The Fed’s two mistakes

Tim Duy has an excellent piece in Bloomberg, discussing the Fed’s perspective on the economy:

Core leadership at the Federal Reserve appears determined to normalize policy via interest rate hikes and balance sheet reduction. But they have run up against a significant roadblock because the inflation data stubbornly refuse to cooperate with their forecast. Don’t expect that to deter leaders of the U.S. central bank just yet. They generally view the inflation weakness as transitory. A labor market circling around full employment serves as the justification they need to keep their foot on the brake.

And if that weren’t enough, they can pivot their focus toward financial stability. Indeed, that’s already underway. But be warned: that road will almost certainly lead to excessive tightening. In it you can see one path by which this expansion comes to an end.

I believe the key test will occur in 2018.  If inflation stays low, the Fed will need to change course or else lose credibility.  Duy worries that low inflation might not be enough to get the Fed to back off from its policy intentions:

Still, one would reasonably think that low inflation would eventually worry a central bank with an inflation target. Indeed, the minutes of the June FOMC meeting noted that “several” participants were concerned that recent inflation weakness would be more persistent than transitory. If such concerns appear justified as the year continues, and especially if combined with a softer labor market, the Fed will reduce its projected path of interest rates.

But the Fed has another worry — that of financial instability driven by a persistent low interest rate environment. That worry was on clear display in recent weeks. Yellen described asset prices as “somewhat rich.” Vice-Chair Stanley Fischer worried that low interest rates are driving home prices higher. And New York Federal Reserve President Bill Dudley warned that the Fed needs to account for the “evolution of financial conditions” when setting policy.

I think Duy is right to be somewhat concerned.  It seems to me that the Fed is wrong about both inflation and asset bubbles, for essentially the same reason.  In recent decades, the Fed has pretty consistently overestimated the natural rate of interest.  If the natural rate is lower than the Fed assumes, then both of these claims are true:

1.  Equilibrium asset prices are higher than the Fed believes.

2.  The Fed’s current policy stance is tighter than the Fed assumes, and hence unlikely to deliver on target inflation going forward.

The markets have been telling us that:

1.  The Fed is likely to raise rates by less than it assumes.

2.  Inflation is likely to be lower than the Fed assumes.

3.  Assets are worth more than the Fed assumes.

Three areas of disagreement, but all boil down to the issue of the equilibrium or “natural” rate of interest.

It’s quite possible that the Fed will be right and the markets will be wrong.  That’s happened before.  But if I were a betting man I’d put my money on the markets.


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37 Responses to “The Fed’s two mistakes”

  1. Gravatar of Kevin Erdmann Kevin Erdmann
    6. July 2017 at 19:36

    Everyone’s so blinkered about this stuff. Most homes in this country right now would be reasonably priced even if LT interest rates were at 7%. Zillow puts the median US price/rent ratio at 11.5x now which is basically where it was from 1985 to 1998.

    It’s just dumb. Millions of households would save thousands of dollars a year if they owned the house they are renting, even after maintenance. We’re in a post – facts world.

  2. Gravatar of msgkings msgkings
    6. July 2017 at 22:16

    @ssumner: This is not new, this critique is out there, at high levels.

    The people at the Fed are not stupid. This is what they do. Why in hell do they act like they don’t understand anything about monetary policy?

  3. Gravatar of foosion foosion
    7. July 2017 at 02:23

    @Kevin, if millions of households would save thousands a year, some group would be receiving thousands less per year (the money the households would save has to come from somewhere). Why should we be more concerned with those who would save than those who would receive less? Alternatively, why wouldn’t there be at least some amount of zero sum here?

    @msgkings, a frequent response is that the Fed acts in the interests of those who don’t want prices to rise much or workers to get raises.

  4. Gravatar of Benjamin Cole Benjamin Cole
    7. July 2017 at 04:15

    Reading Fed minutes…uh, do not do it.

    There is a squeamish hysteria about wages.

    National data shows wages are dead–indeed, median weekly earnings for full-time male adult workers are less now than in 1979. Mercifully, the chart does not go back before 1979.

    https://fred.stlouisfed.org/series/LES1252881900Q

    From the latest Fed minutes:

    “Several participants expressed concern that a substantial and sustained unemployment undershooting might make the economy more likely to experience financial instability ….”

    Yes, financial instability!

    And unforeseeable consequences!

    Unanticipated side-effects!

  5. Gravatar of Becky Hargrove Becky Hargrove
    7. July 2017 at 05:04

    When asset prices (as an equilibrium base) aren’t fully supported by monetary policy, various sectors look for support via other means. Sectors which include time based service product, keep tinkering with budget adjustments. Perhaps corporate cash “hoarding” is a similar response:
    http://pubsonline.informs.org/doi/abs/10.1287/mnsc.2017.2775

  6. Gravatar of tf tf
    7. July 2017 at 05:35

    In 2017, I believe the Fed has raised rates more, not less, than the market expected. Someone correct me if I am wrong.
    TF

  7. Gravatar of LK Beland LK Beland
    7. July 2017 at 06:39

    Kevin Erdmann

    Isn’t it strange that the home ownership rate is at the lowest level it’s been in decades, even though Americans are less mobile than ever?

  8. Gravatar of Charlie Jamieson Charlie Jamieson
    7. July 2017 at 08:10

    The market wants low rates and knows it will get them.

  9. Gravatar of ssumner ssumner
    7. July 2017 at 08:14

    tf, I think that’s right. But keep in mind the market expected about one or two rate increases in 2016. The Fed expected 4. That was a bad error.

  10. Gravatar of ssumner ssumner
    7. July 2017 at 08:15

    Charlie, And in the 1970s the market wanted high rates and knew it would get them?

  11. Gravatar of Michael Sandifer Michael Sandifer
    7. July 2017 at 08:30

    It seems much trouble, from the Great Depression to the tightness of policy after comments about “irrational exhuberance”, has been caused in part by the Fed’s inability to understand the relationship between liquid assets market price movements and nominal economic growth rates. Stock prices, for example, simply move more on macro news than policy makers think they should, because they either have no formal models or use the wrong ones. Hence, they cause the very financial market instability they worry about, while disrupting macroeconomic stability in the process, the latter of which is obviously far more important.

    It’s even worse for the Fed that they can control leverage through margin requirements, yet still have often tightened monetary policy to deal with what they consider to be overheated markets.

    An additional irony, is that they may have contributed significantly to the the longer term lower rate environment that, after wage adjustment, represents real lower capital costs for safe public companies and hence more “pop” in the stock market. It is a defeatist cycle.

  12. Gravatar of Kevin Erdmann Kevin Erdmann
    7. July 2017 at 08:48

    LK, great point.
    Foosion, my point is that if we’re going to keep prices low through financial repression it’s pretty freaking dumb to still be worried about high prices too.

  13. Gravatar of flow5 flow5
    7. July 2017 at 09:38

    There is no such rate as a hypothesized/predictable natural rate of interest. Capital-goods and R&D real-investment hurdle rates (production and productivity factors), are largely idiosyncratic. Interest is the price of loan-funds. The price of money is the reciprocal of the price level.

    I.e., residential and business fixed-investment are not a function of the gross private savings rate (a source of mathematical econometric modeling errors). And therein lies the subpar economic performance problem: the impoundment and ensconcing of monetary savings.

    All commercial bank held savings are dormant, indeed frozen, lost to: both consumption and investment (definitely to any type of payment or expenditure). The only way to activate voluntary savings and put these funds back to work in the economy, completing the circuit income and transactions velocity of funds, is for the saver holder to invest/spend their funds themselves, directly, or indirectly via non-bank conduits.

    The omnipresent theoretical/conceptual error (yes the 300 Ph.Ds. on the Fed’s technical staff are inherently stupid), is that commercial banks loan out the savings placed with them. However, from the standpoint of the entire economy and the domestic banking system, DFIs pay for their new earning assets, with new money (that’s how all new money is created).

    Take the “Marshmallow Test”: (1) banks create new money, and incongruously (2) banks loan out the savings that are placed with them.

    All savings originate within the confines of the commercial banking system. And DFIs are never intermediaries in the savings-investment process (viz., S “≠” I). Contrary to the DIDMCA of March 31st 1980 theoretical and empirical error (the onset of secular strangulation, increasing total credit-market indebtedness, and therefore bad debt), the NBFIs are the DFI’s customers. And deposits are the result of lending and not the other way around.

    Savings flowing through the non-banks never leaves the commercial banking system. And savers never transfer their savings outside of the commercial banking system (there is just a transfer of ownership of existing deposit liabilities within the payment’s system). Remunerating IBDDs is thus regressive, inducing non-bank dis-intermediation (an economist’s word for going broke).

    And aggregate monetary purchasing power, AD, is measured by monetary flows, volume Xs velocity (not Central Bank policy rates nor the prevailing level of market clearing interest rates, here or abroad). Rates-of-change in money flows = roc’s in P*T (where N-gDp is a subset and a proxy).

    Keynes Liquidity Preference Curve (demand for money), is a false doctrine given, for example, the homogeneity or substantial substitutability, liquidity, of portfolio assets, short and long term debt on an increasingly flattened yield curve).

    Ex-ante trajectories of long-term money flows = inflation. In 2018, the rate of inflation will decelerate (as money velocity continues to drop and monetary flows fall).

  14. Gravatar of flow5 flow5
    7. July 2017 at 09:45

    The mistake is that savings flowing through the non-banks increases the supply of loan-funds (but not the supply of money).

  15. Gravatar of Charlie Jamieson Charlie Jamieson
    7. July 2017 at 09:52

    Low rates are good for asset prices (for now, anyway), whether equities or fixed income, and yes, the Fed now answers to the markets.
    We know from the past 20 years that the central bank will go to extraordinary lengths to support those who owns equities and fixed income, at the expense of those who don’t (the labor class.)
    Equities and fixed income assets are a claim on the productivity of others and those who own those assets will do everything in their power to hold onto those claims.

  16. Gravatar of flow5 flow5
    7. July 2017 at 11:17

    I.e., the Federal Reserve Bank’s biggest mistake (and all other professional economists), is that they don’t understand that savings flowing through the non-banks increase the supply of loan-funds, or the distribution of available credit (but not the supply of money). Lending by the NBFIs is a velocity relationship.

    That’s why money velocity has fallen since 1981, and will continue to fall as the Fed remunerates IBDDs and continues to raise the payment of interest on member bank’s master accounts and respondent bank’s pass thru accounts at their correspondent bank (identified by a primary nine-digit Routing Transit Number, RTN), at their District Reserve banks.

    https://fred.stlouisfed.org/series/IOER

    Thus, the Fed, Congress, and the FDIC, have increasingly incentivized consumers and businesses to hold idle balances in the payment’s system (as the NBFIs are not in competition with the DFIs, but have a symbiotic economic relationship). Because of the payment of interest on IBDDs, the commercial banks are able to, and do, outbid the non-banks for loan-funds (inducing non-bank dis-intermediation). That destroys money velocity. It reduces N-gDp growth rates (resulting in stagnant, or falling, overall incomes).

    It is so spectacularly perverse and pertinacious because the DFIs legal and economic lending capacity is not based on the prevailing level of market clearing interest rates, rather on the volume of business associated with credit worthy borrowers. And net changes in Reserve Bank credit (not a tax but Manna from Heaven), since the Treasury-Federal Reserve Accord of 1951, are determined by monetary policy, not the savings practices of the non-bank public. The DFIs could continue to lend even if the non-bank public ceased to save altogether.

    As all savings originate within the payment’s system, there cannot be an inflow of funds (savings) for the system as a whole. NIMs are not applicable to the DFIs (NIMs are “fake news”), as the DFIs pay for their earning assets from the system’s belvedere, by creating, ex-nihilo, new money – demand deposits somewhere in the system.

    Keynes’ “optical illusion” was that the lending equation for an individual commercial bank, its lending capacity, is the same as that of an intermediary (where all newly created deposits flow to other banks in the system). This assumes that the initial inflow of funds, a bank’s positive balance of payments, is a primary deposit to the recipient bank, though it actually represents a derivative deposit coming from a competing bank within the system (the dimensional confusion of stock vs. flow).

    We are saddled with a bunch of morons running our country and destroying our constitutional freedoms. It is an indisputable fact. The escalating murder rates and our social unrest are being ratified by the Federal Reserve Board of Governors period.

  17. Gravatar of Christian List Christian List
    7. July 2017 at 12:05


    Millions of households would save thousands of dollars a year if they owned the house they are renting, even after maintenance.

    Let’s assume that this theory is true then how could the EMH be true in a reasonable way? I believe you are simply wrong. The majority of households is not stupid. There have to be very reasonable economic reasons why millions of households are choosing renting over owning.

    I’m a renter as well and believe me there are very good reasons for renting. Especially in countries with pretty extreme rental laws like most of the US and Germany. A few days ago Scott Sumner wrote about his ‘great’ time as a landlord. So I guess he learnt some lessons by now as well.

  18. Gravatar of Cooper Cooper
    7. July 2017 at 14:03

    People are renting because they don’t qualify for home loans or if they do qualify, they’re reluctant to buy thanks to lingering memories of the home foreclosure crisis.

    Someone who lost their home to foreclosure in 2010 probably isn’t going to rush to buy another home any time soon.

    Would it surprise us that someone who lost a ton of money in the stock market crash of 1929 might be reluctant to open up another brokerage account in 1938?

  19. Gravatar of Kevin Erdmann Kevin Erdmann
    7. July 2017 at 15:37

    Christian & Cooper,

    The average FICO score of denied mortgage applications at the GSEs and the FHA is higher than the average FICO score of approved mortgages was during or before the housing boom.

    There is nothing about this that undermines the EMH. Asset classes that are less liquid or have limited entry provide higher returns (lower prices). This is standard financial thinking.

  20. Gravatar of JMCSF JMCSF
    7. July 2017 at 15:49

    The New York Times had an article on people who rent when they could buy. https://mobile.nytimes.com/2017/05/19/realestate/they-can-afford-to-buy-but-they-would-rather-rent.html

    There are plenty of valid reasons to rent and not buy.

  21. Gravatar of dtoh dtoh
    7. July 2017 at 19:43

    Scott,
    Maybe Trump’s 20% unemployment rate was right. :-)

  22. Gravatar of Benjamin Cole Benjamin Cole
    8. July 2017 at 04:53

    dtoh-

    The U.S. unemployment rate, as measured, actually rose in June to 4.4% from 4.3%.

    Despite flat wages, people are getting off the sidelines as jobs are more available than before.

    I assume with more jobs open, there is a better fit between those who want to work and the jobs that are available.

    Employers, while not raising wages, night be willing to accommodate certain employee requests–simple things, like “Can I start at 8 am not 7 am, as I take my kids to school.”

    Labor participation rates are rising.

    Why any sane person would want to retard this process is beyond me.

    The Fed wishes to retard this process.

    On balance, I guess more homeownership is better than not.

    If the government would get out of the business of property zoning and end the mortgage-interest tax deduction, we might get a more-clear picture of what consumers really want in housing.

    My guess is cheaper housing closer to work.

  23. Gravatar of Scott Sumner Scott Sumner
    8. July 2017 at 05:51

    dtoh, If there’s a joke there, it went over my head.

    Ben, You said

    Labor participation rates are rising.

    Except they aren’t.

    https://fred.stlouisfed.org/series/CIVPART

  24. Gravatar of Patrick Sullivan Patrick Sullivan
    8. July 2017 at 06:21

    ‘The mistake is that savings flowing through the non-banks increases the supply of loan-funds (but not the supply of money).’

    That’s a mistake. Sho’nuff.

  25. Gravatar of Dan W. Dan W.
    8. July 2017 at 12:24

    Kevin,

    Rent payments should account for every cost associated with owning and maintaining the home (if not then the property will become a slum). Mortgage payments at best account for interest, insurance and taxes. Payment for maintenance is extra. How much extra? Well as ever more people are mechanically challenged and resort to hiring help, the cost can be significant – several thousand a year for landscaping, calls to the plumber, electrician and the 10 – 20 year replacement costs on appliances, flooring and roofing.

    I get the impression from your advocacy of real estate that you are ignoring the full cost of home ownership. But consumers are counting these costs. So you see a “tight” market but in reality it is perfectly normal given actual costs.

    By the way, what percentage of income do you think a family should spend on housing? What can they actually pay?

  26. Gravatar of Gordon Gordon
    8. July 2017 at 12:54

    Scott, do economists who believe in the Philips Curve believe that a low unemployment rate pushes the real natural rate higher? If so, it would help explain why some in the FOMC are so anxious to tighten even though they’re not seeing the increase in inflation they’re expecting.

  27. Gravatar of Benjamin Cole Benjamin Cole
    8. July 2017 at 16:01

    Scott Sumner: ???

    The chart you cite shows labor participation rates bottoming last year and rising unevenly since, including a blip up in June.

    That is why in June there was growth in employment and also growth in enemployment, as measured.

    https://fred.stlouisfed.org/series/CIVPART

  28. Gravatar of Scott Sumner Scott Sumner
    8. July 2017 at 17:14

    Gordon, If you mean natural rate of interest, then yes, I suppose they do believe that.
    Just to be clear, I also believe that. It’s just that I don’t think the natural rate is rising as fast as they do. But it generally rises a bit in a recovery. The longer term secular trend has been down, of course.

    Ben, You must have better eyes than me. June 2016 = 62.7. June 2017 = 62.8.

    Is that statistically significant?

  29. Gravatar of Benjamin Cole Benjamin Cole
    8. July 2017 at 23:23

    Scott,

    If you squint, you will see the bottom was 62.4 in Sept 2015, and has been roughly trending up to 62.7 at latest read.

    As you know, LPRs change slowly, a percent or two, unless killed off by a 2008.

    My eyeballs, which are just as old as yours, almost certainly far weaker (I got the coke-bottles deluxe version) see a small upwards drift.

    This, despite the FOMC asphyxiation squad (and ubiquitous property zoning to keep employees as far as possible from work).

    And despite surging SSDI and VA disability rolls.

    Imagine what some pro-growth policies could do….

  30. Gravatar of Jon Jon
    9. July 2017 at 07:34

    Scott,

    The large balance sheet is something worth unwinding–the Fed shouldn’t be allocating credit. When it was focused on treasuries that was a credit allocation but one which was a wash in the consolidated ledger point-of-view. Before the crisis, the fed left credit allocation to the political branches of government. This is ethically firmer than our present situation.

    I advocate shrinking the portfolio and holding interest-rates low.

  31. Gravatar of Major.Freedom Major.Freedom
    9. July 2017 at 18:46

    The Fed’s main mistake is existing.

  32. Gravatar of Kevin Erdmann Kevin Erdmann
    9. July 2017 at 21:00

    Dan W.,

    BEA measures for imputed net rental income, which includes maintenance and depreciation, suggest a real yield on home ownership today that is higher than the nominal interest rate on mortgages. At any time before 2007, the estimate of real yields on homeownership using BEA data was roughly equal to nominal mortgage yields minus inflation. In 2007 there was a sharp shift away from longstanding historical norms in home prices.

    Here is a random house in Atlanta:
    https://www.zillow.com/homes/for_sale/Atlanta-GA/35864517_zpid/37211_rid/0-300000_price/0-1126_mp/globalrelevanceex_sort/33.779002,-84.463242,33.77498,-84.468596_rect/17_zm/

    Estimated mortgage payment $435. Estimated rent $1,295.
    The dislocations in the market since the bust are simply too extreme to explain away.

  33. Gravatar of ssumner ssumner
    10. July 2017 at 04:50

    Ben, That’s called “noise”

    Jon, I agree.

  34. Gravatar of Major.Freedom Major.Freedom
    10. July 2017 at 14:23

    Turkey admits it is abandoning the Paris Accord because of a lack of funding.

    In other words, it was always a scam to transfer money from this country to other countries.

    http://www.reuters.com/article/us-g20-climatechange-turkey-idUSKBN19T11R

  35. Gravatar of Dots Dots
    10. July 2017 at 20:56

    @Major Freedom

    I don’t know anything about international elite scams, but it seems super obvious that rescinding the political center’s promise – to soon halt large, lucrative, mature industries with high levels of investment and innovation, and replace them with unborn or infant players tbd – was a giant pro-growth reform. Trump’s less prudish foreign policy

    Obama, for better or worse, was an enemy of the US economy that actually exists. moves toward stinginess and ‘macroprudence’ in some of the only large sectors with spunk and hiring-habts during the last few decades – Dodd-Frank for FIRE, the sequester and Iraq pullout for fiscal policy, reappointment and in-house successions in Fed chair selection without appointing someone like Rohmer to an empty seat, a bunch of Hansonite cost-savings efforts in Obamacare designed to make US medicine more austere, a bizarre deficit commission, and seemingly every new tax he could get

  36. Gravatar of Postkey Postkey
    11. July 2017 at 03:22

    These organisations are in on the ‘scam’?

    “In the real world, here’s a list of the scientific organizations that have issued statements embracing climate change science:
    •American Association for the Advancement of Science
    •American Astronomical Society
    •American Chemical Society
    •American Geophysical Union
    •American Institute of Physics
    •American Meteorological Society
    •American Physical Society
    •Australian Meteorological and Oceanographic Society
    •Australian Bureau of Meteorology and the CSIRO
    •British Antarctic Survey
    •Canadian Foundation for Climate and Atmospheric Sciences
    •Canadian Meteorological and Oceanographic Society
    •Environmental Protection Agency
    •European Geosciences Union
    •European Physical Society
    •Federation of American Scientists
    •Federation of Australian Scientific and Technological Societies
    •Geological Society of America
    •Geological Society of London
    •International Union for Quaternary Research (INQUA)
    •International Union of Geodesy and Geophysics
    •National Center for Atmospheric Research
    •National Oceanic and Atmospheric Administration
    •Royal Meteorological Society
    •Royal Society of the UK
    The Academies of Science from 80 different countries all endorse the consensus
    •Academia Brasiliera de Ciencias (Brazil)
    •Royal Society of Canada
    •Chinese Academy of Sciences
    •Academie des Sciences (France)
    •Deutsche Akademie der Naturforscher Leopoldina (Germany)
    •Indian National Science Academy
    •Accademia dei Lincei (Italy)
    •Science Council of Japan
    •Academia Mexicana de Ciencias (Mexico)
    •Russian Academy of Sciences
    •Academy of Science of South Africa
    •Royal Society (United Kingdom)
    •African Academy of Sciences”

  37. Gravatar of TravisV TravisV
    11. July 2017 at 06:53

    Tyler Cowen: “Why China May Never Democratize”

    https://www.bloomberg.com/amp/view/articles/2017-07-11/why-china-may-never-democratize

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