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November 28, 2012

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Posted: 14 Nov 2012 12:06 AM PST

Fed Watch: Yellen Supports Explicit Guideposts

Posted: 13 Nov 2012 06:15 PM PST

Tim Duy:

Yellen Supports Explicit Guideposts, by Tim Duy: Today Federal Reserve Vice Chair Janet Yellen discussed the evolution of policy communications. As might be expected from Yellen, there was a dovish tone to the speech. She provides a very nice overview of the Fed's changing communication strategy before shifting to her preferred path for the future. Along the way, she reiterates her estimated optimal path for monetary policy:


The notable feature of the optimal path is that inflation glides to its long-run target from above while unemployment does the opposite. These path are achieved by holding down interest rates longer than the level implied by a Taylor-type rule. Yellen explains that it is challenging to communicate such a rule, particularly in the current circumstances:

The fact that simple rules aren't as useful in current circumstances as they would be for the FOMC at other times poses a significant challenge for FOMC communications, especially since private-sector Fed watchers have frequently relied on such rules to understand and predict the Committee's decisions on the federal funds rate...

...Now, however, the federal funds rate may well diverge for a number of years from the prescriptions of simple rules. Moreover, the FOMC announced an open-ended asset purchase program in September, and there is no historical record for the public to use in forming expectations on how the FOMC is likely to use this tool. Thus, the current situation makes it very important that the FOMC provide private-sector forecasters with the information they need to predict how the likely path of policy will change in response to changes in the outlook...

How can the Fed augment the current communication strategy of an expected time frame for exceptionally low rates coupled with broad economic objectives to be met prior to changing policy? First, more explicit forecasts:

One logical possibility would be for the Committee to publish forecasts akin to those I've presented in figure 1. That is, the Committee could provide the public with its projections for inflation and the unemployment rate together with what it views as appropriate paths both for the federal funds rate and its asset holdings, conditional on its current outlook for the economy.

Yellen notes, however, that the Fed's institutional structure relies on 19 forecasts, which is challenging to synthesize into a single forecast. Research in this area is ongoing. She then supports the basic approach advocated by Chicago Federal Reserve President Charles Evans and Minneapolis Federal Reserve President Narayana Kocherlakota:

Another alternative that deserves serious consideration would be for the Committee to provide an explanation of how the calendar date guidance included in the statement--currently mid-2015--relates to the outlook for the economy, which can and surely will change over time. Going further, the Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range.

While I like explicit targets in theory, I have been concerned that monetary policy is too complex to summarize in two numbers, thus making it a communications nightmare rather than a dream. Perhaps I am too pessimistic. Yellen offers a response:

Under such an approach, liftoff would not be automatic once a threshold is reached; that decision would require further Committee deliberation and judgment.

Not a fixed target that requires action, just consideration of action. Whether the rest of the FOMC follows suit with this approach is another question, but the winds are definitely blowing in that direction. On average then, this is relatively dovish. The Fed is heading toward a policy direction that would explicitly allow for inflation somewhat above target and unemployment below target as long as inflation expectations remained anchored. One would think this should put upward pressure on near term inflation. But Ryan Avent notes the opposite is occuring:

But since mid-October, there has been an unmistakable reversal in the inflation-expectations trend. Based on 5-year breakevens, all of the September spurt has been erased. And 2-year breakevens are back at July levels. Given my optimism over the Fed's September moves and the apparent strength of underlying fundamentals in the economy, I would like to disregard this trend, but one should be very reluctant to abandon guideposts that have served one well just because they've moved in an inconvenient way.



Avent has a point here (with the caveat that TIPS-based inflation expectations might be less than perfect). He also expressed concern about a broader array of assets:

Other proxies for demand—equity prices, bond yields, and the level of the dollar—have also moved, albeit modestly, in worrying ways. The S&P 500 is down a bit over 5% from its September high, the 10-year Treasury yield has fallen more than 20 basis points since October, and the trade-weighted dollar, which plunged after the Fed's September meeting, has been strengthening since the middle of last month.

I would add that Yellen's speech did not even generate a knee-jerk response in the stock market today. I remember a time not long ago when any hint of dovishness was good for a 1% rally. Which, combined with Avent's thoughts, leaves me wondering if open-ended QE is the last of the Fed's monetary tools. We now know the Fed will continuously exchange cash for Treasury or mortgage bonds until the Fed's economic objectives are met. Uncertainty about the course of monetary policy as been largely eliminated. There is not likely to be a premature policy reversal. What if the pace of the economy does not accelerate, sustaining a large, persistent output gap and a low inflation environment? The Fed could increase the pace of purchases, but would this really change expectations? Can we get more "open-ended?"

Bottom Line: Yellen delivers a dovish speech, siding with Evans and Kocherlakota who had previously advocated explicit inflation and unemployment guidelines for policy change. The Fed is moving in this direction, promising to further lock-in a program of aggressive large scale asset purchases. But is this the end of the road for policy? "Open-ended" sounds much like "unlimited." And unlimited sounds like the end of the road. If the economy stumbles, will the Fed pull a new trick out of its policy bag, or is that bag finally empty? And if that bag is empty, then we will need to turn to fiscal policy if the economy stumbles. This is worrisome given the expected path of fiscal policy - tighter, just degrees of tighter. Which means for the moment we just cross our fingers and hope the economy gains traction on the back of housing and accelerates as 2013 progresses.

The GOP Needs to 'Stop Confusing Product with Marketing'

Posted: 13 Nov 2012 02:34 PM PST

Via email from Mohan Kompella, an MBA student at Northwestern University:

I read your "Republicans Should Embrace Competition" post with interest. 
What the GOP really needs to do, is stop confusing Product with Marketing.
In the business world (apt, since the GOP thinks of itself as the "Party of Business"), if a company spent $1 Billion on selling something and failed (actually $3 Billion, if you include the company's "partner" ecosystem), numerous heads would roll.
It would then call for a brutally honest and thorough review of what went wrong with its front-end marketing, its back-end marketing, its competitive strategy and most importantly, its products. The problem though is that the GOP punditry class keeps talking about marketing problems only and no one wants to talk about product.
More at

'The President’s Opening Bid on a Grand Bargain'

Posted: 13 Nov 2012 12:07 PM PST

Robert Reich has a recommendation for an opening bid on deficit reduction:

The President's Opening Bid on a Grand Bargain: Aim High, by Robert Reich: I hope the President starts negotiations over a "grand bargain" for deficit reduction by aiming high. After all,... if the past four years has proven anything it's that the White House should not begin with a compromise.
Assuming the goal is $4 trillion of deficit reduction over the next decade (that's the consensus...), here's what the President should propose:
First, raise taxes on the rich... Why not go back sixty years when Americans earning over $1 million in today's dollars paid 55.2 percent of it in income taxes, after taking all deductions and credits? If they were taxed at that rate now, they'd ... reduce the budget deficit by about $1 trillion over the next decade. That's a quarter of the $4 trillion in deficit reduction right there.
A 2% surtax on the wealth of the richest one-half of 1 percent would bring in another $750 billion over the decade. A one-half of 1 percent tax on financial transactions would bring in an additional $250 billion.
Add this up and we get $2 trillion over ten years — half of the deficit-reduction goal.
Raise the capital gains rate to match the rate on ordinary income and cap the mortgage interest deduction at $12,000 a year, and ... we're up to $3 trillion in additional revenue.
Eliminate special tax preferences for oil and gas, price supports for big agriculture, tax breaks and research subsidies for Big Pharma, unnecessary weapons systems for military contractors, and indirect subsidies to the biggest banks on Wall Street, and we're nearly there.
End the Bush tax cuts on incomes between $250,000 and $1 million, and — bingo — we made it: $4 trillion over 10 years.
And we haven't had to raise taxes on America's beleaguered middle class, cut Social Security or Medicare and Medicaid, reduce spending on education or infrastructure, or cut programs for the poor. ...

Obama should at least reverse the Republican pre-election mantra and insist: raise taxes first, then we'll talk spending cuts.

'Republicans Should Embrace Competition'

Posted: 13 Nov 2012 10:31 AM PST

Since the topic of the day so far seems to be the benefits of competition:

Republicans Should Embrace Competition, by Sandeep Baliga, Cheap Talk: I associate the Republican Party with competition. The Party promotes free market ideals – even in education where it promotes charter schools and vouchers so that traditional public schools will have to improve if they want to successfully compete for students.
So why doesn't the Republican Party embrace these ideals of fully? Republicans won reelection to the House in large part thanks to uncompetitive redistricting.
This makes the GOP weaker in the long run because it protects out of touch politicians from competition and from reality. Gerrymandering means that Republican Representatives can be oblivious to long-term demographic changes that are reshaping the electorate while Democratic Representatives in safe "districts" must disproportionately confront them. The lack of competition makes the Republican Party weaker and less responsive to demographic change. Only watching Fox News probably isn't helping either.
The ramifications of this uncompetitive behavior likely ... made it harder for Romney to win. Mitt Romney embraced positions associated with the far right of the Republican Party in order to win the primary nomination. Many of his opponents who forced this shift in Romney's positions were elected to the House from uncompetitive districts. ...

If the Republican Party wants its next generation of leaders to be able to win state and national elections, it should embrace competition and renounce gerrymandering. It should create House Congressional Districts that reflect demographic trends. ...

'Is Finance Too Competitive?'

Posted: 13 Nov 2012 09:53 AM PST

I don't have any problem at all with the call for more competition in the financial industry, especially measures such as reducing bank size to the minimum efficient scale to reduce their systemic importance and political power. I do have a problem, however, with the idea that competition can substitute for regulation, i.e. that these markets can be left alone to self-regulate:

Is Finance Too Competitive?, by Raghuram Rajan,Commentary, Project Syndicate: Many economists are advocating for regulation that would make banking "boring" and uncompetitive once again. After a crisis, it is not uncommon to hear calls to limit competition. ...
The overwhelming evidence, though, is that financial competition promotes innovation. Much of the innovation in finance in the US and Europe came after it was deregulated in the 1980's – that is, after it stopped being boring.
The critics of finance, however, believe that innovation has been the problem. Instead of Schumpeter's "creative destruction," bankers have engaged in destructive creation in order to gouge customers at every opportunity while shielding themselves behind a veil of complexity from the prying eyes of regulators (and even top management). ... Hence, the critics are calling for limits on competition to discourage innovation.
Of course, the critics are right to argue that not all innovations in finance have been useful, and that some have been downright destructive. By and large, however, innovations such as interest-rate swaps and junk bonds have been immensely beneficial... Even mortgage-backed securities, which were at the center of the financial crisis that erupted in 2008, have important uses... The problem was not with the innovation, but with how it was used – that is, with financiers' incentives.
And competition does play a role here. Competition makes it harder to make money, and thus depletes the future rents (and stock prices) of the incompetent. In an ordinary industry, incompetent firms (and their employees) would be forced to exit. In the financial sector, the incompetent take on more risk, hoping to hit the jackpot, even while the regulator protects them by deeming them too systemically important to fail.
Instead of abandoning competition and giving banks protected monopolies once again, the public would be better served by making it easier to close banks when they get into trouble. Instead of making banking boring, let us make it a normal industry, susceptible to destruction in the face of creativity.

This seems to imply that breaking banks into smaller pieces makes the system immune to taking on too much risk and the problems that come with it, but we had banking problems in eras where most banks are small -- cascading bank failures in response to a large shock are still possible -- so making markets as competitive as we can, including breaking firms into smaller pieces and allowing easy failure, is no guarantee that financial meltdowns will be avoided (it may, in fact, be harder to step in and save the system when you have to fix many, many small banks instead of a few big ones). I think more competition in this industry is a good idea, but we shouldn't be fooled into thinking that means we can stop worrying about the stability of the system. The focus of the article is innovation, but that is not where the main vulnerability lies. Market failures that allow the equivalent of bank runs on the shadow banking system are a much bigger problem, and this problem cannot be solved by simply reducing firm-size. Regulation to reduce the chances of cascading failure will still be needed.

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