“Fed Fantasy”

According to St Louis president Bullard:
In an interview, Federal Reserve Bank of St. Louis President James Bullard said it was “reasonable” to expect the central bank would slowly begin to unwind its easy-money policies before the end of the year.

“We do have rising inflation and rising inflation expectations making me a little bit nervous,” Bullard said. “We’ve got to start taking some steps to start to tighten monetary policy as we continue on through 2011 to make sure we don’t allow inflation to get away from us.”

With interest rates close to zero for more than two years some Central Bankers get nervous. It appears they are not working, and they hate to give that impression to the public.

He (and others) must be delusional, after being too long in the “zero interest rate desert” with no water. President Bullard: Please tell us where the “inflation that makes you nervous” can be seen.

Some pictures that reflect the situation:

First: nominal spending is way below “trend level”.

Second: nominal spending growth is anemic – actually distancing spending from trend level. Compare that with the exit from the 1981-82 recession. Even though at that time nominal spending didn´t fall “off a cliff”, spending growth was robust thereafter. And where did “core” inflation go? Down!

Third: What´s going on with wages & salary growth? Went down and stayed down.

What about the employment situation? A “catastrophe”!

So please, Mr. Bullard: “Come again”?


That´s the logical conclusion from Bernanke´s answers to badly framed questions. The inflation-unemployment nexus is a bad and even dangerous guide to policy. But it´s how the “stabilization” question is framed and acted upon.

To give just one example. To the question:

Since both housing and unemployment have not recovered sufficiently, why are you not instantly embarking on QE3?

The answer is “automatic”:

“Going forward, we’ll have to continue to make judgments about whether additional steps are warranted, but as we do so, we have to keep in mind that we do have a dual mandate, that we do have to worry about both the rate of growth but also the inflation rate…

“The trade-offs are getting — are getting less attractive at this point. Inflation has gotten higher. Inflation expectations are a bit higher. It’s not clear that we can get substantial improvements in payrolls without some additional inflation risk. And in my view, if we’re going to have success in creating a long-run, sustainable recovery with lots of job growth, we’ve got to keep inflation under control. So we’ve got to look at both of those — both parts of the mandate as we — as we choose policy.”

On cue the Saint Louis Fed today released this Economic SYNOPSES: Monetary Policy´s Effects on Unemployment, where we read:

The impact of LSAP programs on economic activity depends on the programs’ effects on longer-term interest rates and the responsiveness of aggregate demand to such changes.


A less-recognized risk in LSAP programs is that permanent increases in the monetary base foreshadow eventual increases in inflation that can increase, rather than reduce, unemployment over the long term.

Funny that that long term interest rates went UP after QE2! But as Scott Sumner never tires of saying: both interest rates and the monetary base are not good indicators of the stance of monetary policy. And monetary policy is (still) tight because money demand has risen more than money supply.

Back in 2008, by giving too much attention to a noisy measure of inflation, the Fed was responsible for the aggregate nominal spending meltdown, one not seen since the 1930´s. The economy fell into a deep hole and is not getting out of it because the Fed refuses to “light up the way” by showing “where it wants to go”. The nice thing about such an action – defining a target level – is that if the Fed has credibility (a big if given the prevailing “modes of thought”) very quickly the “market” will get ahead of the Fed so that very little “prodding” by the Fed will actually be necessary.

But alas, no. We will probably continue to “reside” well inside the “hole” (with unemployment high/employment low) because the Fed´s “flashlight” is out of batteries!

As Scott reminds me via e-mail: “I just noticed that the last time NGDP growth reached 5% was 2007:4.  Nearly two years of “recovery,” and not a single quarter of trend growth in NGDP.  And Bernanke mentioned that faster growth threatened inflation”.


QE2 will end as planned in June. Monetary policy will “passively tighten”. In the Press Conference Bernanke fretted about core inflation going up, about the danger of rising commodity and oil prices and about inflation expectations – up but still anchored. The “hawks” are in control. There was unanimity but Bernanke conceded their points! To him, it´s a pity long term unemployment continues elevated, but the inflation “dangers” take precedence!

But that´s what you get when you obsess with inflation. The hawks have been “crying wolf” for a long time, even while inflation was tanking during most of 2009 – 2010. Ryan Avent of Free Exchange put it well a few days ago:

Unfortunately, the Fed didn’t set a policy target. Instead it opted for the $600 billion figure, thereby inviting critics to judge the Fed on whether $600 billion was, in fact, the right action to take. Since the Fed didn’t establish what, exactly, it was hoping to accomplish with its $600 billion, in terms of an observable policy target, it left the door open for people to assume that it was doing what it viewed as necessary to make the economy work again. And if the economy isn’t quite working again, well, observers can be forgiven for experiencing some skepticism of the value of expansionary monetary policy.

But that’s problematic for the Fed. It will be much easier for people, inside the Federal Open Market Committee and out, to argue that the benefits to additional expansion are smaller than believed and since the economy has improved meaningfully from last summer, there’s less pressure to act in the first place. The Fed chose a direction rather than a destination, and when its action left it short of the destination, it opened the door to criticism that the direction was wrong, when in fact it may simply have traveled an insufficient distance (perhaps thanks to unexpected headwinds). If you target a destination, you don’t run into that problem.

I´m more radical and think it has traveled no distance at all, it just stopped the “nose dive” as the two pictures below attest.


Please Mr. Bernanke, at least in 1999 you suggested Japan adopt a “Price Level Target”. You could do even better and adopt a “Nominal Spending Level Target”. Let “market conditions” determine how that will be divided up between real growth and inflation. If the 1933-37 period is a useful guide, real growth will rule the day. Otherwise you will be repeating the Eccles Fed mistake, which in 1937 raised required reserves because inflation was “rising”!

Update: Ezra Klein on what Bernanke should have said!

So, in conclusion, the economy is terrible, we should be doing more, and Congress should be doing much more, but instead we’re going to pretend the economy isn’t that bad, I’m going to pull back so you guys don’t jail me and everyone who works for me, and Congress is going to do the exact opposite of what economic theory and evidence would suggest and cut spending immediately while passing deficit-financed tax cuts for later. Oh, and I haven’t even mentioned the debt ceiling, because if I start cursing and crying, the markets will really freak out

Who´s who

All FOMC voting members in one place and indications of what they´re thinking about MP going forward. A sample of 1:

Elizabeth A. Duke 
Member, Federal Reserve Board of Governors

“It would not be helpful if monetary policy reacted to every move in a volatile price.”
“The rate of inflation over the medium term is a key and important number for us to pay attention to. But when you look at things like gasoline prices, (they) are very volatile.”
— Q&A on April 14 at the International Factoring Association Conference in Washington, D.C. (Reuters).

Monetary policy powerless?

On the way to the FOMC´s two day meeting, April 26 and 27, there has been much talk about the lack of power of monetary policy to get the economy going. My last post indicated that there was “an untapped power” of monetary policy that could still be harnessed.

First let me review events. It all starts with Bernanke´s Jackson Hole speech of August 27, 2010. There he says:

Policy Options for Further Easing
Notwithstanding the fact that the policy rate is near its zero lower bound, the Federal Reserve retains a number of tools and strategies for providing additional stimulus. I will focus here on three that have been part of recent staff analyses and discussion at FOMC meetings: (1) conducting additional purchases of longer-term securities, (2) modifying the Committee’s communication, and (3) reducing the interest paid on excess reserves. I will also comment on a fourth strategy, proposed by several economists–namely, that the FOMC increase its inflation goals.

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC’s recent decision to stabilize the Federal Reserve’s securities holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions.

Yes, he did do (1) above. Was it disappointing as argued by Binyamin Appelbaum in the Sunday NYT? Or, as argued by Ryan Avent in Free Exchange:

So has QE2 accomplished what most reasonable onlookers expected? I think it’s fair to say that it has, and I think it’s clear, in the light of these realised expectations, that QE2 was a very good thing to have. Asset purchases were designed to improve economic conditions relative to what would have otherwise prevailed. And Mr Appelbaum doesn’t come close to arguing that the policy failed on this count.

This is what Bernanke said on November 4 2010 to explain “what the Fed did and why”:

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

Bernanke is a “credit channel freak”, so he puts much emphasis on “lower rates”. But let us look at what happened in several dimensions after QE1, after QE1 was ended, when QE2 was “hinted” at on August 27 and following implementation on November 3.

The first block of figures shows financial variables:

Long term interest rates do not show the behavior Bernanke “expected”. But that is “good”. As frequently argued by David Beckworth:

If QE2 is successful, then we would expect treasury yields to rise!  A successful QE will first raise inflation expectations.  This alone will put upward pressure on nominal yields.  However, expectations of higher inflation are in effect expectations of higher nominal spending.  And higher expected nominal spending in an economy with sticky prices and excess capacity will lead to increases in expected real economic growth.  The expected real economic growth should in turn increase real yields.  It is that simple.

It has been frustrating to watch the Fed sell QE2 to the public as working through the lowering of interest rates.  This marketing of QE2 creates the false impression it will only work if yields remain low.  It gives critics of QE2 more ammunition and ultimately undermines the effectiveness of the program.

Stocks went up after QE1, fell when it ended and resumed the up trend with “hints” of QE2. The same happened with inflation expectations (a sign of future higher nominal spending).

The second block shows real variables: Real annualized growth and non-farm employment.

A case can be made that the QE program was helpful in giving some boost to growth, but employment was not much affected at all, and that´s probably the main reason why QE2 is perceived as a “disappointment”.

Why is it so? I believe Ryan Avent is on the right track when he writes in the above linked piece on Free Exchange (emphasis mine):

Unfortunately, the Fed didn’t set a policy target. Instead it opted for the $600 billion figure, thereby inviting critics to judge the Fed on whether $600 billion was, in fact, the right action to take. Since the Fed didn’t establish what, exactly, it was hoping to accomplish with its $600 billion, in terms of an observable policy target, it left the door open for people to assume that it was doing what it viewed as necessary to make the economy work again. And if the economy isn’t quite working again, well, observers can be forgiven for experiencing some skepticism of the value of expansionary monetary policy.

Maybe there´s hope. At the end of the coming FOMC meeting Bernanke will inaugurate the “news conference” to explain its decision to the public. That, I believe, could be the first step in implementing his point # (2) from the Jackson Hole speech – modifying the Committee’s communication.

A second policy option for the FOMC would be to ease financial conditions through its communication, for example, by modifying its post-meeting statement. As I noted, the statement currently reflects the FOMC’s anticipation that exceptionally low rates will be warranted “for an extended period,” contingent on economic conditions. A step the Committee could consider, if conditions called for it, would be to modify the language in the statement to communicate to investors that it anticipates keeping the target for the federal funds rate low for a longer period than is currently priced in markets. Such a change would presumably lower longer-term rates by an amount related to the revision in policy expectations.

Again, notice the focus on “low long term rates”. The Fed has to come to grips with the fact that this is not “business as usual”. A drop in nominal spending was last seen in 1938! You cannot talk (or communicate) about monetary policy as if nothing untoward had happened. It´s not just about “getting growth up a bit”. It´s about a very depressed LEVEL of spending!

So please, in your “news conference” don´t indicate that “monetary stimulus” will end in June, when QE2 comes to an end. Come out and state a clear TARGET, not for inflation, because that´s useless and “dangerous”. The following pictures can help you define a good target.

The first is a good indication of why, despite some growth, employment is still in the “toilet”. Note that while spending growth was converging to trend after the low spending growth of the early 2000´s, NFP was rising robustly. As soon as the nominal spending begins to falter, falling below the trend level, NFP stops rising and falls a little, dropping into a “hole” when spending “melts” after mid 2008.

The last figure indicates what you have to “communicate” – a path for nominal spending that in a specified period of time will take you to a “reasonable” spending level path. Simply focusing on “trend growth” will continue to be “disappointing” because the “gap” will remain open!

The untapped power of monetary policy

This piece in the NYT made “waves”:

As the Fed’s policy-making board prepares to meet Tuesday and Wednesday — after which the Fed chairman, Ben S. Bernanke, will hold a news conference for the first time to explain its decisions to the public — a broad range of economists say that the disappointing results show the limits of the central bank’s ability to lift the nation from its economic malaise.

Krugman did a post:

What QE2 might have done — and probably did do for a while — is act as a signal of the Fed’s determination to do whatever is necessary, and maybe of a willingness to accept higher inflation. But this only goes so far, especially with all the political pressure on the Fed and its constant declarations, in the face of that pressure, that it remains as steadfast against inflation as ever.

And so did Steve Williamson, who thinks Philadelphia Fed president Plosser is the right reference:

Charles Plosser certainly comes off well. The guy has good sense, and integrity:

“I wasn’t a big fan of it in the first place,” said Charles I. Plosser, president of the Federal Reserve Bank of Philadelphia and one of the 10 members of the Fed’s policy-making board. “I didn’t think it was going to have much of an impact, and it complicated the exit strategy. And what we’ve seen has not changed my mind.”

It´s been long known among so called “quasi monetarists” that QE2 was a week effort to get the economy going again. This is from David Beckworth a few days ago:

The problem with the QEs all along is that they have been rather ad-hoc and unpredictable.  This has made them less effective and politically polarizing.  Imagine how different the Fed’s monetary stimulus would have been had they adopted an explicit target, preferably a nominal GDP level target.  Such an approach would have given them the freedom to do really aggressive ‘catch-up’ monetary easing until nominal GDP returned to the targeted trend while at the same time ensuring long-term predictability.  It also would be viewed (correctly) as constraining the Fed’s power.

The pictures below give a stylized indication of what a “Nominal Spending Target” would do. In this set up inflation would be allowed to go above “target” temporarily (if that´s what it takes) to get spending back to trend, but the employment population ratio (paraphrasing S. Williamson) would “come out of the toilet”. It´s obviously not good enough just to resume trend growth (at a much lower trend growth path):

Partial Stories

Krugman and Ritholtz say the “conservatives” should not be hysterical about the dollar decline. That´s true, but Krugman doesn´t miss the chance to point out that the “dollar debasement” was not the work of Obama. Guess who´s behind it?

The figure below shows the whole history of the dollar trade weighted exchange rate against a broad basket of currencies since the flexible rate system began in 1973, both in nominal and real terms. Up to the mid 1990´s the dollar appreciated almost continuously in nominal terms. That´s because until that point in time many important emerging market trade partners had high inflation (and devalued accordingly). Since then, with inflation low almost everywhere, the nominal and real exchange rates move in tandem.

Notice the long cyclical swings in the real rate, which have nothing to do with specific presidents or political parties. Maybe now the real exchange rate will break through the long standing “support level” of something close to 80. But who knows?

Krugman wants more Government

Krugman has a post “Our low, low taxes”:

I thought it might be useful to have a cleaner comparison of the major advanced countries. So here are taxes by all levels of government as a % of GDP, removing the clutter by only looking at the G7, and using data from 2007 so that things aren’t confused by the effects of the Great Recession:

And the graph on government revenues as a percent of GDP follows. Sure, the US has a relative low tax ratio. So what? Decades ago Friedman taught us that the share or weight of government in the economy is measured by the level of its expenditures as a share of GDP. Taxes are just the means through which government supports its “weight”.

The figure below shows that what Krugman in effect is advocating is that the US government “perpetuates” its higher share of the economy by raising taxes. Not long ago, in 2000, US government expenditures were “only” 33.9% of GDP while revenues were 35.4%. In 2007 expenditures were up to 36.8 with revenue dropping to 34%.

Don´t say taxes are “low”; say you want a larger role for government. It´s more honest!

“One against all”

The symptoms of Eurozone malaise are very visible, well summarized in this graphics from the Financial Times.

Less visible but fundamental to the euro survival are the political undercurrents that have begun to manifest themselves all over the “zone”. The most recent and potentially the most damaging is the April 17 election result in Finland, where the True Finns party that until then had only 4% of parliamentary seats jumped to 19.0%, coming in third, close on the heels of the Conservatives (20.4%) and the Social Democrats (19.1%).

With their strong election performance, the True Finns could disrupt ongoing efforts (read bailouts) to tackle the euro debt crisis because in Finland the parliament has to approve the country´s participation in the bailouts of member countries and EU rules require unanimous approval for each euro bailout fund.

Finland is special because of its recent history. In the early 1990´s Finland had went through a “Great Recession”. Between 1990 and 1993 real growth was significantly negative and unemployment reached almost 17% in 1994.

Since 1995, Finland stabilized its economy with nominal spending evolving close to a 5% stable trend level growth path until the crisis hit.

Among Eurozone countries Finland is also an exception in that it has remained within the Maastricht deficit and debt limits of 3% and 60% respectively.

Naturally, the Finns must be thinking: If we managed to do it on our own, why shouldn´t Portugal, Greece and others do it also?

It hasn´t helped at all that euro governments went all out to save their banks at the expense of taxpayers. Even “save” is the wrong word since according to Tyler Cowen, many of the Eurozone countries are moving “toward a land inhabited by zombie banks”. The result is that now the crisis is generating a political backlash – a revolt of the taxpayers – that extends from the “northern periphery” to both the large and small euro economies. Bets on the outcome are wide open. But it is almost certain the statu quo will not survive.

“Reading between the lines”

I have one more “nail to put in Bernanke´s coffin”. I´ve already told the story of how he “chickened out” simply by not doing what back in 1999 he advised Japan to do to try and get out of its “hole” (see “Japanese Monetary Policy…” on the Suggested Reading list). For many years, even before becoming associated with the Fed, first as governor and later as its Chairman, he went on and on about the importance of “communication”, or how the Fed shouldn´t “surprise” markets (see “What happens when Greenspan is gone” on the Suggested Reading list).

It appears he has “forgotten” everything. The successive QE program is weekly effective only, so open to “attacks” from many sides. And makes for bad communication about the Fed´s intentions as this FT article reminds us:

When the rate-setting Federal Open Market Committee meets on April 27, it is unlikely to limit its options by ruling out asset purchases beyond the second $600bn “quantitative easing” programme – or “QE2” – that is due to finish by the end of the second quarter. Fed officials, however, know that announcing more asset purchases at the last minute would disrupt markets. Silence on a follow-up “QE3” at next week’s meeting would therefore signal that their current intention is to complete the $600bn QE2 programme and then stop.

The original monetary induced crisis is not being resolved and the derivative fiscal crisis is “ballooning”. So no surprise that the S&P has downgraded the US outlook from stable to negative.