Post-Brexit, what will Janet Yellen’s next excuse be?

A James Alexander post

Well the British have voted for Brexit. We shall see how it turns out.

Carney must not defend sterling

Market Monetarists must hope that Mark Carney doesn’t seek to defend the pound, but let currency weakness do it’s magic, monetarily offsetting any expected economic weakness. A drop in the pound is not like a drop in the price of a company after a profit warning that reflects a weaker future. Of course, a hit to potential economic growth will damage the value of the UK economy but the currency is a different issue. Currency reflects the monetary value of the economy not its real economic prospects.

Low or negative real economic growth but with even lower inflation tends to see currency appreciation, like in Japan or Switzerland. If there were expected to be 5% real growth and 5% inflation, other things being equal, the currency would not move.

If (as 95% of economists forecast) the UK leaving the EU were to result in 5% less real economic growth over time, or even a recession, then the central bank should ensure nominal growth stays at a level 5%. The pound could then fall up to 10%, other things being equal, ie ignoring what other currency blocs are doing. That would be the right thing for the central bank to allow and even facilitate. The currency drop would then automatically boost domestic demand offsetting the drop from “lost confidence” in the future, or whatever is supposed to happen to the UK outside the EU.

I suspect no such dramatic drop in real GDP as things change very slowly when it comes to international affairs, and businesses and consumers adjust their behaviour to fit the expected new environment. The UK government should focus on eliminating any supply side restraints on the economy and any potential tariffs that the EU may impose.

What the EU should do
Clearly the remaining EU members should be very careful about entering tariff wars given the modest nominal and real growth they currently enjoy. The Euro Area likewise. The Euro Area should move to a loose monetary policy by either abolishing the inflation ceiling or better still targeting nominal growth of 4-5%.

Draghi was recently asked in the European Parliament why he didn’t raise the inflation target. His reply betrayed a profound confusion about his current stance. His ECB projects 1.6% inflation two years away. De jure, his monetary stance is only neutral. De facto, market prices indicate much lower inflation two years out, thus the stance is actually very tight. Raising the inflation target or introducing nominal income growth targets would allow the market to expect no tightening if inflation were to go above 2%, thus easing policy as expectations for policy would be easier.

What will Yellen do next?
The more interesting question for the US is what excuse Janet Yellen might now have to come up with to explain away the consequences of the Fed’s tight monetary policy. She may think it is “highly accommodative” because rates are low and the Fed balance sheet bloated with QE securities. To be fair, very many economists and market commentators think likewise, making the same basic mistake. But Market Monetarists know better.

Monetary policy is judged by market expectations for nominal growth and these remain low. Current NGDP growth is low and both straight long duration government bonds and TIPs indicate very low inflation.

Yet the FOMC is indicating seven rate rises of 25bps over the next two and half years, with another three promised in the long run. Tight or what? Policy is tight because it is expected to be tight for the next two years. The result has been weakening nominal growth, weakening real growth, and low nominal wage growth. Real wage growth has supposedly been better but it certainly hasn’t felt like it – hence the rise and rise of populist politics.

Janet Yellen without Hamlet

A James Alexander post

Hamlet without the Prince would not be a very good play. Janet Yellen’s March 29th speech features a world economy without the Fed. It’s not a very good description of the world economy.

The FOMC left the target range for the federal funds rate unchanged in January and March, in large part reflecting the changes in baseline conditions that I noted earlier. In particular, developments abroad imply that meeting our objectives for employment and inflation will likely require a somewhat lower path for the federal funds rate than was anticipated in December.

“Developments abroad” since December have been minimal. The major development since December was a very modest pull back in global real GDP growth estimates for 2016 and 2017, from 3.6% to 3.4% and 3.8% to 3.6% respectively. But at least half of the pullback was due to downgrades to US growth estimates, not “abroad”.

 Given the risks to the outlook, I consider it appropriate for the Committee to proceed cautiously in adjusting policy. This caution is especially warranted because, with the federal funds rate so low, the FOMC’s ability to use conventional monetary policy to respond to economic disturbances is asymmetric. If economic conditions were to strengthen considerably more than currently expected, the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.

Available policy instruments are now more plentiful for tightening than easing. But doesn’t that tell us that the Fed should also be biased towards overshooting on inflation? The risks of undershooting on inflation given the sticky wages problem are far, far more serious than from overshooting on inflation.

One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment. Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy–specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities. While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

Tools, tools, tools. It should be targets, targets, targets. A 2% inflation ceiling is a prison. Have a more realistic, explicitly flexible target for inflation and you stand much more chance of escaping the prison. And you won’t need all the tools if you dig your escape tunnel in the right direction. If the tunnel just goes from one corner of the jail cell to the other you won’t make it out – no matter what tools you have.

Of course, economic conditions may evolve quite differently than anticipated in the baseline outlook, both in the near term and over the longer run. If so, as I emphasized earlier, the FOMC will adjust monetary policy as warranted. As our March decision and the latest revisions to the Summary of Economic Projections demonstrate, the Committee has not embarked on a preset course of tightening. Rather, our actions are data dependent, and the FOMC will adjust policy as needed to achieve its dual objectives.

We all know you are not on a pre-set path of rate rises, praise the Lord. Winds will blow, currents flow. Things happen. But what if your economic projections are consistently much more optimistic than the markets, and the markets believe you will tighten according to the command of those projections? The dotplot for future rates will then cause alarm and market reactions. Not the dots themselves but the economic projections, the models that generate those projections.

In logic if you start with a falsehood anything can follow. The Philips Curve is false and so the market fears anything can come out of the Fed.

Financial market participants appear to recognize the FOMC’s data-dependent approach because incoming data surprises typically induce changes in market expectations about the likely future path of policy, resulting in movements in bond yields that act to buffer the economy from shocks. This mechanism serves as an important “automatic stabilizer” for the economy. As I have already noted, the decline in market expectations since December for the future path of the federal funds rate and accompanying downward pressure on long-term interest rates have helped to offset the contractionary effects of somewhat less favorable financial conditions and slower foreign growth. In addition, the public’s expectation that the Fed will respond to economic disturbances in a predictable manner to reduce or offset their potential harmful effects means that the public is apt to react less adversely to such shocks–a response which serves to stabilize the expectations underpinning hiring and spending decisions.

This penultimate paragraph appears to be a nod towards Market Monetarism. The market reaction to bad economic news will save the day as it carries an implicit reaction function by the Fed. This is the “bad news is good news” meme. Sure it happens sometimes, but only when the Fed is on a loosening bias. Things are much more uncertain when unexpected bad news occurs and the market doesn’t know what the bias of the Fed is. And it is really bad when the Fed is on a tightening bias and there is bad news, “bad news is bad news” days are really bad. We saw them in January and February of this year after Fischer’s disastrous “four more hikes” interview.

A closer reading of this paragraph makes it seem like the Fed just doesn’t know what it is doing, a consequence of its sticking to false Philips Curve models. It needs to get a better target than hard to measure inflation, and then let the market steer monetary policy properly. There is nothing predictable about this Fed other than it will continue to be unpredictable.

Such a stabilizing effect is one consequence of effective communication by the FOMC about its outlook for the economy and how, based on that outlook, policy is expected to evolve to achieve our economic objectives. I continue to strongly believe that monetary policy is most effective when the FOMC is forthcoming in addressing economic and financial developments such as those I have discussed in these remarks, and when we speak clearly about how such developments may affect the outlook and the expected path of policy. I have done my best to do so today, in the time you have kindly granted me.

The whole speech is suffused with a view that the Fed is outside of things, not an active player. Until the Fed realises it is the key player we will never get proper monetary policy. The concrete targets set by the fed to fulfil their dual mandate needs reform. The targets they have now don’t work and cause harm and confusion. We need a Hamlet with the Prince, we need a world economy with a self-aware Fed with the right monetary policy, one that is both player and a writer of the play.

Although some might be impressed by the Yellen Fed’s reaction function, to Market Monetarists it more appears like a willful child, shooting off in pursuit of a shadow (phantom inflationary projections), before being hauled back to reality by their parents (the market).

Perhaps the Fed is reacting better than in 2008, but perhaps not. Perhaps the US economy is weakening much more than they realize, like in 2008, and that merely not tightening is nothing like loose enough. The recent trend in NGDP growth is certainly flashing a warning signal.

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.”

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.”

Well done Janet, well done Stanley (irony alert!)

A James Alexander post

Where are the John Maynard Keynes’ and Milton Friedman’s when you need them? The Fed, led by Janet Yellen and Stanley Fischer, has made a huge mistake in tightening monetary policy. The other members of the FOMC are largely irrelevant noise, with the possible exception of the NY Fed’s Dudley, though all carry blame. During 2015 at first they passively tightened by merely threatening to do so, causing US economic growth to slow, and then in December actively doing so, redoubling the negative impact on US economic growth. A recession is not out of the question thanks to this highly irresponsible action.

The Fed should be the most hated and ridiculed financial institution in the world at the moment but there is barely a whimper of criticism. It will come, just not yet. The market’s current swoon shows how it is building. What must not happen is the swoon becoming the cause of the downturn when the culprit is the Fed, front and centre, for tightening too early.

A near wall of silence, except (mostly) for Market Monetarists

Tightening too soon was always a huge risk, one we have highlighted here time  and time again.

Most of the Fed’s central banker peers seemed to think the Fed was doing the right thing, or at least kept quiet. Most of the economics profession seemed to do the same apart from a few exceptions, most of whom we read but no-one could say are widely read. Some, like Paul Krugman or Danny Blanchflower, are just too one-sidedly partisan to be respected across the political spectrum. Most are just not that well known.

Economists in the commercial world, working for banks and companies, or industry lobby groups, also seemed to keep their heads down. Financial journalists were fairly silent too. There were a few murmurings in the blog-sphere and on Twitter but nothing very loud. Many actually agreed with the tightening, partly explaining the initial market welcome to the raise once it became clear in late October that it would happen by year end. The honeymoon hasn’t lasted long.

Why are Nominal GDP growth expectations so important (again)?

As Market Monetarists we think monetary policy should be guided by expectations of NGDP Growth. Expectations drive activity, economic and personal. Always have, always will. It is probably a truism. If consumers or investors expect bad outcomes they will spend or invest less. What is a bad outcome? Lower expected incomes or returns ahead.

For consumers, the most brutal and feared income loss is caused by loss of work, everything else (economically-speaking) pales in comparison. Idiosyncratic or individual loss of work happens all the time of course, it is part of life. But the widespread loss of work only occurs in a recession. Recessions are rightly feared and should be avoided. Or if they happen that they are speedily remedied.

Mass job-reducing recessions occur when business revenues are expected to fall faster than costs. Because nominal wages are hardly ever flexible downwards jobs must be cut to save costs. The US is the most extreme example of this type of reaction as its labour laws are amongst the most flexible. This flexibility, in the long run, is a key reason why the US economy is so much stronger and the country wealthier than any other large developed nation. Highly organised European welfare-oriented countries like Germany can sometimes reduce wages via social cooperation, at least temporarily, and that can help mitigate the impact of recessions. The UK is somewhere between the two.

Other less organised European countries like Italy or Greece cannot be “more like Germany” as the Germans and other highly homogenous northern European nations constantly dream, or only with massive political turmoil. Others like France or Spain make attempts to act like Germany but usually just end up in two-speed economies:

  • protected workers made up of “insiders” in state jobs (in the civil service or universities or health care) or state-related company jobs in quasi-monopolies (like utilities or telecoms), who see nominal incomes and jobs mostly cushioned against economic turmoil;
  • unprotected “outsiders” in the flexible private sector who see pay slashed and unemployment spike very high.

Younger workers are particularly vulnerable as the insider jobs growth is reduced to zero or slightly negative and outsider jobs growth goes very negative. State and state-company pensions can then become highly political footballs too, especially when not pre-funded, as are hardly any.

To avoid all this horrendous nominal adjustment, society has evolved a relatively painless way to adjust costs to weaker revenues. Macro-economists christened it “money illusion”. They did not invent it, but merely discovered it. Steady nominal growth of real growth plus (perhaps) 3% inflation gives enough room for less severe job cuts in recessions, as nominal wage increases can be limited allowing real wage cuts without people feeling too bad, i.e. far better than losing their jobs. This gentle let down allows real costs to be brought into line with weaker nominal revenues. Money illusion acts like a pain-killer, for a sick person. It is a palliative allowing the patient to get better. Using either none, or too much, is a bad thing, of course.

Why has the Fed got it so wrong? Capture by obsessive inflation hawks

Unfortunately, government monetary policy often gets captured by arch conservative types who think that any inflation (or use of pain-killers) is bad. Partly these conservatives are reacting to spendthrift, profligate governments who find it hard to raise enough taxes to cover their spending, and so resort to printing money instead, causing excessive inflation (over-use of pain-killers). Undoubtedly this latter problem occurs a lot, but so does the first problem, too. And this near zero-tolerance of inflation, or rather no more than near 2%, is where we are now. It seems to be a small difference, but real growth of 2-3% and inflation of 2-3% is a healthy 4-6% nominal growth allowing crucial economic flexibility. As real growth approached 0% and inflation is not allowed above 2%, nominal growth hits an inflexible 2%, denying economies crucial (real) wiggle room.

In almost all modern societies the control of the money supply has become a responsibility of governments. As usual, this takeover does not guarantee success, it is merely a “theory” (aka “a hope”) that it will work better than voluntary or market arrangements. These days the theory of market failure, sponsored by socialists and government-backed economists, remains far more developed than the theory of government-failure or public choice economics. Market monetarists believe markets do better at forecasting future nominal growth than central banks.

When private banks controlled the money supply they do appear to have allowed modest inflation, reacting to increases in demand for money with more money. When government-controlled central banks have been too tight with money supply, private initiatives have kicked in to offset them, but only in extreme conditions .

If we have to have government control of money use markets to do it better

A happy middle path of steady nominal growth for money is the most important contribution macroeconomics has made to the world, but one that is often forgotten. Steady market-expected growth in Nominal Gross National Product (or Expenditure or Income – it’s all the same thing) gives economies a fighting chance of offsetting the worst impacts of recessions. NGDP Expectations Targeting now!

The Fed is set on tightening

The Phillips Curve crowd, led by Yellen, thinks falling unemployment will bring more inflation. But have some qualms:

Fed Minutes: Officials in December Expressed ‘Significant Concern’ About Low Inflation

Minutes also show worries about global growth and strong dollar

“Because of their significant concern about still-low readings on actual inflation and the uncertainty and risks present in the inflation outlook, (officials) agreed to indicate that the (Fed) would carefully monitor actual and expected progress toward its inflation goal,” the Fed said in minutes of its Dec. 15-16 policy meeting released Wednesday.

But they hiked rates anyway!

Then there is the “financial crisis” group led by Fischer

For Vice Chairman Staley Fischer markets are wrong. There will be more tightening:

Fed’s Fischer Says Four Interest-Rate Increases Possible This Year

Fed vice chairman in CNBC interview says market expectations of two interest-rate increases are ‘too low’

Fischer worries Fed can’t head off, contain financial crises

Fischer’s comments suggest that the central bank may need to rely more on monetary policy to restrain financial excesses than it has in the past. In fact, he told the conference that it might be necessary for the Fed to increase interest rates if financial markets were overheating, though the first line of defense should be the use of regulatory measures to head off bubbles.

A rate hike was the “mutually satisfactory” outcome.

The labor-market´s double burden

First it has to gauge how close the economy is to the first mandate (maximum employment) and is then used to predict the second mandate (the inflation rate).

That strategy derives from the Fed´s (and Yellen´s) firm belief in the Phillips Curve, the theory that there is (in some form) an inverse relation between the unemployment rate and the rate of inflation.

But, naturally, there isn´t. So the Fed is “chasing rainbows” and, apparently, wants to continue to do so.

They could take a leaf from Nick Rowe, and start acting very differently:

The business cycle is a monetary exchange thing.

Which would tell them they are on the wrong track!

Not surprising that Bullard is surprised!

Apparently, Janet Yellen is a strong leader:

The leader of the Federal Reserve is often described as among the most powerful people in the world. But in late summer, as the Fed weighed whether to raise interest rates for the first time in nearly a decade, Yellen found herself outnumbered.

Yellen wanted to wait. The wild swings in global financial markets over the summer were potentially bad omens for China’s economy — which in turn could drag down America, she feared. But her colleagues were not as worried. A slim majority of the 17 people who make up the central bank’s top brass was willing to start pulling back the Fed’s support for the recovery in September.

One of those was certainly Bullard:

One of the most vocal officials has been St. Louis Fed President James Bullard. He often pushes the envelope of debate at the central bank, and he is the last top official to speak before the Fed’s big decision. In an interview with The Washington Post, he said not raising rates in September was a “mistake” and that the U.S. economy could be ready to take off.


WP: When you review the last seven years that the crisis occurred and the actions that the Fed has taken since then, would it ever have entered your imagination in, say, 2007 that the Fed ever would provide as much stimulus as it did for the economy?

Bullard: No, I would not in 2007 — certainly not in 2007, or even 2008 or 2009 — think that we would be in the position that we’re in today. Historically, when you had big shocks, you also had a period of bounce back that was stronger than what we actually got here. I certainly did not predict that things would linger this long, seven years later. I think that’s been the major surprise in the aftermath of the big crisis.

Bullard never imagines that this time around there was no “bounce back” simply because he (and his colleagues) didn´t want one!

First, see the drop and timid rise in NGDP compared to the two previous cycles

Janet Leader_1

Given sticky nominal wages, the wage/NGDP ratio rises strongly and falls slowly

Janet Leader_2

Explaining the much weaker rise in employment

Janet Leader_3

Why, one could ask, did employment rise much less robustly in the 2001 cycle than in the 1990 cycle, given that NGDP (and wage/NGDP) behaved similarly?

The reason is mostly due to the 2001 recession being a “productivity rich” recession.

Janet Leader_4

HT Kevin Tryon, James Alexander

The communications “conundrum”

This report dealt with yesterday´s ECB “surprise” – Draghi’s Weeks of Rhetoric Culminate in ECB Stumble on Stimulus. Concluding:

Draghi isn’t alone among central bankers struggling to convey their message. Bank of England Governor Mark Carney was labeled an “unreliable boyfriend” by a U.K. lawmaker last year after he first told investors they were behind the curve, then two weeks later said there was more spare capacity in the labor market than thought.

Yellen has faced criticism this year for holding off on a decision to imposing the Fed’s first rate increases since the financial crisis, contrary to previous signals.

Draghi, who has successfully introduced multiple measures in the face of opposition from politicians and policy makers, may now have to work to repair his reputation among investors who once lauded him as “Super Mario.”

Contrast that with Greenspan´s very “clear” communication “strategy”:

“I know you think you understand what you thought I said but I’m not sure you realize that what you heard is not what I meant”

What this implies is that “communication” does not matter very much. What really matters is that there´s a generalized expectation that monetary policy will continue to be “good”, meaning that expectations of continued future Nominal Stability (at an adequate level of spending) is pervasive!

Janet´s occasionally funny non-sequiturs

From her speech today at The Economic Club of Washington, DC:

N.S. 1Continuing improvement in the labor market helps strengthen confidence that inflation will move back to our 2 percent objective over the medium term.”

But inflation has been moving away from the target, despite falling unemployment!

N.S. 2 The Fed has held its benchmark federal-funds rate near zero for seven years. When it raises the rate, it will be a sign that the economy has “come a long way” toward recovering from the 2007-09 financial crisis. In that sense, it is a day that I expect we all are looking forward to.”

Five years ago, the economy had already recovered from the financial crisis. Why did the Fed wait so long to “tell us”? Maybe only now they got tired of their “extended vacation”.

N.S. 3 Were the [Fed] to delay the start of policy normalization for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals”. “Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.”

That´s exactly what the Fed has been doing, inadvertently, over the past year by indicating “the time is coming”!

N.S. 4 “I anticipate that the neutral federal funds rate will gradually move higher over time.” “In September, most [Fed officials] projected that, in the long run, the nominal federal funds rate would be near 3.5 percent, and that the actual federal funds rate would rise to that level fairly slowly.”

That´s just misplaced faith. By their actions, the Fed is likely stifling the rise in the neutral FF rate.

PS The power of words: Yellen talks and the DOW tumbles

Non sequiturs