Archive for the Category Monetary Policy


Fed policy is bankrupt

With each passing year it becomes more and more obvious that the current Federal Reserve policy regime is finished, and that a new regime will be needed.

The existing regime at the Fed relies on using interest rate control to steer monetary policy.  But they are also reluctant to cut nominal rates below zero.  That means that in a world of low real interest rates (which describes the world of the 21st century) the Fed will not be able to use monetary policy during recessions, if they maintain a low inflation target.

There are several possible solutions.  One solution (favored by Krugman and Blanchard) is to raise the inflation target to 4%.  Another possible solution is NGDPLT. Or NGDP futures targeting. But whatever the Fed decides, one thing is clear—the current policy regime is bankrupt.  The Fed hasn’t yet figured this out, but I suspect that at some level the markets have.  Not that market participants necessarily agree with my specific MM intellectual framework, but rather that they see the failure of the current regime.

I’m told that lots of market participants think low inflation is now a structural characteristic of the global economy, and cite all sorts of factors like cheap imports. Of course that’s nonsense, inflation is never a structural problem, it’s a policy choice. I think what they are actually intuiting is that the Fed is wrong—under the current policy regime we will have very low inflation for as far as the eye can see. And we are seeing that in the bond market.

Today the 30-year TIPS spread fell to 1.71%, a record low.  The 30-year bond yield is 2.74%.  At those rates the Fed won’t be able to use the short term nominal interest rate as a policy instrument during recessions.  The markets are telling the Fed that its policy regime no longer works.  Is the Fed listening?

Update:  The 30-year TIPS spread is not a record low, I relied on a FRED time series that only went back a few years.

All hail Kocherlakota!

To put the following quote in perspective, let’s first summarize how the Fed views the world:

1.  The Fed successfully targets inflation at 2%.

2.  This can only occur if the Fed is able and willing to steer the nominal economy, i.e. NGDP.  So the path of NGDP is determined by Fed actions (or perhaps errors of omission.)

3.  Although the Fed believes it steers the nominal economy, it never takes the blame for bad outcomes, in real time. Later on it might admit that it caused the Great Contraction and Great Inflation (indeed it has admitted to those two crimes) but not in real time, not while it’s committing the crimes.  Thus in 2008-09 it did not admit that the failure to cut interest rates between April and October 2008 was a huge contractionary mistake.

4.  Instead, in real time the nominal economy is assumed to move of its own accord (even though the Fed’s model says they drive NGDP) and the Fed is a like a firefighter who comes in to rescue the economy, when it misbehaves.

But now we have Minneapolis Fed President Narayana Kocherlakota in the WSJ admitting that on a few occasions the Fed actually causes the fire.  And he’s admitting this in real time, not just that they were too contractionary when the sharply cut the base between October 1929 and October 1930, or too expansionary when they cut interest rates in 1967.  They are too contractionary right now.

I participate in the meetings of the Federal Open Market Committee, the monetary policy-making arm of the Federal Reserve. In that capacity, I’m often asked by members of the public about the biggest danger facing the economy. My answer is that monetary policy itself poses the biggest danger.

Many observers have called for the FOMC to tighten monetary policy by raising interest rates in the near term. But such a course would create profound economic risks for the U.S. economy.

Why would a near-term tightening of monetary policy be so problematic? Because given the prevailing economic conditions, higher interest rates would push the economy away from the FOMC’s economic goals, not toward them.

Congress has mandated that the Fed promote price stability and maximum employment. The FOMC has translated its price-stability mandate into a target 2% inflation rate, as measured by the personal consumption expenditures price index. Inflation has run consistently below that objective for more than three years and is currently at 0.3%.

The outlook is for more of the same. Most private forecasters do not see inflation reaching 2% for the next two years. Government bond yields are consistent with that same subdued inflation outlook. In June the FOMC’s own staff forecast was that inflation would remain below the committee’s 2% target until the 2020s.

The U.S. inflation outlook thus provides no justification for policy tightening at this juncture. Given that outlook, the FOMC should ease, not tighten, monetary policy by, for example, buying more long-term assets or by reducing the interest rate that it pays on excess reserves held by banks. Along these lines, the board of directors of the Minneapolis Fed has for the past few months been recommending a reduction in the interest rate that the Federal Reserve charges banks for discount window loans.

Now, this is not to say that increasing the federal-funds rate by a mere quarter of one percentage point, as many advise, would in and of itself have a huge direct impact on the U.S. economy. But even a small change toward tighter policy would send a strong message to financial markets.  [Emphasis added]

I’ve also said the Fed should cut rates now.  Indeed I’ve said just about everything Kocherlakota says here. How did Kocherlakota ever get appointed to the Fed? They need to screen candidates more carefully.

PS.  The 5-year TIPS spread has now fallen to 1.2%, and the 30-year is at 1.75%. Question, what’s the all-time low for the 30-year spread?

PPS.  So much for those who said the Fed wasn’t doing enough in 2013 and 2014 because of the zero rate bound.  They are about to raise rates!  But while many Keynesians were a little bit wrong they can at least point to the conservatives, who have been wrong about monetary policy so many years in a row it’s becoming almost comical.

HT:  Michael Darda

Hey Fed, you’re steering the ship

TravisV sent me to the latest TIPS spreads, which are downright scary if you believe the Fed should actually try to hit its inflation target:

5 year TIPS spread = 1.34%

10 year TIPS spread = 1.66%

30 year TIPS spread = 1.82%

Keep in mind that even if the Fed were on target for 2% CPI inflation, the 30 year spread will usually be a bit over 2%, because long term there is more tail risk of high inflation than deflation.  The 1.82% figure is worse than it looks.

And it’s even worse.  The Fed is actually targeting PCE inflation, which tends to run about 0.3% below CPI inflation, so those spreads actually reflect about 1.04%. 1.36% and 1.52% PCE inflation expectations.  That’s dangerously close to a position where the Fed could lose credibility.

Why then are they planning on raising interest rates?  They seem to be relying on flawed NK models that suggest tight labor markets cause higher inflation.  And they notice that unemployment has recently fallen to 5.3%, and may decline further.

But these NK models are simply wrong; low unemployment does not cause inflation.  Rather unexpectedly high inflation (when caused by demand shocks) causes low unemployment. And monetary policy drives inflation.   The NK models have causation reversed.  The Fed is acting like a bystander waiting for the economy to bring inflation on line, whereas actually the Fed determines inflation.  But to do so they need to ease monetary policy when they are likely to fall short of their target.

In fact, the labor market will eventually adjust to any inflation rate, at least within reason.  If the Fed steers the economy towards 1.4% long run inflation, wages will adjust and unemployment will naturally fall to the natural rate.  There is nothing that will automatically move inflation up to 2%, unless the Fed does something to make it happen.  And raising interest rates in September or December is not the “something” that will get those TIPS spreads up where they need to be.  It won’t just happen; the Fed must make it happen.  They should cut the interest rate on bank reserves from 0.25% to zero.  Tomorrow. There’s your “normalization”, IOR was 0.00% for the first 95 years of the Fed, until October 2008.  How’s that positive IOR working out for you?

Is 1.3% or 1.5% inflation actually that bad?  Not necessarily, but what is bad is a monetary policy that is not steering nominal GDP in a direction consistent with the Fed’s announced goals.  If they can’t get this right, how will their policy have any credibility in the next recession?  Won’t we go back to the old failed policy of procyclical inflation during the next recession?  I hope not, but I’m seeing nothing out of the Fed that gives me any assurance they’ve learned their lessons from the past recession.

PS.  The Fed’s apparent willingness to raise rates in the next few months proves that market monetarists were right in the 2009-13 period.  It wasn’t that the Fed was out of ammo; they simply had an excessively conservative policy target.  If our critics were right (that the Fed wanted to do more, but was out of ammo) then the Fed would not be contemplating a rate increase with these appalling TIP spreads, which are similar to the bad old days of the Great Recession.

PPS.  Michael Darda sent me an excellent paper from the San Francisco Fed:

Slowing down a boom in house prices is likely to require a considerable increase in interest rates, probably by an amount that would be widely at odds with the dual mandate of full employment and price stability. Moreover, the Fed would need a crystal ball to foretell house price booms. In restraining asset prices, while the power of interest rate policy is uncontestable, its wisdom is debatable.

The Fed tried popping the stock bubble in 1929.  It “worked.”  Once is enough. Please, no more bubble popping.

Targeting inflation and offsetting fiscal austerity are the exact same thing

Stephen Williamson has a very good post on the Canadian austerity of the 1990s. But in the comment section I think he misunderstands the concept of “fiscal offset.” First an anonymous commenter says:

Canada has offset the contractionary effects of austerity via monetary policy…

And Williamson responds:

That’s part of the point. It doesn’t look like they did. As you say, Canada has an independent monetary policy, but, post-1991 they appear to be behaving as by-the-book inflation targeters. Basically, they make an agreement with the fiscal authority about their policy rule, and then they stick to it, independent of what the fiscal authority is up to.

Sticking to your target regardless of what the fiscal authority does is exactly what fiscal offset means.  The idea is simple. A fiscal contraction would normally depress AD, causing inflation to slow.  The central bank must do enough stimulus to offset that potential decline in AD, in order to prevent inflation from falling.  If you observe the inflation rate always being on target, then the central bank is successfully offsetting any fiscal action that would have otherwise moved AD and inflation.  As an analogy, if the temperature in your house is always 22 degrees (centigrade), then the thermostat/furnace is doing an excellent job of offsetting the warm and cold fronts that move through your town.

So why do I call the post “excellent”? Start with the fact that Williamson recognizes that fiscal austerity in Canada was not contractionary.  Even better he recognizes something that all too few bloggers understand:

But it might be more appropriate to think about monetary policy in terms of the ultimate goals of the central bank.


PS.  Yes, fiscal policy has other channels besides AD, so real GDP could still change. But the AD channel is what Keynesians obsess over.

HT:  Tom Brown

When the paradoxical becomes mainstream

Market monetarist ideas often sound quite paradoxical to the uninitiated.  Back in 2008 and 2009 it was a struggle to get anyone to even pay attention.  How are we doing today?  One indication is provided in the cover story of a recent Economist magazine:

The danger is that, having used up their arsenal, governments and central banks will not have the ammunition to fight the next recession. Paradoxically, reducing that risk requires a willingness to keep policy looser for longer today.

.  .  .

When central banks face their next recession, in other words, they risk having almost no room to boost their economies by cutting interest rates. That would make the next downturn even harder to escape.

The logical answer is to get back to normal as fast as possible. The sooner interest rates rise, the sooner central banks will regain the room to cut rates again when trouble comes along. The faster debts are cut, the easier it will be for governments to borrow to ward off disaster. Logical, but wrong.

Raising rates while wages are flat and inflation is well below the central bankers’ target risks pushing economies back to the brink of deflation and precipitating the very recession they seek to avoid. When central banks have raised rates too early—as the European Central Bank did in 2011—they have done such harm that they have felt compelled to reverse course. Better to wait until wage growth is entrenched and inflation is at least back to its target level. Inflation that is a little too high is a lot less dangerous for an economy than premature rate rises are.

Here’s the technical explanation.  When the Fed tightens monetary policy, the Wicksellian interest rate falls as the market interest rate rises.  Why is that important?  Because the Fed adopts expansionary monetary policies by reducing its target rate to a level below the Wicksellian equilibrium rate.  The lower that rate, the less room central banks have to conduct “conventional” monetary policy (i.e. raising and lowering short term rates.)  So if you want the ability to cut rates below the Wicksellian equilibrium rate in the future, the best way of insuring that you can do so is by not raising them today.

Notice the Economist suggests that the ECB’s tight money policy of 2011 triggered the double-dip recession.  This is also progress.  A few years ago I recall economists claiming that modern recessions were different.  The idea was that earlier recessions were caused by the Fed raising rates to combat inflation, whereas modern recessions were caused by balance sheet issues.  This is wrong, as you can see from this graph of ECB target rates:

Screen Shot 2015-06-19 at 9.51.27 PM

The ECB raised rates in July 2008, and then twice in the spring of 2011.  In 2008 they raised rates because they were worried about high inflation.  In 2011 they raised rates because they were worried about high inflation.  Of course in both cases they made a mistake, as NGDP growth was weak.  But inflation is the ECB’s special obsession.  Now for the results.  In 2008 the tight money policy caused a mild recession to suddenly become much more severe.  This economic downturn sharply reduced the Wicksellian equilibrium rate, so that even later reductions in interest rates were not enough to make the policy expansionary in an absolute sense.  And in 2011 the tight money policy also caused a recession, and again later rate cuts were not enough to turn things around.  Only when the ECB adopted QE did monetary conditions improve (slightly.)

Before Americans feel too smug about this sorry record, recall that the Fed refused to cuts rates in the meeting after Lehman failed.  Their excuse?  Worry about high inflation.

I’ll end with a quote from Gandhi:

First they ignore you, then they ridicule you, then they fight you, and then you win.

PS.  The rate increases of 2008 and 2011 do not, by themselves, tell us anything about the stance of monetary policy.  For that you look to NGDP growth.  I simply include them for the “people of the concrete steppes”, who complain that central banks didn’t “do anything” to cause the recent recessions.  Yes they did.

PPS.  The Great Recession was triggered by a Fed decision in December 2007 to cut rates by 1/4% rather than 1/2%. Frederic Mishkin and Janet Yellen understood what a horrible mistake the Fed was making.

PPPS.  Over at Econlog I have a new post comparing fiscal policy during 1937 and 2013.