September 23, 2010
What's the Fed signaling?
There's an aspect of Tuesday's statement from the FOMC that's not being emphasized by many analysts.
The Fed's primary ability to influence the economy comes from its control of the interest rate on funds lent overnight between banks. But with that interest rate essentially at zero, nothing happens when the Fed tries to push that gas pedal down any further.
One option for the Fed in this situation is to signal what it intends to do a few years down the road, when interest rates rise off the zero lower bound and the Fed resumes its usual powers. If the public is persuaded today that the future Fed will be more expansionary once we return to that regime, such a perception potentially could help stimulate spending today. Indeed, in a theoretical framework such as that developed by Gauti Eggertson and Mike Woodford, this kind of signaling is the only power that the Fed has in a situation like the present.
Suppose you took that view, and assumed that the Fed sees things the same way. How would you interpret the following passage from Tuesday's FOMC release?
Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability. With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.
The most natural interpretation of those words is that the Fed is aiming at a long-run inflation target that's higher than what we've been seeing lately. By its nature, that is a statement about what the Fed will be doing several years down the road, not a signal of something it's going to do in November. In other words, it sounds a lot like the Fed is trying to follow the Eggertson-Woodford policy prescription.
But the dominant reaction I see from other analysts (, ) is that the Fed is instead communicating the action it plans to take within the next few months, specifically signaling the likelihood of resumed large-scale asset purchases.
Despite the implications of Eggertson and Woodford's theoretical analysis, the empirical evidence persuades me that the Fed could reduce long-term interest rates further in the current environment with such operations; see for example the research by Joseph Gagnon and colleagues, Greenwood and Vayanos, and my paper with Cynthia Wu. And I believe that the FOMC is also persuaded that it has this power. But these kind of nonstandard open market operations are a blunt and potentially risky policy instrument, and are certainly not the only way the Fed is thinking about responding to the current difficulties.
I am not saying that other analysts are wrong in interpreting the FOMC statement as signaling the likelihood of some near-term resumption of quantitative easing. But I don't think that's the only message that the Fed delivered on Tuesday.
Posted by James Hamilton at September 23, 2010 05:30 AMdigg this | reddit
I read that paragraph rather differently. I think they're saying "inflation will probably be on the low side of our target for a while, but eventually it'll go back up there." I don't think that's a signal of being more expansionary in the future. On the contrary, Bernanke's been pretty explicit in knocking down the idea of a higher inflation target (I think that was in his Jackson Hole speech, but I'm not sure).
Posted by: psummers at September 23, 2010 06:19 AM
I think what is lacking from any discussions on what the Fed should do or should not do is the following question: what is the overall objective of the Fed's unconventionnal policy tools? I guess there is a consensus to say that the overall objective is to increase demand for credit thereby helping to "stimulate spending today". So what I take from this is that it would really be a great thing -from the mainstream economic standpoint- to have private households or businesses dive deeper into debt. I have no doubt that this would be a boost to aggregate demand and employment in the short term, but would it be such a great thing medium term? Would it not set the stage for another debt crisis further down the road? Remember that private households are still extremely indebted relative to historical standards, so the last thing we should wish for is for them to take on more debt.
I much prefer to have the Federal Government dives deeper into debt than private households at this stage of the game. The Federal Government controls the short term interest rate on its debt, no households could claim such power.
Private households are busy repairing their balance sheet right now, as painfull as it is for the economy, it is a necessary step coming out of a credit bubble. (See
Posted by: Qc at September 23, 2010 07:01 AM
What the FED is saying has to do with the proxy for inflation, or money flows (our means-of-payment money X's its transactions rate-of-turnover).
As I keep pointing out, contrary to economic theory and Nobel Laureate Milton Friedman, monetary lags are not "long & variable". The lags for monetary flows (MVt), i.e., the proxies for (1) real-growth, and for (2) inflation indices, are historically (for the last 97 years), always, fixed in length. However the lag for nominal gdp (the FED’s target?), varies widely.
It’s a scientific fact that economic forecasts are mathematically infallible. Nominal (gDp) will cascade in the 4th qtr (down in every month - Oct, Nov, & Dec), without added, fiscal/monetary intervention/stimulus.
Actually, since it takes some time for the impact of money to be registered in the price level, countervailing stimulus will be unable to stop the downward economic trend.
Posted by: flow5 at September 23, 2010 07:15 AM
...inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate.
The FED is signalling that it is aware that inflation will return to normal levels when commercial banks get serious about turning excess reserves into loans.
I think you need to add a constraint to your FED objective function - the constraint related to the effect of easing on building equity on commercial bank balance sheets. The unprecedented amount of excess reserves is clearly aimed at helping banks repair their balance sheets. So, it must be inlcuded in the optimization problem.
The FED is signaling that in the future, this constraint will not bind as commercial lending picks up and the FED simultaneously withdraws excess reserves.
Posted by: tj at September 23, 2010 07:57 AM
The BLS August 2010 report noted the widely reported 12-month percent changes in CPI as 1.1% and 0.9% for all items and all items less food and energy, respectively. This has prompted much discussion about disinflation and even some fear of outright deflation. But a closer look at the numbers is revealing. One will note shelter represents nearly 1/3 (32.289%, to be exact) of the weight of the index. Notably, the 12-month percent change in shelter was -0.7%. The BLS calculates that the 12-month percent change in all CPI items less shelter is 2.0%.
So why is this distinction important? It seems the vast majority of economists agree that housing is priced far more fairly now than in recent years. Therefore the subcategories that make up shelter (owners’ equivalent rent of residences, rent of primary residence, lodging away from home, and tenants’ and household insurance) in general are more fairly priced today. The distinction is important because one cannot simply say that we are trending towards deflation if the main component of the CPI suggesting this conclusion is shelter. Housing/shelter and all of the financing and shadow banking forces that played into it was the predominant bubble that has now almost fully become deflated to normal. Housing prices, though may fall a bit more, have likely nearly reached bottom. Thus, to get a good idea of the future, excluding shelter from the last year is important at this point in time.
This weakens the argument of those who accuse the Federal Reserve of violating it’s “Dual Mandate” on both accounts. With 2.0% inflation, using all CPI items less shelter, the Fed seems to make good on its principle of maintaining a low and stable inflation rate. However, skeptics are undoubtedly still correct that the Fed is falling fall short of its mandate of maximizing employment. Even if one believes that 2.0% inflation (all items) will become the new trend, there is something to be said for attempts to nudge this a bit higher in an effort to lower our disproportionately high unemployment.
Posted by: Tristan Bruno at September 23, 2010 08:05 AM
CR has it right : http://www.calculatedriskblog.com/2010/09/paving-way-for-qe2.html
Timing is related to the Nov. election of course.
Posted by: Johannes at September 23, 2010 09:31 AM
Okay - the Fed has the price stability part of their charter figured out (interest rate targeting). Now let's see them focus on the second part of their charter - full employment.
Oh wait there are some economists that think 10% unemployment is full employment. Blah!
The only way to get out of this mess is for the people to get out of debt - the only way to do this is to trade debt for equity. Payroll tax holiday!!
Posted by: Adam at September 23, 2010 10:28 AM
FED policy will, as they say, be to keep interest rates as low as possible for the extended future, in order to prevent a total blow-out of the credit market (large-scale deflation)... They also will support more (non-performing)asset purchases (QE) as necessary to support the banking system... And they will continue to use asset income to purchase more banking assets (to further juice-up the stock market).
I believe that the FED "gets it"... I.E. it knows that the credit market exposure of America has to be reduced. I also believe that their choice is to "manage" the deflation of credit (money) over a very long time (like Japan). 2% inflation (the population growth rate into the labor market), can only be supported when enough debt has been wiped-out to service existing credit, and the banking system has de-leveraged enough to restore safe capital ratios.
You can judge the length of time it will take to "right the ship", by the BIS schedule for Basel III compliance... At least SEVEN MORE YEARS.... If you want a taste of hyper-inflation, I suggest that you move to Buenos Aires
Posted by: MarkS at September 23, 2010 10:54 AM
I'm more in agreement with psummers' assessment of the paragraph in question than with yours. I can see nothing in it that indicates the Fed will be looser when inflation reaches acceptable levels.
But since we're all reading tea leaves, how about the following interpretation? The Fed is aware that there is a very good chance that they won't be able to prevent deflation. They don't want to say that much now (which could have disastrous consequences), but when mild deflation comes, they can modify this statement and at the same time imply "All part of the plan, folks. No need to worry. We anticipated this, as we said earlier, but eventually inflation will return to acceptable (positive) levels." In that way, they may be able to prevent some of the psychological damage (and avoid being pushed into catastrophic actions) when inflation passes the zero mark going down.
The expected path of future short-term rates must equal the long term rate. But there is uncertainty about the path of future of short term rates, and the actual implied path is set by those willing to bet on the market. If someone is willing to bet enough that the path is different from that set by ex-ante expectations of others, he can certainly alter the 'revealed' expected path. Surely, Gauti can't be asserting that this is not possible?
If the Fed had a profit motive, its actions in longer-term markets should influence expectations of the future path of short-term rates, since the Fed has the power to set those rates. But it has no profit motive, and I can't see how its actions in long-term markets should alter the ex-ante expectations about the future path of short-term rates. So, there is a chance to bet against the Fed. Is Gauti assuming that the Fed can't overcome such bets?
Posted by: don at September 23, 2010 12:01 PM
I'm really puzzled that everyone is reading so much into the Fed's statement. The quoted passage is merely a statement of what we already knew to be true. We've seen the Fed's long-range projections, and we knew that they were meant to be interpreted as targets, so we knew that the Fed's target was near 2%. We've seen the Fed's short-range forecasts, and we can see that they are below the target. It's not clear to me how this statement should change our expectations at all, except maybe to give us a little bit more confidence in what we already expected. Apparently this passage is actually some kind of secret code that certain economists and Fed watchers know how to interpret, but they don't seem to agree on the correct interpretation.
Posted by: Andy Harless at September 23, 2010 04:00 PM
The message I got was "Here comes the Mother of All Competitive Devaluations. Buy gold."
Posted by: W.C. Varones at September 23, 2010 06:18 PM
It was both a clear signal of the Fed's readiness to start monetizing part of the deficit near-term, and a clear statement that the Fed wants a long-term inflation rate higher than current levels. You're far from the first to notice the latter, by the way - see for example Gavyn Davies.
Posted by: Tom at September 24, 2010 04:40 AM
I agree with Andy. Instead of reminding us of the days when we could get secret decoder rings in our cereal and Cracker-Jack boxes, the Fed should just say what it means in plain English. Is the ambiguity meant to avoid accountability?
Posted by: Jeff at September 24, 2010 08:20 AM
"It's not clear to me how this statement should change our expectations at all, except maybe to give us a little bit more confidence in what we already expected. Apparently this passage is actually some kind of secret code that certain economists and Fed watchers know how to interpret, but they don't seem to agree on the correct interpretation."
Posted by: Andy Harless at September 23, 2010 04:00 PM
Thanks Andy for the perspective, pretty amazing how easy it is to jump off the rails and over the bluff of speculation.
Posted by: fxretracer at September 24, 2010 09:29 AM
You've touched on something that has been bothering me for a while. I think there should be a law that says the Fed must average inflation over , say, a 5 or 10 year period and then we can compare that number to the 2% target to determine if the Fed is doing their price stability job or not.
Inflation was 5% as recently as 2008, and I hate it when everyone goes into a tizzy if it drops to 1% for a couple months.
Posted by: Cedric Regula at September 24, 2010 01:36 PM
I'm not on the Fed code memo distribution list either, but the only thing I can make out from this statement is:
Interest rates will stay low for a/an considerable/extended period of time.
The dollar index took an immediate hit. Lately it does that on QE1 or QE2 worries, but in the past it can do that if future interest rate expectations are lowered.
The hit was only a penny which is small for QE, so maybe now they are expecting recovery in the US to lag recovery elsewhere. Who knows?
Posted by: Cedric Regula at September 24, 2010 01:48 PM
"Is the ambiguity meant to avoid accountability?"
I thought that was obvious. Have to maintain the infallibility of the great leader, despite some rather blindingly stupid statements and short-sighted policy actions (for both Ben and Alan). I find it particualrly hard to forgive Ben his Congressional testimony citing wildly improbable gains from trade (based on a stupid study by Hufbauer et al.) to discourage any action against currency manipulators, and his early statements about the chances that the housing crash would extend to the rest of the economy. He is either pretty dumb, or willing to 'talk his book' in an attempt to influence opinions. But that can wear thin. In fact, I would go back to his speech in which he claimed enlightened monetary policy can always prevent depression. I wonder if he is still sanguine about that, or if he now sees the limits of the Fed's powers?
Posted by: don at September 24, 2010 02:24 PM
"The dollar index took an immediate hit. Lately it does that on QE1 or QE2 worries, but in the past it can do that if future interest rate expectations are lowered."
Agree. But before we celebtrate too much, we should note that Ben can influence the dollar only against those countries that play by the floating exchange rate rules. And those unfortunate players will suffer all the more, because Asian currencies will fall in lock-step with the dollar. This may well prove to be the stupidest, most short-sighted of his policy actions. In my view, he should be thankful the counterfactual state can never be proven and is the great playground for 'spin.'
Posted by: don at September 24, 2010 02:30 PM
“One option for the Fed in this situation is to signal what it intends to do a few years down the road,”
In l998 I was working as a court interpreter. Since I travel a lot and get paid mileage, my average income was close to 300 dollars a day. Enough to buy an ounce of gold. My salary when measured in gold was an ounce a day. I’m still working as a court interpreter, still traveling and still making around 300 a day. But this is only enough to buy ¼ of an ounce. In other words I have to work four full days to buy one ounce in 2010, when eleven years ago I only had to work one day to acquire the same amount of gold.
You people that write in such fancy words about the Feds intentions are missing the real picture. You seem to be living in a different world where the value of dollars estimated in ounces of gold is irrelevant. This is a result of not studying the classics. Go back to Adam Smith, to David Ricardo and, yes, to Karl Marx. This will allow you to grasp the reality of economic relations in exchange based societies. Study these authors and you will then see that the Fed’s intentions are very clear: to continue devaluing the dollar no matter what.
I doubt very much that this criticism will be posted on your blog. No matter. There are plenty of people that are seeing what I really happening.
Posted by: homeroguajardo at September 24, 2010 08:32 PM
Fed is signaling they see a double dip ahead which they can not do anything about before elections, and not after since Dems will keep the House. More monetary easing also won't change the inevitable consequences of major economic and psychological trauma. So their language is one of trying not to tell the truth why knowing it comes.
A language of a depressed person. Of course, they might hope Reps win the House, but that won't happen since economic news and stock market reaction will be positive until the end of November elections.
Posted by: Ivars at September 24, 2010 10:46 PM
Yes James, I was right, qe2 is coming, now for sure :
Ben, the master himself is speaking.
Posted by: Johannes at September 25, 2010 10:32 AM
Seems quite clear to me. The Fed is telling us to dump the USD and buy gold because it will print as much money as necessary to get inflation higher.
Posted by: Vangel at September 25, 2010 06:34 PM
"The Fed is telling us to dump the USD and buy gold because it will print as much money as necessary to get inflation higher."
Don't worry. They'll break the euro first, creating another big mess, but in the end they'll have to give up trying to prevent deflation.
Posted by: don at September 25, 2010 08:09 PM
Johannes. I agree completely.
They are keeping down the rates, printing money to devaluate the dollar once again. Maybe they are trying to shake the Chinese out of their dollar position! :)
Looks to me like they are trying to stop this double dip from happening, or at worst negate some of it's affect. For now though, as you rightly said it's Gold's moment. You only have to look at the gold price over the last year to see where this is heading. I remember some people scoffing at a few commentators who were predicting Gold at $2000.
Not far now.
Posted by: LeeM at October 1, 2010 05:20 AM
After all these years and the Fed is still confusing the heck out of Americans. The irony of course is that an American (Edwin Prescott) was key in developing the theory that would underpin the development of a different kind of central banking that was not designed to confuse the heck out of everybody. But America will be one of the last rich countries to uncomplicate and demystify central banking.
I suspect that American economists as a group should take a clear lead in changing the Fed's broken mandate. Otherwise they look like they are creating work for their own group, i.e., American economists are self-serving, just like tribal warriors and a whole series of other special interests who seem keen on tearing apart the USA.
Posted by: westslope at October 2, 2010 05:51 AM