Fed Dual Mandate Watch
Last month I inaugurated a new series of blog posts, to be done once a month. We will see if the Fed is fulfilling it’s dual mandate. Here’s what I wrote last month:
I’m thinking of adding a monthly feature to keep track of how the Fed is doing in terms of fulfilling its dual mandate. Recall that the Fed tries to keep inflation close to 2.0% and unemployment close to about 5.6% (the Fed’s current estimate of the natural rate.) One implication of the dual mandate is that they should try to generate above 2% inflation during periods of high unemployment, and below 2% during periods of low unemployment.
In July 2008 unemployment rose above 5.6%, and it’s averaged nearly 9% over the past 46 months. So the Fed’s mandate calls for slightly higher than 2% inflation during this 46 month slump. Last month I reported that the headline CPI had risen 4.6% in the 45 months since July 2008. Now we have the May data, and the headline CPI has gone up 4.3% in the 46 months since July 2008. So the annual inflation rate over that nearly 4 year period has fallen from a bit over 1.2%, to 1.1%. BTW, NGDP growth has been the lowest since Herbert Hoover was in office. Epic fail.
Now we are 47 months into the period of high unemployment, and inflation remains at 1.1% over that period. Some commenters used to say “Yeah, but how about the last 12 months.” They’ve grown strangely quiet. I suppose the inflation nutters can always claim that high inflation is just around the corner, despite 30-year bonds yielding 2.6%.
Winning arguments about inflation with people who don’t believe in market efficiency is like stealing candy from a baby. If it’s not yet in the TIPS spreads, it’s not just around the corner.
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19. July 2012 at 05:27
>>Winning arguments about inflation with people who don’t believe in market efficiency is like stealing candy from a baby.>>
It’s especially fun, as many of the people insisting that inflation and soaring rates just around the corner are the same people who usually proclaim markets uber alles.
19. July 2012 at 05:33
Scott, you should think about creating a visual aid that can illustrate how far away we are from achieving the dual mandate. I would think a distribution type diagram, with all the time spent under the targets (inflation and employment/population or number unemployed over NAIRU or whatever) displayed as a big fat tail. Or, if you want to make it more striking, something that includes the cumulative losses in output.
The NGDP off its level trend doesn’t resonate with people. It’s abstract for them, even the concept is relatively simple. A visual aid of how far the Fed really is off track would be good.
You get all the data from FRED right? Maybe we can start putting something together that we can put on our walls…
19. July 2012 at 05:34
Sorry, that should be “even though the concept is relatively simple.”
19. July 2012 at 05:50
US 30 year treasury yields were around 14%, pricing in sustained high levels of inflation, just before Volcker took office and brought down inflation to 3.2%, rendering such high yields largely unwarranted. Is there an explanation to this from EMH theory?
19. July 2012 at 05:50
In before Major Freedom tests your last couple of sentences.
19. July 2012 at 05:51
You may have done this already, but creating a succinct post in response to the liquidity argument against quantitative easing or further monetary stimulus might be helpful. That argument seems to be the intellectual framework used by many in the financial markets who oppose QE, and they have a powerful influence on the GOP. It goes like this:
QE supplies a flood of liquidity into the markets, which instead of flowing into the real economy, flows into asset markets. This pumps up asset prices, specifically commodities, which perversely acts like a break on the real economy. When QE is finished, asset prices come back down. The excess liquidity act through primarily interest rate channels and financial leverage, as many assets are bought with leverage.
Underlying this is the belief that the real economy needs to go through a restructuring and/or deleveraging, which is why it doesn’t readily respond to monetary stimulus. I believe you have responded to this argument in various posts at various times, though attacking this argument directly as well would further your cause.
An appeal to EMH would not impress these folks, since most financial market participants view the EMH as an example of academic silliness. Regardless, the EMH is a hypothesis that due to the way it is defined cannot be proven, since any evidence in support of it can also be interpreted as evidence against it.
19. July 2012 at 06:25
One implication of the dual mandate is that they should try to generate above 2% inflation during periods of high unemployment
How is a false doctrine an implication? Price inflation isn’t a source of employment. The 1970s falsified that belief.
BTW, NGDP growth has been the lowest since Herbert Hoover was in office. Epic fail.
The Fed doesn’t target NGDP. They can’t fail to target a statistic that they don’t officially target.
Now we are 47 months into the period of high unemployment, and inflation remains at 1.1% over that period.
Price inflation has been 2.4% since Jan 2000. Long term, the Fed is on track.
The Fed isn’t in the business of micromanaging employment.
The reason so many are unemployed is in part because of past inflation from the Fed, minimum wage laws, 99 week paid holidays, and increasing regulatory costs of hiring new workers. Wages are stickier downward than they otherwise would have been, in part, because of inflation psychology.
I suppose the inflation nutters can always claim that high inflation is just around the corner, despite 30-year bonds yielding 2.6%.
They’re right beside the deflation nutters who fail to grasp the far more likely possibility that bond investors aren’t predicting low inflation for 30 years, which is an assumption nuttier than a fruitcake at a circus. That these deflation nutters are ignoring all the subjective factors that go into bond prices that you don’t see in the classroom pedagogical tool R = (1 + r)*(1 + i) – 1.
For instance, the elephant in the room that the bond market is front running the Fed.
On June 14th, the Fed bought $2 billion of 30 year bonds, just hours before the Treasury sold $13 billion in 30 year bonds.
Just a day before, on June 13th, the Fed bought $4.8 billion of 10 year bonds, again just hours before the Treasury sold $25 billion in 10 year bonds.
The bond market is front running the Fed, and clueless monetarists who are yammering that the low yields somehow represents next to zero price inflation….for 30 years(!), is somehow justification for the money printing jets to go into even higher gear, despite the fact that it is precisely the inflation that is decreasing the yields on 10 and 30 year bonds in the first place! Political strategy 101 is fun. It’s better than doing economic science.
Winning arguments about inflation with people who don’t believe in market efficiency is like stealing candy from a baby.
Exactly. The market is so “efficient” that bond prices are now “efficiently” absorbing Fed monetization information, and bond traders are having a field day, buying 10 and 30 year bonds at sky high prices, only to flip them to the Fed at outer space prices.
But yeah, “market efficiency” means R = (1 + r)*(1 + i) – 1. Humans are robots after all. They just keep doing what you expect them to do. Efficiency = Sumner predicts humans like robots.
If it’s not yet in the TIPS spreads, it’s not just around the corner.
TIPS bonds contain an embedded option. It is possible the value of this option can rise, and thus decrease the yield, on the basis of higher inflation expectations in the future, such that the TIPS bond investors are willing to earn a low, or even negative yield today.
————
I’m still calling a bond bubble, which would not have been as bad had Bernanke just let the economy correct post-2008 and did NOTHING. We would have suffered like nothing in US history, but it would have been over as fast as humanly possible given the massive inflationary boom the preceding years. But that’s history. Now we have, I suspect, a bond bubble.
Krugman didn’t say this time that Bernanke should create a bond bubble to replace the housing bubble, like he did in 2002 when he said Greenspan should create a housing bubble to replace the Nasdaq bubble. He knows the gig is up, so he just putters around with “just a bit more inflation” these days.
19. July 2012 at 06:32
And here, from January:
http://www.bloomberg.com/news/2012-01-17/treasuries-remain-lower-after-new-york-fed-s-manufacturing-report.html
“Treasury 30-Year Rises As The Federal Reserve Begins 4 Days Of Debt Buying”
I know it’s just a headline, but even Bloomberg gets it. Yields are not falling because of falling inflation expectations.
Remind me never to give my money to any portfolio manager who has even HEARD of market monetarism.
19. July 2012 at 06:32
foosion, Good point.
Ben, Good idea, someone should do that.
Rademaker, Sure there’s an explanation. Volcker himself didn’t know that he planned to bring inflation down quickly.
No one claims the markets can predict future policy changes. But current policy is not likely to create high inflation. I can’t rule out that a future fed chairman would switch policy, or even that Bernanke would change his mind and go for 10% inflation. But it’s very unlikely.
Dan, You said;
“QE supplies a flood of liquidity into the markets, which instead of flowing into the real economy, flows into asset markets.”
That’s basis on a lack of understanding of EC101. Money doesn’t flow into markets, it flows through markets. And money flowing through markets doesn’t cause asset prices to either rise or fall. On October 19, 1987, a record amount of money was “put into” the stock market, and the Dow fell 22%.
You said;
“Underlying this is the belief that the real economy needs to go through a restructuring and/or deleveraging,”
I must have 100 posts demolishing this myth. Deleveraging should make people want to work harder, not become unemployed. And the restructuring argument simply doesn’t fit the facts at all.
I agree with you that there are people out there who believe this nonsense, but unless someone knows at least basic economics, it’s hard to have an intelligent conversation with them.
19. July 2012 at 06:34
Ron Paul made a shpeel about the definition of inflation to Bernanke in a committee testimony yesterday. Bernanke made the very odd statement that inflation is “the change in prices of current goods and services, so inflation doesn’t capture house prices it captures house rentals.” Paul then went on to define inflation as change in M rather than CPI. I’m pretty sure that’s the Rothbardian definition.
Sen Tom Coburn made a shockingly cogent point in a recent Reason.TV interview about the Fed’s “inflationary policies”. He noted that the Fed has drastically increased M but the money wasn’t really in circulation and was sitting in Fed reserve accounts. Of course he is one of these people that thinks interest rates and inflation are going to skyrocket soon, but he qualifies it by saying ‘once velocity picks up’.
I think you can reach these people with the following line of questioning…
If the Treasury prints $10 Trillion and buries it, it’s almost as if the money wasn’t printed. If you accept that, than what Paul is really saying is that the only measure of inflation is the GDP deflator (MV=PY=Nominal GDP. NGDP/Real GDP=GDP deflator).
19. July 2012 at 06:49
@ Ben, Scott
I track something similar similar to what you are suggesting (i think). Note that FRED requires all bar series to have the same frequency, unfortunately.
http://research.stlouisfed.org/fred2/graph/?g=8SL
19. July 2012 at 06:53
Cthrom:
If the current quantity of base money were permanent, then this would be very inflationary.
It isn’t permanent and shouldn’t be permanent.
The only part of it that should be permanent is whatever part is needed to get nominal GDP back to a target growth path. But that means that no part of it is certainly permanent.
Coburn, I think, is assuming it is all permanent.
19. July 2012 at 07:45
“BTW, NGDP growth has been the lowest since Herbert Hoover was in office.”
Which shows that Obama reappointing Bernanke is like if Roosevelt had reappointed Hoover’s head of the Fed.
This epic blunder may well do Obama in.
19. July 2012 at 07:51
“He noted that the Fed has drastically increased M but the money wasn’t really in circulation and was sitting in Fed reserve accounts.”
Incorrect. Neither M1 nor M2 is sitting in the Fed reserve accounts. A lot of B (the monetary baes) IS sitting in Fed reserve accounts. But it is M1 and, to a lesser degree M2 that affect aggregate demand.
19. July 2012 at 07:55
@ Ben J
A priliminary attempt:
http://thefaintofheart.wordpress.com/2012/07/19/falling-short-of-the-dual-mandate-a-preliminary-attempt-at-illustration/
19. July 2012 at 08:01
“Deleveraging should make people want to work harder, not become unemployed.”
When transactions take place when a market does not clear, realized transactions are determined by the short side of the market. Deleveraging, if not offset by the Fed, reduces aggregate demand and therefore the demand for labor, which represents the short side of the market here. Unemployment therefore goes up because the amount of available jobs down and therefore fewer workers are hired, not because workers want to work less. As a matter of fact deleveraging not only reduces the demand for labor, but increases the supply of labor because workers do want to work more. Therefore the excess supply of labor which represents involuntary unemployment, increases both because the demand for labor has fallen and the supply of labor has increased.
19. July 2012 at 08:08
Scott, I don’t agree with all of major freedoms tone, word choice, or message, but…
It has been widely reported that the fed is buying about 2/3s of newly issued 5yr and longer debt. Most of the remainder seems to be purchased by foreign sovereign and their CB. The latter group has widely been disparaged as dumb money in the past. There are also automatic purchases into people’s retirement accounts. Meanwhile, the smart money and the banks seem to be in bills and short duration notes and tips only.
Prices are set by supply and demand and the supply is inelastic, could it simply be there are enough willing dumb buyers who come to bid that the prices never get low enough to reflect reality?
If not at this level of Fed activity, at what level then can we start to doubt the reliability of this particular market indicator. Remember, technocrats are idiots, when they make moves large enough to move market prices you have to doubt that the market price is efficient.
19. July 2012 at 08:20
Jon:
Scott, I don’t agree with all of major freedoms tone, word choice, or message, but…
I’m not a racist, but…
No offense, but…
I like how I’m now a preface.
19. July 2012 at 08:27
[…] Sumner now has a monthly post – The Dual Mandate Watch – to “keep track”. Commenter Ben J wrote: Scott, you should think about creating a visual aid […]
19. July 2012 at 10:07
Scott: That’s basis on a lack of understanding of EC101. Money doesn’t flow into markets, it flows through markets. And money flowing through markets doesn’t cause asset prices to either rise or fall. On October 19, 1987, a record amount of money was “put into” the stock market, and the Dow fell 22%.
I guess I was not careful enough with my wording.
One counter-argument goes: “QE floods the markets with liquidity, but primarily asset markets, not consumption or labor markets. QE drives down the cost of leverage, derivative and nominal, magnifying the volatility of asset prices – especially those assets where leverage is not limited – which is detrimental to the real economy. The money has to go somewhere, and it is not flowing into the real economy, and instead is circulating in the financial markets, finally ending up as reserves. Therefore, QE is causing more problems then it is solving.”
To Jon’s point, few professionals are interested in buying long-dated treasuries. Most of the bond buying is benchmarked (“indexed”, or buying to fulfill an asset allocation requirement). Instead, investors are borrowing – i.e., applying leverage, and therefore going short, where they can.
I don’t necessarily agree with this argument, however, these effects are readily observable to practitioners. My argument is to acknowledge that QE is not the best tool for managing AD: due to its temporary nature, lack of clear objective, and poor targeting, it opens up arbitrage and speculative opportunities (including perceived arbitrage opportunities). However, that nuance gets lost on many.
19. July 2012 at 10:11
The next non-farm jobs report is expected to be negative.
http://i.imgur.com/rjBjK.png
19. July 2012 at 11:07
Cthorm, Thanks, but I fear nothing can reach Ron Paul.
dwb. Thanks, that’s a nice graph.
Thanks for the link Marcus.
FEH, “If not offset by the Fed?” Sure, but that means it’s tight money, not deleveraging, that is causing the unemployment.
Jon, But can’t the “smart money” sell short in the T-bond market? I’d add that it is stocks, not flows that determine prices, so the figures you quote for new issues are relevant. I’m sure that plenty of bonds are held by “smart money.”
Dan, You said;
“The money has to go somewhere, and it is not flowing into the real economy, and instead is circulating in the financial markets, finally ending up as reserves. Therefore, QE is causing more problems then it is solving.”
Again, money doesn’t go into markets. It goes through markets. I see no mechanism that would affect asset prices without affecting NGDP. As far as the real economy, that depends on the slope of the SRAS curve. Are you claiming it’s vertical?
19. July 2012 at 13:46
In the vernacular, “into markets” means a shift upward in the demand curve caused by printed cash the Fed hands over to sellers of treasuries, therefore pushing up prices of whichever other markets the previous holders of treasuries chose to buy into. It appears commodities are a key beneficiary (hence the hard money types vociferously criticizing the Fed), though I believe it is primarily due to leverage implicit in derivatives, which in the last few years has dramatically expanded relative to prior time periods. Thus, for example aluminum, which has historically tracked short-term fundamentals has started tracking asset markets. Derivatives can be a bet on the underlying asset, and/or they can be a long/short bet on treasuries (usually combined in various ways to create long/short exposures desired).
Does it raise NGDP? Sure. Does it lower unemployment and raise production elsewhere in the economy? I wouldn’t necessarily say no, but many do come to that conclusion. The argument is that it enriches traders.
You may not blame the Fed for asset price volatility, and I may not (though as I’ve stated, I think there are more efficient tools than QE), but that is a key element of the challenge the Fed faces in convincing others that QE is warranted.
Note also that China stockpiling commodities can be and has been explained as a hedge against future dollar inflation.
Also you said,
“I’d add that it is stocks, not flows that determine prices, so the figures you quote for new issues are relevant[sic]. I’m sure that plenty of bonds are held by “smart money.””
While I agree mostly, this is controversial. Flows determine prices in the short run, stocks in the long run. The degree to which stocks drive prices depends on “stickiness”, or institutional inertia. You see this effect in small cap illiquid stocks – a big buyer/seller can throw the price around, and it rarely settles back to where it was after the buyer/seller exits. Treasuries are very large and deep, but if a single player represents 2/3rds of monthly volume, along with automatic purchases by a large proportion of the remainder, it is hard to argue that resulting prices are “natural” (hard, not impossible).
And yes, shorting treasuries can be done, but who shorts in front of the Fed? That would be an exercise in masochism. Shorts won’t emerge until a slide in prices has already begun.
19. July 2012 at 18:56
Scott,
Great blog, I truly enjoy the way you push the NGDP idea forward, even if I am not entirely convinced.
Dan Carroll has hit upon one of my main concerns with regard to the fed’s current stance, especially QE and the large balance sheet (reflected in large excess reserves held at banks). That is that not only Treasuries but in effect the entire spectrum of risk assets, which are spread off the riskless rate (stocks included) are today highly risky, in a greater fool sense. Should things return to semi-normal (we can hope), long investors are going to get creamed. Free investment capital is aware of this and will wait out the fed’s efforts by staying short term, or shifting to commodity type hedges to offset risk to other long dated assets. As I see it, the fed is actually causing risk capital to stay on the sidelines. It is a tug of war in which the economy is losing. I believe you are right that targeting NGDP would help, but it would require that long rates come to reflect a healthier economy, which will crush the bond market – one can hope.
19. July 2012 at 19:13
Major. I like you, keep up the good work. But don’t make the perfect the enemy of the good. Sumner, perhaps subconciously, is threading a needle here. So the money illusion shouldn’t matter – it does. Unemployment causes all kinds of stupid ideas to become politically feasible. I am coming to see NGDP targeting as a politically palatable way to retain a free economy.
19. July 2012 at 19:49
Scott, I don’t short-selling of treasuries is easy. When you ‘borrow’ to short the fees involved are usually around 0.75%-1% annualized. Second, a short-sell strategy follows the adage: markets can stay irrational longer than you can stay solvent. I’m sure you won’t like that phrase–but my claim is that it is plausible the treasury bond market is no longer efficient due to the heavy thumb of the Fed and other CB buyers. Last, shorting the stock requires finding a willing counter-party. When most of the market participants are clearly not going to be willing counter-parties, I could easily see the market for borrowed bonds is tight and the expenses high.
Indeed I looked at RYJUX which is an inverse gov bond fund… and it lists interest expenses of 3.6% in its prospectus.
20. July 2012 at 00:01
[…] Source […]
20. July 2012 at 00:26
There is no information from the future, so if one is determined to discount current facts in favour of future fears then the case for optimism (or, at least, no dire pessimism) can never be “made”. Greenies argue on that basis all the time. (A good point to make against free market inflationphobics and debthysterics.)
But we have lots of good information to base our assessment on, and I go with the markets, not with massively discounting facts in favour of fears.
21. July 2012 at 02:30
[…] Sumner notes: Recall that the Fed tries to keep inflation close to 2.0% and unemployment close to about 5.6% […]
21. July 2012 at 02:38
[…] Sumner notes: Recall that the Fed tries to keep inflation close to 2.0% and unemployment close to about 5.6% […]
21. July 2012 at 10:24
[…] Sumner notes: Recall that the Fed tries to keep inflation close to 2.0% and unemployment close to about 5.6% […]
22. July 2012 at 08:10
Dan, You said;
“In the vernacular, “into markets” means a shift upward in the demand curve caused by printed cash the Fed hands over to sellers of treasuries, therefore pushing up prices of whichever other markets the previous holders of treasuries chose to buy into.”
I think this confuses relative and absolute prices. If you raise the money supply 10%, the price of everything will rise by 10% in the long run. In the short run relative prices might change, but certainly not because money “goes into” markets. It doesn’t. If commodities rise, it’s presumably because expected RGDP growth rises.
Of course the high global commodity prices of recent years are not due to easy money in the US, because:
1. Money hasn’t been easy.
2. Real GDP growth has been slow.
I don’t follow your comments about selling short. More likely they are reluctant to do so because they’ve noticed Japan.
ds123, Certainly the long rate would go up with a high NGDP target. I’d suggest staying away from phrases like “risk capital staying on the sidelines.” As I told Dan, money doesn’t go into markets. If you buy a risky asset someone else sells it. It leads to confused thinking. Focus on the prices of assets, and what economic fundamentals explain those prices.
And stop reading MF. He’s confused about almost everything, and will lower your IQ by one point per week. I’m still in recovery.
Jon, You are right, I hate the argument “the market can stay irrational longer . . . ” I’ve done whole blog posts smashing it. It’s a copout.
23. July 2012 at 09:34
ds123:
Major. I like you, keep up the good work. But don’t make the perfect the enemy of the good. Sumner, perhaps subconciously, is threading a needle here. So the money illusion shouldn’t matter – it does. Unemployment causes all kinds of stupid ideas to become politically feasible. I am coming to see NGDP targeting as a politically palatable way to retain a free economy.
Central banking is not consistent with free economies. Free economies entail economic freedom in money production and use.
And contrary to Sumner’s desperate pleading, I will leave it to you to decide whether or not you want to read what I write. I won’t tell you what to do. I am not scared.
Sumner is wrong about almost everything there is to know about money, and he won’t address my challenges because he knows he can’t. He HATES it when others show even the slightest hint of agreeing with me, and he pipes up every time it happens, because he knows that means NGDP targeting is one step away from “political infeasibility”. He wants obedience, not your rational mind. He doesn’t care about truth. He only cares about appearances. So I should warn you to take his words with a grain of salt.