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October 17, 2015

Latest Posts from Economist's View

Posted: 13 Oct 2015 12:24 AM PDT
Tim Duy:
Brainard Drops A Policy Bomb, by Tim Duy: What if a Federal Reserve Governor drops a policy bomb in the woods and no one is there to hear it? Did it really make a noise?
That's what happened today. While the bond market was closed and whatever financial journalists were left focusing their efforts on newly-minted Nobel Prize recipient Angus Deaton, Federal Reserve Governor Lael Brainard dropped a policy bomb with her speech to the National Association of Business Economists. It was nothing short of a direct challenge to Chair Janet Yellen and Vice Chair Stanley Fischer. Is was, as they say, a BFD.
That, at least, is my opinion. Consider, for example, Brainard's opening salvo:
The will-they-or-won't-they drumbeat has grown louder of late. To remove the suspense, I do not intend to make any calendar-based statements here today. Rather, I would like to give you a sense of the considerations that weigh on both sides of that debate and lay out the case for watching and waiting.
Wait, who is making calendar-based statements? Yellen:
...these two judgments imply that the real interest rate consistent with achieving and then maintaining full employment in the medium run should rise gradually over time. This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.
and Fischer:
In the SEP, the Summary of Economic Projections prepared by FOMC participants in advance of the September meeting, most participants, myself included, anticipated that achieving these conditions would entail an initial increase in the federal funds rate later this year.
After essentially saying that such calendar-based guidance is beneath her, she says what she is going to do: Explain why policymakers should delay further. Note however this stands in sharp contrast with Yellen and Fischer. Their efforts have been spent on explaining why rates need to rise soon. Hers will be spent on why they do not.
After assessing the quality of the recovery, Brainard asserts:
In contrast to the considerable progress in the labor market, progress on the second leg of our dual mandate has been elusive. To be clear, I do not view the improvement in the labor market as a sufficient statistic for judging the outlook for inflation. A variety of econometric estimates would suggest that the classic Phillips curve influence of resource utilization on inflation is, at best, very weak at the moment. The fact that wages have not accelerated is significant, but more so as an indicator that labor market slack is still present and that workers' bargaining power likely remains weak.
Recall that Yellen, in her most recent speech, made the Phillips Curve the primary basis for her case that rates will soon need to rise:
What, then, determines core inflation? Recalling figure 1, core inflation tends to fluctuate around a longer-term trend that now is essentially stable. Let me first focus on these fluctuations before turning to the trend. Economic theory suggests, and empirical analysis confirms, that such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy--as approximated, for example, by the gap between the actual unemployment rate and its so-called natural rate, or by the shortfall of actual gross domestic product (GDP) from potential output. This relationship--which likely reflects, among other things, a tendency for firms' costs to rise as utilization rates increase--represents an important channel through which monetary policy influences inflation over the medium term, although in practice the influence is modest and gradual. Movements in certain types of input costs, particularly changes in the price of imported goods, also can cause core inflation to deviate noticeably from its trend, sometimes by a marked amount from year to year. Finally, a nontrivial fraction of the quarter-to-quarter, and even the year-to-year, variability of inflation is attributable to idiosyncratic and often unpredictable shocks.
Yellen concludes, after breaking down the inflation shortfall into its constituent parts, that the resource utilization component is now fairly small and will soon dissipate, having only the temporary components to worry about:
Although an accounting exercise like this one is always imprecise and will depend on the specific model that is used, I think its basic message--that the current near-zero rate of inflation can mostly be attributed to the temporary effects of falling prices for energy and non-energy imports--is quite plausible. If so, the 12-month change in total PCE prices is likely to rebound to 1-1/2 percent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeably further.
Brainard, however, is not buying this story. Brainard's focus:
Although the balance of evidence thus suggests that long-term inflation expectations are likely to have remained fairly steady, the risks to the near-term outlook for inflation appear to be tilted to the downside, given the persistently low level of core inflation and the recent decline in longer-run inflation compensation, as well as the deflationary cross currents emanating from abroad--a subject to which I now turn.
While Yellen sees the risks weighted toward rebounding inflation, Brainard sees the opposite. Moreover, policymakers have been twiddling their thumbs as the world economy turns against them:
Over the past 15 months, U.S. monetary policy deliberations have been taking place against a backdrop of progressively gloomier projections of global demand. The International Monetary Fund (IMF) has marked down 2015 emerging market and world growth repeatedly since April 2014.
While all of you have been arguing about when to raise rates, the case for raising rates has been falling apart! As a consequence:
Over the past year, a feedback loop has transmitted market expectations of policy divergence between the United States and our major trade partners into financial tightening in the U.S. through exchange rate and financial market channels. Thus, even as liftoff is coming into clearer view ahead, by some estimates, the substantial financial tightening that has already taken place has been comparable in its effect to the equivalent of a couple of rate increases.
Brainard buys into the view that recent activity in financial markets has already tightened monetary conditions. Later:
There is a risk that the intensification of international cross currents could weigh more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in U.S. policy could impose restraint through additional tightening of financial conditions. For these reasons, I view the risks to the economic outlook as tilted to the downside. The downside risks make a strong case for continuing to carefully nurture the U.S. recovery--and argue against prematurely taking away the support that has been so critical to its vitality.
Not balanced, but to the downside. That calls for different risk management:
These risks matter more than usual because the ability to provide additional accommodation if downside risks materialize is, in practice, more constrained than the ability to remove accommodation more rapidly if upside risks materialize.
In effect, the Fed can't cut rates quickly, but they can raise rates quickly:
...many observers have suggested that the economy will soon begin to strain available resources without some monetary tightening. Because monetary policy acts with a lag, in this scenario, high rates of resource utilization may lead to a large buildup of inflationary pressures, a rise in inflation expectations and persistent inflation in excess of our 2 percent target. However, we have well-tested tools to address such a situation and plenty of policy room in which to use them.
Brainard is willing to risk a rapid rise in rates. Yellen is not. Indeed, quite the opposite. Yellen desperately wants a very slow pace of rate increases:
If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.
The more I think about it, the less I am worried about this issue. Suppose that the Fed needs raise rates at twice the pace they currently anticipate. What does that mean? 25bp at every meeting instead of every other meeting? Is that really an "abrupt tightening?" Not sure that Yellen has a very strong argument here. Or one that would withstand repeated attacks from her peers.
I feel like I haven't scratched the surface on this speech, but I will cut to the chase: This is an outright challenge to the Yellen/Fischer view.
I think these three players are all products of their experience. Yellen received her Ph.D in 1971. Fischer in 1969. Both experienced the Great Inflation first hand. Brainard earned her Ph.D in 1989. Her professional experience is dominated by the Great Moderation.
I think Yellen wants to raise interest rates. I think Fischer wants to raise rates. I think both believe the downward pressure on inflation due to labor market slack is minimal, and the Phillips Curve will soon assert itself. I think both do not find the risks as asymmetric as does Brainard. I think they believe the risk of inflation is actually quite high. Or, probably more accurately, that the risk of destabilizing inflation expectations is quite high.
I think that Brainard knows this. I think that this speech is a very deliberate action by Brainard to let Yellen and Fischer know that she will not got quietly into the night if they push forward with their plans. I think that she is sending the message that they will not have just one dissent from a soon-to-be-replace regional president (Chicago Federal Reserve President Charles Evans), but a more-difficult-to-ignore Fed governor still voting when January 1 rolls around.
And now that Brainard has laid down the gauntlet, it will look very, very bad for Yellen and Fischer if their plans go sideways. This is very likely the last big decision of their careers. They know what happened to Greenspan's legacy. I doubt they want the same treatment. Why risk their reputations when the cost of waiting is a 25bp move every meeting instead of every other meeting? Is it worth it?
Brad DeLong suggested the Fed commit to one of two policy messages:
I must say that they are not doing too well at the clear-communication part. I want to see one of following things in Fed statements:
  1. We will begin raising interest rates in December at a pace of basis points per quarter, unless economic growth and inflation fall substantially short of our current forecast expectations.
  2. We will delay raising interest rates until we are confident that it will not be appropriate to return them to the zero lower bound after liftoff.
If we had one of these, we would know where we stand.
But Stan Fischer's speech provides us with neither.
I think that Fischer wants the first option, but knows Brainard's views, and hence knows that December is not a sure thing if Brainard can build momentum for her position. Hence the muddled message. Brainard could be the force that drives the Fed toward option number two. An option closer to that of Evans and Minneapolis Federal Reserve President Narayana Kocherlakota. That would be a game changer.
Bottom Line: This is the most exciting speech I have read in forever. Not necessarily for the content. But for the politics. Evans and Kocherlakota are no longer the lunatic fringe. This could be a real game changer that shifts the Fed toward the Evans view of the world, with no rate hike until mid-2016. Brainard muddied further the already murky December waters.
Posted: 13 Oct 2015 12:06 AM PDT
Posted: 12 Oct 2015 01:31 PM PDT
This Economic Letter from Vasco C├║rdia of the SF Fed finds that even though interest rates are very low, so is the natural rate of interest, and that implies that monetary policy is "relatively tight."  "The model projections for the natural rate are consistent with the federal funds rate only gradually returning to normal over the next few years, although substantial uncertainty surrounds this forecast":
Why So Slow? A Gradual Return for Interest Rates: Short-term interest rates in the United States have been very low since the financial crisis. Projections of the natural rate of interest indicate that a gradual return of short-term interest rates to normal over the next five years is consistent with promoting maximum employment and stable inflation. Uncertainty about the natural rate that is most consistent with an economy at its full potential suggests that the pace of normalization may be even more gradual than implied by these projections.
To boost economic growth during the financial crisis, the Federal Reserve aggressively cut the target for its benchmark short-term interest rate, known as the federal funds rate, to near zero around the beginning of 2009. Since then the time projected for the rate to return to more normal historical levels has been continually postponed.
To understand the level of the federal funds rate and when it might be normalized it is useful to consider the concept of the natural rate of interest first proposed by Wicksell in 1898 and introduced into modern macroeconomic models by Woodford (2003). The natural rate of interest is the real, or inflation-adjusted, interest rate that is consistent with an economy at full employment and with stable inflation. If the real interest rate is above (below) the natural rate then monetary conditions are tight (loose) and are likely to lead to underutilization (overutilization) of resources and inflation below (above) its target.
This Economic Letter analyzes the recent behavior of the natural rate using an empirical macroeconomic model. The results suggest that the natural rate is currently very low by historical standards. Because of this, monetary conditions remain relatively tight despite the near-zero federal funds rate, which in turn is keeping economic activity below potential and inflation below target. The model projections for the natural rate are consistent with the federal funds rate only gradually returning to normal over the next few years, although substantial uncertainty surrounds this forecast. ...
And the conclusion:
... This Letter suggests that the natural rate of interest is expected to remain below its long-run level for some time. This implies that low interest rates over the next few years are consistent with the most efficient use of resources and stable inflation. The analysis also finds that the output gap is expected to remain negative even after the natural rate is close to its long-run level. Additionally, there is considerable uncertainty about both the short-run dynamics as well as what level should be expected in the longer run. All these considerations reinforce the possibility that interest rate normalization will be very gradual.
Posted: 12 Oct 2015 10:38 AM PDT
Busy this morning. Here's the press release on the award of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2015 to Angus Deaton:
Consumption, great and small: To design economic policy that promotes welfare and reduces poverty, we must first understand individual consumption choices. More than anyone else, Angus Deaton has enhanced this understanding. By linking detailed individual choices and aggregate outcomes, his research has helped transform the fields of microeconomics, macroeconomics, and development economics.
The work for which Deaton is now being honored revolves around three central questions:
How do consumers distribute their spending among different goods? Answering this question is not only necessary for explaining and forecasting actual consumption patterns, but also crucial in evaluating how policy reforms, like changes in consumption taxes, affect the welfare of different groups. In his early work around 1980, Deaton developed the Almost Ideal Demand System – a flexible, yet simple, way of estimating how the demand for each good depends on the prices of all goods and on individual incomes. His approach and its later modifications are now standard tools, both in academia and in practical policy evaluation.
How much of society's income is spent and how much is saved? To explain capital formation and the magnitudes of business cycles, it is necessary to understand the interplay between income and consumption over time. In a few papers around 1990, Deaton showed that the prevailing consumption theory could not explain the actual relationships if the starting point was aggregate income and consumption. Instead, one should sum up how individuals adapt their own consumption to their individual income, which fluctuates in a very different way to aggregate income. This research clearly demonstrated why the analysis of individual data is key to untangling the patterns we see in aggregate data, an approach that has since become widely adopted in modern macroeconomics.
How do we best measure and analyze welfare and poverty? In his more recent research, Deaton highlights how reliable measures of individual household consumption levels can be used to discern mechanisms behind economic development. His research has uncovered important pitfalls when comparing the extent of poverty across time and place. It has also exemplified how the clever use of household data may shed light on such issues as the relationships between income and calorie intake, and the extent of gender discrimination within the family. Deaton's focus on household surveys has helped transform development economics from a theoretical field based on aggregate data to an empirical field based on detailed individual data.
More here, here, here, here, and here.
Update: Here too.

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