward.

This is going to be a long slow process – opinions about something as dear as real estate are slow to change. This is painfully obvious when reviewing a recent survey in Barron’s where it is learned that more than 90 percent of the people surveyed still think that home prices only go in one direction – up.

More than three-fourths of those polled saw their home’s value rising over the next few years. More importantly, almost half believe the gain will be more than five percent per year and almost a third believe future gains will top ten percent annually.

Inflation Central

On inflation, there was near consensus that vigilance is still needed. Efforts to tame the cost of owners’ equivalent rent have met with some success – it’s too bad this is a cost that no one pays. In the view of the assembled board, there is clearly more work to do.

Many meeting participants emphasized that they continued to be quite concerned about the outlook for inflation. Recent rates of core inflation, if they persisted, were seen as higher than consistent with price stability, and participants underscored the importance of ensuring a moderation in inflation. To be sure, very recent data on inflation suggested some improvement from the situation in the late spring, partly reflecting slower increases in owners’ equivalent rent. Also, the considerably lower level of energy prices of recent weeks, if sustained, would help reduce overall inflation and damp increases in core prices.

Moreover, businesses would meet more resistance to attempts to pass through cost increases in the less robust economic circumstances that were likely to prevail at least for a time. However, energy prices remained quite sensitive to a wide range of forces, including geopolitical developments, and might well rebound. To date, the available evidence indicated that inflation expectations remained contained–indeed, expectations of price increases for the next few years had fallen some as energy prices declined. Nonetheless, several participants worried that inflation expectations could rise and the Federal Reserve’s willingness to carry through on its intention to seek price stability could be called into question if cost and price pressures mounted or even if there was no moderation in core inflation. Looking forward, most participants thought that the most likely outcome was a reduction in inflation pressures, but the anticipated decline was only gradual and the uncertainties around that forecast were skewed toward higher rather than lower inflation rates.

Still wondering how poll respondents can assess future inflation based on anything other than what they see at the gas pump each week, the thought of the Fed’s inflation fighting resolve being called into question if the public doesn’t see core inflation recede – well, that’s just silly.

The decision to hold rates steady in September was easier than in August, a decision that was described as “a particularly close call”. Bond prices fell on word that inflation is not yet dead and the expectation of future rate cuts declined.

Meanwhile the Dissenter Speaks

At about the same time that the Fed meeting minutes were released, Jeffrey Lacker of the Richmond Fed spoke before the Washington D.C. Chamber of Commerce on the regional economic outlook. Recall that Mr. Lacker has been the lone dissenter at both of the last two Fed meetings, casting his vote for a another quarter point hike while the rest of the board felt that “no-change” was the correct course.

He made a point to express his discomfort with what he’s seen in the inflation statistics lately.

I’ve said on several occasions that I would like to see inflation average about 1.5 percent over time, as measured by our preferred statistic, the price index for core personal consumption expenditures (often referred to as just “the core PCE index.”) Moreover, I have also said that I would be comfortable if inflation was a little higher or lower, coming in between 1 percent and 2 percent. Several other policymakers and economists have also endorsed that range as a functional definition of price stability. But inflation has been outside that comfort zone for over two years now. It was 2.2 percent in 2004, 2.1 percent in 2005, and has come in at a 2.5 percent annual rate so far this year. And inflation looks worse if, instead of using the core PCE index, we were to use the overall index, which includes energy prices. That measure of inflation was 3.2 percent over the last 12 months.

That’s funny – inflation looks worse if you include energy.

The official definition of inflation is now clearly two steps removed from reality – first you have the prices that people actually pay for things, then you have the overall consumer price index, and then finally, there is the definition of inflation in the eyes of practitioners of the dismal science – the core rate.

But, there appears to be a breach in the core.

Moreover, the longer inflation remains elevated, the more difficult it will be to bring it back down. As people observe actual core inflation of 2.5 percent, along with the FOMC’s reactions, they adjust expectations regarding future inflation, and those expectations become the basis for price setting in product and labor markets. (By the way, it was for his contributions to economic research on exactly this phenomenon that Professor Edmund Phelps was awarded the Nobel Prize in economics a few days ago.) If the Fed were to allow inflation to remain above target for too long, inflation expectations could become centered around the higher rate. Once that occurs, history tells us that strong and more costly policy actions would be needed to bring inflation and inflation expectations back down. We don’t have any perfect measures of inflation expectations, but what we do have suggests that market participants do not foresee a rapid fall in core inflation. This is why I have argued for further policy actions to convincingly restore price stability.

Economists really are a naive lot. For some reason they think that market participants are tuned into the whole idea of core inflation, and that somehow this is an indication of whether or not the Fed is doing its job? While we can all dream of inflation only being around two percent, that appears to be a concept that exists only in Fed studies and classrooms.

Someday, people will realize what is happening to their money, and if this survey is any indication – a survey that shows the number one worry people currently have is rising prices – that day may be sooner rather than later.

This article was republished with permission from Tim Iacono.

Bernanke Taking Backseat, Economist Says

Economist Tim Duy believes that Federal Reserve Chairman Ben Bernanke’s latest address to Congress sounded a lot like he was trying to shift the responsibility for economic recovery to fiscal policymakers. Duy argues, however, that it is the Fed that must work to normalize monetary conditions by allowing inflation to rise so as to escape the current liquidity trap and achieve a nominal GDP or price level. Otherwise, fiscal policy reinforces deficit spending that will lead to successive recessions or worse. Duy says the Fed’s insistence that inflation stay below 2% is not going to help secure economic recovery in the long term and that fiscal policy will not change that. For more on this continue reading the following article from Economist’s View.

Tim Duy:

Don't Let Monetary Policy Off The Hook, by Tim Duy: Re-reading Federal Reserve Chairman Ben Bernanke’s latest testimony to Congress left me increasingly puzzled by his conclusion:

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies--pertaining to labor markets, housing, trade, taxation, and regulation, for example--also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

This is a clear effort to shift the focus away from monetary policy onto the fiscal side of the equation. But I think there is a significant flaw in that position. Fiscal policymakers will be completely unable to address medium- or long-term budget issues as long as there exists a sizable output gap and high levels of unemployment. Persistently low levels of output will necessitate deficit spending, and low interest rates will justify that spending. That is the lesson of Japan. Nor will the economy naturally gravitate toward such any other outcome – we are stuck in a liquidity trap. That is also the lesson of Japan.

Assuming the proximate cause of the current US economic environment is indeed a liquidity trap, then a solution to that problem lays solely in the hands of monetary policymakers. In short, the primary economic challenge is to lift the US from the zero bound floor; until that happens fiscal policy will limp along like that of Japan, with ever-growing debt that does little than serve as a partial stopgap. The deficit spending becomes a long-run outcome rather than a short-run solution.

Simply put, the Federal Reserve needs to take responsibility for ending the liquidity trap. Instead, as Scott Sumner summarizes:

The Fed has plenty of credibility, that’s not the problem. The problem is that they are using the credibility to assure investors that low inflation is here to stay. With the right target, there would probably be no need for massive quantitative easing, or other extraordinary policies.

First and foremost, low inflation is the primary objective of Fed policy. They have repeatedly set expectations that the increase in the balance sheet is only temporary, and will be reversed as soon as possible. On not one but two occasions this cycle they prematurely shifted gears to setting expectations for tighter policy, which is effectively the same thing as engaging in tighter policy. They have offered a half-hearted attempt to remedy this situation by announcing a commitment to low rates, but have made it remarkably clear it is not a real commitment. From the Fed minutes:

Most members, however, agreed that stating a conditional expectation for the level of the federal funds rate through mid-2013 provided useful guidance to the public, with some noting that such an indication did not remove the Committee's flexibility to adjust the policy rate earlier or later if economic conditions do not evolve as the Committee currently expects.

Fear of inflation prevents the Federal Reserve from making an unconditional commitment. And therein lies the stumbling block to real policy change. It is virtually impossible to imagine reestablishing the pre-recession nominal GDP trend, and entirely impossible to regain the pre-recession price trend, without accepting a temporary acceleration of inflation along the way.

More succinctly, we will not lift the economy off the zero-bound without accepting higher than 2% inflation. Since the Federal Reserve has made it clear they will not accept inflation greater than 2%, the economy will not clear the zero-bound. And if the economy does not clear the zero-bound, we will be faced with perpetual and unavoidable deficit spending.

Deficit spending is not accommodated by the Federal Reserve via low interest rates; it is made necessary because the Federal Reserve sees no urgency ending the lower bound challenge. Which means it is ridiculous to believe that the Fed can dump off this problem on fiscal policymakers. How can the state of monetary policy have deteriorated so much that now even Bernanke claims “regulation” is holding back the economy? Yet here we are.

Where should the Fed go from here? First and foremost, they need to make a commitment to pull away from the zero-bound. As Sumner suggests, they need this commitment clearly defined by a target such as reestablishing nominal GDP or price level. The need to implement open-ended action to achieve this target. My suggestion is to announce they will make permanent additions to their balance sheet by purchasing on the secondary market $5 billion of US Treasury securities every week until the target is reached. I think they need to make permanent additions to be credible – they have clearly expressed that previous balance sheet expansions should be viewed only as temporary.

Won’t this amount to monetization of deficit spending? Yes, but if Sumner is correct, less than might be feared, as the commitment is more important than the size of the purchases. And I already arrived at the conclusion, aided by Bernanke’s 2003 speech, that the situation requires a greater coordination of monetary and fiscal policy. Moreover, even if sizable purchases are required, there is no reason this needs to be a problem. As Bernanke has already explained, the Fed simply needs to make clear its target and once that target has been reached, they will adjust policy appropriately to maintain the nominal GDP or price level trend. In other words, purchases will be suspended and policy will by that point revert to traditional interest rate management, with the possible reduction of the portion of the balance-sheet expansion that to-date has been viewed as temporary.

Once the Fed achieves normal monetary conditions, the ball will be back in the hands of fiscal policymakers, who may then soon understand that policy is a lot different when interest rates create real constraints on spending and taxes. But that is a battle for another day.

Bottom Line: It is ludicrous for the Fed to declare the primary economic responsibility is now on fiscal policy. As long as we are in a liquidity trap, fiscal policy is stuck in a never-ending cycle of deficit spending. Absent that spending, the economy will simply slip backwards into recession again and again. The exit from the liquidity trap can only come from the monetary side of the equation. Try as he might Federal Reserve Chairman Ben Bernanke cannot escape his policy responsibilities. And we shouldn’t let him.

This blog post was republished with permission from The Economists View

Bernanke Passes Buck

Tim Iacono takes an unimpressed stance with regard to Federal Reserve Chairman Ben Bernanke’s statements to the Joint Economic Committee on October 4, 2011. Bernanke remarked that while the Fed would do everything in its power to create an optimal economic environment for Americans, the responsibility for economic recovery rested on the shoulders of everyone, including those who negotiate fiscal policy in the areas of trade, housing, taxation and regulation. In other words, Bernanke admitted printing more money in every instance of financial dire straits may not be the best answer, and that it was time for Congress to do its part. For more on this continue reading the following article from Tim Iacono.

It would appear that Federal Reserve Chairman Ben Bernanke is doing all that he can to ensure that conditions for both the U.S. economy and financial markets get worse not better. At least, that’s the conclusion that can be drawn from his statement before the Joint Economic Committee today in Washington on the central bank’s outlook for the economy.

Monetary policy can be a powerful tool, but it is not a panacea for the problems currently faced by the U.S. economy. Fostering healthy growth and job creation is a shared responsibility of all economic policymakers, in close cooperation with the private sector. Fiscal policy is of critical importance, as I have noted today, but a wide range of other policies–pertaining to labor markets, housing, trade, taxation, and regulation, for example–also have important roles to play. For our part, we at the Federal Reserve will continue to work to help create an environment that provides the greatest possible economic opportunity for all Americans.

Unless he says something in the Question & Answer session to contradict this dismal view of our current condition and an expressed unwillingness for the Fed to act, it would seem that the helicopter fleet is permanently grounded and markets shouldn’t expect the printing press to again be summoned for the greater good.

This blog post was republished with permission from Tim Iacono.

Fed Powerless to Make Change, Says Economist

Economist Tim Duy refers to the next meeting of the Federal Open Market Committee as “rearranging the deck chairs” on the Titanic, arguing it is clear the organization’s monetary policy is ineffectual without new fiscal policy to back it up. New fiscal policy, however, is a non-starter due to Congress’s inability to agree on legislation. Duy believes it may help to push interest rates into negative territory, effectively charging banks for their growing reserves, so that they may start lending again, but acknowledges it may only result in money being pushed back into safe funds and cause banks to start charging fees to customers, which will result in less people turning to banks for loans or even basic services. For more on this continue reading the following article from Economist’s View.

Tim Duy says he has "trouble seeing the FOMC doing anything really big at this point":

Rearranging the Deck Chairs, by Tim Duy: Here we are, again staring down the barrel of an FOMC meeting while deeply entrenched in a subpar equilibrium, with output well below the pre-recession trend and unemployment stuck in the high single digits. What will the Fed bring to the table this time around? Considering the magnitude of the economic challenge, expectations are low: A modification of the FOMC statement to reflect an increasingly pessimistic outlook couple with some version of “Operation Twist,” an effort to reduce longer-term interest rates by extending the duration of the Fed’s portfolio of Treasury securities. There is an outside change the Fed lowers interest on reserves, but I view that as unlikely at this juncture. Even more unlikely is another round of quantitative easing. I don’t think there is much appetite at the Fed for additional asset purchases given the inflation numbers and the stability of longer-term inflation expectations relative to the events that prompted last fall’s QE2.

Will additional Fed action accomplish much if anything? I admit to being increasingly skeptical that the Fed is doing much more than pushing on a string. Interest rates on are less than 1 percent out to five year, which pretty much means whatever the Fed is doing at that horizon is just shifting around the composition of risk free assets. There is some room as you move to the 10-year horizon – at least there you have 200 basis points to play with. But even with some room to maneuver, in order to have significant impact, I think they need to be throwing around some big numbers when it comes to Operation Twist. Via Marketwatch, former Federal Reserve Vice-Chair Alan Blinder:

Blinder agreed that “some version of twist” is “the likely next step.” The Federal Open Market Committee will meet for two days next week to determine whether and how to ease further.

Blinder said the program needed to be large to have a meaningful impact.

“The twist is a sufficiently weak instrument so to do it in tiny amounts it almost becomes laughable,” he said.

Likewise, the same holds for another round of quantitative easing. Recall that estimates of the interest rate effect of QE2 were relatively modest, on the order of 20bp. I am not sure that any of us believe that another 20bp will be the bullet that pulls us out of the slump.

So if the Fed wants to have any meaningful impact, it needs to do something really, really big, and even then, a “meaningful” outcome is not assured. And, in any event, I have trouble seeing the FOMC doing anything really big at this point – it seems the center of the Fed questions the basic effectiveness of policy to do much more than raise inflation given what are increasingly perceived as structural impediments to growth. It could be the Fed is inclined to take additional actions only to look like they are doing something.

Moreover, there is this ongoing concern the Fed is doing nothing more than aggravating the lending situation by crushing down longer-term yields. The logic is that banks need some interest rate spread to justify lending. In the current environment, they see no reason to take on additional lending to any but the safest clients – not enough margin to justify the risk of a loan default.

What can be done to steepen the yield curve and this induce additional lending while at the same time holding long term rates low to encourage borrowers to line up at the bank? Override the zero lower bound to induce negative short-term interest rates. Blinder again:

Blinder said the Fed could first cut the interest rate on excess reserves to zero “just to make sure that there are not some unintended consequences that are horrendous,” he said.

The rate could then be pushed into negative territory.

The notion is strongly opposed by banks, who view it as a tax.

Blinder doesn’t disagree with that characterization.

“The whole notion is you should tax things you don’t like people to do, and subsidize things that are essential,” he said.

“One thing we don’t like is banks just piling up idle reserve,” he said. “We would like to push that money out of the banks and have them do something with it.”

Although some money will undoubtedly go into super-safe money funds, “the hope is that some fraction goes into increased lending,” he said.

You get the idea – whatever money the Fed has injected into the economy via QE2 has been reabsorbed by the Fed in the form of excess reserves rather than supporting loan growth in the economy. To solve that problem, charge banks for holding reserves at the Fed, thus inducing them to get their acts together and start lending.

Will it work, or will there be some serious, negative unintended consequences? Consider this story of soaring bank deposits (hat tip to CR):

Americans are pumping money into bank accounts at a blistering pace this year, sending deposits to record levels near $10 trillion on escalating fears that the U.S. economy is on the verge of another implosion.

There's no sign that the flood into checking, savings and money market accounts is slowing down. In the last three months, accounts at U.S. commercial banks have increased $429 billion, or 10%, almost double the increase for all of last year.

The money is coming in fast! Good news? No:

There's one big problem: Banks don't want your money.

"Banks and credit unions are doing everything they can to get rid of the cash except make loans," said Mike Moebs, a Lake Bluff, Ill., banking consultant.

He said banks are driving away deposits by refusing to renew CDs at higher rates and by imposing fees on checking accounts for depositors who don't use other, profitable financial services as well.

The banking sector is reacting to a flood of money by trying to push back the tide, not by opening up the loan spigot. If the Fed pushes the interest on reserves into negative territory, will that be enough to spur lending? Or will banks simply do more of what they are already doing? The path of least resistance is to keep doing more of the same.

And if consumers are only charged for money they hold in the bank, effectively earning negative interest rates themselves, will they spend more money, or just start stuffing their mattress? And maybe start stuffing it twice as fast. You know its bad when banks won’t take your money. Time to dust off the Roubini portfolio – dried food, ammunition, and gold. I guess that is how gold can go off the charts in both an inflationary or deflationary environment.

In short, it is not evident that more monetary policy will make its way down to the heart of the problem:

Bankers such as Robert H. Smith, former chairman of L.A.'s Security Pacific Corp., say the industry is being throttled by a combination of the weak economy and regulations that were tightened in the aftermath of the financial crisis.

"What little demand that is out there for loans is regarded very skeptically [by the banks] because of the pressures from the regulators," said Smith, who sold Security Pacific to Bank of America 20 years ago and is now a founding director of Commerce National Bank in Newport Beach.

Which came first, the chicken or the egg? Is the economy weak because lending is tepid, or vice-versa? The lack of potential borrowers with sufficient cash flow who actually want to borrow money clearly hampers the effectiveness of monetary policy through either traditional or nontraditional channels.

So what is left? I keep coming back to the same conclusion. That to be effective at this juncture, additional monetary policy must be coordinated with additional fiscal policy. The Fed creates the money, fiscal policymakers ensure it gets into the hands of someone who will spend it, boosting demand until interest rates rise and the pool of ready and willing borrowers swells. At that point the banking sector has someone to loan to and a spread to work with.

Bottom Line: When the Fed meets this week, will they accommplish anything more than rearranging the deck chairs? I increasingly see the need for dramatic action to decisively lift the economy off the zero bound. The comparisons to Japan and getting a little too close for comfort; it is easy to how the US economy limps along for the next decade characterized by rock-bottom interest rates and never-ending fiscal deficits.

This article was republished with permission from The Economist's View.

Finding Shelter From Unrestrained Money Printing

There is an outcry of investors who worry about the consequences of unimpeded printing of dollars, as it increases the danger of hyperinflation. Can our unbacked fiat money system survive the aggressive monetary policies of the central bank? If the history of fiat money is any indication, gold investment is as attractive as ever. For more on this, see the following post from The Prudent Investor.

Neither CNBC, the Bull Street Journal or the Debt Times have covered the latest earth-shaking news reported in the new media concerning gold price suppression by governments and central banks. Let me first send respectful hat tips to Zerohedge, EconomicPolicyJournal.com and GATA who all came out in the last 2 weeks with official documents that prove that especially the USA has a most vital interest to keep the price of gold as low as possible. Please check out all three sources to find links to countless official declassified documents that deal with the hot issue of gold manipulation.

Looking at the 10-year chart shows that all multi-billion operations by central banks in the gold market have led to nothing else than the current near-to-record prices although these institutions can short gold unlimited via futures markets.

The fear of a gold price that would correctly mirror the uncountable money printing excesses which show us that central banks are no more than one-trick-ponies. Take away their privateering privileges of creating money out of thin air and it becomes understandable that tireless Congressman Ron Paul wants nothing less than abolishing the Fed.

While Ron Paul has still many hurdles in front of him he at least nurses a strongly growing community supporting him.

Happy USA - it has at least a few million citizens who understand the biggest ponzi scheme in history, AKA Federal Reserve Notes (FRN) created by the trillions nowadays, and who begin to fight this scheme that led to the impoverishment of every generation in the last 3 centuries.

The Situation in Europe is Sad at Best
The situation in Europe is sad at best. I presume that the number of Europeans understanding the diabolic actions of central banks which always ended in hyperinflation would not fill more than a small town concert hall.

While Fed Chairman Ben Bernanke encounters a more and more aggressive environment on his trips to Congress and Senate, ECB President Jean-Claude Trichet can still get away with such blatant disinformation in the European Parliament (EP) like the following 5 bullet points presented to EU politicians on September 28:

1. First, we have fully accommodated banks’ liquidity needs at fixed interest rates.
2. Second, we have further expanded the list of assets eligible as collateral.
3. Third, we have further lengthened the maturities of our refinancing operations.
4. Fourth, we have provided liquidity in foreign currencies, notably the US dollar, to address the need of euro area banks to fund their dollar assets.
5. Fifth, and finally, we have launched a direct covered bonds purchase programme to support financial markets.

You don't have to be an expert to get angry on the nonsense Trichet tells a generally disinterested EP with no second-guessing of his elaborate speeches that hide the simple process of creating unbacked fiat money by the shipload below a couple of technical terms that work like Quaalude on the EP members.

Trusting that my readership knows about the undeniable fact that so far all experiments with unbacked money ended in hyperinflation I nevertheless want to point out that the abolition of metal standards - gold and/or silver - had at least one positive fact: All kingdoms and empires collapsed, beginning with the revolution in France in 1789 that became the first democratic republic and set a precedent for the rest of the world. Monarchic rulers have only survived on a representative level and they are certainly a proper looking circle for ribbon-cutting ceremonies of all kinds.

Allow me to point you again to the 3 sources in the first paragraph of this post (and save me from uploading PDFs when they can be found there easily) that show us that the real power has moved from policymakers to central banks since the USA abandoned the gold standard in 1971 under a pardoned criminal by the name of Richard Nixon.

The gold standard is most uncomfortable for politicians as it would limit their spending. After almost 4 decades where the public was talked out of gold with the main argument that gold is the relic of a past of un-sophisticated finance, gold is stronger than ever.

Gold has Never Lost its Value in 6,000 Years
Gold has never lost its value as all fiat currencies did and it is the last measure we have to calculate real inflation. If you were told that a bag of potatoes cost 3 guilders or 6 florins or 1 mark some decades ago you would not be able to get down to the real price. But if you are parsing historical price statistics and you find out that one troy ounce bought you 100 bags of potatoes it becomes pretty easy to compare it with current prices.

But this probably the last thing those in charge of the financial world want. Inflation can fool people for a long time as every history of a fiat currency begins with the soothing effect that everybody feels richer.

But there is also another undisputed pattern in the history of unbacked money. The trust about its purchasing power took always only a few months, e.g. Germany's hyperinflation, that collapsed in less than 2 years and set the ground for the rise of Adolf Hitler which then led to the demolition of Europe.

In my opinion it is astonishing that in the presently running ruination of the Western world because of unbacked paper money any discussion dogmatically avoids a return to metal backed money. While China's central bank governor favored a commodity based currency last March in a most interesting article I cannot agree to use a commodity basket as backing for a new international monetary system. All commodities are too volatile and can be manipulated in many ways. Just imagine Russia/China/India announcing that their grain stocks have been erased because of bacterial contamination.

There is only one solution to arrive at a stable monetary system: The paper money must be backed by gold and/or silver as they are a value in itself. This worked well for 5,700 years. It would be better for the world to return to this old fashion instead of wasting more time discussing how to repair the monetary system with the same built in weaknesses that have disowned every generation since 1720.

This post has been republished from Toni Straka's blog The Prudent Investor.