The (inflation expectations) lights are dimming

Maybe that´s why the hawks and ‘inflationphobes’ are not aware of it. Every month, accompanying the CPI release, the Cleveland Fed releases its estimates of inflation expectations ranging from 1 year to 30 years. In March I did a post trying to show that, although it´s pretty much ignored, the measure of inflation expectations gouged by the Cleveland Fed appeared to be pretty consistent.

The chart below shows how short (1 year), medium (5 years) and long run (10 years) inflation expectations have evolved since the recession began in December 2007. It´s interesting to note how expectations reacted to both the start and finish of QE1 & QE2.

Now, just try to imagine if over three years ago, in March 2009, the Fed had implemented QE1 within a broader plan which targeted a specific level of nominal spending. If that had happened, I believe:

a)      QE2 would not have been needed

b)      By now aggregate demand would likely be on (or close) to the targeted value

c)       Unemployment would be much low and real output much a higher, and

d)      Inflation would be “on target”

Update: Ryan Avent at Free Exchange ends his post citing Menzie Chinn:

A construction-oriented phase of recovery would be most welcome now given the shaky state of export markets. But any rebound in residential investment will be bounded by the Fed’s tolerance for inflation. Indeed, as Joshua Aizenman and Menzie Chinn argue, housing might have ended its long swoon earlier had the Fed been willing to generate—or at least tolerate—a bit more inflation.

Unfortunately, “tolerating a bit more inflation”, is not the way to do it.

Please, less “technique” and more substance

I think there is something very wrong with this kind of analysis and its implications. The Federal Reserve Bank of New York has just published this post on its blog, Liberty Street. It´s called: “The Great Moderation, Forecast Uncertainty, and the Great Recession” and here´s what they have to say:

The Great Recession of 2007-09 was a dramatic macroeconomic event, marked by a severe contraction in economic activity and a significant fall in inflation. These developments surprised many economists, as documented in a recent post on this site. One factor cited for the failure to anticipate the magnitude of the Great Recession was a form of complacency affecting forecasters in the wake of the so-called Great Moderation. In this post, we attempt to quantify the role the Great Moderation played in making the Great Recession appear nearly impossible in the eyes of macroeconomists.

In the twenty years that preceded the Great Recession, the U.S. economy had displayed remarkable stability—a phenomenon that James Stock of Harvard and Mark Watson of Princeton dubbed “the Great Moderation.” Most economists attributed this relatively sudden reduction in the volatility of macroeconomic variables, starting around 1984, to a combination of “good luck”—in the form of less severe external shocks hitting the economy—and “good policy,” especially in the form of greater Fed vigilance on inflation, as well as to other forms of structural change (see this 2004 speech by then Fed Governor Ben Bernanke for an overview).

Their conclusion:

In sum, our calculations suggest that the Great Recession was indeed entirely off the radar of a standard macroeconomic model estimated with data drawn exclusively from the Great Moderation. By contrast, the extreme events of 2008-09 are seen as far from impossible—if unlikely—by the same model when the shocks hitting the economy are gauged using data from a longer period (third-quarter 1954 to fourth-quarter 2007). These results provide a simple quantitative illustration of the extent to which the Great Moderation and more specifically the assumption that the tranquil environment characterizing it was permanent, might have led economists to greatly underestimate the possibility of a Great Recession.

The chart depicts the volatility of real output (RGDP) over the 1954-12 period. Notice that the “longer period” contains “shocks” of magnitude matching the one that characterizes the recent “dramatic macroeconomic event”. And as he says: “the extreme events of 2008-09 are seen as far from impossible—if unlikely—by the same model when the shocks hitting the economy are gauged using data from a longer period (third-quarter 1954 to fourth-quarter 2007)”.

Note he says “unlikely”, because even taking account of the shocks over a longer period the size of the downfall was “way down the left side of the distribution”.

There´s a religious connotation here. It seems that we are on earth to “pay for sins” so that “tranquil environments” must be an “aberration”. It is said that people become complacent and undertake “excessive risks”, not taking into account the fact that people can do more stuff exactly because the macro environment became less risky!

I think the key phrase shows up in the intro to Scenario 1:

Scenario 1 assumes that “this time is different”—meaning that the Great Moderation permanently changed the structure of the U.S. economy and the nature of the shocks that buffet it.

I believe it was not the “nature” of the shocks that changed, but how “good policy” was “good” exactly because it was managed in such a way as to contain the propagation of the shocks, not because it showed “greater vigilance on inflation”. For example, no one can say that the Fed was not paying attention to inflation in the first half of 2008 (just read the statements). Things went sour exactly because the Fed was paying too much attention to “inflation”, letting monetary policy tighten so much that aggregate demand plunged. And so did inflation! The rest is history.

What´s “cramping” the pluck?

I see that John Taylor thinks it´s economic policy – policy uncertainty and increased regulation – that´s holding back a repeat of Friedman´s “plucking model”:

Milton Friedman’s “plucking model” should be back in fashion now because it reminds us of the historical fact that throughout American history—until now—the deeper the recession, the faster the recovery. I like to bring a guitar to talks and lectures to illustrate this: Like a guitar string, when the economy is “plucked” down or pulled down, the “string” or the economy always springs back up. The more the economy is “plucked” down, the faster it springs back up. This has been true throughout recorded American history, and it holds whether or not there has been a financial crisis. Here is a link where you can find Hoover Institution Working Paper E-88-48 in which Friedman described the model. (He also envisioned a board on top of the guitar string to prevent a reverse action on the upside, which he argued was not in the data).

Of course something is now interfering with the usual economic response, because our current recovery is certainly not springing back to normal. I have argued that economic policy is holding the economy back, and I think recent research by Ellen McGrattan and Ed Prescott (on increased regulations) and by Scott Baker, Nick Bloom, and Steve Davis (on policy uncertainty) supports this view. Their work is part of a forthcoming book (Government Policy and the Delayed Economic Recovery) edited by Lee Ohanian, Ian Wright and me.

Several months ago I did a post on Friedman´s “plucking model”. The picture I copy over here gives you a good idea of what it´s about.

And there I wrote:

After the strong bounce back from the deep 1981/82 recession the economy enters a period that came to be known as “Great Moderation”, that lasts through 2007. This period was characterized by an almost complete absence of “plucks” and, therefore, of “big bounce backs”. The defining characteristic of the period is the maintenance, for most of the time, of a stable spending growth along a level path.

This comes to an end in 2008, when the Fed allows nominal spending to tank, to a degree not seen since the 1930´s! The reasons have been exhaustively discussed by the group of Market Monetarists. The question is: why was there no vigorous “bounce back” from such a strong “pluck”?

The figure below illustrates. While from the recession through in late 1982 nominal spending (well controlled by the Fed) rebounded strongly – and this is a characteristic of all the observed “bounce backs” – following the through of the 2007/09 recession nominal spending growth, despite the previous “off the charts” drop, has been constrained by “inflation hawkishness” and other fears. The result, no “bounce back”, so the economy stays inside the hole and unemployment “up in the clouds”.

So which is it? I believe excess regulation and such mostly have an effect on the long run possibilities of the economy and very little effect on its capacity to “bounce back”. That´s mostly dependent on monetary policy, in particular the Fed´s willingness to bring nominal spending back to a “reasonable” trend level.

On that regard, as additional evidence that “lack of demand” is the major factor, David Beckworth has a nice post, where he shows that, according to the National Federation of Small Business (NFIB) survey of Small Business Economic Trends, the single most important problem is “sales” (i.e. demand).

“Saint and Sinners “: Germany & the Periphery

Germany is engaged in a purifying crusade, epitomized by its push for the unconditional adoption of “austerity” by all member countries of the euro, in particular the so-called PIIGS.

As demonstrated by recent results coming from the polls, a resistance to the Germanic dictates begins to manifest. The escalation of this process is almost inevitable, especially given the inconsistency of the requirements. Also, “Merkollande” will not be anything like “Merkozy”

The arguments of this text will be illustrated with the most obvious cases of inconsistency, and exemplified by Germany, Ireland and Spain.

Ireland and Spain are seriously injured victims of the German narrative that everything boils down to “fiscal irresponsibility.” Let’s take a look at this “rampant borrowing and spending” of Spain and Ireland relative to Germany.

The figures below show the debts and deficits relative to GDP of Spain and Ireland compared to Germany.

Note that both Spain and Ireland, until the moment when the crisis struck, were more “austere” than Germany and, unlike her, never disrespected the limit of 3% for the Deficit / GDP ratio set in the Maastricht agreement .
Now, notice what was happening with the flow of private capital, reflected in the current account balance relative to GDP in the three countries.

Given these facts, what would naturally happen? If the current account surplus of Germany was the counterpart of the current deficits of Spain and Ireland, now would be the time for a reversal of roles. For those who believe in fairy tales this may seem possible!

And what happened to growth and employment when the “music stopped and there were not enough chairs to accommodate the participants’? The following figures illustrate.

What a turnaround! And in order to correct the course Ireland and Spain have to promote an “internal devaluation”. This point is important and interesting. One reason for the formation of a bloc with a single currency was the elimination of currency risk inherent in a regime of fixed exchange rates, such as the EMS (European Monetary System).

In fixed exchange rate regimes, such as EMS or Bretton Woods regime that prevailed in the postwar period until 1971, a problem that always came up in times of turmoil or crisis in the balance of payments was about who would bear the burden of adjustment. Since the crisis manifested itself only when the foreign reserves of deficit countries had been exhausted, these countries were at the mercy of creditors. And creditors were quick to impose unilateral adjustment. After all, “sinners” have to atone for their sin!

It was hoped that monetary union would change all that. However, the adjustment process within the euro area seems to be as asymmetrical as the adjustment mechanisms that prevail in fixed exchange rate regimes. In this case it does not happen due to traditional balance of payments crisis, since this type of crisis cannot manifest itself in a context where internal foreign exchange markets have disappeared. However, another mechanism is at work.

This new mechanism derives from the weakness inherent in a monetary union where national governments issue debt in a currency over which they hold no control. In such a system when the fiscal position of a country deteriorates as a result of, for example, the deflationary effects of an internal devaluation, investors may be gripped by fear, which leads to a collective manifestation of distrust. The ensuing sales of securities leads to a liquidity contraction in the countries concerned. This ‘sudden stop’ in turn leads to a situation in which the government of the country cannot finance its debt unless interest rates are prohibitively high. The conclusion is that in the absence of a lender of last resort – a role that the ECB (European Central Bank) is not permitted to undertake  – a member country in a monetary union can be driven to default by panic in financial markets.

Thus, in the same way as in a fixed exchange rate regime, a government in a monetary union that is hit by crisis has to go “begging” creditor countries. And these – the “saints” – cannot be  pressured to contribute to the adjustment process, i.e. making it more symmetrical.

The figure below shows how much internal devaluation has taken place in Ireland and Spain since the peak in 2008 or 2009, and in the case of Germany, the “internal revaluation” that  has occurred over this period.

While Ireland has “promoted” an internal devaluation (a fall in unit labor cost) of 15% and Spain 7%, the internal revaluation in Germany does not reach 4%. And as illustrated in the figures depicting growth and unemployment, suffering must have a limit. Thus, while an imagined political imperative  created  the euro, real world political disillusionment will likely bring its downfall.

For a short time this week hope sparked from the French and Greek election fallout. On Wednesday  May 9th a Bundesbank economist was bold enough to say  that “the country) could tolerate slightly higher inflation in return for more domestic demand”. The next day Finance Minister Wolfgang Schaeuble chimed in, saying “inflation of up to three percent was “acceptable” in the short-term”.

According to this source:

The two comments sparked speculation Germany was ready to relax its hardline stance against wage rises and inflation in a bid to boost consumption in the European powerhouse and thereby help to ease the crisis in the eurozone.

But hope was short-lived because on Friday Jens (“Big Stick”) Weidmann, Bundesbank head,  intervened sharply to slap down what he termed an “absurd debate” about inflation.

So it seems that things will progress as they always have and the required adjustments will fall almost completely on the “sinners”. The charts below are a good indicator of the relatively comfortable German position. If anything it seems Germany wouldn´t complain if domestic aggregate demand were contained a little. And the rest be damned!

Kocherlakota “shoots from the hip”

He´s back with his “it´s structural” meme. Back in 2010, less than a year after becoming president of the Minneapolis Fed, Kocherlakota made a speech in which:

  1. He argued that unemployment was structural and
  2. That if the Fed Funds rate was kept at zero the appearance of deflation was only a question of time!

With regard to (1) he said:

What does this change in the relationship between job openings and unemployment connote? In a word, mismatch. Firms have jobs, but can’t find appropriate workers. The workers want to work, but can’t find appropriate jobs. There are many possible sources of mismatch—geography, skills, demography—and they are probably all at work. Whatever the source, though, it is hard to see how the Fed can do much to cure this problem. Monetary stimulus has provided conditions so that manufacturing plants want to hire new workers. But the Fed does not have a means to transform construction workers into manufacturing workers.

With regard to (2) what he meant was something like:

With the federal funds rate near zero since December 2008 and expected to remain there for the next year or two, the Fisher equation has important implications for the expected inflation rate. If the real economy is currently rebounding to a sustainable growth trend, the real interest rate will rise and the only outcomes possible will be either a higher nominal federal funds rate or a negative expected inflation rate…

The operative word is IF, and two years on we know the economy has not rebounded – climbed out of the hole into which it dropped after mid-2008.

So now Kocherlakota, to be consistent, says that:

MINNEAPOLIS (Reuters) – Unemployment may not have too much farther to fall before inflation threatens, forcing the U.S. Federal Reserve to respond by raising interest rates sooner than expected, a top Fed official said on Thursday.

The fact that inflation continues to run above the Fed’s 2-percent target, Minneapolis Fed President Narayana Kocherlakota told the Economic Club of Minnesota, is “a signal that our country’s current labor market performance is much closer to ‘maximum employment’ than the post-World War II U.S. data alone would suggest.”

The U.S. central bank’s monetary policy “should be responsive to such signals,” he said.

At least he dropped his “low interest rate-spells-deflation” sequence. And his “it´s structural” follows from his reading of the Beveridge Curve, a creation of Lord William Beveridge who wrote the Beveridge Report of 1942 which paved the way for the development of the British welfare state.  The Curve establishes a negative relation between the rate of job openings and unemployment, grounded on idea that if the unemployment rate is elevated firms would find it easier to fill vacancies. If that doesn´t happen, it means that the curve is shifting up, indicating that firms have greater difficulty in filling vacancies.

This could be due to several factors, among them greater difficulty in matching workers to jobs and the persistence of long-term unemployment (which may “depreciate” human capital and/or increase “negative perceptions” about the unemployed by potential employers).

The “mismatch” view is difficult to reconcile with the observation that, with the notable exception of the Leisure & Hospitality sector, employment most everywhere is still way below the pre-recession peak, even though we´re almost three year into the “recovery”. And in no sector are wages differentially rising to indicate that labor demand outstrips supply.

Maybe the high rate of long term unemployment is the main factor behind the Beveridge Curve dynamics. Pity that the JOLTS data only begins in late 2000, so we cannot compare present behavior with that observed, for example, in the deep recession of 1981-82.

The point is that there are always “structural” elements present in the unemployment rate observed. After all, the economy is permanently in motion and all sorts of “frictions” are present. But I believe that for most situations the strength of aggregate demand will help in the adjustment process, so I´m willing to bet that in the early eighties we would not be discussing, like now, about the “structural” nature of unemployment. While between 1982 and 1985 aggregate demand grew on average 10.6%, since 2008 it has only expanded at 2.9%, barely more than half the 5.6% growth observed during the twenty years of “Great Moderation” (1987-07).

So, while in the early eighties long term unemployment averaged 18.7 between 1982 and 1985, it has averaged 35.1% since 2008, having remained above 40% for the last 28 months.

HT P. Stefani & Lars Christensen

Many are quick to shout “it´s structural”

But Ryan Avent does a great job in setting the record straight. It´s a must read. The conclusion:

So let’s be clear; the primary evidence for permanent loss of potential is the slow recovery in the size of the labour force, which would appear to be largely due to cyclical variation. We are not seeing a surge in labour costs, or prices generally, indicating that the economy is actually running up against capacity constraints. The Fed could have taken the approach that it would seek above-trend growth, as one normally expects to see after a recession (especially a deep one), and then step on the brakes if it became apparent that potential had been lost, that real growth was falling consistently short of trend while inflation was accelerating. That would have made a lot of sense, given the real economic costs of prolonged high unemployment.

That’s not what the Fed has done. Instead, it’s been happy to accept at- or below-trend growth, despite the fact that the large remaining output gap has quickly translated shocks into worrisome disinflationary pressure. Now the public is increasingly willing to read Fed failure as a loss of potential. If the Fed comes to agree, it may begin to fear that it has less room to boost the economy, it may consequently boost the economy less, and it may therefore ensure that the output gap persists until it does indeed become permanent.

This is self-induced paralysis: the fear that trying to do things to fix current problems will generate consequences worse than the present problems, all evidence to the contrary. It’s frustrating—galling, even—though I suppose at this point we shouldn’t find it surprising.

One last point: a country to which tens of millions of people around the world—including highly skilled, ambitious, educated workers—would gladly move is one that never has to worry about slowing labour force growth. If we’re going to diagnose America’s ills, let’s diagnose them correctly.

I´ll just “nitpick” on the highlighted sections of the paragraphs below.

On Friday, I tweeted that there was no structural unemployment in America that couldn’t be eliminated in a late 1990s-style labour market. This prompted a wave a responses from individuals arguing that if America has to count on a once-in-a-lifetime internet boom for such growth, then it rightly should be called structural. This, however, confuses the macro with the micro. There were a number of microeconomic trends underway, including the first stirrings of the internet economy, that made the late 1990s a prosperous era. What made the period a job-rich time was accommodative Fed policy; nominal GDP growth averaged well above 6% from 1997 to 2000. After falling about 2.5% in 2009, by contrast, it rose just over 4% in 2010 and just below 4% in 2011. That’s below trend at a time in which the economy ought to be catching up to where it previously was.

The Fed allowed such rapid growth in the late 1990s because unusual macro circumstances at the time placed substantial downward pressure on broad prices: oil was dirt cheap, a strong dollar was reducing import costs, and China was a net disinflationary force at the time—its cheap products dominated its impact on commodity prices. Core prices hung just a shade over 2% for much of the period. In the absence of those disinflationary forces, a rate of nominal GDP over 6% would probably correspond to a higher inflation rate. And since the Fed seems to have, if anything, become more intent on maintaining a strict 2% limit on inflation, it has been unwilling to do more, leading to disappointing nominal (and real) GDP growth, and correspondingly disappointing employment and labour-force growth.

The late 1990s was certainly an interesting period. 1997-98 were the “crises years”. First Asia, notably Korea, and then Russia and Brazil. They were deflationary/recessionary shocks. Output growth in Korea was negative 8% in 1998! And there was the Russia spillover on LTCM. Concurrently, in the US a positive productivity shock was taking place. In such a case, real output growth increases and inflation falls. If you are targeting inflation this indicates (wrongly) that monetary policy has to “ease up”.

Maybe it was all those different things happening at the same time, but the fact was that US monetary policy was expansionary in 1998-99. That can be gleaned from the behavior of the “NGDP Gap”, i.e. the difference between the level of NGDP and it´s “Level Target”. The chart illustrates.

The other charts show the positive productivity shock, reflected in the increasing growth of output per hour, the fall in unemployment and the drop in inflation.

Even without the “unusual circumstances” mentioned by RA, which directly affected the conduct of monetary policy, inflation in the US would have come down at the same time that growth rose and jobs would be “rich”. More than 10 years into the “Great Moderation”, and being fortunate to be buffeted by a positive and significant productivity shock, the US economy was strong enough to be the “buyer of last resort” to the world, significantly reducing the pain of adjustment in the crisis-impacted economies.

Now it is unwilling to “ease the pain” within itself!

The ship´s sinking and the rats are fighting over crumbs

Reuters –

President Barack Obama’s two nominees to the Federal Reserve appear likely to fall victim to a long-running political feud, which would leave the central bank short-handed as it struggles with tough regulatory and monetary policy questions.

Republican Senator David Vitter has demanded that the Senate hold a debate before any vote on the nominees, which would require Democratic leaders to muster a super majority to move forward – a hurdle that may be too high to clear.

Not being a strong leader Bernanke will have more difficulty navigating the stormy seas ahead.

Time-Inconsistent set ups

“Paul Krugman has famously argued that the BOJ can’t inflate, because any commitment to inflate wouldn’t be believed” – Scott Sumner (HT Benjamin Cole).

Long ago, Krugman wrote about Japan:

In short, approaching the question from this high level of abstraction already suggests that a liquidity trap involves a kind of credibility problem. A monetary expansion that the market expected to be sustained (that is, matched by equiproportional expansions in all future periods) would always work, regardless of whatever structural problems the economy might have; if monetary expansion does not work, if there is a liquidity trap, it must be because the public does not expect it to be sustained.

More recently (2008) he took a leaf from another long ago piece to say, now in reference to the US:

The whole subject of the liquidity trap has a sort of Alice-through-the-looking-glass quality. Virtues like saving, or a central bank known to be strongly committed to price stability, become vices; to get out of the trap a country must loosen its belt, persuade its citizens to forget about the future, and convince the private sector that the government and central bank aren’t as serious and austere as they seem.

And a little less than two years ago he wrote:

Yes, America has long-run budget problems, but what we do on stimulus over the next couple of years has almost no bearing on our ability to deal with these long-run problems. As Douglas Elmendorf, the director of the Congressional Budget Office, recently put it, “There is no intrinsic contradiction between providing additional fiscal stimulus today, while the unemployment rate is high and many factories and offices are underused, and imposing fiscal restraint several years from now, when output and employment will probably be close to their potential.”

It seems to me there is a huge inconsistency in the argument summarized by the Elmendorf quote above. At the same time Krugman and Keynesians in general are saying that monetary policy cannot get the economy out of a “liquidity trap” situation because of credibility questions, it is saying that fiscal policy, which does not suffer from that constraint, can!

But time-inconsistency questions affect both. Since Keynesians are “hooked” on the short run (“In the long run we´re all dead”), who would consciously believe that “fiscal restraint will be imposed several years from now…”? What if another recession happens? Do you think they´ll keep their promise to be austere, just because the deficit from the previous fiscal stimulus is still high? Most certainly not and in that case America would only increase its long-run budget problems so no recovery would be forthcoming today!

Bernanke made a bad move earlier this year when he made the 2% inflation target official. He tied his hands, but note that he did so voluntarily. Old fox Greenspan never accepted falling into that “trap” (and while a Fed Governor Bernanke promoted internal discussion on the matter). In that case, being “credibly” expansionary, even if you don´t mention things like a “temporarily higher inflation target”, doesn´t fly!

As Nick Rowe just wrote on the importance of expectations:

Recessions are always and everywhere a monetary (medium of exchange) phenomenon. Recessions are an excess demand for money (the medium of exchange). The demand for money is the demand for an asset. Since the demand for money, like the demand for all assets, depends very much on expectations, especially when interest rates are low, recessions depend very much on expectations too, especially when interest rates are low.

It appears the solution, once again, is to change the monetary policy target. In the wings, garnering new adepts by the month, NGDP Level Targeting.  It´s much better and credible than Krugman´s oft-suggested Central Bank commitment to be “irresponsible”.

Missing Federal Reserve Board Members, Hawks and Weak Leadership

The Atlantic has a story with the title “The Most Important Economic Story Nobody Is Talking About”, on how Obama´s failure to fill all the Board of Governors of the Federal Reserve seats has been damaging:

Here’s a depressing reminder: We’re in a $1 trillion hole. That’s how much income we have been losing every year since the onset of the Great Recession. Ben Bernanke and Co. have done a good job preventing a full-on replay of the Great Depression, but Ben Bernanke and Co. have not done a good job preventing a lost decade. The key phrase here is “and Co.”

Bernanke doesn’t set monetary policy by himself. That’s what the Federal Open Market Committee (FOMC) votes on. Its structure is a bit Byzantine and not terribly important, but what is important is that the Fed Chairman usually gets his way without any dissent. That hasn’t been true lately. The Fed’s unconventional measures have unsurprisingly not been too popular with the FOMC’s more conventional members. Unfortunately, that hasn’t stopped Bernanke from trying to reach a consensus. He thinks he needs to. Bernanke recently told Roger Lowenstein that he thinks any policy that doesn’t get at least a 7-3 majority simply won’t be credible. This political calculation gives the hawks more policy influence than they would otherwise have.

And now it looks like there are more hawks. As Greg Ip of The Economist has pointed out, most of Bernanke’s colleagues now want to raise rates before he does. He increasingly looks isolated. Even if Bernanke is inclined to ease a bit more — and reading between the lines, he might be — there’s little chance of it happening. It’s worth remembering that even the hawks’ project  inflation to remain below target and unemployment to remain above target for the next few years. If the Fed believes its own forecasts, it should be doing more.

Regrettably, the Obama administration has consistently underestimated the importance of the Fed. That there are still two empty FOMC seats proves as much. So do the administration’s (blocked) nominees. Consider Peter Diamond. He’s a phenomenal economist — a Nobel-prize winner — who’s clearly qualified to serve on the FOMC. But he’s said that he doesn’t think there’s much more the Fed can do now. Even if he’s right — and I clearly don’t think he is — wouldn’t you rather appoint someone who thinks otherwise and find out if the Fed really is powerless? Someone like … former Council of Economic Advisers Chair Christina Romer.

“Let’s try pushing some more before we declare that we’re pushing on a string”.

I wholeheartedly agree that Obama´s failure to make good board appointments has made life harder for Bernanke. But there´s another reason for what many view as Fed ‘passivity’ and that is Bernanke´s weak leadership qualities.

After all, during Greenspan´s years at the Fed´s helm, the FOMC had its usual assortment of “hawks”. Back in 1991, Murray Rothbard, a quintessential hawk, put it thus:

It is interesting that, of the rulers of the Fed, the only ones that seem to be worried about the inflationary nature of the system are those Fed regional bank presidents who hail from outside the major areas of bank cartels. The regional presidents are elected by the local bankers themselves, the nominal owners of the Fed. Thus, the Fed presidents from top cartel areas such as New York or Chicago, or the older financial elites from Philadelphia and Boston, tend to be pro-inflation ‘doves,’ whereas the relatively anti-inflation ‘hawks’ within the Fed come from the periphery outside the major cartel centers: e.g., those from Minneapolis, Richmond, Cleveland, Dallas, or St. Louis. Surely, this constellation of forces is no coincidence.

During his long tenure, Greenspan had to deal with such Regional Fed hawks as Michael Moskow, Robert Parry, William Poole, Alfred Broaddus (known as ‘chief hawk’), Jerry Jordan, Gary Stern and Thomas Hoenig, with the last two also in Bernanke´s FOMC.

Why, for example, during Greenspan´s years Thomas Hoenig, with all his ‘hawkishness’ never had ‘top billing’ in the media and never had the gall to dissent in eight consecutive meetings?

Or take the case of ‘hawk’ Laurence Meyer who joined the Board in 2006. In one of his first speeches as Fed Governor, Larry Meyer innovated by richly detailing the framework (model) that he uses to make the predictions that ultimately will guide his monetary policy vote:

 [L]let me be specific about the causal structure of the model that underpins my judgment with respect to appropriate monetary policy action.

I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate source of an increase in inflation is excess demand in labor and/or product markets. In the labor market, this excess demand gap is often expressed in this model as the difference between the prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment. Second, once an excess demand gap opens up, inflation increases indefinitely and progressively until the excess demand gap is closed, and then stabilizes at the higher level until cumulative excess supply gaps reverse the process.

There is a third principle that I subscribe to, which, though not as fundamental as the first two, also plays a role in my forecast and in my judgment about the appropriate posture of monetary policy today. Utilization rates in the labor market play a special role in the inflation process. That is, inflation is often initially transmitted from labor market excess demand to wage change and then to price change. This third principle may be especially important today because, in my view, there is an important disparity between the balance between supply and demand in the labor and product markets, with at least a hint of excess demand in labor markets, but very little to suggest such imbalance in product markets.

It is important to understand that the Phillips Curve is a model of inflation dynamics, not a model that determines the equilibrium inflation rate. For this reason, the Phillips Curve paradigm is not at all inconsistent with the view that inflation is, in the long run, exclusively a monetary phenomenon. Perhaps the easiest way to appreciate this is to recall that the long-run Phillips Curve is widely understood to be vertical. In other words, NAIRU is consistent with any constant rate of inflation, including zero. The Phillips Curve therefore cannot determine inflation in the long run because it is consistent with any constant rate of inflation. What does determine the rate of inflation in the long run? The rate of money growth, of course, though one needs to assume a stable money demand function to get a stable relationship between money growth and inflation. What does the Phillips Curve explain, if not the long-run level of inflation? The answer is that it explains the dynamics of the inflation process, how the economy evolves from one inflation rate to another, for example, in response to an increase in the rate of money growth. The dynamics of changes in inflation operate through excess demand in labor and/or product markets. Thus the Phillips Curve indicates that, if the unemployment rate is maintained at a level below NAIRU, inflation increases over time, progressively and indefinitely.

But contrary to some present day “hawks”, Larry Meyer was a learner (and he gives a lot of credit for that to Greenspan). Early in his book – A term at the Fed – he recounts:

When I arrived at the Board, I thought I had a pretty good idea of what the number (“full employment”) was. But the surprising economic developments during my term – especially the failure of inflation to rise despite declines in the unemployment rate to a level that, in the past, would have triggered higher inflation – soon made me realize that we didn´t really know what that number was at the present moment or what it might be tomorrow…

Maybe Greenspan, not being an academic, was pragmatic. He didn´t appear to have “obsessions”, saying phrases such as: “with the ‘appropriate monetary policy’ we will keep risks to inflation and growth balanced”. What the heck does ‘appropriate monetary policy’ mean? That was for the ‘Fed Watchers’ to figure out!

But Bernanke is obsessed with inflation – in particular with its negative manifestation deflation. He´s not a natural leader, so he could not bring the hawks to see things his way – as he had long ago figured out for Japan – especially during critical junctures. Take, for example, this comment from July 2008, right at the moment aggregate demand (NGDP) was about to take its biggest plunge since 1938:

Following the collapse of Fannie Mae (FNM) and Freddie Mac (FRE), Ben Bernanke’s Congressional testimony last week had Fed watchers predicting interest rates would remain flat, or possibly fall, by the end of the year.

But surging share prices last week and tough talk from two FOMC board members has delivered an expectations U-turn.

According to interest rate futures, investors had priced in a 42 percent chance of a 2008 rate hike following Bernanke’s testimony. But after falling oil prices and not-as-horrible-as-expected earnings from banks drove stocks higher through Thursday, a hike by year-end had been fully priced in by finicky investors.

Then on Friday, Minneapolis Fed President Gary Stern said that the Fed couldn’t wait for the double-threat posed by jittery housing and financial markets to subside in order to fight higher inflation. In similar remarks, the Philadelphia Fed’s Richard Plosser said this morning that rate hikes should be expected “sooner rather than later.”

Adding to the mix, the Financial Times fronted a story with the headline “Fed appears to focus on inflation ahead of growth”:

In effect the Fed has moved from doing whatever it can to support growth, subject to an inflation constraint, to seeking to start raising rates as soon as it can, subject to a growth constraint.

All of this has helped pushed up the expectations of higher rates even further with a hike by October almost fully priced in at 90 percent.

We know nothing of the sort happened and when October came around rates were forcefully reduced!

But weak leadership gives rise to articles with titles such as this, also from The Atlantic: “A rebellion at the Federal Reserve”? which can be interpreted as a cry for change, or to Tyler Cowen´s nihilistic conclusion on “Why Monetary Policy Matters Less each Day”.

I wonder how, in a few decades time, the monetary history of this period will be told.

Flexing its muscles in “occupied territory” – The 1945 outcome has been reversed!

From The Economist:

THE European Central Bank (ECB) decided a year ago to hold this week’s monetary-policy meeting in Barcelona, but the timing turned out to be perfect. Spain is in the crosshairs of the markets, not least because of budgetary overruns by regional governments such as Catalonia’s. And the contrasting economic fortunes of beaten-up Spain, where the jobless rate has reached 24%, and resilient Germany, where it is below 6%, exemplify the difficulty of finding the right monetary policy in a currency union of 17 members.

Behind the scenes, however, there are acute tensions within its 23-strong governing council, made up of six board members and the heads of the 17 national central banks. In particular Jens Weidmann, the president of the powerful German Bundesbank, opposed the decision to cut interest rates to 1% in December, and frets about the adequacy of the collateral against which the ECB has lent so much money to banks in recent months.

Among other things Germany’s top central banker wants to avoid a home replay of the credit and property boom whose excesses have been so harmful in Spain. Loose monetary policy makes him nervous about the possibility of a property bubble in Germany. After a long period when house prices fell and then stagnated, they have picked up in the past couple of years (see chart).

If Mr Weidmann is minded to take pre-emptive action, he will soon have the means to do so. At present the Bundesbank can preach about risks to financial stability but it cannot impose counter-measures such as setting higher capital requirements for banks or putting constraints on specific types of lending such as mortgages. The authority for implementing these steps lies with BaFin, Germany’s bank supervisor (which is assisted on the ground by Bundesbank staff).

This will change under new proposals to set up a joint committee, which will have representatives from the finance ministry and BaFin, but which will give the Bundesbank the leading role and enable it to push through binding directives. The legislation won’t come into force until next year, but since it is designed to strengthen his hand, Mr Weidmann would probably be able to get his own way before then.

The reform is part of a general move to add “macroprudential” instruments to the toolkit of central banks, allowing them to choke off credit excesses while monetary policy is set for the economy as a whole.

But in the current climate there is also the danger that such regulations may be used in bigger economies to grab back power from the ECB. By reducing credit availability national central banks can contravene the euro zone’s wider monetary stance. Speaking in New York in late April Mr Weidmann said that if monetary policy becomes too expansionary for his home country, “Germany has to deal with this using other, national instruments.” If Mr Weidmann does use his new powers overzealously that could dash one of the few remaining hopes for the hard-hit peripheral economies: a strong recovery in the euro area, led by Germany.

Oh yes! It´s a very different world. In this one, “macro prudential instruments” are the new “occupation army”!