Dudley to the rescue

Happy days are returning to Wall Street, in an unusually vivid illustration of the “circularity problem.”

Wall St. advances for third day after Dudley comments

NEW YORK (Reuters) – Stocks climbed for a third straight day on Thursday as concerns receded that the Federal Reserve would begin to unwind its stimulus efforts earlier than expected. .  .  .

“The Fed had to be shocked at how much of a move Bernanke’s testimony generated … so now it is trying to alter expectations,” said Nick Sargen, chief investment officer at Fort Washington Investment Advisors in Cincinnati.

William Dudley, head of the New York Federal Reserve, said Thursday the Fed’s asset purchases would be more aggressive than the timeline Bernanke had outlined if U.S. economic growth and the labor market prove weaker than expected.

Dudley stressed that the timeline for slowing the pace of the Fed’s bond buying would depend not on calendar dates but on the economic outlook, which remained unclear.

“The Fed got ahead of itself talking about tapering, since the data remains very mixed but consistent with the sub-par two percent growth trend,” said Sargen, who helps oversee $45 billion. “The message now is that investors need to hang on.”

Note that economic growth is very likely to prove weaker than the Fed expected.  If the Fed really thought austerity was slowing the economy, why did they have such a high growth forecast for 2013?

I vaguely recall Dudley was a cartoon hero, rescuing the damsel in distress (the US economy in this case) from the evil villain (Ben Bernanke, with a beard instead of the handlebar mustache most villains have.)



21 Responses to “Dudley to the rescue”

  1. Gravatar of maynardGkeynes maynardGkeynes
    27. June 2013 at 15:07

    I don’t understand why the circularity problem would not also occur under NGDP futures targeting. Wouldn’t traders still be looking at what the Fed thinks will happen, rather than what is actually going to happen in the real economy?

  2. Gravatar of Edward Edward
    27. June 2013 at 15:24

    Bernanke seems to have betrayed everything he stood for before as a professor and an objective scholar…

    He’s been assimilated by the FedBorg

  3. Gravatar of Saturos Saturos
    27. June 2013 at 17:01

    Someone tell Posner that Japan and Europe should be encouraging “retaliation”: http://www.becker-posner-blog.com/2013/06/should-the-european-union-emulate-japans-inflationary-monetary-policyposner-.html

  4. Gravatar of Dylan Dylan
    27. June 2013 at 17:51

    Scott, did anyone ever show you this comic? The League of Economic Supervillians, led by Depreciatrix:


    A monetary version would be a little too true to life, I suppose.

  5. Gravatar of Steve Steve
    27. June 2013 at 17:56

    The underlying problem is that the market believes in the flow theory of QE, but the Fed wants the market to believe in the stock theory of QE. So the Fed says that ending QE is not tightening, and when the market gets upset about that the Fed says the market misunderstands.

  6. Gravatar of Bill Ellis Bill Ellis
    27. June 2013 at 19:33

    Who is setting policy here ? The Fed or the stock market ?

    If the Fed is going to let a few days of stock market activity determine their actions, then some questions come to mind.

    Could a large constituency of institutional investors sway the market on their own ? If so, they could do so pointedly to sway the Fed, ( I am guessing this would violate some law ?)
    So they would have to do it covertly but the prohibition on it makes too hard and risky for all but a few outlier people…It will be limited to rare instances.

    So the way things are…the market signaling the Fed only happens Organically. Organically is good.

    But what if it were legal ? What if it were common practice for institutional investors to signal the Fed by moving the market ? OK… I know at this point the Fed would stop paying attention to the temporary tantrums of the institutional investors, (They would lose benefits of getting signals from the market ) but let’s let it play out…
    So if the Fed for some insane reason kept taking signals from the institutional stock market investors, is their any doubt that the investors would be playing the Fed for their own narrow coalition interests?

    …in this instance the Market is asking for the right policy, because it happened organically, without collusion. And because of this the Fed can trust the signal.

    It seems like too much freedom for investors can be detrimental to a well functioning market .

  7. Gravatar of Edward Edward
    27. June 2013 at 19:51

    Bill, are you out of your frigging mind?

    Markets aren’t perfect. Everyone knows that. I don’t even hold with the strong version of the EMH in the short run. Yet Id rather trust the market, with all of its imperfections, than Fed forecasts, which have proved over optimistic repeatedly, both as a matter of history, (1930’s, 1990’s Japan?)and as theory. markets saw crashing NGDP before the Fed and the Treasury did in 2008. the stock market was RIGHt to violently and vehemently rebuke Uncle Ben the traitor for his hawkish speech on inflation

  8. Gravatar of Saturos Saturos
    27. June 2013 at 20:50

    There’s talk of helicopter drops again: http://www.aei-ideas.org/2013/06/is-it-time-for-the-fed-to-do-a-true-helicopter-money-drop/

    (Ashwin needs to read NoI’s earlier comment that there is no such thing as a neutral policy. When helicopter drops are capable of working they will no longer be necessary.)

  9. Gravatar of Benjamin Cole Benjamin Cole
    27. June 2013 at 22:24

    Let’s see:

    QE is good for the market.
    QE is good for the economy.
    QE should help employment go up.
    QE pays down the national debt.
    QE and inflation? Well, inflation now at 0.7 percent. Less than this and will have to use a microscope to see it.

    So…the Fed needs to talk about tapering down QE every chance they get…right?

  10. Gravatar of J J
    28. June 2013 at 04:33

    It would be insanely difficult for an investor to covertly shift the entire US stock market. Soros broke the BoE, but everyone knew he was doing it.

  11. Gravatar of J J
    28. June 2013 at 04:33

    That was directed to Bill Ellis.

  12. Gravatar of dlr dlr
    28. June 2013 at 05:48

    Jeremy Stein is obviously a very smart guy who understands monetary macro; he is no Richard Fisher. That said, it is starting to look like he was a terrible choice as a central banker. His speech today, in a risible effort to talk down volatility, argued that the market shouldn’t expect the Fed to overreact to the latest noisy economic release in determining its policy. By way of example, he hypothesized that a bad September payroll number wouldn’t itself deter the Fed from tapering, since the accumulated and trend employment progress has been substantial. He immediately followed this by patronizingly advising markets not to get too worked up about asset price reactions in the wake of Fed communications, since most of it is probably animal spirits and margin calls.

    Central bankers need to understand that they are on a constant first date with markets. Their communication is not about theorizing, it is about signalling. The tensions between the two are admittedly blurry, but they exist. Don’t tell markets what to care or not care about. Markets will care about what they want. And what they care about is the CB reaction function; the one where the CB actually has monopoly power and not theory power. And signalling means that if you are the CB with the financial bubble complex and you give a hypothetical example about noise versus longer term information that only describes a potentially noise negative employment shock and never mentions the symmetrical possibility or even a single nominal indicator, you are saying something important. And stupid. His speech reads as “our reaction function is now mainly about not allowing too much real growth, even if recent data slows and nominal expectations make it optimal, but you should not care about this or your own reaction to it as expressed in asset markets, because maybe carry trades are unwinding.”

  13. Gravatar of ssumner ssumner
    28. June 2013 at 06:15

    Maynard, The Fed’s views don’t matter under NGDP futures targeting, the market sets policy.

    Saturos, Posner is a brilliant economist, but just a horrible macroeconomist. Horrible.

    Dylan, Reasoning from a price change. 🙂

    Steve, I wish people wouldn’t use terms like “stocks” and flows” for that dispute, it really doesn’t have anything to do with that distinction.

    dlr, Good point.

  14. Gravatar of mpowell mpowell
    28. June 2013 at 07:15

    Steve, I wish people wouldn’t use terms like “stocks” and flows” for that dispute, it really doesn’t have anything to do with that distinction

    Could you clarify this further? It seems to me that we don’t have a futures market and the fed isn’t targetting any market based forecast. So you have the fed forecast and the market forecast and also both sides’ interpretation of the action of certain policy levers. If the fed thinks that ‘tightening’ or ‘loosening’ is about the stock of fed bond purchases than they can justify slowing purchases if their internal forecast shows solid growth. But when they announce that, the market, which believes that it is the flows that matter, then moves to anticipating contractionary monetary policy and the fed loses in the expectations game and their internal model is doomed.

    I see two factors at work here: no agreed upon NGDP forecast and market expectations playing a big role in the monetary policy transmission channel. At that point the fed has to care about whether the market regards a particular move as tightening or not relative to current policy.

  15. Gravatar of pct pct
    28. June 2013 at 07:42

    But Dudley Do-Right was Canadian, and Canadian economy isn’t experiencing these issues…

  16. Gravatar of Doug M Doug M
    28. June 2013 at 11:47

    I can tell that Bernanke has actually signaled than he intends to do anything different from what he said months ago.

  17. Gravatar of ssumner ssumner
    29. June 2013 at 05:07

    mpowell, Both sides agree that tapering is tighter money than not tapering, whatever else they have to say about it. Both sides agree that the Fed will fall short of hitting its employment/inflation mandate, under either policy track.

    Yes, I agree that expectations are important, I just don’t think the terms “stocks” and “flows” are at all helpful.

    pct, That explains it.

    Doug, ????

  18. Gravatar of Jon Jon
    30. June 2013 at 19:13

    Scott, I think it is interesting to unpack how different elements of Fed policy impact the yield curve. I think there are some interesting aspects of that…

    first, the near end of the curve is pegged by the fed funds target. second, the long dated end of curve ought to be set by expectations–real return and inflation.

    So what does QE of 30yr bonds do? First you’d expect it to lower the near end, which it doesn’t because of IOR. Second you’d expect two contrary forces on the long end, first raising long-rates through changes in expected inflation. Tapering talk acts against this because it reflects a dedication to hold inflation low. IOR also acts against this because it a practical tool for increasing money demand. Second there is supply effect in the long market. The interest rate is a price, the fed is shifting the supply curve. This lowers the long-rate.

    So what does the tapering talk reaction tell us? It tells us this latter mechanism is dominant. If it is dominate, then the fed is flattening the yield curve. Does a flatter yield curve act upon the economy or is it merely an indicator?

    Perhaps more interestingly, doesn’t this suggest the injections are viewed as temporary. If they are viewed as temporary, wouldn’t we conclude they aren’t stimulative? So what’s the transmission mechanism of QE? There clearly is one, as the taper talk moved the stock market not just the bond market.

    I would say, the transmission mechanism is inflation. Taper talk signaled PCE=1% was the real target not PCE=2%. What do you say?

  19. Gravatar of Full Employment Hawk Full Employment Hawk
    1. July 2013 at 20:50

    “Note that economic growth is very likely to prove weaker than the Fed expected”

    Has anybody made a systematic study of Fed’s forecasting errors for ouput and unemployment since the onset of the Great Recession? My subjective impression is that the Fed has almost consistently overestimated GDP growth and underestimated unemployment. According to the rational expectations hypothesis, rational forecasters will use their forecasting errors to improve their forecasts. The Fed does not appear to be doing this.

  20. Gravatar of Full Employment Hawk Full Employment Hawk
    1. July 2013 at 21:14

    “But Dudley Do-Right was Canadian”

    In the TV program, Rocky the Flying Squirrel, Dudley Do-Right did not oppose the mustached villain, the Russian Boris Badenov (a take off on Boris Gudunov). Rocky the Flying Squirrel opposed Boris. Dudley had his own cartoon on the program.

  21. Gravatar of ssumner ssumner
    3. July 2013 at 07:15

    Jon, You said;

    “Taper talk signaled PCE=1% was the real target not PCE=2%. What do you say?”

    They act as if 1% is the target, but they may be inept.

    Regarding QE, I’d says that this time tapering raised long term rates, but on another occasion it might reduce them.

    FEH, They’ve consistently overestimated both RGDP growth and unemployment.

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