Fed Prints More Money

A quick look at the Federal Reserve’s balance sheet in terms of assets has led some economist’s to wonder what the Fed is planning to do, while others say there is no plan at all. The lion’s share of assets are tied up in U.S. Treasury securities and mortgage-backed securities, which doesn’t seem like a problem when inflation rates are kept in check as they are now, but when considering the financial turmoil experienced in the last seven years there are some who believe that more quantitative easing may lead to rude awaking in this fragile financial ecosystem. For more on this continue reading the following article from Tim Iacono. 

After catching up a bit on all the commentary related to the Federal Reserve’s ongoing money printing effort such as this item from yesterday and today’s offering from Jim Jubak at MSN Money where it was concluded that “The Fed has no endgame“,  refreshing the simplified graphic of the central bank’s balance sheet below seemed like a good idea, particularly since they are rapidly closing in on the $4 trillion mark.



Of course, there is a growing consensus that this is all benign (or at least irrelevant as long as stock prices are rising) and that argument is lent some credence by the low rates of inflation for consumer prices reported in the West (inflation in developing nations is an entirely different matter). Somehow, it seems the quadrupling of the Fed’s balance sheet (and then some) will prove to be anything but benign.

This article was republished with permission from Tim Iacono.

Economist Skewers Fed’s Expert Outlook

Tim Iacono takes note of Neil Irwin’s recent critique in the Washington Post of U.S. government economists and their prognostications for the last few years, arguing that they basically don’t know what they’re talking about and may even be guessing. He points to their GDP growth predictions for 2011 and 2012 and how they were both similarly inflated. He then points to the outlook for 2013 and suggests the rhetoric could have been cut and pasted from previous years, leaving some to expect the worst when it comes to this year’s economic performance. For more on this continue reading the following article from Iacono Research.

A look at the abysmal track record in recent years in forecasting economic growth by the nation’s top government economists as related by Neil Irwin in this Washington Post story. Also see the related graphic that depicts how poor a job the economy has been doing in getting back to its “potential” growth.

They say that the essence of futility is to keep doing the same thing while expecting a different result. But is that what key government forecasters are doing in determining their outlook for the economy?

Throughout the halting economic recovery that began in 2009, the formal economic projections released by the Congressional Budget Office, White House Council of Economic Advisers, and Federal Reserve have displayed quite a consistent pattern: This year may be one of sluggish growth, they acknowledge. But stronger growth, of perhaps 3.5 percent, is just around the corner, and will arrive next year.

Consider, for example, the Fed’s projections in November of 2009. Sure, growth would be slow in 2010, they held. But 2011 growth, they expected, would be 3.4 to 4.5 percent, and 2012 would 3.5 to 4.8 percent growth. The actual levels of growth were 2 percent in 2011 and 1.5 percent in 2012.

What’s amazing is that the Fed’s newest projections, released in December of 2012, look like they could have been copy and pasted from 2009, just with the years changed: They forecast sluggish growth in 2013, 2.3 to 3 percent, followed by a pickup to 3 to 3.5 percent in 2014 and 3 to 3.7 percent in 2015.

Increasingly, it appears that this is one of those times when “it really is different” in that we’re not about to return to “trend growth” and for good reason – it was artificial, based on a reckless expansion of credit.

Then again, another reckless expansion of credit might just do the trick.

This blog post was republished with permission from Tim Iacono.

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.

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.

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.

Return of Depression-Era Economics

Some economists are arguing for a shift in economic perspective as the U.S. faces the threat of credit default while struggling to lift itself out of a recession that many observers deny still exists despite high unemployment and market instability. The doctrine of supply-side economics is not holding true as the country segues into a position of a lack of demand to keep up with production. No one wants to face the prospect of inflation, including policy makers at the Federal Reserve who continue to dodge it through regulatory means, even though many economists feel it is obvious that inflation is the only thing that will stave off an actual Depression that could cause the country and the world to fall into a financial tailspin. For more on this continue reading the following article from Economist’s View.

Paul Krugman is taking a break from his column today (Arrrr!), so here's a summer rerun. Can you guess when he wrote this?:

Stop worrying and learn to love inflation, by Paul Krugman: ...depression economics - the kinds of problems that characterized much of the world economy in the 1930s but have not been seen since - has staged a stunning comeback.

Five years ago hardly anybody thought that modern nations would be forced to endure bone-crushing recessions for fear of currency speculators; that a major advanced country could be persistently unable to generate enough spending to keep its workers employed; that even the Federal Reserve would worry about its ability to counter a financial market panic. The world economy has turned out to be a much more dangerous place than we imagined. For the first time in two generations, failures on the demand side of the economy - insufficient private spending to make use of the available productive capacity - have become the clear and present limitation on prosperity for much of the world.

Economists and policymakers weren't ready for this. The specific set of silly ideas known as 'supply-side economics' is a crank doctrine, which would have little influence if it did not appeal to the prejudices of wealthy men; but over the past few decades there has been a steady drift in thinking away from the demand side to the supply side of the economy. The truth is that good old -fashioned demand-side macroeconomics has a lot to offer in our current predicament - but its defenders lack all conviction.

Paradoxically, if the theoretical weaknesses of demand-side economics are one reason we were unready for the return of depression-type issues, its practical successes are another. Central banks have repeatedly managed demand - cutting rates to keep spending high - so effectively that a prolonged slump due to insufficient demand became inconceivable. Except in the very short run, then, the only limitation on economic performance was an economy's ability to produce - that is, the supply-side. ...

The question of how to keep demand adequate to make use of the capacity has become crucial. Depression economics is back. ... The free-market faithful tend to think of Keynesian policies - deliberate efforts by governments to stimulate demand - as the enemy of what they stand for. But they are wrong. For in a world where there is often not enough demand to go around, the case for free markets is a hard case to make. ...

The right perspective is to realize how very much good free markets and globalization have done; the point is to preserve those gains. One cannot defend globalization merely by repeating free-market mantras as economy after economy crashes. If we want to see more nations making the transition from abject poverty to the hope of a decent life, we had better find answers to the problems of depression economics. ...

I don't like the idea that countries will need to interfere in markets - to limit the free market in order to save it. But it is hard to see how anyone who has been paying attention can still insist that nothing of the kind needs to be done, that financial markets will always reward virtue and punish only vice.

One of the most important obstacles to sensible action, however, is prejudice -by which I mean the adherence of too many influential people to orthodox views that are no longer relevant to our changed world. ...

This brings us to the deepest sense in which depression economics has returned. The quintessential economic sentence is supposed to be 'There is no free lunch'; it says that there are limited resources; to have more of one thing you must accept less of another. Depression economics, however, is the study of situations where there is a free lunch, if we can figure out how to get our hands on it, because there are unemployed resources that could be put to work.

In 1930, John Maynard Keynes wrote that 'we have involved ourselves in a colossal muddle, having blundered in the control of a delicate machine, the working of which we do not understand'. The true scarcity in his world - and ours - was therefore not of resources, or even virtue, but understanding.

Originally published, 6.20.99

Then, as now, he points to inflation as the answer to a liquidity trap:

So what should we be doing differently? ... Japan, having fallen in its liquidity trap - unable to recover by means of conventional monetary policy, because even a zero interest rate is not low enough - and having exhausted its ability to spend its way out with budget deficits, must now radically expand its money supply. It must convince savers and investors that its current deflation will turn into sustained, though modest, inflation. Once the Japanese make up their mind to do this, the results will startle them. ... There is no economic evidence suggesting that inflation at the ... 4 per cent rate I believe Japan should target, does any noticeable harm; and the things advanced countries need to do to counter depression economics do not involve any compromise of the commitment to free markets. ...

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

Fed Moving Toward “QE3”

The Federal Reserve’s answer to woeful economic performance since the onset of the recession in 2008 is to print more money to buy up U.S. government debt in a move described as “quantitative easing.” Now it appears that despite Chairman Ben Bernanke’s stance that the Fed was through with this practice following the end of QE2, there will be a need for another round of “easing” to keep stocks from plummeting as unemployment rises. The theory is that the stimulus encourages borrowing and spending by keeping interest rates lower while buying more time for a turnaround without default, but without sound policy decisions being made in the interim it just amounts to a delay of the inevitable. For more on this continue reading the following article from Tim Iacono.

It would appear that the magic elixir of a two-year pledge for freakishly low interest rates from the Federal Reserve has an effective life of only about 18 hours since, after yesterday’s remarkable 400+ point move higher for the Dow Jones Industrial Average, that gain has been reversed in trading today, markets effectively telling Ben Bernanke and the rest of the staff at the central bank, “What else you got?”

Recall that, yesterday, the Fed fired off the first of a possible three shots that could be seen prior to what some analysts predict will be another $1 trillion or so in outright money printing to buy government debt or some other asset that, if all goes well, would goose the markets for another six months or so, just like it did last year.

After the low rate promise yesterday, what’s likely to be heard next from the Fed is: a) they intend to lower the interest paid on excess reserves to compel banks to lend a little more, or b) they’re going to fiddle with the two trillion dollars in assets they’ve purchased in recent years to somehow convince somebody to do something that would somehow right the quickly sinking ship.

Neither of these steps are likely to have a more lasting impact than yesterday’s move, so, what we’re really looking at here is either the Fed can embark on QE3 and, if all goes well, boost asset prices until mid-2012, or they can sit on their hands and watch the stock market fall further while the jobless rate rises.

Based on the three dissenting votes for yesterday’s action, any subsequent moves by the Fed will be met with similar disapproval by some voting members, however, that’s not likely to stop the doves from printing up another trillion dollars or so for the greater good.

After yesterday’s baby step in that direction, Goldman Sachs said today that QE3 sometime later this year or in early-2012 is now likely and, based on how markets are moving today, it’s hard to disagree with that view, the only variable seeming to be the size and the timing.

With the Dow now closing in on bear market territory while other stock indexes have already breached that level, you’d think that it won’t take too much more of this for the Fed to act. Moreover, the only way that we’ll likely make it to the Jackson Hole group therapy session in two weeks (where a major policy initiative could be announced) without an even more severe breakdown in equity markets is if all the Fed doves start making speeches about QE3 – when, how much, and how they see this as the best of a handful of policy options.

They’re probably already working on those speeches…

This blog post was republished with permission from Tim Iacono.

Trusting the Fed on Inflation? Apparently.

In a press conference on Wednesday, Federal Reserve Chief Ben Bernanke attempted to convince consumers that inflation in the long-term won't be an issue. Read more about this in the full post by The Mess That Greenspan Made.

The Federal Reserve seems to have those they think matter most – consumers responding to surveys and the bond market – convinced that inflation over the long-term is not going to be a problem, one of the key points made by Fed Chief Ben Bernanke in Wednesday’s press conference. This report in the Wall Street Journal today takes up that issue and presents the key measures that economists at the central bank watch closely.

Long-term inflation-expectations, from consumers and from the bond market, remain subdued and are little changed from a year ago. They point to inflation that isn’t far above the average of the past decade, when inflation was historically low.

One rough gauge of future inflation expectations is the gap between yields on plain-vanilla Treasury bonds and Treasury inflation-protected securities of the same maturity.

One favorite such measure is the “five-year, five-year-forward” break-even rate, which measures inflation expectations starting five years from now and running five years from that date.

The Federal Reserve Bank of New York’s five year, five-year forward break-even rate estimate, widely acknowledged as the gold standard of such rates, was recently 3.02%, slightly below its level in November, when the Fed announced its $600 billion quantitative easing program, or QE2.
…
A measure of long-term consumer inflation expectations echoes the message of the TIPS market. According to a monthly survey by the University of Michigan, consumers expect CPI inflation of just 2.9% in the next five years, according to a preliminary survey in April.

That long-term calm is in stark contrast to consumers’ short-term view, which sees inflation jumping 4.6% in the next year, the highest since August 2008, when oil prices were just off their highs near $150 a barrel.

Let’s hope that the Bernanke Fed is better at predicting the future path of consumer prices than they were at seeing into the future a few years ago and forecasting where home price might go and how credit markets and the banking system would hold up.

This blog post was republished with permission from The Mess That Greenspan Made.

Did The Fed Do Enough To Curb Double-Dip Risk?

Economist James Picerno breaks down the Federal Reserve's decision to invest proceeds from its mortgage and agency debt portfolio into US Treasuries. The market showed disappointment in this tepid response and Picerno says that the committee was trying to design a horse and ended up with a mule. See the following post from The Capital Spectator.

The Federal Reserve recognized that the economic recovery has slowed in recent months, according to the FOMC statement issued yesterday. The central bank also said that inflation has "trended lower in recent quarters" and that pricing pressures are likely to remain "subdued for some time." What will the Fed do to a) help keep deflationary pressures from gaining strength and b) bolster growth? Two things, according to the FOMC announcement. One, it will keep Fed funds at a zero-to-25-basis-point target rate for an "extended period." Two, it will invest the proceeds from its bloated mortgage and agency debt portfolio in longer-term Treasuries to help keep long rates low. The question, of course, is whether this will suffice to offset the downshift in economic momentum of recent months? No one really knows, but the argument that this is enough looks thin.

There are additional quantitative easing steps the Fed could embrace, including a more aggressive effort to lower long rates by "printing money" and buying long-dated Treasuries. It could also stop paying interest on bank reserves, or even charge banks a fee to keep reserves at the Fed. It's not clear how effective such actions would be, but those are tools at the central bank's disposal and it's premature to argue that they're ineffective.

In any case, the stock market certainly wasn't impressed with the Fed's statement yesterday. Equity investors initial reaction was more or less a yawn after reading the FOMC press release. The S&P 500 slipped by around 0.5% on Tuesday. By Scott Sumner's pre-emptive standard for what the Fed needed to accomplish, the crowd's early reaction was a disappointment. "In my view a stock market rise of 2% to 4% would be an indication that the Fed had done something significant, making a double dip recession considerably less likely," Sumner wrote a few days back. We didn't get anywhere near that in terms of an initial vote of confidence in stocks. Strike one.

What about changes in inflation expectations? That's a little better, but just barely. On Monday, the market's 10-year inflation outlook was 1.82%, based on the yield spread between the nominal and inflation-indexed 10-year Notes. A day later, after the Fed had spoken, the inflation outlook was higher by a thin 2 basis points, rising to 1.84%. As the chart below reminds, that's a disappointment too, given the decline in recent months.



Of course, not everyone's worried about deflation or the threat that the tenuous recovery will continue to weaken. There are still some who worry that inflation is a real and present danger now, today--and that the economy is poised to pick up a head of steam. Indeed, some who subscribe to this outlook are voting members of the FOMC, and so one could argue that yesterday's tepid response by the central bank to lean more heavily in favor of growth was a political compromise of sorts. A committee trying to design a horse ends up with a mule.

Maybe the problem is that the published economic numbers that I'm reading hide some emerging trend that favors expansion. Perhaps there are those on the FOMC who see what I can't: an imminent and robust rebound in the broad trend. If so, I wish they'd share their analysis in detail with the rest of us.

Unfortunately, the numbers, at best, speak of mediocrity in the trend, at least the numbers that are publicly available. At worst, it appears that the trend is deteriorating. As such, it doesn't take a great leap of faith to think that inflation and economic activity generally may continue to slow in the weeks and months ahead. Is this destiny? No, not yet, but neither is it beyond the pale.

If ever there was a case for more quantitative easing in an effort to elevate aggregate demand, the time is now. If not now, when? Under what conditions? Isn't the data sufficiently discouraging? Isn't the outlook convincingly soft? Or should we wait for even more discouraging numbers? Then again, if you're expecting salvation in the next round of numbers, the case for doing nothing, or even tightening, looks stronger.

Yes, there's a risk that the Fed may be laying the groundwork for higher inflation if it moves to the next level of monetary stimulus. Of course, that's the point, isn't it? We want higher inflation for the near-term future; we want higher prices, including a rise in nominal GDP. On that, we can all agree (maybe). The debate is over whether this state of affairs is fate via the current level of monetary policy. Or does the trend need additional help?

The full compliment of economic reports argues for the latter, or so it appears to this observer. Unfortunately, the Fed's degree of assistance is open to some debate. The current conditions are relativley unprecedented, and so to some extent we're knee-deep in a grand experiment.

But the numbers looking backward don't lie. For instance, one measure of the money supply is contracting (as defined by the annual percentage change in MZM money stock, calculated as M2 less small-denomination time deposits plus institutional money funds). As the second chart below shows, MZM shrunk by 2% in late July vs. a year earlier. Given the current economic climate, this trend looks inappropriate by more than a trivial amount.



What's the risk of trying to go to the next level of monetary stimulus? Unleashing runaway inflation in the years ahead is the worst-case scenario. Of course, the Fed knows how to control inflation by mopping up excess liquidity, assuming it has the discipline to act in a timely manner. That's not easy, but central banks weren't invented to be country clubs.

Then again, given the central bank's actions of late, we shouldn't assume that Bernanke and company has the stomach for a monetary battle on either the inflationary or deflationary fronts. It's always easier to split the difference and stand on the middle ground. But sometimes monetary policy requires something more. Arguably, this is one of those times.

This post has been republished from James Picerno's blog, The Capital Spectator.

The History Of Uncertainty Following Recent Recessions

Jeff Kleintop, writing for The Street, points out some interesting similarities between the current state of the economy and the period following the 1992 and 2001 recessions. About a year after the 1992 and 2001 recessions, the Fed recognized a high level of uncertainty, which led to a final monetary stimulus to overcome a post recession soft spot. See the following article from The Street for more on this.

In his recent testimony to Congress, Federal Reserve Chairman Ben Bernanke used the phrase "unusually uncertain" to describe the U.S. economic outlook. The word uncertain was used five times in the statement released at the conclusion of the June 23 meeting, and was used 16 times in the minutes released on July 28. We may see more of the word uncertain this week, as the Fed releases the statement from its Aug. 10 meeting at 2:15pm that day.

The economy again began to grow last summer, putting the current bout of early cycle uncertainty at about four quarters since the end of the recession. In contrast to Chairman Bernanke's remark, the current uncertainty is not all that unusual at this early stage of an economic cycle. In fact, based on the Fed's own words, the current level of uncertainty is actually common at this stage of the economic cycle.

• In March 2003, about five quarters after the 2001 recession had ended, the Fed's Beige Book used the word uncertain 30 times to describe the economic environment, almost twice as often as the July 2010 Beige Book. Also, the minutes of the March 2003 Fed meeting used the word uncertain 16 times, three times as often as the five times it was used in the June 2010 meeting minutes.

• In Oct. 1992, about six quarters after the end of the 1991 recession, the word uncertain appeared 23 times in the transcript of the Oct. 1992 Fed meeting.

The response by the Fed to uncertainty over the economic environment has been anything but uncertain. They have always provided the economy with one last booster shot of stimulus. During the past four decades, the Fed has cut rates one last time well after the recession had ended when a soft spot emerged. For example, related to the above examples of Fed uncertainty, the Fed cut the Federal Funds target rate in June 2003 and in Sept. 1992.

With the Federal Funds target rate effectively at zero the typical rate cut is not an option this time, so what will the Fed's uncertainty lead it to do?

• First, the Fed will likely signal its sensitivity to heightened risk by updating the message from the June meeting that it "will employ its policy tools as necessary" to reflect the latest language from the recent semiannual testimony that it "is prepared to take further actions as needed." This will send the signal that the Fed has a greater bias toward easing monetary policy. This signal alone may have some of the effects desired by the Fed on the markets.

• Second, an answer to the question of what the Fed may do in lieu of cutting rates is to reinvest interest and principal payments on the Fed's holdings of Mortgage-Backed Securities back into the market with the intention of adding money to the system and keeping rates low. However, we believe the Fed is not likely to take this step without a downgrade to its recently stated growth outlook for above-average Gross Domestic Product (GDP) growth in 2011 and a 1% decline in the unemployment rate over the next year. The Fed has the ability to wait on any additional stimulus given the improvement in market conditions, from the stock market to the TED spread, since the last Fed meeting in June. If the uncertainty lingers, and the Fed further downgrades their outlook, the Fed could pursue the path of further easing consistent with prior early cycle periods of uncertainty.

Uncertainty is to be expected given the challenges facing an economy in the early stages of growth following an unprecedented upheaval. The sentiment of unusual uncertainty is expressed in this excerpt from the pages of TIME magazine:

"If America's economic landscape seems suddenly alien and hostile to many citizens, there is good reason: they have never seen anything like it. Nothing in memory has prepared consumers for such turbulent, epochal change, the sort of upheaval that happens once in 50 years."

"The outward sign of the change is an economy that stubbornly refuses to recover. In a normal rebound, Americans would be witnessing a flurry of hiring, new investment and lending, and buoyant growth. But the U.S. economy remains almost comatose a full year and a half after the recession officially ended. Unemployment is still high; real wages are declining."

"The current slump already ranks as the longest period of sustained weakness since the Great Depression. That was the last time the economy staggered under as many "structural" burdens, as opposed to the familiar "cyclical" problems that create temporary recessions once or twice a decade. The structural faults represent once-in-a-lifetime dislocations that will take years to work out. Among them: the job drought, the debt hangover, the defense-industry contraction, the savings and loan collapse, the real estate depression, the health-care cost explosion and the runaway federal deficit."

The same article quoted an economist as saying, "this is a sick economy that won't respond to traditional remedies. There's going to be a lot of trauma before it's over." But it was over. This excerpt is from Sept. 28, 1992.

The recession ended in 1991 and real GDP was an above average +3.4% in 1992 (about the same pace of growth the economy has averaged this year). Yet, in Sept. 1992, TIME described the economy as "comatose". When the article was published, the economy had already been growing for six quarters. Hiring had weakened to averaging only +77,000 jobs per month in the four months leading up to this article, but in the following four months it averaged +210,000. In addition, while the structural problems apparent then seemed unsolvable for years to come, real GDP was +2.9% the following year.



It is not easy to assess the health of the economy as we are living through it. The amount of current press coverage devoted to fretting over a double-dip recession will be expanded by last Friday's lackluster private payroll growth report of +71,000 for last month. We continue to believe the data supports a typical economic soft spot (much like the one in 1992) that always comes about one year after a recovery begins and not the double-dip that has been largely priced into the stock market.

In 1992, the uncertainty expressed in the sentiment from the Fed and in the media at the end of the third quarter set the stock market up for a solid fourth quarter rally after a relatively flat year for stocks in the first three quarters. The stock market in 1992 ended with a modest single-digit total return (including dividends) of 7.6%, very similar to our outlook for a modest single-digit gain this year.

This article by Jeff Kleintop has been republished from The Street, an investment news and analysis site.

Is The Fed Right To Discuss An Exit Strategy When The Economy Is Weak?

Tim Iacono discusses whether all the talk by the Federal Reserve of plans for an "exit strategy" is premature with the poor state of jobs, consumer confidence, and the housing market. While the economy is far from full strength, could winding down monetary stimulus be a preemptive strike necessary to prevent runaway inflation? See the following post from The Mess That Greenspan Made.

Boy, for a group of policymakers at the nation's central bank who, in a best case scenario, are going to just sit on their hands for at least the rest of the year, there sure has been a lot of talk about an "exit strategy".

That is, how the Federal Reserve plans to withdrawal the trillions of dollars in asset purchases, emergency lending facilities, and liquidity measures that have been undertaken over the last year that purportedly saved us from another Great Depression.

While it's probably a good idea to begin thinking about this sort of thing, the way Fed chief Ben Bernanke and others at the central bank have been talking lately, you'd think that the economy is about ready to fire on all cylinders again and that there's a pressing need to begin dialing back on some of the aid they've been providing.

What they should probably be worried about instead is the massive wave of foreclosures now washing up onto shore and the waning inventory rebuilding cycle that, when combined, will require more assistance in the form of money printing in the year ahead, not less.

Just this morning, Philadelphia Federal Reserve Bank President Charles Plosser said that he would favor selling some of the $1.25 trillion in mortgage-backed securities that have been piling up on the Fed's balance sheet "sooner rather than later", as if, he really thinks that the economic recovery we've been experiencing over the last six months - built mostly on government bailouts and handouts - is going to last.

Last week, it was Chairman Ben Bernanke who detailed a plan to Congress that would have the central bank adjusting the interest paid on "excess reserves" - money held by member banks at the Fed - in order to keep credit from expanding too rapidly and realizing the worst of the inflation hawks' fears - runaway inflation.

Shouldn't the question of what will happen to the market for home loans when the Fed stops their monthly purchases of between $60 to $100 billion worth of mortgage-backed securities next month be a more pressing concern?

Sure, they now own a considerable amount of the souring mortgage debt in the U.S., but they'll probably have to buy at least another trillion dollars or so to keep the housing market propped up, that is, unless there is some other plan in the works where, with their loss limits recently removed, wards of the state Fannie Mae and Freddie Mac can take on the job.




[The graphic above is from Standard and Poor's report on troubled mortgages]

Goldman Sachs weighed in last week with something about the Fed not raising interest rates until 2012 and there are more than a few who think that we'll be turning Japanese this decade in a very big way, as in, ZIRP (Zero Interest Rate Policy) for as far as the eye can see.

Maybe all this talk about "exit strategies" is simply a way for policymakers to generate confidence that might not otherwise be there.

For example, anyone looking at consumer spending, consumer confidence, or the unemployment rate could easily come to the conclusion that we've got a long way to go before the economy begins to grow again in any substantive sort of way.

But, if they were to listen to the Federal Reserve talking about how they're going to get out of the business of printing money on a scale never before seen by Mankind, then maybe they'll think that, just maybe, the Fed knows something that they don't know.

Then again, the more likely explanation is that economists at the central bank are just as clueless about where the economy is headed today as they were a few years ago before we all experienced the worst financial market crisis and the sharpest economic contraction since the end of World War II.

In case anyone needs to be reminded, here's what Fed chief Ben Bernanke thought about the economy and financial markets back in the middle of the last decade.

Is there any reason to think that he'll do any better in this decade than he did in the last one?

Isn't this talk of the Fed's "exit strategy" way too premature?

This post has been republished from Tim Iacono's blog, The Mess That Greenspan Made.

Bernanke Deflects Blame For Financial Crisis

Bernanke's denial that monetary policy was a main factor leading up to the financial collapse may prevent the Fed from learning from past mistakes says James Picerno from The Capital Spectator. The real Fed funds rate was negative for roughly three years leading up to the financial collapse, suggesting that monetary policy was aggressively stimulative. See the following post from The Capital Spectator.

Fed Chairman Ben Bernanke says the central bank's monetary policy played no role laying the groundwork for 2008's financial debacle. The issue here is one of debating if interest rates were too low for too long and if that was a catalyst for sending the real estate market into overdrive.

"Monetary policy during that period [2002-2006] -- though certainly accommodative -- does not appear to have been inappropriate, given the state of the economy and policymakers' medium-term objectives," he said at a speech today in Atlanta at the American Economic Association, CNNMoney reports. The culprit, Bernanke added, was ill-conceived mortgages that made buying homes too easy.

The Fed head is half right. It's hard to imagine that the real estate boom would have been as strong as it was if interest rates weren't as low as they were in 2002-2006. Consider our graph below, which shows the effective Fed funds rate less the annual change in inflation, as defined by the consumer price index.



It's obvious that for a roughly three-year period starting in late-2005, the real Fed funds rate was negative, which is to say that monetary policy was aggressively stimulative. The case for keeping rates low was compelling in the wake of the 2000-2002 stock market correction and the mild 2001 recession. But the central bank misjudged what the economy needed at the time. That's clear now, with the benefit of hindsight, as a number monetary economists advise.

For example, Anna Schwartz, an economist at the NBER, recently opined that "the Fed was accommodative too long from 2001 on and was slow to tighten monetary policy, delaying tightening until June 2004 and then ending the monthly 25 basis point increase in August 2006."

We can argue if central bankers should have made better policy decisions in real time. In a world of fiat money, mistakes are inevitable when mere mortals are at the monetary helm, as we discussed recently. That's the price of doing business in central banking as it's currently practiced. What's troubling is arguing that the Fed played no role in stoking the fires of the former real estate bubble. Policy is never going to be perfect, but the degree of error in 2002-2006 now looks extraordinary. Yes, hindsight is 20-20, and so we should be careful here in arguing that another crew might have done things differently. But if we can't at least recognize an error, the odds of learning from past mistakes look virtually nil.

The question is less about blame and more of figuring out how to improve monetary policy going forward. Indeed, the stakes are higher than ever for the years ahead.

Progress comes slowly in economics and finance. It's even slower with a brick of denial tied to your legs.

This post has been republished from James Picerno's blog, The Capital Spectator.

No End In Sight For Fed's Massive Monetary Interventions

The Federal Reserve is walking a fine line on when to start retreating from its massive monetary interventions. If history is any indication, central banks tend to err on the side of inflation, suggesting a rate increase will be delayed even as the dollar falls rapidly in relation to gold. See the following post from The Capital Spectator.

“We have to be sure that the recovery is final, that domestic demand is self-sustaining and the peak in unemployment is on the foreseeable horizon,” Dominique Strauss-Kahn, managing director of the IMF, said yesterday in London yesterday in connection with a speech he gave at a British industry conference.

The topic of discussion was the exit strategy, and the ever-topical question of when to begin retreating from the massive liquidity injections that remain the status quo in the global economy, particularly in the U.S. Straus-Kahn emphasized that “a premature exit is the main danger,” and that’s probably true. But the risk associated with keeping the stimulus running too hot for too long isn’t exactly chopped liver either.

Waiting for absolute certainty is waiting for the impossible in central banking. As we discussed last week, prescience is the stuff of dreams in a world where mortals manage monetary policy. Mistakes are inevitable, which implies that central bankers should hedge their bets if only slightly.

Should the Fed start hiking rates immediately by a large degree? No, but it’s time to begin the inexact science of sending a message to the crowd that the price of money will climb in the months and years ahead. A 25-basis-point increase in Fed funds wouldn't derail the stimulus efforts but it would send a timely reminder of things to come.

The soaring price of gold suggests it’s time for a nudge upward in the price of money. A similar message arises from the internal discussions at the Fed these days. As discussed in the FOMC earlier this month, “members [of the Fed] noted the possibility that some negative side effects might result from the maintenance of very low short-term interest rates for an extended period, including the possibility that such a policy stance could lead to excessive risk-taking in financial markets or an unanchoring of inflation expectations.”

But while the Fed is on record as worrying about irrational exuberance and the possibility that the central bank might be promoting the next bubble, the official position is that such a risk is at present “relatively low.” And the Fed funds futures market is inclined to agree. Futures are priced in anticipation that the current 0-0.25% target rate will endure at least through next year's first half.

That's no surprise, of course. Central banks prefer to err on the side of inflation, modestly so if possible. It's what they know and monetary policy works better with a little pricing juice. That implies that even a small 25-basis-point hike is probably far off in the future. Ultimately we won’t know for sure if the Fed made a timely decision to keep inflationary pressures at bay until several years down the road. Of course, by that time it’ll difficult to retroactively correct any mistakes. Waiting for absolute clarity is a nice idea, but only if it works.

This post has been republished from James Picerno's blog, The Capital Spectator.

When The Federal Reserve Gets It Wrong

While often criticized as ignorant and misguided, central bankers make decisions that they deem as the best for their country using the facts and information that they have available to them at the time. Setting monetary policy is a high-stakes, high-skill game played by fallible humans, and flawed decisions have led to major consequences throughout history. See the following post from The Capital Spectator.

Central bankers are a powerful lot and so it’s an easy to assume that they’re also prescient. When you’re making decisions that affect the livelihoods of millions of people—billions on a global scale—confusing people with their institutional authority can become habit forming. But central bankers are mortal, and therefore prone to mortal decisions, a.k.a. flawed decisions. Heck, it happens to the best of us at times. The only difference is that most people’s day jobs don’t cast a long shadow over a nation’s money supply.

No less an expert on central banking than Paul Volcker, the patron saint of inflation slayers everywhere, advises that “central bankers suffer from hubris like everybody else.” That’s not surprising, but it does have consequences.

The monetary policy du jour, as a result, may not be exactly what the macroeconomic gods ordered. A mismatch between the optimal monetary policy and current events is in some sense fate. Working with limited information makes it hard to know if today’s actions will suffice for the uncertainty that arrives tomorrow. As a result, we can talk of monetary policy in terms of its degree of inaccuracy or accuracy.

Intelligently dispensed or not, monetary policy steers economic activity, ranging from decisions in asset pricing to lending preferences to choices that affect the labor market. Alas, poor decisions have a habit of delivering less-than-satisfying results.

Remember all the talk of the Great Moderation? “One of the most striking features of the economic landscape over the past twenty years or so has been a substantial decline in macroeconomic volatility,” Ben Bernanke pronounced in early 2004 in his then-current position as a Fed governor. “Reduced macroeconomic volatility,” he went on to explain, “has numerous benefits. Lower volatility of inflation improves market functioning, makes economic planning easier, and reduces the resources devoted to hedging inflation risks. Lower volatility of output tends to imply more stable employment and a reduction in the extent of economic uncertainty confronting households and firms. The reduction in the volatility of output is also closely associated with the fact that recessions have become less frequent and less severe.”

It’s debatable how much the Fed was influenced by the past for setting monetary policy in 2004 and beyond, but some observers of central banking suggest that the calm history in those halcyon days led policymakers astray. Anna Schwartz of the National Bureau of Economic Research speaks for many dismal scientists when she charges in a recent essay that the Fed kept interest rates too low for too long earlier in this decade. In turn, the inappropriate interest rates distorted markets, she says, and the fallout wasn't trivial. “In the case of the housing price boom, the government played a role in stimulating demand for houses by proselytizing the benefits of home ownership for the well-being of individuals and families.” The net result, to state the obvious, was less than optimal.

Volcker has commented that the preference for low interest rates earlier in this decade was based on a “misreading of the Japan situation.” The worry that deflation threatened in 2001-2005 was simply wrong, as was the resulting prescription: low interest rates.

Economist Scott Sumner opines that another Fed mistake of some consequence was the decision in September 2008 to leave interest rates as is. “On September 16, 2008, the Fed made one of its most costly errors ever,” he recently wrote. “Immediately after the failure of Lehman Brothers, the FOMC decided to leave the target rate unchanged at 2.0 percent.” Monetary policy, in other words, should have been far more supportive given current events. It wouldn’t have prevented the financial crisis, but it might have minimized the fallout, perhaps by more than a trivial amount.

The idea that central banks have power of the ebb and flow of economies isn’t new. In 1963, Milton Friedman and Anna Schwartz reordered perceptions of the Great Depression with their the monumental A Monetary History of the United States, 1867-1960, which indicts the central bank’s monetary policy for the events of the 1930s. Friedman and Schwartz argued that the central bank’s errors in managing the money supply were the primary catalyst that turned recession into something far worse. “Prevention or moderation of the decline in the stock of money, let alone the substitution of monetary expansion, would have reduced the [economic] contraction’s severity and almost as certainly its duration,” they wrote.

Today, central bankers the world over are faced with another decision of above-average consequence. The exit strategy, as it’s called, requires that the Fed and its counterparts choose when to begin drawing back the enormous liquidity that’s been injected into the global economy.

“It is clear…that our exceptional support cannot last for too long a period of time since there are negative side effects,” Jürgen Stark, a member of the European Central Bank’s executive board, said last week. Jan F Qvigstad, deputy governor of the Central Bank of Norway, also remarked last week that the country’s current target policy rate of 1.5% “will be 2.75 per cent around the end of next year.”

Some central banks have already begun raising rates, as we noted a month ago. The Fed too must return monetary policy in the U.S. to something approaching a normal state. As always, the possibility of raising rates too early, too late or insufficiently keeps everyone guessing. Accordingly, inflation may or may not be a problem in the years ahead.

“At some point, the economic trends will shift and waiting too long to raise interest rates will be the primary hazard,” we wrote in March. “We don't know if the turning point will come in a few months or a few years, but we shouldn't delude ourselves that it's never coming.”

The risk tied to the timing and magnitude of the exit strategy isn’t necessary limited to inflation, as the tumultuous history of this decade reminds. We might add that we also shouldn’t kid ourselves that the Fed will make exactly the right decisions at exactly the right time.

There are many advantages to fiat money. But the main advantage is also the primary risk: flexibility. As with democracy and investing, choices matter. Rarely are those choices perfect. Sometimes they’re egregiously wrong, sometimes they’re more or less productive. The great question is what outcome will the decisions give us this time?

This post has been republished from James Picerno's blog, The Capital Spectator.

Preparing For The Consequences Of The Great Stimulus

While the aggressive action by the government may have prevented a depression, Warren Buffet is one of the many who are concerned about the future side effects on the economy. Is now the time for the Fed to start tightening monetary policy to prevent economic fallout? James Picerno from The Capital Spectator discusses why we should be shifting more attention to the future.

Warren Buffett advises in today's New York Times that the Great Stimulus must one day be clipped as the Great Recession fades. As the Oracle of Omaha explains, the "enormous dosages of monetary medicine continue to be administered and, before long, we will need to deal with their side effects."

We've been making a similar argument for some time, although the cause seemed lost when we advised in May that the crowd should recognize that the Federal Reserve must begin raising interest rates at some point. That future has been easily ignored, and perhaps for obvious reasons, given the economic events of the past year or so. But the arrival of Buffett's warning suggests that sentiment may be set to turn by focusing the crowd's gaze on the inevitable. If so, that's healthy, if only because recognizing the risks that loom, as opposed to the ones that just passed, is always a productive exercise in managing money and otherwise boosting one's odds of survival.

As we wrote in May, "At some point, the economic trends will shift and waiting too long to raise interest rates will be the primary hazard. We don't know if the turning point will come in a few months or a few years, but we shouldn't delude ourselves that it's never coming."

If more pundits and policymakers are on board with this outlook, chalk up another win on the side of progress. But lurking behind this rise in enlightened thinking is another problem, which can be summed up as the expectation that the central bank will begin tightening at a time when it's clear that the economy is on a sustainable path to recovery. A nice idea, but like fairy tales and campaign promises, danger lurks in accepting such notions without question.

For the same reason that mere mortals can't hope to sell exactly at market peaks or buy at bear-market bottoms, the Fed is destined to be early or late at the start of the next great change in monetary policy. This is a critical point because it belies the notion that the Fed will be able to tighten monetary policy at just the right time and keep everyone happy in the process. Wrong. Not only does the Fed face a tough challenge in purely monetary policy terms, the potential for political and even economic fallout are commensurately large as well.

Central banks, like the rest of us, are making real-time decisions with lagging data. Even worse, it takes time to assess if the decisions were timely, or not. The folly or fortune of policy choices made today will be evident a year or two hence. It's a bit like a surgeon working in the dark and then finding out a year later if the patient survived.

So be it. That's how running fiat currencies works: it's a job that's highly subjective in real time. The question is whether the crowd understands what's coming. Normally, the margin for error is relatively wide in the highly subjective business of central banking. These days, that margin has shrunk considerably, even if the ramifications won't be obvious for several years.

No one will ring a bell at the ideal moment for tightening. The fact that the Fed's timing wasn't perfect in the years running up to the Great Recession reminds that fallibility infects the institution, just as it does every other area of human decision making.

What's more, when the Fed launches the new monetary era, the criticism is likely to be deep and broad, from politicians and investors, businesses and the people on the street. No one has perfect information and insight, but that doesn't stop anyone from thinking (and speaking) as if they did. The net result: lots of noise and confusion.

With the benefit of hindsight at some point, it's a virtual certainty that we'll recognize that the Fed was too early, or too late. Heck, maybe they'll get it exactly right this time, although we're not holding our breath. In any case, such things can only be determined after the fact.

The stakes are high, perhaps unusually high compared with previous business cycles of recent vintage. But at least we know what the two main threats will be. On the one hand, the central bank runs the risk of choking off the incipient recovery by tightening too early. At the other extreme, the central bank may wait too long and thereby give inflationary pressures a foundation to pester the economy for some time after.

No, these risks aren't absolute. One or the other may arrive but in moderate form, which still leaves the natural forces of inflation-adjusted growth to dominate eventually. Nonetheless, let's not forget that one or the other still looms. Markets and economies are forever evolving, as are the embedded hazards and opportunities. Perhaps the biggest risk of all is thinking otherwise.

This post has been republished from James Picerno's blog, The Capital Spectator.

Anti-Federal Reserve Sentiment On The Rise

No one is immune from blame for the financial crisis, including the Federal Reserve, which is facing renewed anti-fed sentiment. This has reintroduced the debate on whether the role of the Federal Reserve should be part of the reform of the financial system. Mark Thoma from Economist's View discusses this issue in the following post.

Continuing the recent discussion here and elsewhere on Fed independence, this is not the first time audits and other threats to independence have been seriously considered:

On the mend, The Economist: It has been a long time since comments on the economy by an official of America’s Federal Reserve comments could be described as cheerful. Yet there was no denying the upbeat tone of Ben Bernanke’s testimony to Congress on Tuesday... His fingers may be crossed but it is clear that Mr. Bernanke thinks the recession, if not over now, soon will be.

That is a far cry, though, from seeing a threat from inflation and Mr. Bernanke made it clear that the federal funds target rate, now near zero, will remain there for a long time. On Wall Street, most reckon that means until well into 2010 at least.

Yet the Fed is already under pressure to explain how it intends to tighten monetary policy, even by congressmen who usually want nothing of the sort. ... Whether inflation [occurs] depends on if the Fed raises interest rates in time and thereby curbs the appetite for credit. Mr. Bernanke spent much of his testimony explaining how he can do just that. ...

Politics could ... interfere with the Fed’s willingness to tighten monetary policy in time. Congress’s nonpartisan investigative arm, the Government Accountability Office, can now audit the Fed with the exception of its monetary policy, lending programs or relations with foreign central banks. A bill in Congress would lift those prohibitions. Mr. Bernanke argued that the threat of such audits would lead investors to question the Fed’s willingness to do unpopular things, like tighten monetary policy, unsettling them and driving up long-term interest rates.

This is not idle speculation. Anti-Fed sentiment was also strong in the 1970s, when Congress first sought to have the GAO audit the central bank. Arthur Burns, chairman at the time, fought back, and a compromise was struck to allow audits, but with the current prohibitions. Mr. Burns later reflected that the effort of “warding off legislation that could destroy any hope of ending inflation” involved “political judgments” that may have weakened his anti-inflationary resolve.

For all the discussion, any tightening of policy is a long way off. ...

I think one of the problems that people are trying to get at when they want to take away the Fed's independence is the concentration of power within the Board of Governors (the view by some that the Board represents special rather than public interests, e.g. Wall street, also plays a role), and they see devices such as audits from the GAO as a check on that concentration of power. Here's an edited version of part of an old post:

While the Fed was initially structured to balance competing interests and to share power, the system has evolved into an institution with centralized rather than shared power. The intent to share power and balance competing interests is evident in the structure of the Federal Reserve system. For example, individual district banks are overseen by a board of nine part-time directors. These directors come in three types. Three of the nine are type A and are bankers, and three are type B and represent the business community. Legislation prohibits type B board members from being bankers. In a further attempt to make the process representative, type A and type B directors representing banking and business interests are elected by member banks within each of the twelve Federal Reserve districts. Type C directors are appointed by the Board of governors and are intended to represent the public interest within the district banks.

Thus, the districts themselves provide geographic representation that is population based, while control of the district banks balances public, banking, and business interests. Initially, the district banks functioned as twelve cooperating banks and each district had considerable control of monetary conditions within the district. It was very much a shared power arrangement. As one example of the power district banks had, each bank had full control of the discount rate for its district (the discount rate was the only tool available for controlling the money supply when the Fed was formed, open-market operations were not well understood until later and there was no provision for the Federal Reserve system to control reserve requirements, another way to affect the money supply).

The shared power arrangement within the Federal Reserve system changed after the Great Depression when monetary authorities failed to respond adequately to crisis condition. The problem, or so it seemed, was the shared power nature of the system. The deliberative, democratic nature of the institution prevented it from taking quick, decisive action when it was most needed. Furthermore, the Fed did not have the tools it needed to deal with system-wide disturbances, it was mostly equipped to deal with problems at individual banks (the discount window is well-suited to help individual banks, but not system wide disruptions; on the other hand, open-market operations can inject reserves system-wide and hence is a better tool for systemic problems).

The solution to this was to concentrate power into the hands of the central bank so that should a crisis occur, they can act quickly. There are risks, of course, to concentrating power so narrowly, but in the aftermath of the Depression we were quite willing to take that risk if it helped to avoid another catastrophic outcome (as it may well have done).

Thus, after the Great Depression power was concentrated. For example, banks no longer control the discount rate in their districts. They can propose a change in the discount rate at an FOMC meeting, but the Board of Governors must approve the rate and they will only approve one rate, the rate they decide. So while the rates are still formally set in the districts, they are essentially set by the Board of Governors. When all such changes in the concentration of power over time from the districts to the Central Bank in Washington D.C. are considered, it becomes very clear that the Fed has evolved from a very democratic, shared power arrangement at its inception to one where it functions, for all intents an purposes, as a single bank in Washington, D.C,. with twelve branches spread across the U.S.

*****

I am not at all in favor of lessening the degree of independence that the Fed currently has, but I do think we need to make changes in the way the President and Boards of the district banks are chosen. As it stands, the Board of Governors in Washington has considerable influence over who is appointed to key positions such as the President of the district banks, and those Presidents represent five of the twelve votes at the meetings where monetary policy is set. More independence of the district bank Presidents and other district bank personnel from the Board of Governors would be a healthy change (there is also a question of whether geographic representation through district banks is the best way to capture the public interest, but I'll leave that aside for now).

This article was republished from Mark Thoma's blog, Economist's View.