August 08, 2006
Econbrowser (and hopefully Bernanke) gets it right
I continue to believe this was the right decision for the Fed, notwithstanding the concerns expressed by some such as Harvard Professor Martin Feldstein:
A soft landing is a natural aspiration for any central bank confronting an unacceptably high rate of inflation. For today's Federal Reserve, that means bringing inflation down to less than 2% without the fall in output and employment that would constitute a recession....
Although this optimistic outlook is possible, experience suggests that it is unlikely. A mild slowing of economic growth is generally not sufficient to reverse rising inflation. That generally requires a sustained period of excess capacity in product and labor markets, with GDP growth falling significantly or even turning negative.
I think Feldstein is correct that, if we want to obtain an immediate response from the monthly CPI, it may take extreme measures from the Fed to see any consequences. But I would urge that instead our policy objective should be to make sure that the average inflation rate over the next 5-10 years remains below 2-3%. And the key to achieving that is to keep money growth just a little above the average real GDP growth rate and the real interest rate above its historical average.
I believe that the alternative strategy of hammering the economy until you've brought the whole house down has, contrary to Feldstein's analysis, often been something that undermines rather than enhances the goal of price stability. The reason is that once the economy goes into a recession, the Fed becomes convinced that faster money growth and lower interest rates are the only way to get out of it. The overhang of household debt and possible real estate price collapse could make it particularly hard not to come to that same conclusion if we end up in another recession later this year. But the problem is that any such recession-fighting monetary expansion, like the one we saw in 2002-2003, can easily lay the seeds for the next round of inflation.
It's far easier to see where to draw the line and maintain the monetary discipline needed to truly curb inflation as a long-run phenomenon if we just hold steady in a position of slower but not negative GDP growth. This is exactly what the Fed is trying to aim for.
What would convince me that the current tightening hasn't gone far enough? One indicator that continues to give me some reassurance is the above graph, which plots the difference in yield between nominal 10-year Treasuries and 10-year Treasury Inflation-Protected Securities, whose coupon and redemption value are both indexed to increase with the consumer price index. This difference might be interpreted as the average inflation rate that markets are anticipating over the next 10 years, as it will be measured by the "headline CPI".
This spread did edge up slightly this spring, but the Fed's rate hikes at the May and June meetings have so far been sufficient to bring it back down around 2.6%. Perhaps we're seeing the first tentative hints of this series resuming its upward urge again now. However, if this measure of inflation expectations continues to make a significant move northward, I think you can count on more rate hikes from the Fed.
There are those who will doubtless never surrender their conviction that Ben Bernanke is in reality a bird, with the latest FOMC statement confirming him as a member of the family Columbidae. To those pundits I repeat my previous warning-- if you invest based on that misunderstanding of Bernanke, you're going to get whacked down by reality.
And for the rest of us, I acknowledge that this is a tricky balancing act. It's possible the Fed hasn't yet gone far enough, and it's possible the Fed has gone too far already. But, my fellow pessimists, let's also acknowledge the possibility that the Fed has done exactly the right thing.
It's at least a rational hope, to me.
Posted by James Hamilton at August 8, 2006 01:36 PMdigg this | reddit
My reading is a little different.
In late March, April and the first few days of May inflation expectations implied by the TIPS spread(s) were steadily rising - at which point Dr. B and other Fed Governors started speaking out in hawkish tones and the monetary pause-nics were forced into a hasty retreat. As that occurred, the 10 Yr TIPS spread dipped back under 2.60 and stayed under . . . . . . UNTIL.
Just the past week or two, as chronicled on this blog and elsewhere, the capital markets' consensus decided that the Fed was likely to pause at this meeting rather than raise by 25 bps, and behold it has happened.
I'm pretty worried about the nascent surge in the 10 Yr (and other maturities) TIP spread in response to anticipation of a Fed pause. I would expect the response to the REALITY of the Fed pause to be an acceleration of the anticipation surge. We'll see.
My sense is that Dr. B is a great academic economist with a strong following in academia; however, he's light on real-world experience and observed from a distance he seems a fair bit naive about the realities of the capital markets. With a reputation (deserved or not) as an inflation dove, Dr. B would have been better off tightening a bit much in order to establish his anti-inflation bona-fides with the capital markets' skeptics.
This will be an interesting upcoming week or two. I'd expect the bond market to be rather unhappy by the end of next week or sooner, with the stock market being a harder call. In addition to the TIPS, keep your eye on GOLD, SILVER and Dr. Copper.
Posted by: Anarchus at August 8, 2006 02:47 PM
How many of you believe that after the unemployment numbers begin posting 5s and the GDP numbers begin posting 2s (or even high 1s) that BB will find the will to restart a period of raising short rates to combat the upward drift in the inflation measures?
If he did not possess the little measure of courage requisite to take a little stand here how will he find the larger measure of courage when the conditions are far more challenging?
It seems that he possesses some sort of 'faith' that the inflation measures either will not drift up or will drift back down without any pain whatsoever.
So we have some sort of 'faith based FED' within a 'faith based Administration.'
We failed to learn the lessons of the Vietnam experience and it seems that we have failed to learn the lessons of the Arthur Burns experience.
So we will be treated to the fallout of war and stagflation once again.
Good luck to all of us.
Posted by: esb at August 8, 2006 03:04 PM
Anarchus, I love your phrase "monetary pause-nics". You're of course right about the timing. It was the fact that the Fed credibly signaled its intention to raise rates in June that actually brought the spread down.
Esb, Bernanke isn't Burns, and we're not going to see a replay of the 1970s. Just isn't going to happen. What we have here is a difference of opinion about (1) the amount of pain which will indeed be experienced as a result of measures already taken, and (2) the question as to what the Fed will do if that proves to be insufficient and the spread now moves back up as Anarchus fears.
Posted by: JDH at August 8, 2006 03:38 PM
Good call on the Fed's timing, JDH.
The future indeed looks solidly under control: the Fed possibly tightens a few more times, so-called inflation returns below 2% thereabouts, Daniel Yergin's predictions come true, and oil returns below $35. La la la.
Posted by: Thomas James at August 8, 2006 04:40 PM
Anarchus makes a good point. The capital markets seized upon a few choice words that opened the door to a pause. Since the real action in the markets happened during the "blackout" before the meeting, Bernanke and Co. had no way to get out in front of it. It's not necessarily the way they wanted it to go, but you play the hand that you're dealt. Since it was going to be a close call anyway, less is lost by pausing now than roiling the markets further.
Bernanke is not a "dove," nor does he have to prove himself to my satisfaction. I agree totally with your assessment there. I also agree with your comments on the Fed's objectives. Well put.
There was going to be a pause in either August or September. That was clear a while back. While I would have hiked one more time here, given a stronger statement, and then waited, I don't think they've set their cause back too terribly far.
But I will be watching the TIPS spread like a... um... hawk!
Posted by: William Polley at August 8, 2006 05:02 PM
There is also the possibility that the fed has already gone too far.
Posted by: vincentm at August 8, 2006 05:13 PM
Oops, left out watching the exchange rate on the USD off my list -- I suspect that gold and the dollar may a more sensitive indicator of inflation expectations and confidence in Fed Policy than the TIPS spread.
Posted by: Anarchus at August 8, 2006 05:16 PM
I find it interesting that anyone would attribute to buyers of nominal 10-yr. Tresuries a prescience any greater than is attributed to participants in the stock market.
As one who anticipates inflation to be significant in the coming decade, I cannot imagine those lending the gov't money for 10 yrs at 5% not losing money.
The Fed's task is extremely difficult because of their looseness in '97-'99 & even worse in '01-'03. The second bout of money creation has induced a very high level of indepbtedness that makes the present tightening more painful.
Later, when foreigners decide they have enough US$ & US debt, the Fed's job gets harder. When the boomers start retiring in mass, it gets harder yet.
Posted by: algernon at August 8, 2006 08:02 PM
JDH (and others):
For those of you who have WSJ online or print subscriptions (and I assume that is all or most of you), I suggust that you read the 9 August 2006 lead editorial re: BB and his FED. Read every word and then read them again.
When the nation's leading financial organ trashes the nation's central bank in such a manner (and yes, our old friend Arthur Burns gets a little more than a little slap), we can be sure of one thing for certain.
We's in a whole heap o' trouble here, Andy.
.....BTW It was not 'I' who wrote the piece.....but I must confess that I knew that it was coming.
Posted by: esb at August 8, 2006 11:39 PM
If the TIPS spread can be said to have widened significantly since it became obvious the Fed would pause in August, that is only because the yield on regular 10-year Treasuries fell below 5 percent. In what sense is that consistent with higher expected inflation? Why do some people assume some markets (gold, FX or TIPS) have more foresight than others (stocks and bonds)? Don't all agents share the same information?
Posted by: Alan Reynolds at August 10, 2006 01:24 PM
Alan, absolutely all markets have the same information, but different assets have different payoff contingencies. For example, if the price of gold goes up relative to potatoes, as a consequence, say, of geopolitical turmoil, then holding gold is going to do something for you that TIPS won't. The one pure CPI-measured-inflation play is to go long TIPS and short nominals, which is why I think of the spread as a more reliable way to infer inflation expectations than looking at something like gold prices. I also discussed this issue here.
And, by the way, I'm not signing on to the conclusion that we've already seen the TIPS spread widen significantly. See also Tim Duy's graph which puts it in a longer-term perspective. My point was that, because I don't see the spread as having widened signficantly so far, the Fed may be OK, but that if it does widen a lot from here, we're likely going to see more rate hikes.
Posted by: JDH at August 10, 2006 01:46 PM