June 28, 2012
Guest Contribution: The Fed Shirks Its Duties
Today we are fortunate to have a guest contribution written by Joseph E. Gagnon of the Peterson Institute of International Economics.
On June 20, 2012, the Federal Reserve System’s Federal Open Market Committee extinguished the last shred of doubt as to whether it intends to achieve its mandated objectives. Despite a substantial markdown of an already inadequate forecast, the Fed did not take any actions that would make it possible to achieve either of its objectives over the foreseeable future. The action that was announced--additional purchases of longer-term Treasuries worth $267 billion--is estimated to reduce the 10-year Treasury yield by no more than 5 to 10 basis points. That is an amount that is lost in the daily fluctuations of the Treasury market and not enough, even in the Fed’s own models, to have an appreciable effect on the economy.
For more than two years, the Fed has dragged its feet and resisted the obvious need for more aggressive action. At this point it is not clear that the Fed has the tools it needs to get the best possible outcome without help from fiscal policy. Nevertheless, the Fed has considerable firepower remaining. It should aggressively push down mortgage interest rates and state clearly that it would welcome an inflation rate temporarily above its 2 percent target in order to make faster progress on its employment objective. These measures, discussed below, would substantially improve the economic outlook, even if there is disagreement about whether they are sufficient by themselves.
Why No Action?
A number of well-known Fed watchers have wrung their hands in despair at this policy paralysis. What lies behind the Fed’s inaction?
- Many observers believe that the Fed has done all it can do to help the economy. Yet Chairman Bernanke asserted in his press conference last week that the Fed has not run out of ammunition. And his previous academic research strongly supports that view.
- Tim Duy, in his Fed Watch blog, wonders if the uncertainty over the effect of unconventional monetary actions has caused the Fed to be so timid. One thing is certain, unconventional actions taken to date have not been sufficient to achieve the Fed’s mandate. Surely the lesson must be to take larger steps, not smaller ones.
- Ryan Avent, of the Economist, suggests that concern about unspecified “costs and risks” is the most likely reason the Fed is not taking more aggressive actions, and the Chairman’s remarks at last week’s press conference seem to support this view. I discuss potential risks of further action below, but none seem anywhere near as costly as the well-known cost of continued high unemployment.
- Paul Krugman guesses that the Fed is intimidated by Congressional Republicans. Indeed, it is remarkable that despite falling short of both of its objectives, neither the Administration nor Congressional Democrats have criticized the Fed for doing too little, whereas Congressional Republicans have denounced the Fed for doing too much. Countering these claims, Chairman Bernanke told reporters last week that political considerations have no effect on the Fed’s decisions, and Congressional action that would harm the Fed or individual Fed officials seems unlikely.
- Some have described the Fed’s action last week as one of saving ammunition to deal with a future crisis, such as a collapse in Europe. But this explanation assumes that the Fed believes it is running low on ammunition -- which the Chairman has denied -- and it goes against the Fed’s prevailing philosophy of proactively boosting the economy when major risks are tilted to the down side.
The Risks of Action
After his dissenting vote last week, the president of the Federal Reserve Bank of Richmond, Jeffrey Lacker, stated: “I do not believe that further monetary stimulus would make a substantial difference for economic growth and employment without increasing inflation by more than would be desirable.” The view that unconventional monetary policy will lead to inflation is commonly held on Wall Street. Yet, more than three years after the launch of such policies, inflation remains at or below the Fed’s target. Moreover, past statements by Chairman Bernanke, Vice Chairman Janet Yellen, and other members of the Fed’s policy committee indicate that they do not share President Lacker’s view that monetary stimulus can increase inflation without also increasing growth and employment. A large majority of the committee projects that inflation will be below target over the next two and a half years. If they assign any weight to their employment objective, they should be willing to accept inflation at least modestly above target in order to get a better outcome on employment.
Purchasing more long-term assets at low interest rates raises the risk that the Fed will incur losses in the future. That might give the Fed some political discomfort. But maximizing profit is not part of the Fed’s mandate. Moreover, any losses on the Fed’s balance sheet would be more than offset by gains to the Treasury’s balance sheet.
In his press conference, Chairman Bernanke listed the potential risks of unconventional monetary policies as those related to market functioning, financial stability, and the exit process. Considering the staggeringly high cost of record long-term unemployment, these risks would have to be serious indeed to justify the lack of policy action. Yet, the Fed has provided no evidence that these risks should be taken seriously.
- The risk to market functioning arises from the large role the Fed plays in some markets when increasing or decreasing its balance sheet. During the first and largest bout of quantitative easing in 2009, the Fed at times was buying almost all newly issued agency mortgage-backed securities (MBS). Other buyers were displaced from the market, which was in fact one of the goals of the policy. However, when the Fed ceased buying in March 2010, other participants returned quickly and there was no harmful disruption.
- The risk to financial stability is that unconventional policies may make asset price bubbles more likely. So far, however, asset prices remain depressed and raising them is much to be desired. If a bubble were to grow in the future, the Fed should use its regulatory and supervisory tools to counter it. But for now the greater risk to financial stability arises from allowing the economy to continue to perform badly, which increases the pace of bankruptcies and nonperforming loans.
- The risk to the exit process is a variant of Wall Street’s concern about inflation, which is merely postponed into the indefinite future. However, the Chairman has repeatedly told Congress that the Fed has the tools it needs to achieve its mandate now and in the future. Assets that were bought can be sold or lent in the repo market, and the Fed now has the enormously powerful tool of setting the interest rate on excess bank reserves. At its root, this risk is simply that the Fed will make a mistake in the future. Given the unusual circumstances we face now and over the next few years, it is reasonable to worry that the Fed may not choose the best policy. But it is not obvious whether a future Fed mistake would lead to too little or too much inflation. Moreover, fear of a future policy mistake is not an excuse to make a current policy mistake.
What Is to Be Done?
The best option within the Fed’s legal authority is to announce a target range for the 30-year mortgage rate of 2.5 to 3 percent to be maintained for the next 12 months. This target would be enforced through unlimited purchases of MBS guaranteed by the federal housing agencies. The 12-month commitment would encourage banks to beef up their mortgage staffing and it would give potential homebuyers some assurance of the financing they could expect while they shop for a house. This is similar to a program I outlined last fall. The Administration could help by forcing the housing agencies to stop dragging their feet on refinancing and loan modifications for underwater borrowers whose mortgages are already guaranteed by the agencies.
Although not a panacea, the above measures are substantial and would be viewed as such by market participants. The Fed could enhance their effects by stating clearly that a little more inflation would be welcome. A temporary increase of inflation to as much as 4 percent would be justified to the extent that it enabled a faster return to full employment. Raising expectations of future inflation moderately—in conjunction with a continued commitment to a near-zero policy rate—would lower the real interest rate, providing additional impetus to economic activity.
Running Low on Ammunition?
If necessary, the above program could be extended in time at a slightly lower interest rate. But the Fed is unlikely to be able to push the 30-year mortgage rate below 2 percent or the 10-year Treasury rate much below 1 percent.
The main alternative instrument in the Fed’s toolkit is foreign exchange, generally in the form of sovereign bonds of foreign governments. The point of such purchases would be to drive the dollar down and boost US exports. Massive purchases of such bonds would be considered an act of economic warfare by many recipient governments, despite the hypocrisy implied by the large purchases of US bonds by many of the same foreign governments.
A foreign-exchange program that would not face opposition from abroad would be large-scale purchases of Italian and Spanish bonds. That would defuse the euro debt crisis at a stroke, thereby eliminating the main downside risk to the US economy. But such purchases would expose the Fed to even stronger domestic political attacks than it has already faced. Chairman Bernanke explicitly ruled out this option last week.
The best alternative would be to purchase exchange-traded funds of the total US stock market. That would have broad-based benefits, repairing household balance sheets and unlocking consumption and investment. Unfortunately, the Fed is not authorized to buy equities and Congress is not likely to grant it that power anytime soon.
This post written by Joseph E. Gagnon.
Posted by Menzie Chinn at June 28, 2012 10:15 AMdigg this | reddit
More DENIAL... The FED failed to control credit creation for 30 years, allowing the debt bubble to expand to 500% of the civilian GDP. Expanding that bubble with more treasury debt or with free handouts to the financial sector via equity purchases or QE3 purchases of impaired mortgage securities will not alleviate the problem.
America has too much leverage. Domestic inflation has pushed up production costs too high for exports to be viable. Like it or not, credit losses have to be realized and production costs have to be reduced. That means credit defaults, lower wages, lower commercial profit margins, and lower financial yields for several decades.
America recovered from the depression and WWII debts by suffering under financial repression for more than 30 years during the 40's, 50's and 60's. The FED and congress will have to employ the same discipline to get us out of this jam.... Priming the pump is useless when the piston seals leak like a sieve.
Posted by: MarkS at June 28, 2012 02:03 PM
Sorry Mark, your idea would destroy Capitalism. The Middle Class would rebel and you would have national socialist dictatorship which Americans would cheer. I would even go far enough that the "United States" would be abolished eventually and the new heads would be considered a new set of "founding fathers" of America.
Credit creation replaced the Keynesian wage inflation model to your own disaster. You can't control what is your main source of economic growth. This was the deal the New Right made with capital.
Lower wages are not going to restore capitalism. Nor is lower production costs. America recovered from the depression not through financial repression, but through massive government spending(including the war) and union backed wage inflation. The country was all but dead in 1933. Labor was going to start seizing production before FDR and the capitalists that backed him put up their hand.
Americans don't even understand their own history. They follow intellectual fairytales that suit them.
Posted by: The Rage at June 28, 2012 03:22 PM
"Purchasing more long-term assets at low interest rates raises the risk that the Fed will incur losses in the future. That might give the Fed some political discomfort. But maximizing profit is not part of the Fed’s mandate. Moreover, any losses on the Fed’s balance sheet would be more than offset by gains to the Treasury’s balance sheet."
The fed will not share in Treasury's capital gains, and while the Fed is not in the business of making a profit, their independence depends on them running a surplus from which they can take their budget needs without need for an appropriation from Congress. Nor is it clear that their authority does (or should) extend to operations that would generate large losses. Otherwise, where is the line between fiscal and monetary policy?
"The risk to financial stability is that unconventional policies may make asset price bubbles more likely. So far, however, asset prices remain depressed and raising them is much to be desired."
I don't think so. I see asset prices as still bloated.
"The main alternative instrument in the Fed’s toolkit is foreign exchange, generally in the form of sovereign bonds of foreign governments. The point of such purchases would be to drive the dollar down and boost US exports. Massive purchases of such bonds would be considered an act of economic warfare by many recipient governments, despite the hypocrisy implied by the large purchases of US bonds by many of the same foreign governments."
The Fed takes its orders from Treasury on buying foreign exchange. But in any event, QE has already accomplished this result very effectively by spurring the dollar carry trade (to the rage of many trade partners, including those with the least reason to complain - China and Japan). The main victim has been the euro area, which has already suffered significant losses of AD from past QE initiatives and is poorly positioned to take any more.
"A Foreign-exchange program that would not face opposition from abroad would be large-scale purchases of Italian and Spanish bonds. That would defuse the euro debt crisis at a stroke, thereby eliminating the main downside risk to the US economy. But such purchases would expose the Fed to even stronger domestic political attacks than it has already faced. Chairman Bernanke explicitly ruled out this option last week."
This is another good example of kicking the can down the road. The purchases of euro denominated debt would, by the balance of payments identity, push the euro area into greater deficit and harm the local economies for the sake of a possible short run palliative from abating an immediate liquidity crisis. The best result that could be hoped for would be to delay the defaults, while increasing the pressures to ensure that they will happen. And if China or the U.S. were to buy the bonds to spur their own economies, they would justly deserve to lose their principle.
Posted by: don at June 28, 2012 05:19 PM
Ben Bernanke is an early entry this century for the World's Greatest Moral Monster as he stands idly by while tens of millions of lives are destroyed.
He has told the firemen to roll up their hoses as the orphanage burns to the ground with all inhabitants because of the 1% chance that a drought next year will require the water instead to keep rich people's swimming pools filled.
Normally the dual mandate is a dynamic tension between the two. It takes a spectacularly incompetent or indifferent Federal Reserve to miss both targets simultaneously.
This concept of a politically independent Federal Reserve is a failure if it just means they are free to cater to the whims of the banking class.
Posted by: Joseph at June 28, 2012 05:43 PM
I am sorry, but I find it simply frightening that you think it is acceptable for the FED to purchases exchange traded funds. Without going into the counter-evidence, because I am sure you have read it. I hope you are wrong.
Posted by: Stewart at June 28, 2012 05:45 PM
the other problem with dollar depreciation is that it would lead to higher import prices (like oil) and feed the inflation concerns of the hawks. I, for one, am unperturbed by demand-induced import price increases. In fact i would welcome it: it would mean higher employment and it would just speed the switch to shale gas. but i seem to be in the minority.
Posted by: dwb at June 28, 2012 05:45 PM
An other attempt to find a political issue to unemployment and the issue remains the same, the Central banks. The fundamental belief underpinning a steadfast devotion in the C Banks, cheaper and more abundant supply of money will be self fulfilling. A consultation with the Fed St Louis data and charts may outlay the results. The same with the ECB statistical data ware house, may supplement the doctrinal faith.
The actual reading is, banking crisis, currencies crisis, balance of payment crisis, sovereign risks insolvencies. In horse betting probability parlance, this is a rare Trifecta.
“The experience of a number of economies, including Japan, suggests that if output
remains below its precrisis trend over the medium term, then a substantial part of the shortfall
reflects lower potential. Therefore, to the extent that this paper identifies output losses seven years after a financial crisis, it is likely that lower potential explains most of those losses.
However, attempting to precisely identify shifts in potential output is beyond the scope of
It may be worth as well, to read the the central banks mandates.They are carefully crafted in such a way,as to reflect not only their responsibilities but their condition precedent.
Posted by: ppcm at June 29, 2012 12:31 AM
I'll just add a note on some of Joe Gagnon's professional qualifications to help readers better understand his qualifications in talking about the Fed. (You can read them yourself at http://www.iie.com/staff/author_bio.cfm?author_id=653)
"Joseph E. Gagnon, senior fellow since September 2009, was visiting associate director, Division of Monetary Affairs (2008–09) at the US Federal Reserve Board. Previously he served at the US Federal Reserve Board as associate director, Division of International Finance (1999–2008), and senior economist (1987–1990 and 1991–97). He has also served at the US Treasury Department (1994–95 and 1997–1999) and has taught at the Haas School of Business, University of California, Berkeley (1990–91)."
Posted by: Simon van Norden at June 29, 2012 04:27 AM
This is like the blind clockmaker, who upon hearing the clock not ticking, winds the mainspring even tighter to get a few more hours out of the mechanism. All the while potential energy builds until in a certain-to-come Rube Goldberg-like moment, the mainspring bursts apart, screws and metal bands and parts flying every which way in one horrific last ding dong of doom. You have no idea where this monetary experiment is going to end up any more than Bernanke does, as it has never been tried before. But caution to the wind, let’s apply more linear pressure anyway in what is manifestly a nonlinear world. Limited to only a two-pony Keynesian show – monetary policy and fiscal policy – you are blind and impotent to seeing anything else. Get out your HP-12C and calculate what happens to the value of $6 trillion of mortgage-backed securities on the books of Fannie, Freddie, or the Fed when they reprice from 3% yield to at least 8% as the fed funds rate normalizes in the out years as for certain it will. And yes, let’s buy some broken Spanish and Italian clocks and wind them up too.
Posted by: JBH at June 29, 2012 04:57 AM
I have done the math. The gains to the Treasury exceed the losses to the Fed, Fannie, and Freddie in all possible outcomes, including outcomes in which QE is assumed to cause inflation without any benefit to output, despite the total lack of evidence for such an outcome.
Posted by: Joe Gagnon at June 29, 2012 06:30 AM
Understood that we have to live with a permanent strabismus,but still it is not easy.
Posted by: ppcm at June 29, 2012 06:34 AM
Which central banks purchase equities?
Posted by: westslope at June 29, 2012 08:10 AM
The Bank of Japan and the Hong Kong Monetary Authority have purchased equities, the latter in a big way in 1998, which saved Hong Kong from the Asian Financial Crisis.
Posted by: Joe Gagnon at June 29, 2012 10:24 AM
Regarding the hypothetical of the FED purchasing equities:
What would you say to all the asset managers and people trying to manage their retirement portfolios who base their asset allocation on the assumption that the FED will not buy equities?
It seems these folks would be hosed on the day the FED announced it was buying equities.
Posted by: tj at June 29, 2012 12:02 PM
Countries are cutting spending in Europe and their deficits are shrinking. Why? If that is true, the converse must be true. Fiscally stimulating increases deficits.
Anyone who thinks these countries can grow their way out of this is just silly.
Posted by: Anonymous at June 29, 2012 12:48 PM
Joe Gagnon wrote:
The Bank of Japan and the Hong Kong Monetary Authority have purchased equities, the latter in a big way in 1998, which saved Hong Kong from the Asian Financial Crisis.
Posted by: westslope at June 29, 2012 01:40 PM
tj What would you say to all the asset managers and people trying to manage their retirement portfolios who base their asset allocation on the assumption that the FED will not buy equities?
So are you saying that currently asset managers do not pay any attention to the amount of bonds and MBS assets the Fed buys? There might be good reasons for worrying about the Fed buying equities, but worrying about portfolio allocations seems like a third or fourth order concern at most.
Posted by: 2slugbaits at June 29, 2012 03:13 PM
I agree with The Rage that "Lower wages are not going to restore capitalism", but... the point made by MarkS:"America has too much leverage", seems to be the question that Keynesian theory fails to contend with. But, if I understand the underlying problem of our times correctly, it is not exactly "too much leverage" that is the core issue, it is instead 'excess liqidity'. More accurately, it is the dynamic of real incomes trending downward as the amount of investment capital is trending upward. Leverage is therefore a deturmining factor, but not all inclusive in regards to grasping the dynamics.
But I may not grasp the dynamics?
Posted by: rl love at June 29, 2012 05:05 PM
"The best option within the Fed’s legal authority is to announce a target range for the 30-year mortgage rate of 2.5 to 3 percent to be maintained for the next 12 months"
- this is very dangerous! I discourage my friends and family to take any long time assets in the current market. By this proposed tool, you can cure one part of the disease. But one day in the near future, you will have to foreclosure or bailout housing market, because people who won´t be able to pay. How can FED assure 2.5-3 per cent rate? We don´t know what will happen in five years. There is no mathematical model that could predict it.
I´m from Canada and our current real estate is near its peak. It resembles me 2009 in US.
Sooner or later, Home Prices in Vancouver and Canada are going to fall down. This will be a tough moment for banks. They know it, but they do nothing. Why? Because they know there will be a bailout. Simple.
I hope that current direction of FED policy will change. For the sake of American citizens.
Posted by: John B. at June 30, 2012 03:51 AM
"The best option within the Fed’s legal authority is to announce a target range for the 30-year mortgage rate of 2.5 to 3 percent to be maintained for the next 12 months. The 12-month commitment would encourage banks to beef up their mortgage staffing and it would give potential homebuyers some assurance of the financing they could expect while they shop for a house."
That's assuming the problem with housing is a lack of financing for mortgages. Or unaffordable rates. Neither of which is really the problem right now. Rates are pretty darn low already. The GSEs will buy up basically any loan that meets their criteria. When the housing bubble collapsed, "experts" claimed that programs to lower rates (to 5.25%!) would boost housing. They were wrong. They're still wrong. The problem is that to qualify for those rates, you need savings and a steady job and good credit. No matter how low you force the rates, low rates by themselves are not going to make more buyers with those attributes. Unless you want to argue that we need to recreate the conditions of the bubble (no downpayments, no worrying about income or credit history). We've been hearing the "low rates will boost housing" mantra for four years, and we have low rates, and there's no evidence in sight that it's helped the housing market.
Posted by: MacCruiskeen at June 30, 2012 06:18 AM
I´m from Canada and our current real estate is near its peak. It resembles me 2009 in US.
1) The US market peaked in 2006. The trough was 2009 (when prices were down by about 1/3 according to Case-Shiller) when prices stopped falling rapidly. The Teranet index (www.housepriceindex.ca) shows the Canadian market is at a record high and is pretty much following its 10-year growth trend rate.
2) Given the trend growth in Canadian house prices, your advising your friends not to buy any long-term assets could be costly if there is no major price correction. The article that you link to gives no suggestion that a price correction is expected.
3) When you say that house prices are near their peak, do you just mean that the index is at an all time high? or that it will soon fall substantially? When you say that house prices will "fall down" sooner or later, what evidence makes you think it will be sooner?
4) Canadian house prices fell significantly in 2008-2009. This did not seem to stress Canadian banks, which were seen as among the best capitalized and safest in the world in 2009.
Posted by: Simon van Norden at June 30, 2012 07:58 AM
Maybe you don't have to manage your retirement account, or maybe you have defined benefit. I don't know and I don't care, but my account is defined contribution, so I have to change my asset allocation from time to time based on fundamentals. There have been a few times where I have been burned because the fundamentals or risk environment indicate equities should be underweighted, but the FED has stepped in to prop them up.
There are millions of individuals in my situation and trillions of dollars under the control of asset managers. The FED used to be predictable so there were few surpises. Now they are a wildcard. I can overwieght equities waiting for them to jump in with their next move, but in the current risk envionment equities could nosedive. I don't worry about the market running away from me because Obama's policies will keep a lid on macro-growth in output and employment.
You dismiss my concern with the wave of your hand, but that's exactly what I would expect from someone who expects cradle to grave care from the government and views economic self-determination as evil.
Posted by: tj at June 30, 2012 09:45 AM
The market would see right through a 12-month MBS program, regardless of what form it takes. When any investor NPV's that paper they'll be looking a re-investment + inflation risk. Doubtful anyone would want to load up on that paper.
Re Italy and Spain: What possible benefit would U.S. taxpayers get from being long Italian and Spanish debt? The structural problems in those economies are so huge that they likely cannot ever be corrected. Demographically, they are losing an entire generation of 20- and 30-somethings to foreign shores. Both countries' populations are going to start aging at an accelerating rate. What do you think happens to aggregate demand in those conditions? What happens to the capital stock? Productivity? Wages? Again, who would want to be long that kind of paper over the long haul? Their only hope is to inflate their way out of the wreckage they have created. How would we possibly benefit from holding their IOUs when inflation -- hence rates -- explode?
Posted by: markets.aurelius at June 30, 2012 09:58 AM
The lack of aggregate demand is selective. There is no lack of demand in the corridor from Galveston to the Canadian border in North Dakota (indeed, all the way up through Alberta). Now why is that? And what is the relationship of that to the rest of the country? Why is it that Newfoundland and Alberta have become net contributors to the Canadian budget and Ontario and Montreal net recipients? Could it because Alberta and Newfoundland have oil and the other provinces don't?
Could it be because, for that for every barrel--that's 42 gallons--of increased oil consumption in China, US consumers are providing 36 gallons (85%)? Could that be a problem, and explain why industrial and manufacturing areas are struggling so and energy producing regions doing so well?
It should be remembered that the Great Moderation started when the Saudis threw in the towel in 1985, and it lasted as long as the surplus oil production capacity, installed in 1979-1983, lasted. The 1980s surplus capacity was exhausted a decade ago, and the oil supply stalled in late 2004. And we're still in that world.
So by all means, let's look to the Fed. But it's not the whole story, and maybe not even the most important part.
Posted by: Steven Kopits at June 30, 2012 12:04 PM