Tag: Federal Reserve

Must-read: Narayana Kocherlakota: “It’s Time to Make a Hard U-Turn”

Posted on by Brad DeLong

Must-Read: Narayana Kocherlakota: It’s Time to Make a Hard U-Turn.: “Market-based measures of long-term inflation compensation…

…have fallen persistently and dramatically since mid-2014. This decline means that the Federal Open Market Committee (FOMC)  is confronting a significant risk to its credibility. It must act aggressively in the near-term to eliminate this risk. 

It is true that there are two possible explanations for this decline in market-based measures of long-term compensation. The first explanation is that should be viewed as a transitory phenomenon, due to some mysterious (to me) interaction between the market for inflation-protected TIPS bonds and declining oil prices. The second is that the decline means that market participants believe that the FOMC will be unable or unwilling to keep inflation as high as 2% on a sustainable basis.  This interpretation seems a lot less mysterious to me, since the FOMC continues to tighten policy in the adverse of severe disinflationary headwinds (associated in part with the decline in oil prices). 

There’s no easy way to tell these stories apart in the data.  But this challenge is irrelevant for policymakers.  The first story simply tells policymakers to ignore the decline in longer-term breakevens. Because the first story makes no specific policy recommendation, policymakers can simply ignore the possibility that it is true.  (Things would be different if, for example, the first story argued in favor of tighter monetary policy.)

In contrast, as long we put the slightest weight on the second story of declining credibility being true, it matters considerably for policy.  The FOMC’s tightening cycle is systematically lowering longer-term inflation expectations generally, and especially during future recessions.   The erosion of credibility means that real interest rates will be higher whenever the Fed is at the zero lower bound in the future – and that means lower employment and prices in those times.  (You can start to see the potential for a self-fulfilling trap that has so many so concerned.)

All central bankers agree that, without anchored inflation expectations, a central bank cannot be effective at achieving its price and employment objectives.   That’s why the main mission of a central bank is to keep inflation expectations well-anchored.  The evidence continues to mount that the FOMC is failing at this task. The Committee needs to confront this significant credibility threat by reversing its tightening cycle quickly and decisively.

Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed

Must-read: Duncan Black: “Time To Increase Interest Rates!”

Posted on by Brad DeLong

Must-Read: And Duncan Black comes up with a very good phrase to describe what we think the Federal Reserve is doing based on what we think is its misspecified and erroneous view of the inflation process: “taking away the punchbowl before the DJ even shows up to the party”:

Duncan Black: Time To Increase Interest Rates!: “As I’ve said, I don’t think small upticks in interest rates by the Fed…

…will really destroy the economy. They just signal that the Fed will never let wages (for most of us) rise ever again. They’re taking away the punchbowl before the DJ even shows up to the party. Killing inflation is easy and you don’t have to pre-kill it. The best argument for Fed actions is that they need to increase rates so that they’ll be able to decrease them again if the economy sours. There’s a bit of an obvious problem with this reasoning. Exciting days at the dog track probably do get their attention. Wonder why that is.

Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed

How many FOMC members would have voted to raise interest rates back a month and a half ago if they had known that from then until now would say a 50 basis-point downward lurch in the 5-year ahead 5-year forward inflation breakeven? 4? 3? 2? 1? If they do not reverse that December rise at the next FOMC meeting, it seems as if something is wrong…

Must-read: Olivier Blanchard: “The US Phillips Curve: Back to the 60s?”

Posted on by Brad DeLong

Must-Read: Olivier Blanchard says that he and Paul Krugman differ not at all on the analytics but, rather, substantially on “tone”. When I read Olivier, I find his tone so measured and reasonable that casual and even more-attentive-than-casual readers are likely to completely miss the point.

When Olivier believes that the Federal Reserve did right to raise interest rates last month. But when he says “each of the last three conclusions presents challenges for the conduct of monetary policy”, what he means the conclusion I draw is: The Federal Reserve has made and is making three mistakes in its assessment of the relationship between inflation and unemployment:

  1. It believes that the relationship is tight, so that you can make policy by simply looking at the forecast without looking at asymmetric consequences in the tails of the distribution of future outcomes. But the relationship is not tight, but loose. It has always been loose.
  2. It believes that the gearing between unemployment and inflation is strong, so that minor falls of unemployment below the natural rate produce substantial increases in inflation even in the short run. But that gearing has not been strong since the early 1980s. It is weak.
  3. It believes that increases in inflation substantially and rapidly affect expectations of future inflation, so that we are never far from a wage-price spiral. But that gearing has not been strong since the late 1980s, if then. Inflation expectations are anchored.

Why the Federal Reserve is working today as if the Phillips-Curve relationship is still what it was in the years around 1980 is a great mystery. But it is, I think–and I think Olivier thinks, though with his reasonable tone it is hard to tell–leading the Federal Reserve to place bad monetary-policy bets right now:

Olivier Blanchard: The US Phillips Curve: Back to the 60s?: “The US Phillips curve is alive…

…(I wish I could say “alive and well,” but it would be an overstatement: the relation has never been very tight.) Inflation expectations, however, have become steadily more anchored, leading to a relation between the unemployment rate and the level… rather than the change in in inflation… [that] resembles more the Phillips curve of the 1960s than the accelerationist Phillips curve of the later period. The slope of the Phillips curve… has substantially declined…. The standard error of the residual… is large…. Each of the last three conclusions presents challenges for the conduct of monetary policy…

Www piie com publications pb pb16 1 pdf Www piie com publications pb pb16 1 pdf Www piie com publications pb pb16 1 pdf

Must-read: Barry Eichengreen: “Reforming or Deforming the Fed?”

Posted on by Brad DeLong

Barry Eichengreen: Reforming or Deforming the Fed?: “Some… proposals by Bernie Sanders… deserve to be taken seriously…

…The fact that three of the nine directors of the Fed’s regional reserve banks are private bankers is an anachronism that creates the appearance, and potentially the reality, of a conflict of interest. Sanders’ suggestion that the US president, rather than their own directors, nominate the regional reserve banks’ presidents is also worthy of consideration…. The peculiar arrangements prevailing today were designed to overcome the financial sector’s opposition to the establishment of a central bank when the Federal Reserve Act was passed in 1913. This, clearly, is no longer the problem….

Other proposals… are more dubious…. To release full transcripts six months after Fed meetings would guarantee a scripted debate. Meaningful discussion would simply move to the anteroom. The result, perversely, would be a decline in policy transparency.

Today’s economic history: William McChesney Martin’s “Punchbowl Speech”

Posted on by Brad DeLong

William McChesney Martin (1955): Punchbowl Speech (October 19, 1955): “In framing the Federal Reserve Act great care was taken to safeguard…

…this money management from improper interference by either private or political interests. That is why we talk about the overriding importance of maintaining our independence. Hence we have our system of regional banks headed up by a coordinating Board in Washington intended to have only that degree of centralized authority required to discharge effectively a national policy. This constitutes, as those of you in this audience recognize, a blending of public interest and private enterprise uniquely American in character. Too few of us adequately recognize or adequately salute the genius of the framers of our central banking system in providing this organizational bulwark…

Must-read: Gavyn Davies: “China devaluation – a necessary evil?”

Posted on by Brad DeLong

Must-Read: Gavyn Davies: China devaluation – a necessary evil?: “The 9 percent drop in global equity prices in the first two weeks of 2016…

…is certainly alarming, even for those of us who believe that the outlook for the world activity has not deteriorated much recently. The fundamental cause is the same as it was last August – a clash between a severe loss of credibility in Chinese economic policy and a Federal Reserve that still seems determined to continue tightening US monetary policy without much regard to international risks and a slowing domestic economy (see the hawkish Bill Dudley speech on Friday)…

Must-read: Barry Eichengreen: “Reforming or Deforming the Fed?”

Posted on by Brad DeLong

Barry Eichengreen: Reforming or Deforming the Fed?: “Proposals for a ‘Taylor rule’ are… merely a formula purporting to explain…

…why the Fed set its policy interest rate as it did in the 1980s and early 1990s, the period Taylor considered in his original study… a guide for desirable policy only if one thinks that the policies followed in that period were desirable, or, more to the point, that similar policies will be desirable in the future. It provides no direct way to address other concerns, such as financial stability, which most people will agree should, in light of recent events, figure more prominently in monetary-policy decisions.

Must-read: Paul Krugman: “Strangely Self-Confident Permahawks”

Posted on by Brad DeLong

Must-Read: Paul Krugman: Strangely Self-Confident Permahawks: “An odd thing about permahawks…

…They are, by and large, free-market acolytes who insist that markets know best; yet they also insist that we ignore financial markets that have been telling us that inflation is quiescent and the U.S. government is solvent…. It’s OK to conclude that markets are currently wrong, although if you believe that they make huge errors that should influence your views on policy in general. But your confidence in your dismissal of market beliefs should bear some relationship to your own track record. If you’ve been warning about inflation, wrongly, for six or so years, and markets current show no worries about inflation… I would expect some diffidence….

But I’m not Martin Feldstein.

Marty Feldstein: A Federal Reserve Oblivious to Its Effect on Financial Markets: “The sharp fall in share prices last week was a reminder of the vulnerabilities created by years of unconventional monetary policy…

…t was inevitable that the artificially high prices of U.S. stocks would eventually decline. Even after last week’s market fall, the S&P 500 stock index remains 30% above its historical average. There is no reason to think the correction is finished. The overpriced share values are a direct result of the Federal Reserve’s quantitative easing (QE) policy…. The strategy worked well. Share prices jumped 30% in 2013 alone and house prices rose 13% in that year. The resulting rise in wealth increased consumer spending, leading to higher GDP and lower unemployment. But excessively low interest rates have caused investors and lenders, in their reach for yield, to accept excessive risks…. As the Fed normalizes interest rates these prices will fall. It is difficult to know if this will cause widespread financial and economic declines like those seen in 2008. But the persistence of very low interest rates contributes to that systemic risk and to the possibility of economic instability….

Moreover, the Fed is planning a path for short-term interest rates that is likely to raise the rate of inflation too rapidly…. The danger is that very low interest rates in this environment would lead to a higher rate of inflation and higher long-term rates. The Fed could prevent that faster rise in inflation by increasing the federal-funds rate more rapidly this year and next. Fed officials also make the case that stimulating the economy by continued monetary ease is desirable as protection against a possible negative shock—such as a sharp fall in exports or in construction—that could push the economy into a new recession. That strategy involves unnecessary risks of financial instability. There are alternative tax and spending policies that could provide a safer way to maintain aggregate demand if there is a negative shock. The Fed needs to recognize that its employment goals have essentially been reached and that the inflation rate will reach its target of 2% in the foreseeable future. The economy would be better served by a more rapid normalization of short-term interest rates.

Must-read: Narayana Kocherlakota: “Information in Inflation Breakevens about Fed Credibility”

Posted on by Brad DeLong
Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed

Must-Read: Narayana Kocherlakota: Information in Inflation Breakevens about Fed Credibility: “The ten-year breakeven refers to the difference in yields between a standard (nominal) 10-year Treasury and an inflation-protected 10-year Treasury (called TIPS)…

…The five-year breakeven is the same thing, except that it’s over five years…. The five-year five-year forward breakeven is defined to be the difference between the 10-year breakeven and the five-year breakeven… shaped by beliefs about inflation over a five year horizon that starts five years from now… conceptually… the sum of… 1. investors’ best forecast about what inflation will average 5 to 10 years from now, [and] 2. the inflation risk premium over a horizon five to ten years from now…. My own assessment is that both components have declined. But my main point will be a decline in either component is a troubling signal about FOMC credibility.  

It is well-understood why a decline in the first component should be seen as problematic for FOMC credibility. The FOMC has pledged to deliver 2% inflation over the long run…. A decline in the first component of breakevens signals a decline in this form of credibility…. A decline in the inflation risk premium means that investors… increasingly see standard Treasuries as being a better hedge…. But Treasuries are only a better hedge than TIPs against macroeconomic risk if inflation turns out to be low when economic activity turns out to be low…. [Thus] a decline in the inflation risk premium… reflects investors’ assigning increasing probability to a scenario in which inflation is low over an extended period at the same time that employment is low….

In the world of policymaking, no signal comes without noise.  But the risks for monetary policymakers associated with a slippage in the inflation anchor are considerable.   Given these risks, I do believe that it would be wise for the Committee to be responsive to the ongoing decline in inflation breakevens by reversing course on its current tightening path.

Must-read: Barry Eichengreen: “Reforming or Deforming the Fed?”

Posted on by Brad DeLong

Must-Read: Barry Eichengreen: Reforming or Deforming the Fed?: “We have proposals by Republican candidates Ted Cruz, Rand Paul, and Mike Huckabee…

…to require the Fed to maintain a fixed dollar price of gold. To call these actual proposals is a bit generous…. [Would] the Fed… be obliged to provide gold at this price to all… as before 1933, or only to foreign governments, as between 1945 and 1971….[Could] that obligation could be suspended in an emergency, as in those earlier eras[?] More fundamentally, they fail to… clarify why the Fed should focus on stabilizing the price of this particular metal, rather than on the price of a representative basket of goods and services. Indeed, if the critics focused on the latter, they could give their proposal a name. They could call it ‘inflation targeting.’