Tag: Monetary Policy

Must-Read Pre-Liftoff Lollapalooza: Tim Duy: Makes You Wonder What The Fed Is Thinking

Posted on by Brad DeLong

Must-Read Pre-Liftoff Lollapalooza: The extremely-thoughtful Tim Duy is… genuinely frightened…

Tim Duy: Makes You Wonder What The Fed Is Thinking: “My interest tonight is a pair of Wall Street Journal articles that together call into question…

…the wisdom of the Fed’s expected decision… inflation, or lack thereof, by Josh  Zumbrun… the growing consensus among economists that the Fed faces the zero bound again in less than five years…. Fed officials expect the terminal fed funds rate in the 3.3-3.8 percent range (central tendency) while the 2001-03 easing was 5.5 percentage points and the 1990-92 easing was 5.0 percentage points. You see of course how the math works….

The policy risks are asymmetric. They can always raise rates, but the room to lower is limited by the zero bound. But that understates the asymmetry. You should also include the asymmetry of risks around the inflation forecast. The Fed has repeated under over-forecasted inflation. It seems like they should also see an asymmetry in the inflation forecast that compounds the policy response asymmetry. Asymmetries squared. Given all of these asymmetries, I would think the Fed should continue to stand pat until they understand better the inflation dynamics. The Fed thinks otherwise. Why would Federal Reserve Chair Janet Yellen allows the Fed to be pulled in such a direction? Partly to appease the Fed hawks. And then… Yellen is wedded to the theory that the sooner the Fed begins normalizing policy, the more likely the Fed can avoid a recession-inducing sharp rise in rates. She follows up this concern with: “Moreover, holding the federal funds rate at its current level for too long could also encourage excessive risk-taking and thus undermine financial stability.”

This is what Mark Dow calls ‘avalanche patrol’… becomes a story of a Fed caught between a world in which the policy necessary to meet their inflation target is inconsistent with financial stability…. And my sense is that Yellen feels the best way to slip through those cracks is early and gentle tightening….

The Fed likely only gets one chance to lift-off from the zero bound on a sustained basis…. They [sh]ould wait until they were absolutely sure inflation was coming. Even more so given the poor performance of their inflation forecasts. But the Fed thinks there is now more danger in waiting than moving. And so into the darkness we go.

Must-Read Pre-Liftoff Lollapalooza: Jared Bernstein: Will Inflation Really Snap Back Once “Temporary Factors” Abate?

Posted on by Brad DeLong

Must-Read Pre-Liftoff Lollapalooza: Even if there were no model uncertainty, the asymmetry of the situation would lead a rational optimizing policymaker to keep interest rates at zero until the need for liftoff was undeniable. With model uncertainty, a rational optimizing policymaker would keep interest rates at zero for considerably longer…

Jared Bernstein: Will Inflation Really Snap Back Once “Temporary Factors” Abate?: “I noted the Fed’s theory of the case as to why inflation isn’t accelerating…

…temporary factors, including low, low oil prices and the strong dollar, are blocking the usual signal…. [But] it’s not just that inflation isn’t picking up as output gaps close and unemployment falls. Inflation didn’t fall as much as expected when such activity gaps were much wider…. Blanchard, Cerutti, and Summers… a flat slope of the Phillips curve… ain’t exactly a new development…. The slope of the PC has been low for a decade… about 0.2, well below it’s historical levels in the 70s and 80s…. Larry Ball, in commenting on BCS, runs particularly transparent models and finds more stable, significant PC coefficients (though they are of the same magnitude as BCS)…. However, [he] do[es] not give much support to the view that the flat PC is temporarily low as a function of a few unique factors…. Inflation hawks, pull in your talons!

Must-Read Pre-Liftoff Lollapalooza: Jon Faust: Liftoff? And then…

Posted on by Brad DeLong

Must-Read Pre-Liftoff Lollapalooza: I find this from Jon Faust inadequate, mostly because if its failure to make even a bow in the direction of asymmetric risks. If the hawk scenario comes true, the Federal Reserve can then raise interest rates quickly to get to where it wants to be. If the dove scenario comes true, the Federal Reserve cannot lower interest rates far below zero and so cannot get to where it wants to be. Thus liftoff should wait until it is pretty damn clear that the hawk scenario is overwhelmingly more likely. And it is not overwhelmingly more likely now. The Fed is making a mistake. And Faust’s on-the-one-hand-on-the-other-hand without acknowledging the asymmetry in the situation…

Jon Faust: Liftoff? And then…: “The Fed’s policy projections going into the December FOMC last year showed a year-end 2015 median federal funds rate…

…of about 1.5 percent, with a range from zero to three percent. And the situation is almost the same this year: the funds rate is zero entering the December meeting, and the projections for year-end 2016 have a span of approximately zero to three percent, with a median just below 1.5 percent. More Groundhog Day than Christmas…. For the hawkish faction, the extraordinary accommodation that has long been in place is causing–or at least planting the seeds for–distortions and excesses, including inflation. In the main dovish scenario… any adverse development might be sufficient to push the economy into a pernicious deflation and require the Fed to dip deeper into the bag of unconventional tools…. By raising the federal funds rate now, the FOMC may counter some distortions and will make future rate increases less fraught should the hawk’s scenario come to pass. But raising rates inevitably entails some drag on Main Street…. What I’d most like for the holidays, of course, is for those projections of solid growth and accelerating inflation to come true, in which case we’ll all be toasting better times and more normal interest rates next holiday season.

Must-Read Pre-Liftoff Lollapalooza: Harriett Torry and Jon Hilsenrath: Lesson for Fed: Higher Interest Rates Haven’t Been Sticking

Posted on by Brad DeLong

Must-Read Pre-Liftoff Lollapalooza: Why does the Fed think that it will be different, and not desperately want to lower interest rates in two years, but be scared to admit it made a mistake? Much better to wait until you are sure that you will not have to return to zero in short order. Yet, somehow, that asymmetric-risks argument does not have purchase within the Fed…

Harriett Torry and Jon Hilsenrath: Lesson for Fed: Higher Interest Rates Haven’t Been Sticking: “Central banks in the eurozone, Sweden, Israel, Canada, South Korea, Australia, Chile and beyond…

…have tried to raise rates in recent years, only to reduce them again as their economies stumbled. Central-bank U-turns on rates in recent years had different causes and consequences…. The Bank of Israel, under Stanley Fischer, who is now the Fed’s vice chairman, was among the first to move. It started raising rates from 0.5% in September 2009, just as a global recovery took hold, pushing them up to 3.25% by May 2011. With Israel’s economy buffeted by Europe’s downturn and global inflation slowing, Mr. Fischer’s successor, Karnit Flug, has since pushed rates back down to 0.10%. Two central banks that haven’t raised rates since the crisis—the Fed and the Bank of England—have enjoyed stronger recoveries than others. Their patience might pay off. Their economies might now finally be healthy enough to bear higher rates…. “Tightening too early can have very large costs, as it has had in the Swedish case,” said Lars Svensson, who quit as Riksbank deputy governor in 2013 in protest at the bank’s policy decisions…

Must-Read Pre-Liftoff Lollapalooza: Robin Wigglesworth: How the US Federal Reserve Intends to Raise Rates

Posted on by Brad DeLong

Must-Read Pre-Liftoff Lollapalooza: Yes, the Federal Reserve has the tools it needs in order to liftoff interest rates. But how will it use its tools? How it is going to manipulate interest on reserves, the monetary base, reserve requirements, and the amount of duration risk it has taken off the private market will be very interesting to watch…

Robin Wigglesworth: How the US Federal Reserve Intends to Raise Rates: “Buckle up. On Wednesday, the Federal Reserve is expected to raise interest rates for the first time since 2006…

…and reversing the past seven years of extraordinary monetary policy looms as being an experimental, possibly bumpy lift-off. When economists talk about the Fed’s official borrowing rate, they refer to the Fed funds rate, which since late 2008 has been confined to a corridor between zero and 0.25 per cent…. The Fed funds rate sets a benchmark for the cost of credit that ripples through markets and guides borrowing costs for everyone in the US (and much further afield)….

Acting as a floor for now at 0.05 per cent, the overnight reverse repo programme, or Overnight RRP, is primarily aimed at money market funds, and is expected to do much of the heavy lifting. In a typical RRP the Fed’s market desk sells a Treasury bond from its portfolio to a money-market fund and agrees to buy it back the next day at a certain price, a process known as ‘repo’, short for repurchase. In practice, the central bank’s balance sheet does not shrink, but this sets a benchmark for cash interest rates paid by the Fed itself. These RRP operations will happen every business day between 12.45pm and 1.15pm in New York…. Currently the RRP programme is capped at $300bn to avoid the Fed’s operations distorting money markets, but economists expect its size to have to be expanded… to be enlarged to $750bn to $1tn, or perhaps be unlimited in size to ensure a smooth lift-off….

Some economists argue that the Fed should look for a new mechanism to set US interest rates, since the Fed funds market is so small and thinly traded nowadays. There used to be close to $350bn a day that changed hands before the crisis, but daily volumes are now roughly $50bn a day. Some are therefore urging a radical rethink. Even Simon Potter, head of the New York Fed’s markets division — and thus the man that will have to implement the central bank’s decision — hinted that this may be needed…. Fed officials are confident they have the tools to raise the Fed funds rate to roughly where they want it, and while the recent rash of market abnormalities has raised eyebrows, most expect other important interest rates to rise in conjunction. But it could still be a bumpy take-off.

Must-Read Pre-Liftoff Lollapalooza: Financial Times: The Federal Reserve May Be Jumping the Gun

Posted on by Brad DeLong

Must-Read Pre-Liftoff Lollapalooza: The Financial Times editors argue that the Federal Reserve is making a mistake with tomorrow’s liftoff of interest rates.

They are right.

The only wrong thing they say that I see is their statement that “it would probably be more disruptive if the Fed sat on its hands”. The Fed is likely to have to break its policy commitments at some point because its policy commitments are dangerous and faulty. Given that, the least disruptive moment to break them is now. Breaking them later will only be more disruptive.

Financial Times: The Federal Reserve May Be Jumping the Gun: “Just because it seems inevitable does not mean it is a good idea…

…The Federal Reserve’s Open Market Committee, which on Wednesday announces its decision on interest rates, has widely telegraphed that it will raise borrowing costs for the first time since 2006 after seven years on hold. Janet Yellen, the Fed chair, has apparently overcome opposition from some more dovish members on the central bank’s governing board…. The Fed will, on balance, be moving too early…. The value of waiting outweighs that of acting now…. Year after year, the Fed… has overestimated inflationary pressure, suggesting either a miscalculation about the economy’s output capacity or something even more fundamental going wrong. While American unemployment is low… the US’s number of economically inactive people [is high]… discouraged workers who have left the labour market never to return, or they may be people who would start looking for a job if the offers were there…. With consumer price inflation having undershot its informal 2 per cent target for so long, there is a good case for remaining behind the curve until it is quite clear which way the curve is moving.

Having come this far in signalling that interest rates are about to rise, it would probably be more disruptive if the Fed sat on its hands on Wednesday than if it moved…. Yet at the very least it should do its utmost to make clear that this is not the first in a series of preordained interest rate rises. In that sense, too, it needs to make a break with historical precedent in which the first US rate rise is reliably followed by a string of further moves. If it does raise rates, the Fed should signal that it stands ready to reverse course…. The central bank should leave interest rates on hold this week.

Must-Read: Tim Duy: And That’s a Wrap

Posted on by Brad DeLong

Must-Read: The principal question the Federal Reserve should be discussing right now is: When the next adverse macro economic shock comes, the Fed needs to be in a position to cut the federal funds rate by up to 500 basis points. What should we be doing now to create an economy as fast as possible that is strong enough to allow for such a federal funds rate? Yet I am seeing no chatter around this question at all. Perhaps the silence is simply a consensus of despair?

Tim Duy: And That’s a Wrap: “The service sector number continues to bounce around a respectable range…

…A bit less so for… manufacturing…. The Fed is betting that a.) this data is noisy and b.) that the service sector is much, much more important to the economy than manufacturing and c.) some of the weakness in manufacturing will be alleviated as the oil/gas drilling and export drag soften over the next year in relative terms. Speaking of exports, the trade report came with a larger-than-expected deficit, a factor that added another hit to GDP nowcasting…. The Atlanta Federal Reserve Bank’s GDPnow indicator is currently tracking at 1.5%…. No fear, though… Janet Yellen… highlighted total real private domestic final purchases as the number to watch:

Growth this year has been held down by weak net exports…. By contrast, total real private domestic final purchases (PDFP)… has increased at an annual rate of 3 percent this year….

That sent everyone to FRED (the code is LB0000031Q020SBEA)…. When they search through the data for the happy numbers, you know they are looking to hike. Indeed, the clear takeaway from Yellen’s speech was that a rate hike was coming….

We are now well beyond the issue of the first rate hike. The new questions are how gradual will ‘gradual’ be and when will the Fed begin widening down the balance sheet…. Federal Reserve Governor Lyle Brainard argued to hold the balance sheet at current levels until interest rates are sufficient to provide a cushion for the next recession…. Brainard knows she has lost the battle to forestall the first rate hike further and has now chosen to stake out a position on one of the next big issues…. The pace of subsequent tightening, the normalization–or not–of the balance sheet, and the countdown to the next easing are all issues now on the table.

Must-Read: Larry Summers: Central Bankers Do Not Have as Many Tools as They Think

Posted on by Brad DeLong

Must-Read: As John Maynard Keynes famously wrote, a government dedicated to producing a high-pressure economy is needed to enable entrepreneurship, enterprise, and growth. A government that does not only fail to work to generate high-pressure now, but also lacks a plan for fighting the next recession, is a government that drives the Confidence Fairy far away indeed:

Lawrence Summers: Central Bankers do Not Have as Many Tools as They Think: “It is agreed that the ‘neutral’ interest rate…

…has declined substantially and is likely to be lower in the future than in the past throughout the industrial world because of a growing relative abundance of savings relative to investment…. Neutral real interest rates may well rise over the next few years…. This is what many expect…. [But a] number of considerations make me doubt the US economy’s capacity to absorb significant increases in real rates over the next few years… leav[ing] me far from confident that there is substantial scope for tightening in the US and there is probably even less scope in other parts of the industrialised world. The fact that central banks in countries, including Europe, Sweden and Israel, where rates were zero found themselves reversing course after raising rates adds to the cause for concern.

But there is a more profound worry…. Once a recovery is mature the odds of it ending within two years are about half…. When recession comes it is necessary to cut rates more than 300 basis points. I agree with the market that the odds are the Fed will not be able to raise rates 100 basis points a year without threatening to undermine recovery…. [Thus] the chances are very high that recession will come before there is room to cut rates enough to offset it. The knowledge that this is the case must surely reduce confidence….

The unresolved question that will hang over the economy is how policy can delay and ultimately contain the next recession. It demands urgent attention from fiscal as well as monetary policymakers.

The Keynes quote, from the General Theory:

If effective demand is deficient… the individual enterpriser who seeks to bring… resources into action is operating with the odds loaded against him. The game of hazard which he plays is furnished with many zeros…. Hitherto the increment to the world’s wealth has fallen short of the aggregate of positive individual savings; and the different eras been made up by the losses of those whose courage and initiative have not been supplemented by exceptional skill or unusual goo fortune. But if effective demand is adequate, average skill and average good fortune will be enough….

It is certain that the world will not much longer tolerate the unemployment which, apart from brief intervals of excitement, is associated… with present-day capitalistic individualism. But it may be possible by a right analysis of the problem to cure the disease while preserving efficiency and freedom…

Marginal Notes on Janet Yellen’s Footnote 14

Posted on by Brad DeLong

The answer to the last point Janet Yellen makes in her famous Footnote 14 is:

  • If is indeed the case that targeting an inflation rate of 4%/year “stretch[es] the meaning of ‘stable prices’ in the Federal Reserve Act”, then targeting an inflation rate of 2%/year does not stretch the meaning of but rather eliminates the “maximum employment” objective in the Federal Reserve Act. Congress has left the Federal Reserve freedom to deal as best as it can with an imperfect world in which all of the statutory objectives cannot be achieved perfectly. It is the Fed’s choice how to balance.

The answers to her other points are:

  • If it is indeed that case that “changing the FOMC’s long-run inflation objective would risk calling into question the FOMC’s commitment to stabilizing inflation at any level…” failing to change does not risk but does call into question the FOMC’s commitment to maximum employment and to financial stability as well.

  • If it is indeed that case that “it is not obvious that a modestly higher target rate of inflation would have greatly increased the Federal Reserve’s ability to support real activity…” it is still the case that a higher inflation target allows the Federal Reserve to achieve the same degree of monetary ease measured in terms of real interest rates without putting nearly as much adverse and unfortunate pressure on the commercial banking system’s finances. A Federal Reserve that seeks–as it should–to both use monetary policy to support increased real activity as well as avoid putting undue destructive pressure on the commercial banking sector should welcome the additional sea room provided by a higher inflation target, even if the benefits from lower real interest rates in terms of supporting real activity are only modest.

  • If it is indeed the case that the Federal Reserve is confident that it can “use large-scale asset purchases and other unconventional tools to mitigate the costs arising from the ELB constraint…” the Federal Reserve is unique in being the only organization of economists that possesses such confidence.

  • And, last, it is indeed the case that the “earlier analyses of ELB costs” that underpinned the decision to adopt 2%/year as an inflation target “significantly underestimated the likelihood of severe recessions and slow recoveries of the sort recently experienced…” A policy choice substantially based on the wrong assumptions is highly likely to be exchanged at some point for one based on the right assumptions. And the sooner the shift is made, the better–both in terms of avoiding the costs of having bad policy, and avoiding the costs of uncertainty and lack of credibility generated by claiming a credible commitment to permanently pursue a not-very-credible policy.

Janet Yellen: Footnote 14: “Blanchard, Dell’Ariccia and Mauro (2010), among others…

…have recently suggested that central banks should consider raising their inflation targets, on the grounds that conditions since the financial crisis have demonstrated that monetary policy is more constrained by the effective lower bound (ELB) on nominal interest rates than was originally estimated. Ball (2013), for example, has proposed 4 percent as a more appropriate target for the FOMC. While it is certainly true that earlier analyses of ELB costs significantly underestimated the likelihood of severe recessions and slow recoveries of the sort recently experienced in the United States and elsewhere (see Chung and others, 2012), it is also the case that these analyses did not take into account central banks’ ability to use large-scale asset purchases and other unconventional tools to mitigate the costs arising from the ELB constraint.

In addition, it is not obvious that a modestly higher target rate of inflation would have greatly increased the Federal Reserve’s ability to support real activity in the special conditions that prevailed in the wake of the financial crisis, when some of the channels through which lower interest rates stimulate aggregate spending, such as housing construction, were probably attenuated. Beyond these tactical considerations, however, changing the FOMC’s long-run inflation objective would risk calling into question the FOMC’s commitment to stabilizing inflation at any level because it might lead people to suspect that the target could be changed opportunistically in the future. If so, then the key benefits of stable inflation expectations discussed below–an increased ability of monetary policy to fight economic downturns without sacrificing price stability–might be lost.

Moreover, if the purpose of a higher inflation target is to increase the ability of central banks to deal with the severe recessions that follow financial crises, then a better strategic approach might be to rely on more vigorous supervisory and macroprudential policies to reduce the likelihood of such events. Finally, targeting inflation in the vicinity of 4 percent or higher would stretch the meaning of ‘stable prices’ in the Federal Reserve Act…

Must-Read: Paul Krugman: The Not-So-Bad Economy

Posted on by Brad DeLong

**Must-Read: Mark Thoma sends us to Paul Krugman on the Fed’s forthcoming likely policy mistake with respect to this month’s interest-rate liftoff. My take: there is one chance in two that in June of 2018 the Federal Reserve will be wishing it had not raised interest rates in December 2015–it is, of course, unable to effectively catch up in policy terms:

Paul Krugman: The Not-So-Bad Economy: “I believe that the Fed is making a mistake…

…But the fact that hiking rates is even halfway defensible is a sign that the U.S. economy isn’t doing too badly. So what did we do right?… The Fed and the White House have mostly worried about the right things. (Congress, not so much.) Their actions fell far short of what should have been done…. But at least they avoided taking destructive steps to fight phantoms…. Meanwhile, on the other side of the Atlantic, the European Central Bank gave in to inflation panic, raising interest rates twice in 2011–and in so doing helped push the euro area into a double-dip recession….

Unfortunately, the U.S. ended up doing a fair bit of austerity too, partly driven by conservative state governments, partly imposed by Republicans in Congress via blackmail over the federal debt ceiling. But the Obama administration at least tried to limit the damage.
The result of these not-so-bad policies is today’s not-so-bad economy…. Things could be worse.

And they may indeed get worse, which is why the Fed’s likely rate hike will be a mistake…. I’m not sure why this [asymmetric risks] argument, which a number of economists are making, isn’t getting much traction at the Fed. I suspect, however, that officials have been worn down by incessant criticism of their policies, and want to throw the critics a bone. But those critics have been wrong every step of the way. Why start taking them seriously now?