Don’t assume it’s the zero rate bound that’s stopping the Fed
Imagine a developed economy with a highly regarded central bank and a long and distinguished tradition of progressive, state-of-the-art monetary policy-making. Imagine that central bank has been given a mandate of high employment and price stability. Imagine that it interprets “price stability” as 2% inflation, and it regards the natural rate of unemployment as being around 6%. Sound familiar?
Now imagine that the current unemployment rate is 7.8%, and inflation is expected to run below 2% over the next few years. They have a policy meeting, where a couple people advocate greater monetary stimulus, while the majority decides to stand pat, despite the fact that their mandate would pretty clearly call for additional easing. Why does the majority favor doing nothing?
There are limits to what monetary policy can achieve. Many of the problems on the labour market are of a structural nature. The structural problems include the possibility for new groups joining the labour force to find work, matching of vacancies to job-seekers and the flexibility of the wage formation process.
In addition, the policy recommended by the doves would better fulfill their mandate, but there are vague “risks” involved in doing the right thing, and “uncertainty” is holding back the economy, not monetary policy:
Although a larger cut, as advocated by Ms Ekholm and Mr Svensson, could bring inflation up to the target more quickly, and the forecast would thus “look better”, Ms Wickman-Parak’s assessment was that the effects on the real economy would not be particularly significant and that there were risks associated with such a policy.
It is not an excessively high interest rate that is holding back investment; this is due to the high level of uncertainty about the future course of the economy.
And let’s not forget that the low level of interest rates show that policy is already accommodative:
Ms af Jochnick pointed out that the Riksbank is currently conducting an expansionary monetary policy.
Sounds exactly like the Fed. But it’s not, it’s the Riksbank, with Svensson playing the role of Charles Evans. And here’s what’s most important, the current level of short term interest rates in Sweden is 1.5%, and the debate is over whether rates should be cut. They aren’t at the zero bound. Sweden faces a situation similar to that of the US, which calls for monetary easing to hit their dual mandate. A few members of their central bank favor a rate cut, but most are opposed. That tells me that the problem probably isn’t the zero bound, rather it’s excessive caution at the Fed. We need to accept that fact that exiting the zero bound won’t end our malaise. The Fed will still be too tight, worried about inflating new bubbles (another worry mentioned in the Riksbank’s minutes.) Like the Riksbank and the BOJ and the ECB, the Fed will raise rates too soon and then have to cut them again.
As usual the markets figured all this out long before I did. The 2.6% yield on 30 year bonds is basically a forecast of future premature tightening by the Fed. What I don’t understand is how markets can be so damn smart when they are composed of individuals who are individually quite stupid. I suppose for the same reason that Albert Einstein’s brain was quite smart, despite being composed of neurons that are individually quite stupid.
HT: Stefan Elfwing
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18. July 2012 at 06:59
“No comment”.
But I,m sure M_F will manage to put in 1000 words!
18. July 2012 at 07:34
I’d imagine central bankers around the world listen to what their counterparts in other countries are saying. Could Bernanke’s hodgepodge of vague and generally meaningless justifications for doing nothing be giving the Riksbank an easy excuse to do nothing? Something along the lines of, “Well, if the US Federal Reserve isn’t doing anything despite facing higher unemployment and lower inflation, there’s certainly nothing WE can do.” I just wonder what they’d be saying if the Fed were actually doing its job and succeeding. I’d imagine it would provide a moment of accountability for other central banks around the world. (Indeed, for a long time it looked like the Riksbank was doing that.)
18. July 2012 at 07:38
“What I don’t understand is how markets can be so damn smart when they are composed on individuals who are individually quite stupid.”
This is an easy one. Suppose the participants in the market make their decisions based on 1% true information and 99% noise. If there are enough players and their opinions are diverse the noise will begin to cancel itself out, while the signal holds true.
18. July 2012 at 07:53
I thought id mention that bad monetary policy is unraveling another country: http://krugman.blogs.nytimes.com/2012/07/05/guest-post-romania-unravels-the-rule-of-law/
Romania has its own currency but the CB pegs it to the Euro due to large household debts denominated in euros. The government is under an IMF program and instituted 25% pay cuts for civil servants. There have been protests and the past two governments have fallen under the pressure (in quick succession). Now the Social Democrats are in power. In Romania, the social democrats ARE remanents of the communist party–renamed itself right after the revolution in 1989.
I won’t say more, read the article. Asking people to take pay cuts is a big barrier.
18. July 2012 at 08:09
Marcus Nunes:
“No comment”. But I,m sure M_F will manage to put in 1000 words!
Sorry to disappoint you. I’m only going to write 999 words 😀
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Now imagine that the current unemployment rate is 7.8%, and inflation is expected to run below 2% over the next few years.
Expected by whom? There is no one expectation of inflation. There are those who expect higher than 2% price inflation, those who expect 2% price inflation, those who expect lower than 2% price inflation, and those who aren’t making any expectations of price inflation at all, but whose actions will nevertheless affect price inflation (this latter group is always ignored).
You can’t look at TIPS yields or TIPS spreads and infer expected price inflation mathematically. This is because, like I have argued before, there is an embedded option in TIPS bonds. It is possible that bond investors expect higher than 2% inflation say 3 years out, and are willing to earn a low or even negative yield today, the very low yields you’re thinking are the result of low price inflation expectations (because you need those TIPS bonds as another piece in your agenda of more money printing).
The 2.6% yield on 30 year bonds is basically a forecast of future premature tightening by the Fed.
This is false. The 2.6% yield can be the result of all sorts of factors that have nothing to do with future inflation expectations 20, 25 years out. The 10 year bonds sold at a yield of 1.459%.
What factors are you missing? Well how about the obvious one of front running the Fed? If I could resell my bond to a money printer, for a positive profit, I wouldn’t give a rat’s ass if the implied yield is 0.50% on a 1000 year bond. I’ll pay the super high price now, and resell it to the Fed at an even higher price. How in the world can you infer from that action that I expect inflation to be 0.50% for 1000 years? Not every road leads to market monetarism. Some roads lead to places you don’t dare touch because they’re brutal and gruesome.
There are other possible factors. How about institutions that simply need good collateral for margin calls and are willing to pay a higher price that also makes you think inflation expectations are low?
Or how about the possibility that there was a large covering of shorts?
What I don’t understand is how markets can be so damn smart when they are composed on individuals who are individually quite stupid. I suppose for the same reason that Albert Einstein’s brain was quite smart, despite being composed of neurons that are individually quite stupid.
You mean like stupid people who can’t spell?
Anyway…well how about the fact that the market doesn’t think, and you are attributing a consciousness to where there isn’t any, and so the “beautiful”, “pure”, “clean”, “rigid”, “ideal” aggregate conceptualizations you have of the market, cannot “fit” into the real world of individuals who act almost completely ignorant of everyone else?
How can a population of people who have so little knowledge of what everyone else knows, and what everyone else is doing, even work at all? This is where the real beauty is, and it is also where, unfortunately, ugliness and deceit are most prevalent: in our socialist monetary system. I am rather amazed that the market is even more resilient than I thought it was. Those of us who are pro-market, and not fake pro-market, have been admittedly taken aback at how much punishment it can take.
18. July 2012 at 08:14
has there ever been a time in history when
printing little pieces of papergenerating electrons used for final payment in sufficient quantity was inflationary? in the current 8% UE environment, i would not expect material inflation from a little money printing, but surely if the Fed bought all 15 Tn of treasuries, we would get … what 30-40% inflation.here’s to more Fed action Aug 1, although i am still 50-50 on it since the jobs report does not come until august 3.
18. July 2012 at 08:20
“was NOT inflationary.” as i tell my kids listen to what i mean, not what i say. lol
18. July 2012 at 08:23
It isn’t only central bankers who are perverse;
http://seattletimes.nwsource.com/html/nationworld/2018709321_guar18.html
‘India produces about 85 percent of the world’s guar. As worries rose about the prospects for this year’s monsoon, which is vital for an adequate crop, speculation over guar production built to a frenzy. Trading in guar futures was even suspended, and with the monsoon still behind schedule, it remains postponed. Ramesh Abhishek, India’s chief commodities market regulator, said guar trading would resume when supplies proved adequate.
‘”If the physical market doesn’t provide enough supplies, then the futures market causes more harm than good,” Abhishek said.’
18. July 2012 at 09:18
“I suppose for the same reason that Albert Einstein’s brain was quite smart, despite being composed of neurons that are individually quite stupid.”
I don’t see the analogy here at all. People often explain financial market efficiency in Hayekian terms, even though he was talking about commodity prices (such as those of production inputs) being determines by the dispersed knowledge of separate marginal use values, whereas asset prices have a common fundamental value. Instead I think it has more to do with what Robin Hanson says about prediction markets: if you know, you speak up, if you don’t, you shut up. It’s your money on the line, and there is a selection process to retain those who predict correctly.
18. July 2012 at 09:20
Patrick, sounds like the market expects conditions to be even worse in the future. Or demand much higher.
18. July 2012 at 09:30
The typical central banker wants to conduct monetary policy for the benefit of the moneyed elite, and not ordinary working people. This explains the low weight that is put on fighting unemployment relative to other conerns, such as not inflating new bubbles and preventing inflation.
Bernanke is an excellent example of this. When the economy was facing a crisis, so that the moneyed elite was in danger of losing their wealth, Bernanke was bold an innovative and took decisive actions. Once the crisis was past and the wealth of the moneyed elite was safe, he became super cautious in his conduct of monetary policy, and the fact that ordinary working people were still hurting badly has not been a significant concern.
This is why progressive heads of state need to look at ordinary central bankers as major obstacles to achieving their agenda. Their highest priority upon taking office is to fill positions on the central bank as quickly as possible with people committed to achieving full employment. Obama’s failure to do so may well cost him a second term.
All progressive heads of state need to be warned:
BEWARE OF CENTRAL BANKERS!
18. July 2012 at 10:58
“The 2.6% yield on 30 year bonds is basically a forecast of future premature tightening by the Fed.”
Explain this one further… I understand that in an arbitrage free expectations would suggest that the most likely path for Fed funds over the next 30 years will average close to the 30 year rate. But it doesn’t say a thing about what the Fed does in the next 2-5 years when it begins its next tightening cycle, and whether that is “premature.”
18. July 2012 at 11:03
Alexander. Good point.
Doug, Yes, of course you are right. I first learned that argument from Robert Lucas, when I took his class back in the 1970s.
Long time readers know I was joking, I am a fan of the EMH.
Jon, Thanks for the link.
dwb. Let’s hope the last report was bad enough. Don’t forget Q2 NGDP comes out soon.
Patrick, Yes, blame the messenger.
Saturos, The dispersed knowledge of indivual neurons adds up to some pretty impressive knowledge in aggregate.
In any case, I was half-joking. I agree with you and Doug.
FEH, When I was in school we had one model after another explaining why all central bankers were biased in favor of inflation. But that was back in the 1970s.
18. July 2012 at 11:06
Doug, If they tighten prematurely then we’ll fall right back into a slump, as Japan did several times in the last 15 years. The 2.6% rate only makes sense if they expect a Japan-type outcome. Otherwise rates would be higher (with say 4% or 5% NGDP trend growth.)
18. July 2012 at 11:20
Central Bankers are coordinating economic hardship until Europe can be forced/tricked into giving up more soveriegnty in exchange for higher taxes and the privelege of making bigger monthly interest payments.
The beatings will continue until morale improves. Either that or Ben Bernanke just hasn’t ever bothered to contemplate NGDPLT yet…surely someone will alert him to this blog soon.
18. July 2012 at 12:19
Scott,
first I’d like to quote Svensson:
“In my view, it should only be possible to neglect price stability and highest sustainable employment for a limited period if there are clear signs of problems with financial stability, if there are no means of addressing these problems without setting aside price stability and highest sustainable employment and if it can be credibly demonstrated that another, for example a higher, repo-rate path would lead to better target fulfilment for inflation and unemployment in the longer run. This last condition is important. The government bill that contained the proposal for the Sveriges Riksbank Act states namely that the policy rate may only be used to prevent a financial crisis if such a crisis threatens the price stability objective.”
http://www.riksbank.se/Documents/Tal/Svensson/2012/tal_svensson_120608_eng.pdf
Interestingly, it may well be the case that the Riksbank majority indeed think that their actions will contribute to better target fulfillment over the long run at the small short term cost. However it is simply impossible to justify the actions of the Fed in the same way.
In the same speech Svennson argues with a Phillips curve model that the avergage inflation in Sweden has undershot the target since ’97 by 0.6%, at the cost of 0.8% increase in the average unemployment rate. Do you agree with his conclusion? Is it possible to argue that Svennson is wrong because NGDP growth did not undershoot the target by that much over this period?
18. July 2012 at 12:59
And of course the ECB has never hit ZLB either.
I blame the incompetent-policymakers-malcontented-punditocracy complex: Central Banks mess up badly, which gives them an incentive not to fix the problem–otherwise, it looks like they could have prevented it. The impasse in turn lends unusual creditability to the stories of naysayers: they would have blamed capitalism, or regulation, or the deficit, or cultural decay no matter what, but now they look suddenly more sensible. All this in turn helps convince others that money was never the problem in the first place. Wash, rinse, repeat.
The real question then becomes why select economies have not developed the scourge of the IPMP complex.
18. July 2012 at 13:00
Presumably the Riksbank is terrified of even getting close to the zero bound and is starting to ‘ration’ any rate cuts accordingly. Even some commentators in Australia (where the official cash rate is 3.5%) are starting to make similar arguments, suggesting that rates should not be cut now in case something bad happen in Europe or whatever and they need to cut then.
18. July 2012 at 13:01
Isn’t the point about debt that once banks stop wanting to lend and people want to start paying down debt that this puts downwards pressure on NGDP ? If total debt is several times bigger than NGDP and the holders of this debt decide to start paying it down then 1) This itself causes NGDP to fall and 2) This fall in NGDP then causes investment (including borrowing to invest) to fall and NGDP to fall further.
I guess that as long as the money supply is increased sufficiently then NGDP can be kept on target more or less. But if the underlying issue is high debt-levels then one would predict that there will not be a self-sustained recovery until debt has been sufficiently well paid down for this to happen which could take several years at the current rate during which time the fed and the govt will need to repeatedly fill the NGDP void just to avoid actual deflation.
Looking at the chart it seems obvious (with hindsight) that debt-levels were out of control. All it needed was the fallout from the sub-prime crisis for the debt-path to go into reverse and turn a normal slowdown into a full blown “great recession”
18. July 2012 at 14:48
“What I don’t understand is how markets can be so damn smart when they are composed of individuals who are individually quite stupid. I suppose for the same reason that Albert Einstein’s brain was quite smart, despite being composed of neurons that are individually quite stupid.”
There are certainly some pretty dumb market participants around, like Donald Trump who thinks there are big problems in the future for the U.S. dollar after the “Treasury bubble” pops.
The bond king himself, Bill Gross, put his money where his mouth is on the same idea and lost his shirt. Still, at least he admitted he was mistaken.
Even dumber is the oil guy Jim Rogers who did the same thing as Gross and plans to do it again. He thinks it was just that his timing was off.
18. July 2012 at 20:56
ssumner:
The 2.6% rate only makes sense if they expect a Japan-type outcome. Otherwise rates would be higher (with say 4% or 5% NGDP trend growth.)
This is false. Yields can be low even with high future inflation expectations. Front running the Fed, institutions needing collateral, short cover, etc. There are many possibilities none of which have anything to do with inflation calculations.
18. July 2012 at 23:04
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19. July 2012 at 07:43
Gabe. Amazing coincidence, you used the same line as the title of my next post. (Which I just finished writing.)
123, I don’t know enough to comment on the Swedish PC. I very much doubt the rest of the Riksbank committee has any sort of coherent model in their heads, based on the minutes I read (and I’ve read them for a number of meetings.)
Shane, Good point.
Rajat, But they set rates lower in the past, as I recall.
Ron, No, my next post discusses why NGDP is the problem, not debt. There is no reason why a lot of debt would make people want to work less.