Fed Chair Janet Yellen Defends 3% Inflation Floor; Says Lower Target Requires Cutting Structural Impediments

A Benjamin Cole post

February 11, 2016, Washington, D.C.—Defiantly defending the U.S. Federal Reserve’s 3% inflation floor, Fed Chair Janet Yellen’s swatted away questions from U.S. Senators who said lower rates of inflation could be obtained safely.

The “public and representatives have embraced thickets of structural impediments to growth,” retorted Yellen. “For the economy to scrape through to minimally acceptable rates of GDP growth requires a bedrock of 3% inflation. Below that floor threatens stall speed, and financial instability.”

Yellen noted “the joke is that it takes an Act of Congress to get housing built in many cities of America—and that is what I am saying: Congress has to turn some screws to boost housing production is key metropolitan regions.” Without that, asserted Yellen, housing inflation will also boost general inflation numbers, even in a slack economy.

The Fed Chair tried to unruffle Senatorial feathers by pointing out that many structural impediments are state and local government sacred cows, such as property zoning, occupational licensing, and the near-universal criminalization of push-cart vending.

“But I have to tell this body that many federal structural impediments, be they rural subsidies and the USDA, or the SSDA and VA disability programs, the minimum wage, the ethanol fuel program, or the $1 trillion in annual national security outlays, are impediments to a freer economy that could grow more rapidly at lower rates of inflation,” Yellen explained. “The real path to lower rates of inflation lies in Congress.”

Yellen again tried to smooth matters with Senators by reminding them of the “bad old days” when the U.S. was characterized by unionization, limited foreign trade, and regulated rates in transportation, including trucking, airlines and railroads. “Back then Chairman Paul Volcker accepted a 5% rate of inflation,” reminded Yellen, speaking of the 1980s Fed Chief. “And you know what Vocker thought of inflation.”

In conclusion, Yellen pointed the economic struggles in Japan and Europe, two economies that have sunk into persistent deflation and slow growth. “It may be ungracious of me to say so, but it was only the Fed’s decision in 2008 to target and forcefully obtain rates of inflation well above 3% that kept us from sinking into the deflationary stalls we have seen since in Europe and Japan,” said Yellen. “The $7 trillion of QE was controversial but effective; the resolve and credibility of the Fed was affirmed; and we have never looked back.”

Timothy Lee points Yellen the way

The next recession could be around the corner, and the Fed isn’t ready for it:

Around the world, markets are in chaos. Japan’s stock market plunged 5 percent on Friday, while markets in France, Germany, and the UK all saw big losses on Thursday. The US stock market is doing better than most, but it is also down since the start of the year. Oil hit a new low on Thursday of $26 per barrel.

These declines reflect growing concerns that the world economy is headed for another recession. Before 2007 we’d say “if things get bad, the Fed will cut interest rates.” But with the Fed’s benchmark rate below 0.5 percent already, a substantial cut would mean rates that are below zero. That’s an unorthodox strategy, and it might not even be legal, according to testimony by Fed Chair Janet Yellen before congressional committees this week.

The Fed needs a new strategy: Stop targeting interest rates and instead target the growth of the overall economy. Moving away from interest rate targeting would give markets confidence that the Fed has the tools to deal with the next economic downturn, which would reduce the danger of another 2008-style meltdown.

Unfortunately, there’s little sign that the Fed is laying the groundwork for a shift in strategy. Instead, Yellen seemed to be in denial about the magnitude of the challenge she is facing.

“Let’s remember that the labor market is continuing to perform well,” Yellen said to the Senate Banking Committee on Thursday. “We want to be careful not to jump to a conclusion about what is in store for the economy.”

Maybe not — but the Fed needs to be prepared for the worst.

And…

So even if the Fed adopted negative rates, it wouldn’t improve the effectiveness of the current interest rate targeting regime very much. Just as the Fed got stuck at zero percent interest rates in 2008, it could get stuck at -1 percent interest rates in 2017 or 2018. So the Fed is going to need a new framework that’s less dependent on interest rates regardless. It might as well get started.

The chart illustrates that:

  1. Don´t lose the “target trend”
  2. If you do, try to get the economy back on it as soon as possible
  3. If you demure, it will become harder and harder to do it. You´ll have to be satisfied with an increasingly partial recovery!

Tim Lee

Naturally, if you wait too long, the present trend level will become the “new normal”!

As always, the Fed is just an innocent bystander!

Yellen in the Senate:

Economic growth has once again disappointed the Fed’s expectations in the early months of 2016. Investors, nervous about the global economy, have sent prices tumbling in equity markets — the market was down sharply again on Thursday — and pulled back from lending money to riskier borrowers. Domestic economic growth slowed in the fourth quarter, and much of the rest of the world has fared even worse, which has curtailed foreign demand for American exports.

Yet Ms. Yellen’s tone was far from bleak. Asked about the possibility of another recession, she responded that anything is possible but “expansions don’t die of old age.”

She also said she still expected lower oil prices to lift growth. The magnitude of the decline took the Fed by surprise, and the costs have been larger than expected, but Ms. Yellen said the average household still would reap a benefit of about $1,000.

And she said Fed policy was still headed in the same direction: The question is not whether to raise rates, but when.

Ms. Yellen has previously pointed to stronger wage growth as an important sign that the economy was improving, and on Thursday she said that she was not impressed by a pickup in the recent data. “At best the evidence of a pickup is tentative,” she said.

But in an interesting exchange with Senator Chuck Schumer, Democrat of New York, Ms. Yellen also backed away from her previous emphasis on that indicator.

“I would not say that wage growth is a litmus test for changes in monetary policy,” Ms. Yellen said.

Ms. Yellen also said that she did not think the Fed, by raising rates in December, had contributed significantly to the latest round of economic problems. When Senator Dean Heller, Republican of Nevada, asked Ms. Yellen whether the Fed had caused stock prices to fall, she responded, “I don’t think it’s mainly our policy.”

Circular reasoning or, reasoning from a price change, pervades Yellen´s testimony to Congress

Lately, Yellen has been sounding as “robotic” as Marco Rubio:

Financial conditions in the United States have recently become less supportive of growth, with declines in broad measures of equity prices, higher borrowing rates for riskier borrowers, and a further appreciation of the dollar. These developments, if they prove persistent, could weigh on the outlook for economic activity and the labor market, although declines in longer-term interest rates and oil prices provide some offset.

Of course, economic growth could also exceed our projections for a number of reasons, including the possibility that low oil prices will boost U.S. economic growth more than we expect.

To a large extent, the low average pace of inflation last year can be traced to the earlier steep declines in oil prices and in the prices of other imported goods. And, given the recent further declines in the prices of oil and other commodities, as well as the further appreciation of the dollar, the Committee expects inflation to remain low in the near term. However, once oil and import prices stop falling, the downward pressure on domestic inflation from those sources should wane, and as the labor market strengthens further, inflation is expected to rise gradually to 2 percent over the medium term.

Yellen confirms the “gradual normalization” framework of monetary policy:

The decision in December to raise the federal funds rate reflected the Committee’s assessment that, even after a modest reduction in policy accommodation, economic activity would continue to expand at a moderate pace and labor market indicators would continue to strengthen. Although inflation was running below the Committee’s longer-run objective, the FOMC judged that much of the softness in inflation was attributable to transitory factors that are likely to abate over time, and that diminishing slack in labor and product markets would help move inflation toward 2 percent. In addition, the Committee recognized that it takes time for monetary policy actions to affect economic conditions. If the FOMC delayed the start of policy normalization for too long, it might have to tighten policy relatively abruptly in the future to keep the economy from overheating and inflation from significantly overshooting its objective. Such an abrupt tightening could increase the risk of pushing the economy into recession.

In the accompanying Monetary Policy Report presented to the Congress we read a beautiful example of circular reasoning:

Policy divergence between the U.S., where the economic recovery is strong enough to warrant a gradual tightening of monetary policy, and Europe and Japan, where downside risks are prompting central banks to boost stimulus, have pushed up the dollar. That appreciation is damping U.S. exports and thereby economic growth, and also contributing to stabilization abroad.

All else being equal, a smaller contribution to the U.S. economy from the external sector likely points to a more gradual pace of policy normalization in the United States. By the same token, the economic stimulus from more-depreciated currencies abroad may allow foreign central banks to provide less monetary accommodation — or to start removing it earlier — than would otherwise be the case.

Not for a moment does Yellen consider that it may be the tightening of Fed policy, as gleaned from the downward trend in NGDP growth which began in mid-2014, that is responsible for the price effects she alludes to!

Yellen in Congress_1

Yellen in Congress_2

Contrasting views on negative rates

By two former central bankers.

Narayana Kocherlakota writes:

So, going negative is daring but appropriate monetary policy.   But it is a sign of a terrible policy failure by fiscal policymakers.

The reason that the FOMC has to go negative is because the natural real rate of interest r* (defined to be the real interest rate consistent with the FOMC’s mandated inflation and employment goals) is so low.   The low natural real interest rate is a signal that households and businesses around the world desperately want to buy and hold debt issued by the US government.   (Yes, there is already a lot of that debt out there – but its high price is a clear signal that still more should be issued.)  The US government should be issuing that debt that the public wants so desperately and using the proceeds to undertake investments of social value.

But maybe there are no such investments?  That’s a tough argument to sustain quantitatively.  The current market real interest rate – which I would argue is actually above the natural real rate r* – is about 1% out to thirty years.  This low natural real rate represents an incredible opportunity for the US. We can afford to do more to ensure that all of our cities have safe water for our children to drink.  We can afford to do more to ensure that our nuclear power plants won’t spring leaks.  We can afford to do more to ensure that our bridges won’t collapse under commuters.

These opportunities barely scratch the surface.  With a 30-year r* below 1%, our government can afford to make progress on a myriad of social problems.  It is choosing not to.

If the government issued more debt and undertook these opportunities, it would push up r*.  That would make life easier for monetary policymakers, because they could achieve their mandated objectives with higher nominal interest rates. But, more importantly, the change in fiscal policy would make life a lot better for all of us.

William Poole writes:

It won’t work. Negative central-bank interest rates will not create growth any more than the Federal Reserve’s near-zero interest rates did in the U.S. And it will divert attention from the structural problems that have plagued growth here, as well as in Europe and Japan, and how these problems can be solved.

Part of the impetus behind a central bank’s negative interest-rate policy is a desire to devalue the currency. With lower market interest rates, holders of euros, for example, may sell them to flee to countries with higher interest rates—driving down the euro’s exchange rate, boosting European exports and growth. But it is impossible for every country in the world to depreciate its currency relative to others. If the European Central Bank hopes to force euro depreciation against the yen and the Bank of Japan hopes to force yen depreciation against the euro, one or both of the central banks will fail.

Where central banks can help is by identifying the structural impediments to growth and recommending a way forward. In the U.S., Congress should force the Federal Reserve to come clean about why growth has been so slow. The forthcoming congressional monetary policy oversight hearings—Feb. 10 for the House Financial Services Committee and Feb. 11 for the Senate Banking Committee—are the right place to explore what is wrong with the U.S. economy.

These committees ought to insist that the Fed, with its large and expert staff, present relevant studies by mid-June, in time for the annual oversight hearings in July. At the July hearings, the Fed can discuss its research. Academic and other experts can offer their analysis of the Fed’s findings. Instead of vague Fed statements about “headwinds,” the nation deserves solid empirical work on the problem.

Note, however, that both appeal to monetary policy to correct fiscal/structural failures! NK, for example, did much better in a previous post:

The Committee needs to change its basic policy framework.  Monetary policy is not about targeting the level and volatility of interest rates. The FOMC needs to have a framework in which the fed funds rate (and its other tools) are much more responsive to its medium-term forecasts of inflation and employment shortfalls.  Markets would then have to adjust to the possibility that interest rates might have to change rapidly, at any time and in either direction, if the FOMC believes that change is necessary to achieve its macroeconomic objectives more rapidly.

The story behind the “scariest jobs chart ever”

Bill McBride (Calculated Risk) posts Update: “Scariest jobs chart ever” where he presents a version of this chart

Scary Chart_1

And writes:

This graph shows the job losses from the start of the employment recession, in percentage terms, compared to previous post WWII recessions.  Since exceeding the pre-recession peak in May 2014, employment is now 3.5% above the previous peak.

Note: I ended the lines for most previous recessions when employment reached a new peak, although I continued the 2001 recession too.  The downturn at the end of the 2001 recession is the beginning of the 2007 recession.  I don’t expect a downturn for employment any time soon (unlike in 2007 when I was forecasting a recession).

By choosing to break with the way he presented the chart originally, with lines ending when the previous employment peak was reached, he ‘pollutes’ the chart, and detracts attention from an interesting characteristic.

Note that the 2001 Employment Recession is one of the shallowest, only less so than the 1990 Employment Recession; but the second most persistent, only less so than the present Employment Recession.

Interesting question that comes up from eyeballing the chart:

What accounts for the depth and persistence of the employment recessions?

The short answer: monetary policy, whose stance is well described by the growth of NGDP.

The chart below is a powerful illustrator.

Scary Chart_2

The 1981 employment recession was deep. The fall in NGDP growth was high. The objective of monetary policy at the time was to bring inflation down significantly. It came from double digit rates to the 3%-4% range. The intensity of the employment pick-up is commensurate with the strength of the rise in NGDP growth.

In the 1990 cycle, monetary policy was slightly less tight than in the 2001 cycle and NGDP growth increased sooner, making the 1990 cycle a little less deep and less persistent than the 2001 cycle.

The 2007 cycle is the clincher, and “living proof” of the responsibility of monetary policy in generating the “Great Recession”. Note that for the initial months/quarters since the cycle peak, the fall in employment during the 2007 cycle was par with the fall in employment in the 1990 and 2001 cycles. As should be expected, the behavior of NGDP growth during this stage was very similar in the three cycles.

But suddenly the Fed makes the second largest error since its inception in 1913. The massive drop in NGDP growth, which remains for an “eternity” in negative range, “destroys” employment. The timid monetary pick up, both in relative and absolute terms, fully explains the persistence of the employment recession in the present cycle.

Decades in the future, when the history of the last 30 years will be written by dispassionate researchers, one interesting footnote will surely describe the “NK Trip”, where NK does not stand for “New Keynesian”, but for Narayana Kocherlakota and will show that the “last step” in the “trip” completely denies the “first step”. Furthermore, the “ingredients” deemed important in the stories told today: the house price boom & bust, “greedy bankers”, “spindrift consumers”, will be seen as bit players, in part victims of the monetary “mayhem” brought on by the Fed!

Ester and Mester Are The Fed

A Benjamin Cole post

Ester and Mester were never elected by the citizenry, yet arguably they have more influence on American prosperity than any U.S. Senator, or Cabinet member.

The dynamic duo is Ester George, the Kansas City Fed President and a 34-year veteran of the central bank, having started as a bank examiner. Loretta Mester, the Cleveland President, is a 31-year soldier, having started as an economist for the Philly Fed.

The rhyming deuce are an interesting pair for what they reveal about the U.S. Federal Reserve. Ester and Mester are nearly purely professional creatures of the Fed, having never worked outside the central bank, let alone having started a business, or run the division of, say, a mid-sized manufacturing concern.

As Marcus Nunes recently pointed out (Marcus stole some of my thunder) Ester and Mester publicly rhapsodize about tighter money, and often ruminate about getting back to “normal.”

However, it does not appear that “back to normal” is what Ester/Mester want, but rather a “new normal.” After all, from 1982 to 2007, the average CPI was nearly 3%, and real growth was a little bit better. That used to be “normal.” But that sort of “normal” does not make Ester and Mester nostalgic.

The twins are pointing at sub-2% inflation (despite the official 2% PCE target), and as for economic growth—well, who is sure if growth is anymore on the Fed’s radar.  No matter, the Ester-Mester tag team does want “normal” interest rates, meaning higher than now, despite falling factory output, a rising U.S. dollar, an epic commodities slump, and national and global economies characterized by gluts of everything.

As lamented in this space often, the Fed refuses to target nominal GDP growth, which has been declining steadily. Neither does the Fed target real growth. Fedsters do jibber-jabber about inflation incessantly, even monomaniacally, and often fret about “low” unemployment, that being any rate below 6%.

Keep your central banker spy-eyes on Ester and Mester, as nearly undiluted products of Fed institutional culture and thinking. Chair Janet Yellen may be the face of the Fed, but the heart and soul is Ester and Mester. And with the passing of Fed Chairman-giants, such as Paul Volcker, or Alan Greenspan, Fed policy today is institutionally and consensus-driven. Watch Ester and Mester.

Conclusion

It was not supposed to be like this, when the Fed was established. The Fed regional bank presidents, who rotate on-and-off of the policy-making Federal Open Market Committee, were intended to bring the economic outlooks of the states they serve to the national central bank, and to serve as an institutional bulwark against money-center financier-dominated monetary policy.

Instead, we see Ester and Mester playing at national policy posturing, pettifogging on global economics, and reciting Fed nostrums.

The independent Fed has proved a failure of gathering ossification and self-reverence. Better to place the central bank into the U.S. Treasury Department, and have monetary policy made by the Executive Branch. At this point, fine, let the President goose the economy to get reelected. A goosed economy is a misdemeanor compared the Fed felony of monetary murder.

Funny thing about democracy. It is a lousy way to run a country, until you try the next best way.

Market Monetarism needs people to predict recessions … and growth

A James Alexander post

Scott Sumner made a somewhat light-hearted comment in a recent post that “no-one can predict recessions”. It made me stop and wonder what was the point of Market Monetarism in that case. The essence of MM is that market forecasts of NGDP Growth should guide monetary policy, should be monetary policy. Fair enough. But does this imply, in the case of a negative demand shock, which increases money demand, an immediate increase in base money supply? Perhaps it does and we will all be very happy.

In our imperfect current world where the monetary authorities seem to mostly target less than 2% Core CPI two years out, the markets will still anticipate the impact of this goal on monetary policy and therefore on both real and nominal economic activity.

But markets are nothing more than numerous individuals, or trading robots programmed by individuals, making investment decisions. Some will certainly forecast recessions and invest appropriately. Is Scott saying that these people are inevitably going to be wrong? The Efficient Market Hypothesis (EMH) may say that it is impossible to be right all the time, to consistently beat the market, but it doesn’t and won’t stop people trying.

Indeed, people have to try to forecast the future or Market Monetarism would not work. You have to have markets for Market Monetarism. Scott has correctly advocated a specific market for NGDP Futures, but all financial markets are essentially futures markets, in the sense of forecasting or predicting future streams of revenues from assets, either income or some capital gain.

Is Scott saying no one can forecast future streams of revenues?

Perhaps he is just being careful, like most academic economists. The most famous economist of the twentieth century, J M Keynes, was of course famous also for his financial acumen. Putting his money where his mouth was, or at least putting his money to work in a highly successful way. Perhaps he made his pile by inside information, who really knows, but successful at forecasting asset price movements for money he certainly was.

“Entre les deux, mon coeur balance”

This is the imaginary scale that hangs over the center of the FOMC´s meeting table.

Entre les deux

Unemployment and inflation are the two objects on the scale. The Fed wants to keep the scale “balanced”. For that purpose, it has a policy framework best described as “gradual normalization”.

As Janet Yellen said last September, telegraphing a rate increase in the near future:

“But we are getting closer. The labor market has improved. And as I’ve said in the past we don’t want to wait until we’ve fully met both of our objectives to begin the process of tightening policy given the lags in the operation of monetary policy.”

In other words, it wants to be able to “normalize gradually”. The “link” between the two plates of the scale is the Phillips Curve/NAIRU subscribed by several FOMC members, according to which, “too little” rate of unemployment will shift the inflation plate up, maybe abruptly, forcing the FOMC to abandon the “gradual” half of the framework!

But there are tensions. According to this Binyamin Appelbaum piece in the NYT:

One wing of the Fed sees an undiminished case for raising rates.

Esther L. George, president of the Federal Reserve Bank of Kansas City and one of the 10 Fed officials voting on the direction of policy this year, said this week that the Fed “should continue the gradual adjustment of moving rates higher to keep them aligned with economic activity and inflation.”

She also played down concerns about the economic impact of recent market volatility. “While taking a signal from such volatility is warranted,” she said, “monetary policy cannot respond to every blip in financial markets.”

Loretta J. Mester, president of the Federal Reserve Bank of Cleveland and another voter, said on Thursday in New York that it was “premature” to change her economic outlook.

“At this point, solid labor market indicators, including strong payroll growth, and healthy growth in real disposable income, suggest that underlying U.S. economic fundamentals remain sound,” Ms. Mester said. “Until we see further evidence to the contrary, my expectation is that the U.S. economy will work through the latest episode of market turbulence and soft patch to regain its footing for moderate growth.”

Other Fed officials, however, say the volatility has given them pause.

William C. Dudley, president of the Federal Reserve Bank of New York and a close adviser to Ms. Yellen, said in an interview with Market News International this week that he was worried about the economic impact of jittery markets.

“If those financial conditions were to remain in place by the time we get to the March meeting, we would have to take that into consideration in terms of that monetary policy decision,” Mr. Dudley said.

And Lael Brainard, a Fed governor who has been particularly outspoken in warning that global pressures will weigh on domestic growth, told The Wall Street Journal this week that “recent developments reinforce the case for watchful waiting.”

Investors, oddly, have walked away from this debate feeling confident that the Fed will not raise rates in March. Indeed, asset prices tied to expectations about the future level of short-term interest imply only about a 50 percent chance of any rate increase this year.

That contrasts sharply with the Fed’s own prediction in December that it planned to raise rates by about one percentage point in 2016, most likely in four discrete steps.

Many analysts have taken a more measured position, predicting that the Fed is less likely to move in March, but that it will still raise rates two or three times this year.

Michael Gapen, chief United States economist at Barclays, said on Friday he now expected the Fed to raise rates twice, instead of three times, and to start in June, instead of March.

Michael Feroli, chief United States economist at JPMorgan Chase, said the continuation of low inflation probably meant Fed policy makers would hesitate at their next session.

“Were the meeting held tomorrow, we still think the Fed would stay on hold — primarily because of concerns about inflation and inflation expectations,” he said. “But it would be an uncomfortable hold.

Uncomfortable, indeed! But that has to do with the policy framework adopted.

Soon meteorology will be required credit for economic majors

In the first quarter of last year and the year before, “unusually bad weather” was deemed responsible for the negative growth surprises.

The “weather factor” is becoming more common.

Example 1:

In addition to seasonal effects, abnormal weather can also affect month-to-month fluctuations in job growth. In my paper “Weather Adjusting Economic Data” I and my coauthor Michael Boldin implement a statistical methodology for adjusting employment data for the effects of deviations in weather from seasonal norms. We use several indicators of weather, including temperature and snowfall.

Example 2:

As for the slight slowdown in consumption at the end of 2015, December was both the warmest and the wettest on record. The warmth reduced spending on heating; the wet may have kept people indoors. Spending at restaurants fell by 1.7%, notes Paul Ashworth of Capital Economics, a consultancy. Now that the heavens have closed, wallets should reopen.

Agree that sometimes it´s a fun read!