Relevant and even prescient commentary on news, politics and the economy.

The Other Rule

Brad DeLong’s famous rule (Originally: “If you think Paul Krugman must be wrong, you severely overestimated Niall Ferguson“) needs a corollary.

If Olivier Blanchard says your macroeconomic policy doesn’t work, and that you should double your inflation target to make it reasonable, it’s worth trying:

The International Monetary Fund’s top economist, Olivier Blanchard, says central bankers should consider aiming for a higher inflation rate than they do currently to lessen the chances of repeating the recent severe recession.

…[T]he global economic downturn revealed flaws in macroeconomic policy, especially the reliance primarily on interest rates to manage economies. Although Japan had fallen into a decade-long funk despite low inflation and low interest rates, “most people convinced themselves that the Japanese didn’t know what they were doing,” Mr. Blanchard said in an interview.

In particular, [Mr. Blanchard’s new paper with two other IMF economists, Giovanni Dell’Ariccia and Paolo Mauro] suggests shooting for a higher-level inflation in “normal time in order to increase the room for monetary policy to react to such shocks.” Central banks may want to target 4% inflation, rather than the 2% target that most central banks now try to achieve, the IMF paper says.

At a 4% inflation rate, Mr. Blanchard says, short-term interest rates in placid economies likely would be around 6% to 7%, giving central bankers far more room to cut rates before they get near zero, after which it is nearly impossible to cut short-term rates further.

None of the major Macro work ever done, from Barro forward, has ever found damage to economic growth from 4% inflation.

The paper is available here (PDF).

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The One Sentence Everyone Needs to Read and Understand

Bruce Bartlett:

The Fed has talked openly about new procedures to soak up the bank reserves it has created even as those reserves remain largely idle and unlent.

You don’t get inflation if there is no money multiplier in play. So long as the banks are just holding the cash, worries about monetary policy leading to inflation are at best a shibboleth.

(via Brad DeLong)

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Today in "Economists Are NOT Totally Clueless" (Interlude; Part 2 of 3 or 4)

Tyler Cowen can count:

In sum, maybe three percent expected inflation conflicts with the desire to rapidly recapitalize banks through maintaining a wide interest rate spread. Maybe we need that zero nominal short rate or at least the Fed thinks we do….

I also regard this as a somewhat gruesome hypothesis. It means that “Main Street” is paying for “Wall Street” (forgive me the use of those awful terms) in at least two ways: high unemployment and inability to earn much on one’s savings….

The term structure also implies that the market is expecting rising short rates, so if the bank mess isn’t cleaned up soon, heaven forbid. The spread, as a means of restoring bank profitability, won’t last forever.

And Ryan Avent (via Brad DeLong) points out the next piece of that puzzle:

[T]he Fed’s commitment to undo its interventions is already having an effect. In expectation of more of these moves to come (as well as, perhaps, increases in interest rates) markets have been bidding up the dollar, which has busily appreciated during the month of December. That, in turn, will deprive the American economy of a potential source of demand—growth in consumption of American exports thanks to the effect of a weak dollar.

More bluntly, we’re seeing a move toward contractionary monetary policy at a time when unemployment is at 10%. Funny that.

I can’t think of a scarier way to end the year. Sorry about that. Best wishes for 2010—we’re all going to need them.

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What the Frock was the reason for TARP, TALF, etc. then?

Rahm Emanuel accidentally Tells the Truth and Shames the Devil:

“We have to get them off the sidelines and get them to play a more active role in our economic recovery,” Rahm Emanuel, the White House chief of staff, said on Sunday. “They play an essential role in helping the economy grow.”

Gosh, the Administration has noticed that the banks have been “on the sidelines” (read: reaping windfall profits from tax dollars and funneling those funds to themselves). Guess

Brad DeLong probably will be next. (At least, he seems savable.)

Subtle hint to the Chicago School (who are not savable): the reason we don’t believe Monetary Policy works is that it hasn’t worked.

(h/t Lance Mannion’s Twitter feed)

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Inflation Detour II: Crisis and Recovery across Great "Fluctuations"

We are now almost 24 months into the Great Recession. While many expect NBER will eventually say that The Great Recession ended several months ago, they have not yet.

By contrast, the recession that began The Great Depression, per NBER, lasted 43 months. It seems only fair to compare the two, so I trust I can be forgiven for not yet having declared The Great Recession over.

One of the problems is that of official government data. Many of the statistics we now consider “standard” were first tracked as part of the government funding and jobs created by FDR’s Administration. (The irony of multiple economists and idiots arguing that the data shows that those programs should never have happened should not be lost on the reader.)

For an examination of Wall Street, though, reasonable proxy data is available. With some issues noted, we can use the change in Real Prices as a proxy. Comparing the two periods produces:

Fairly comparable. The market had a better six months prior to the October 1929 crash, which is rather neutralized by the drop about five months after the first Depression Recession begins, which is steeper than the comparable drop in the current period.

In spite of all the support for the banking system, the recovery is fairly comparable to the one from the Great Depression—at least so far.

Below the fold, let’s look at Main Street.

As noted above, most of the data required for measuring Main Street—most especially a reliable measure of unemployment—is not available publicly. (If anyone wants to provide me with a copy of the Haver Analytics data, for instance, I won’t complain. Meanwhile, see this post at CR for a graphic of that data from the Depression Era.)

So let’s take another approach. Accept, for the sake of discussion, the traditional Republican argument that inflation reduces the ability of Main Street to grow business, borrow money, and generally live.

If we therefore take the inverse of the Annual Inflation Rate, we can see the “gain” the consumer makes. (Note that, in most periods, the consumer is deemed to have lost. Reality may be different, as smoothing hides may variances. But that is always true, and likely always shall be.)

So let’s look at how Main Street fares, then and now:

Judging strictly by the two periods, it appears that Main Street did significantly better—speaking in terms of earning power—during the time leading up to and beginning the Great Depression than it has during the Great Recession. Indeed, the two paths track each other rather well.

It would appear—information that will surprise few other than perhaps Larry Summers and Tim Geithner—that all of the efforts of the Federal Reserve Board and the U.S. Treasury have had no positive effect on Main Street, leaving its purchasing power significantly lower than the same period of the Great Depression.

Probably more on this on a future rock. Comments and suggestions are rather welcome.

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I Be Officially Right of Center Now?

As I am arguing on the same side as Henry Kaufman, and against the kind-hearted Mark Thoma, does the phrase “left-of-center” at the top of this blog have as much Memory Meaning as the Suzanne Vega song from Pretty in Pink?


During the Greenspan years (1987-2006), the Fed clearly failed to recognize the significance of the many structural changes in the financial markets—such as the rapid growth of securitization and derivatives—on economic and financial behavior and thus for its monetary policy. The Fed also failed to foresee how the 1999 repeal of the Glass-Steagall Act, which had separated commercial from investment banking since 1933, would sharply accelerate financial concentration through mergers and acquisitions and thus contribute to the “too-big-to-fail” phenomenon.


The hope is that an independent Fed can overcome the temptation to use monetary policy to influence elections, and also overcome the temptation to monetize the debt, and that it will do what’s best for the economy in the long-run rather than adopting the policy that maximizes the chances of politicians being reelected.

On of those people lives in reality. The other, apparently, is a good econometrician.

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Lender of Only Resort?

Ken Houghton, having realized there is still a Commercial Paper market, looks at one implication of it.

One of the things that gets ignored in all the fussing about government debt is how small it is by comparison to corporate debt.

The shortest-term debt, Commercial Paper, can be very interesting. With a maturity that is by definition nine months (270 days) or less—and often for financial institutions overnight, for others rolled over weekly—Commercial Paper can be the lifeblood of an institution.

For Financial Institutions, it’s even more extreme. The prime example is Drexel Burnham Lambert, which failed in large part due to its CP being downgraded, leaving it to turn to the Fed as its Lender of Last Resort. Wikipedia tells the story, using James B. Stewart’s Den of Thieves as its source:

Unfortunately for Drexel, one of first hostile deals came back to haunt it at this point. Unocal’s investment bank at the time of Pickens’ raid on it was the establishment firm of Dillon, Read—and its former chairman, Nicholas F. Brady, was now Secretary of the Treasury. Brady had never forgiven Drexel for its role in the Unocal deal, and would not even consider signing off on a bailout. Accordingly, he, the SEC, the NYSE and the Fed strongly advised Joseph to file for bankruptcy. Later the next day, Drexel officially filed for Chapter 11 bankruptcy protection.

Financial Institutions live and die by their CP sales. Or at least they did before the Greenspan Put. Here’s a chart of Domestic Financial CP Outstanding and Excessive Reserves over the past twelvemonth:

It certainly appears that the banks are using their “excess reserves” to make up for an inability to issue Commercial Paper in the amounts they did before. Perhaps the Fed Governors who are talking up recovery (h/t David Wessel’s Twitter feed) should wait until the debt markets strengthen a bit as well.

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The Fed’s attempt to assuage inflation fears that don’t need assuaging

by Rebecca

There is no shortage of speeches by US central bankers these days. The following is an excerpt from a NY Times article that highlights the debate among key Fed officials about the speed and method of stimulus withdrawal once the decision to exit has been made:

Mr. Bernanke and other officials want to see evidence that the economic recovery is self-sustaining, strong enough to generate jobs without the crutch of extremely low interest rates.

But Mr. Warsh, as a Fed governor, has begun arguing that the central bank cannot afford to wait for irrefutable evidence of a solid expansion. Mr. Warsh recently argued that the Fed should take at least some of its cue from stock prices and other financial indicators, which turn around earlier and more quickly than the underlying economy.

Mr. Warsh and some other Fed officials also argue that when the time does come to change gears, the central bank may have to raise rates almost as fast as it slashed them when the crisis began.

We are far from seeing “irrefutable evidence of a solid expansion”. This debate is likely confusing the public more than anything else, or as my title puts it: the Fed is attempting to assuage inflation fears that don’t need assuaging. There is simply no measured inflation concern at this time, not even over the next ten years.

The chart illustrates the 30-day moving average of expected inflation for the next 5, 7, 10, and 20 years. Expected inflation, roughly speaking, is the nominal Treasury Security rate minus the associated Treasury Inflation-Protected Security (TIPS) rate, the real rate of return or the break-even rate. Technically this break-even rate is not a perfect measure of inflation expectations; but it’s close and measured daily (see this SF Fed article for more on TIPS).

The “inflation problem” is way overstated in the media. Roughly speaking, markets have priced in just 1.3% annual inflation each year over the next five years, 2% over the next ten years.

By giving speech after speech (Bernanke’s latest), the Fed is attempting to keep inflation expectations in check. However, the Fed is walking a fine line between alleviating concerns about long-term inflation prospects and overemphasizing the short-term disinflation (deflation) risks.

Rebecca Wilder

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The Fed called a mulligan

by Rebecca

Ex post, it is obvious that the Fed was way too tight in the second half of 2008. To be sure, the FOMC was actively engaged in its standard easing policies; however, the Fed got the Treasury to aid in its sterilization efforts, and later the Fed fast-tracked the interest on reserves (IOR) program (originally set for an October 1, 2011 start). The Fed was misguided in its sterilization efforts, as aggregate demand was already collapsing.

Something was afoot well before the collapse of Lehman Brothers. David Beckworth at Macro and Other Market Musings backs up Scott Sumner’s (TheMoneyIllusion blog) theories with an intuitive analysis using the equation of exchange (MV = PY):

Below is a table with the results in annualized values (Click to enlarge):

This table confirms what we saw in the levels: a sharp decline in velocity appears to be the main contributor to the collapse in nominal spending in late 2008 and early 2009 as changes in the monetary base and the money multiplier largely offset each other.

… (And a little later)

Unfortunately, though, it appears the Fed was so focused on preventing its credit easing program from destabilizing the money supply that it overlooked, or least underestimated, developments with real money demand (i.e. velocity). As a consequence, nominal spending crashed.

This line research essentially posits that the Fed got it terribly wrong in the second half of 2008. As David shows in the table above, the velocity of money was dropping with households clinging to cash under heightened economic uncertainty.

If this theory is true, then one could view the $300 billion Treasury buyback program (see the NY Fed’s Q&A here) as the Fed’s equivalent of “calling a mulligan” in an attempt to take back its sterilization efforts in 2008.

The $300 billion buyback of Treasuries will restock about 75% of the Fed’s Treasury holdings (focused in notes and bonds rather than bills, but there is a contemporaneous objective to pull long rates down) that dwindled previous to the onset of the SFP account. Unfortunately, though, it was already too late.

(The Treasury issued short-term notes and deposited the proceeds with the Fed in order to aid in the Fed’s sterilization efforts – see an old post of mine for a more thorough explanation of the SFP, or the Supplementary Financing Program.)

Another event recently occurred that would support the view that the FOMC is backpedaling: the Treasury’s Supplementary Financing Program (SFP) is going bye bye.

The Treasury started this week to unwind its account with the Fed (the SFP listed on the liabilities side of the Fed balance sheet). This is almost surely going to end up as excess reserve balances in the banking institution, as the Fed is unlikely to sterilize these flows. (Note that one could see if the Fed was sterilizing the flows if its Treasury holdings started to fall again.)

I guess that the real question is: where would we be now if the Fed had pushed harder on the money supply in 2008? I imagine that Angry Bear readers have many thoughts on this.

Rebecca Wilder

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Draining liquidity from the banking system

by Rebecca
(cross posted at Newsneconomics)

Prof. Jim Hamilton at Econbrowser (thanks Mark Thoma for the link) addresses one of the Fed’s standard methods of draining liquidity from the banking system: reverse repurchase agreements. Basically, the Fed will transfer some of its assets to the banking system via short-term loans taken out with its Primary Dealers, presumably offering standard (Treasuries) and less standard (MBS or agency bonds) assets as collateral.

Reverse repurchase agreements simply slosh around the assets (MBS, agencies, and Treasuries) between the Fed and the Primary Dealers, rather than removing the assets from the Fed’s balance sheet permanently. Eventually, though, the Fed must sell the securities outright onto the open market – we are far, far from that!

This is all hot air for now. How can the Fed soak up the expansionary liquidity, let alone unwind $1 trillion in assets, when the banking system is still shedding pounds?

The Fed is considering another route, too: conducting the same repurchase agreements with the money-market mutual fund industry in tandem. An excerpt from the FT:

The Federal Reserve is looking to team up with the money-market mutual fund industry as part of its strategy to ensure that its unconventional policies to stimulate the economy do not produce a bout of post-crisis inflation.

The central bank envisages eventually draining liquidity from the financial system by engaging in trades called “reverse repos” with the deep-pocketed money-market funds. In these, the Fed would pledge mortgage-backed securities and Treasuries acquired during the crisis as collateral for short-term loans from the funds.

The obvious counterparties for reverse repo deals are the Wall Street primary dealers. However, the Fed thinks they would only have balance sheet capacity to refinance about $100bn of assets. By contrast, the money-market funds have $2,500bn in assets, which means they could plausibly refinance as much as $500bn in Fed assets. Officials think there would be appetite on the part of the funds, which are under pressure from regulators and investors to stick to low-risk liquid investments.

The Fed is solely attempting to assuage inflation angst at this time; it’s still very premature to talk about an exit of expansionary policies when credit markets still crimp the stimulus that the Fed so desperately wants to get into the open market (much of the base, roughly $855 billion on September 23, 2009 and up from $2 billion in August 2008, remains on balance with the Fed in the form of “excess reserves). Just look at the crunch in the consumer credit space (chart to left).

As Prof. Hamilton suggests, the mechanisms of the reverse repos should successfully sterilize the base before it starts to become inflationary (with either the Primary Dealers and/or the Mutual Funds industry). However, one of the programs through which the Fed utilized previously to sterilize its liquidity, and to which Prof. Hamilton refers, – the Supplementary Financing Program – is unlikely to be an avenue for removing liquidity.

In fact, it’s quite the opposite. The Treasury already announced its imminent plan to liquidate the bulk of its $200 billion account with the Fed. There’s another $200 billion in excess reserves with which the Fed must contend (see my previous post here).

It’s easy to get the liquidity into the financial system. But getting it out without collapsing the economy or allowing inflation pressures to build? Well, that’s a different story.

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