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October 13, 2014

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Paul Krugman: Revenge of the Unforgiven

Posted: 13 Oct 2014 12:24 AM PDT

Why didn't homeowners, unlike banks, get the debt relief they needed?:

Revenge of the Unforgiven, by Paul Krugman, Commentary, NY Times: Stop me if you've heard this before: The world economy appears to be stumbling. For a while, things seemed to be looking up, and there was talk about green shoots of recovery. But now growth is stalling, and the specter of deflation looms.
If this story sounds familiar, it should; it has played out repeatedly since 2008. ... Why does this keep happening? ... The answer, I'd suggest, is an excess of virtue. Righteousness is killing the world economy.
What, after all, is our fundamental economic problem? ... In the years leading up to the Great Recession, we had an explosion of credit..., debt levels that would once have been considered deeply unsound became the norm.
Then the music stopped, the money stopped flowing, and everyone began trying to "deleverage," to reduce the level of debt. For each individual, this was prudent. But ... when everyone tries to pay down debt at the same time, you get a depressed economy.
So what can be done? Historically, the solution to high levels of debt has often involved writing off and forgiving much of that debt. ...
What's striking about the past few years, however, is how little debt relief has actually taken place. ...
Why are debtors receiving so little relief? As I said, it's about righteousness — the sense that any kind of debt forgiveness would involve rewarding bad behavior. In America, the famous Rick Santelli rant that gave birth to the Tea Party wasn't about taxes or spending — it was a furious denunciation of proposals to help troubled homeowners. In Europe, austerity policies have been driven less by economic analysis than by Germany's moral indignation over the notion that irresponsible borrowers might not face the full consequences of their actions.
So the policy response to a crisis of excessive debt has, in effect, been a demand that debtors pay off their debts in full. What does history say about that strategy? That's easy: It doesn't work. ...
But it has been very hard to get either the policy elite or the public to understand that sometimes debt relief is in everyone's interest. Instead, the response to poor economic performance has essentially been that the beatings will continue until morale improves.
Maybe, just maybe, bad news — say, a recession in Germany — will finally bring an end to this destructive reign of virtue. But don't count on it.

Fed Watch: The Methodical Fed

Posted: 13 Oct 2014 12:15 AM PDT

Tim Duy:

The Methodical Fed, by Tim Duy: Just a few months ago the specter of inflation dominated Wall Street. Now the tables have turned and low inflation is again the worry du jour as a deflationary wave propagates from the rest of the world - think Europe, China, oil prices. How quickly sentiment changes.

And given how quickly sentiment changes, I am loath to make any predictions on the implications for Fed policy. The very earliest one could even imagine a possible rate hike would be March of next year, still five months away. But since that month is the preference of Fed hawks, better to think that the earliest is the June meeting, still eight months away.

Eight months is a long time. We could pass through two more of these sentiment cycles between now and then. Or maybe the story breaks decisively one direction or the other. Given the uncertainty of economy activity, it is clearly dangerous to become too wedded to a particular date for liftoff. At best we can describe probabilities.

But what I think is often missing is a recognition that through all of the ups and downs of last year, the Fed has sent a very consistent signal: The ongoing improvement in the US economy justifies the steady removal of monetary accommodation. To be sure, we can quibble over the timing of the first move, but consider the path since last May:

  1. In May of 2013, then-Federal Reserve Chair Ben Bernanke opens the door for tapering of asset purchases.
  2. The actual tapering begins in December of that year, two meetings later than expected. I think it is heroic to believe those 12 weeks were materially important. By that point, the underlying expectation was well established.
  3. Although they claimed that the pace of tapering was data dependent, they proceeded on a very methodical path of $10 billion cuts at each meeting. They proceeded on this path despite persistent below target inflation.
  4. They clearly established that this month's meeting is very, very likely to be the end of the asset purchase program. Again, they stated this expectation despite low inflation.
  5. Despite the current turmoil, I still expect the asset purchase program to end. I think hawks and doves alike want out of that program. They want to return to interest rate-based policy.
  6. Even as inflation bounces along below target, they formulated and announced the path of policy normalization. That normalization includes the expectation that the expansion of the balance sheet was temporary and thus will be reversed.
  7. Even as inflation has bounced along below trend, they have repeatedly warned via the Summary of Economic Projections that rate hikes are just around the corner, and that market participants should plan accordingly.
  8. And while New York Federal Reserve President William Dudley foreshadowed the minutes and a week of Fedspeak that was generally interpreted dovishly, the key takeaway was although the US economy was not expected to accelerate further, the current path was sufficient to believe in the "consensus view is that lift-off will take place around the middle of next year. That seems like a reasonable view to me" even "if it were to cause a bump or two in financial markets." Those remarks were seconded by San Francisco Federal Reserve President John Williams. So the moderates and hawks both continue to send signal rates hikes by the middle of next year, leaving the voices of doves Minneapolis Federal Reserve President Narayana Kocherlakota and Chicago Federal Reserve President Charles Evans sounding very lonely. Fed Chair Janet Yellen has been somewhat absent from the current debate, although we suppose she sympathizes more with the dovish position.

Given the consistent, methodological approach to policy normalization witnessed over the past year, is it wonder that inflation signals all look soft? For example:

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Fed signaling resulted in consistent, downward pressure on inflation expectations. Hence what they view as a dovish policy stance, I view as a hawkish policy stance. And most remarkable to me is that they never realized what I always thought was obvious - that they were setting the stage for a return trip to the zero bound in the next recession. Matthew C Klein at the Financial Times points us to this from the Fed minutes:
For example, respondents to the recent Survey of Primary Dealers placed considerable odds on the federal funds rate returning to the zero lower bound during the two years following the initial increase in that rate. The probability that investors attach to such low interest rate scenarios could pull the expected path of the federal funds rate computed from market quotes below most Committee participants' assessments of appropriate policy.
The most hawkish projection for the long-term Federal Funds rate is 4.25%. During the downside, cutting cycles are generally in excess of 500bp. The math here is not that complicated. I struggle to find the scenario by which policy does not revert to the zero lower bound. That would imply that the Fed allows conditions to evolve such that the appropriate Fed Funds rate is well in excess of 6%. But given the Fed thinks that the equilibrium real rate has fallen, this implies a willingness to support higher inflation expectations, which is something I just don't see at this point.
And I don't think it is just me. I don't think Wall Street sees the path out. Hence the high probability assigned to a return to the zero bound. Hence also the flattening of the yield curve since tapering began:

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I think the Fed should very much change its messaging if policymakers want to lift us from the zero bound for more than a couple of years. I think they should drop the calendar-based guidance they are all now giving. I think they should drop the SEP dot plot, because that clearly sends a hawkish message. I think they should drop reference to the labor market outcomes in terms of quantities in favor of price signals (wages, a direction they seem to be moving). I think they should define their policy strategy to make clear they intend to lift the economy off the zero bound permanently, but that I believe requires them to abandon their 2% inflation fetish (and note that on this I believe their behavior is clearly more consistent with a 2% ceiling then a symmetrical target). They also need to adandon their claim that the balance sheet will be reversed. The size of the balance sheet should not be a policy objective, only the economic outcomes yielded by the size of the balance sheet.
That said, I am also beginning to expect that a return to the zero bound is almost guaranteed. I fear the time has passed for the appropriate mix of fiscal and monetary policy that leaps the economy to a higher equilibrium. But that is a topic for another post.
Bottom Line: Fed policy might sound dovish this week, but take note the the underlying tone has been methodically hawkish for a long, long time. And markets have responded accordingly, including anticipating a return to the zero bound when the next recession hits. Nor should this be unexpected. Monetary policymakers have yet to set clear objectives that includes a high probability that the zero bound is left behind for good.

Links for 10-13-14

Posted: 13 Oct 2014 12:06 AM PDT

'In Defense of Obama'

Posted: 12 Oct 2014 09:35 AM PDT

In case you missed this from Paul Krugman:

In Defense of Obama, by Paul Krugman, Rolling Stone: When it comes to Barack Obama, I've always been out of sync. Back in 2008, when many liberals were wildly enthusiastic about his candidacy and his press was strongly favorable, I was skeptical. I worried that he was naive, that his talk about transcending the political divide was a dangerous illusion given the unyielding extremism of the modern American right. Furthermore, it seemed clear to me that, far from being the transformational figure his supporters imagined, he was rather conventional-minded: Even before taking office, he showed signs of paying far too much attention to what some of us would later take to calling Very Serious People, people who regarded cutting budget deficits and a willingness to slash Social Security as the very essence of political virtue.
And I wasn't wrong. Obama was indeed naive: He faced scorched-earth Republican opposition from Day One, and it took him years to start dealing with that opposition realistically. Furthermore, he came perilously close to doing terrible things to the U.S. safety net in pursuit of a budget Grand Bargain; we were saved from significant cuts to Social Security and a rise in the Medicare age only by Republican greed, the GOP's unwillingness to make even token concessions.
But now the shoe is on the other foot: Obama faces trash talk left, right and center – literally – and doesn't deserve it. Despite bitter opposition, despite having come close to self-inflicted disaster, Obama has emerged as one of the most consequential and, yes, successful presidents in American history. His health reform is imperfect but still a huge step forward – and it's working better than anyone expected. Financial reform fell far short of what should have happened, but it's much more effective than you'd think. Economic management has been half-crippled by Republican obstruction, but has nonetheless been much better than in other advanced countries. And environmental policy is starting to look like it could be a major legacy.
I'll go through those achievements shortly. First, however, let's take a moment to talk about the current wave of Obama-bashing. ...

Factors Behind Lower Oil Prices

Posted: 12 Oct 2014 08:51 AM PDT

Jim Hamilton:

Lower oil prices: For the last 3 years, European Brent has mostly traded in a range of $100-$120 with West Texas intermediate selling at a $5 to $20 discount. But in September Brent started moving below $100 and now stands at $90 a barrel, and the spread over U.S. domestic crude has narrowed. Here I take a look at some of the factors behind these developments. ...

One factor has been weakness in Europe and Japan, which means lower demand for commodities as well as a strengthening dollar. ...

In terms of factors specific to the oil market, one important development has been the recovery of oil production from Libya. ...

But the biggest story is still the United States. Thanks to horizontal drilling to get oil out of tight underground formations... Just how low the price can go before some of the frackers start to drop out is subject to some debate. ...

'The Great Mortgaging'

Posted: 12 Oct 2014 08:34 AM PDT

"This column turns to economic history to investigate whether the financial sector is too big":

The great mortgaging, by Òscar Jordà, Alan Taylor, Moritz Schularick, Vox EU: Understanding the causes and consequences of the rise of finance is a first order concern for macroeconomists and policymakers. The increasing size and leverage of the financial sector has been interpreted as an indicator of excessive risk taking1 and has been linked to the increase in income inequality in advanced economies,2 as well as to the growing political influence of the financial industry (Johnson and Kwak 2010). Yet surprisingly little is known about the driving forces behind these trends.
In our recent research we turn to economic history. We build on our earlier work that first demonstrated the dramatic growth of the balance sheets of financial intermediaries in the second half of the 20th century and how periods of rapid credit growth were often followed by systemic financial crises and severe recessions (Schularick and Taylor 2012, Jordà, Schularick, and Taylor 2013).
We unveil a new long-run dataset covering disaggregated bank credit for 17 advanced economies from 1870 to today (Jordà, Schularick, and Taylor 2014). The new data allow us to delve much deeper than has been previously possible into the forces driving the growth of finance. For the first time we can construct the share of mortgage loans in total bank lending for most countries back to the 19th century. In addition, we can calculate the share of bank credit to business and households for most countries for the decades after WW2, and back to the 19th century for a handful of countries. ...
In the second half of the 20th century, banks and households have been heavily leveraging up through mortgages. Mortgage credit on the balance sheets of banks has been the driving force behind the increasing financialisation of advanced economies. Our research shows that this great mortgaging has been a major influence on financial fragility in advanced economies, and has also increasingly left its mark on business cycle dynamics.

[There is quite a bit more discussion and evidence in the article.]

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