The Federal Reserve, the ‘Twist,’ Inflation, QE3, and Pushing on a String
In a move that some are calling QE3, the Federal Reserve announced yesterday that it will engage in a policy called “the twist” — selling short-term bonds and buying long-term bonds in hopes of artificially reducing long-term interest rates. If successful, this policy (we are told) will incentivize more borrowing and stimulate growth.
I’ve freely admitted before that it is difficult to identify the right monetary policy, but it certainly seems like this policy is — at best — an ineffective gesture. This is why the Fed’s various efforts to goose the economy with easy money have been described as “pushing on a string.”
Here are two related questions that need to be answered.
1. Is the economy’s performance being undermined by high long-term rates?
Considering that interest rates are at very low levels already, it seems rather odd to claim that the economy will suddenly rebound if they get pushed down a bit further. Japan has had very low interest rates (both short-run and long-run) for a couple of decades, yet the economy has remained stagnant.
Perhaps the problem is bad policy in other areas. After all, who wants to borrow money, expand business, create jobs, and boost output if Washington is pursuing a toxic combination of excessive spending and regulation, augmented by the threat of higher taxes.
2. Is the economy hampered by lack of credit?
Low interest rates, some argue, may not help the economy if banks don’t have any money to lend. Yet I’ve already pointed out that banks have more than $1 trillion of excess reserves deposited at the Fed.
Perhaps the problem is that banks don’t want to lend money because they don’t see profitable opportunities. After all, it’s better to sit on money than to lend it to people who won’t pay it back because of an economy weakened by too much government.
The Wall Street Journal makes all the relevant points in its editorial.
Read the rest of this post »
Inflation Expert
Who knows more about inflation, Richard Galanti or Ben Bernanke? I maintain that, when it comes to the facts, Mr. Galanti knows more than the Fed chairman. Galanti is the CFO of Costco Wholesale Corp.
The Wall Street Journal reported last Thursday (May 26th) on a conference call with Mr. Galanti. He said “we saw quite a bit of inflationary pricing” in the 3rd quarter.
Price increases occurred in a broad range of products” dry dog food (3.5%). Detergents (10%+), plastic products (8-9%). Costco will “hold prices as long as we can.” When it can no longer, the consumer will face rising prices.
Costco is a good leading indicator of inflation at the retail level. It turns over inventory quickly, and is leading other retailers in restocking at higher prices. Costco offers a forward-looking view of consumer price inflation.
Meanwhile the Fed and its chairman, Ben Bernanke, rely on backward looking measures of inflation, like the CPI. That index, and the “core” component that excludes food and energy prices, overweight the depressed housing sector. And they are yesterday’s news.
For years, American consumers have benefitted from cheap imports from China and India. When those countries liberalized and opened up to global commerce, Americans got the benefit of the hard work and low wages of 2 ½ billion workers. The era of cheap labor is coming to an end, and with it the flood of imports that held down prices in the U.S. Especially in China, wage rates are rising rapidly.
Heretofore, the flood of dollars has chiefly affected asset prices and inflation in other countries. The flow through to U.S. consumer prices will now be quicker. You’ll experience it when you go to Costco to restock.
Can We Rely on Inflation Expectations?
The Wall Street Journal has pointed out that in his recent press conference Federal Reserve Chair Ben Bernanke used the words “inflation expectations” (or some variation) 21 times. His argument is that we need not worry about inflation because we will see it coming, and then the Fed will do something about it. Such an argument relies heavily on the ability of inflation expectations to predict inflation. Which of course raises the question, just how predictive are inflation expectations?
The graph below compares inflation, as measured by CPI, and inflation expectations, as measured by the University of Michigan consumer survey, the longest times series we have on inflation expectations.
Clearly the two move together. For instance, the correlation between current inflation and expectations is almost 1 (its 0.93), while the correlation between inflation and actual inflation a year later is slightly less at 0.81. The relationship declines as we move further into the future. So yes, consumer expectations appear a reasonable predictor of the direction of inflation. However, they don’t appear to be a great predictor of the magnitude or the frequency of changes. For instance, the standard deviation of actual inflation is about twice that of expected inflation. As one can easily see from the chart, expectations are quite sticky and rarely pick up the extremes. During the late 1970s and early 1980s, expectations did move up, but then never reached the heights actually experienced, nor did consumers ever actually expect deflation during the recent financial crisis (if we are going to base policy on expectations, we should at least be consistent about it).
For about the last decade we also have market based measures of inflation, based upon inflation-indexed bonds. The TIPS measure tends to be less correlated with actual inflation, but does a better job of capturing the extremes. Although interesting enough, TIPS was already predicting that deflation would be short-lived before we even experienced any deflation.
The point is that while expectations are useful for qualitatively purposes, they do not have a strong record of recording the extremes. Given that most of us expect some positive level of inflation, the real debate is over how much. In this regard, either survey or market-based expectations are likely to be both a lagging indicator and an under-estimate of actual inflation.
Wednesday Links
- New research suggests that there has been more monetary and macroeconomic instability since the Federal Reserve’s inception than in the decades preceding it.
- New thinking about the usefulness of government programs will help us from restore fiscal balance and economic well-being in America.
- New geopolitical circumstances should make us wonder: why are we still a part of NATO?
- New Deal-era jurisprudence may soon be overturned as challenges to the Affordable Care Act reach the U.S. Supreme Court.
- New means of funding public roads will increase efficiency by confronting drivers with the costs of using them, and reducing congestion:
- Reminder: If you’re in the DC area, please join us this Friday at 4:00 p.m. Eastern for a special sneak preview of Free or Equal and Q&A with Cato senior fellow Johan Norberg.
The Ben Bernanke Variety Hour
April 27th begins a new chapter in Federal Reserve history: the Fed joins other major central banks in having a press conference after its monetary policy meetings (the Federal Open Market Committee). Apparently the record lows in public support for the Fed, along with rising gas and food prices, have driven Bernanke to attempt to change the narrative. After all, his appearance on “60 Minutes” did wonders for the Fed’s reputation. I’m excited to hear even more about his childhood in Dillon, South Carolina or his time working at South of the Border. Maybe an enterprising reporter could ask how much menu prices at South of the Border have increased since Bernanke took over the Fed.
Perhaps you’ve noticed that I don’t have high expectations for his press conference. It is probably fair to say that no Federal Reserve Chair has had as much public exposure as Bernanke. Yet with all those public appearances, he has consistently managed to avoid any real discussion about the costs and benefits of the Fed’s actions. Are we likely to hear concern about food and gas prices, and how such are being driven by loose money? Probably not…just more on how increasing world demand is to blame. Just like it was the “global savings glut” that drove interest rates earlier this decade, it is always somebody else’s fault — never the Fed’s. They are capable of only good.
Hopefully Bernanke will at least avoid the Obama line that it is those “speculators” that are behind the increase in energy prices. After all, if we believe the governments of Europe, those evil speculators brought down Greece too.
As per usual, I truly hope I’m wrong here. Bernanke has a real opportunity to be honest and straightforward with the American public. We don’t need another lecture. We need to hear that the Fed isn’t a slave to some imaginary Phillips Curve or that we can’t have inflation with slack in the economy (where was Bernanke in the 1970s?). The real risk is that Bernanke uses the press conference to drown out the many voices of concern and dissent on the FOMC. Which, of course, would be a real irony given all of Bernanke’s talk about “democratizing” the Fed when he first became chair.
Johan Norberg on Bubbles Yet to Come
Cato senior fellow Johan Norberg, author of In Defense of Global Capitalism and Financial Fiasco, has the cover story in this week’s issue of The Spectator, the eminent 182-year-old British weekly. Titled “The great debt bubble of 2011,” it warns that governments are repeating their mistakes of the past decade:
There is a broad consensus that the financial crisis of 2007 was at least in part a result of record-low interest rates, huge deficits and large-scale credit-financed consumption. Today, governments across the world are trying to solve the crisis — by means of record-low interest rates, huge deficits and large-scale credit-financed consumption. This time, they are also using more novel means of creating easy money: bank bailouts, stimulus packages and quantitative easing.
After discussing the soaring debt burdens of European countries, Norberg writes:
At this point, it is traditional to say: thank God for those roaring economics in East Asia, India and Brazil. But how real is their remarkable growth? Look closely, and even this may be in part a result of artificial stimulus. India’s and Brazil’s growth is financed by short-term capital from abroad: money that could disappear overnight. Easy money always ends up somewhere. The last time it was in property, this time it is in emerging markets (and often in the property markets of emerging markets)….
Aside from the foreign capital inflows, China had its own stimulus package, as big as America’s. Beijing has printed yuan and pushed banks and local governments to spend like drunken Keynesians. Absurdly, China’s money supply is now larger than America’s, even though its economy is a third of the size. We can see the results of this stimulus in stock market prices and in new roads, bridges and housing complexes all over the country.
Happy New Year! And watch for more on incipient bubbles in the January-February issue of Cato Policy Report.
Is There an Inflation-Unemployment Trade-off?
Much of what drives the policy choices of Ben Bernanke and the Federal Reserve is a belief in the ability to trade higher inflation for lower unemployment, known within the economics profession as the “Phillips curve.” But does this trade-off actually exist?
While its true that many have found a negative correlation between inflation and unemployment prior to 1960, looking at U.S. data, this relationship appears to have broken down in the mid-1960s, just about the time policy-makers thought they could exploit it (Lucas critique anyone?).
It is hard, looking at the graph, which displays the annual change in consumer prices over the previous year and unemployment, to see much of a relationship. In fact, since 1960, the correlation between changes in CPI and unemployment has been positive. We have generally seen rising unemployment along with rising inflation. Of course, one might be concerned that the stagflation of the 1970s is driving this result. But looking at the data since 1980, there still remains a positive correlation between inflation and unemployment. While I am not arguing that inflation causes unemployment (after all, correlation is not causation), it should be clear from the data that there is not some exploitable trade-off that policymakers get to choose.
The Richmond Fed also has a great history of the Phillips curve that is well worth the read. Perhaps Fed President Jeff Lacker should bring copies to the next FOMC meeting.
Bernanke’s Twist on Price Stability
While it’s been obvious for years, Bernanke showed his rationale for more easing in today’s Washington Post. He believes we are in danger of too little inflation. While common sense might imply that price stability means neither inflation nor deflation, in Bernanke’s book, anything below the Fed’s target of 2 percent is bad.
First of all, there really needs to be a public debate over the Fed’s 2% target. After all, a 2% rate of inflation over, say, 30 years erodes almost half of one’s wealth. How that can seriously be viewed as “price stability” is beyond me. While a 2% rate of inflation is not going to bring the economy to a halt, it is still a massive theft of wealth over the long haul.
Bernanke has also expressed the fear that “low and falling” inflation could lead to deflation, which would raise the real value of debt, which could lead to additional defaults. But what Bernanke doesn’t seem to get is that inflation isn’t falling. Let’s go to the data.
The graph below is simply the consumer price index (CPI) over the last year. Does it appear to be falling? Of course not. In fact, the trend is one that is rising.
Now CPI includes lots of things, some of which are temporary trends. The Fed has a nasty habit of excluding those items it doesn’t like. But let’s take a look at something that matter to the typical family: food.
Bernanke on Monetary Policy
Every August, the Federal Reserve Bank of Kansas City sponsors a conference on monetary policy. It is the most valued invitation of the year for central bankers and Fed watchers. The Fed Chairman typically presents his views on monetary policy and the economy, and his talk inevitably makes headlines. (A select few reporters are invited.)
This year, Ben Bernanke promised the Fed will do whatever it takes to aid the faltering U.S. recovery, and most of all to prevent deflation. The problem for the Fed Chairman is that the central bank is plainly running out of options, as some had the cheek to observe. He suggested the Fed could do more of the same (purchase long-term securities), or try something new and untested (tweak the interest rate it pays on bank reserves).
Bernanke also suggested a third option, plus offered some professorial speculation on another. Taken together, these suggest the Fed may be prepared to chart a dangerous course.
In its policy statement, the Federal Open Market Committee has promised to keep interest rates low “for an extended period.” Bernanke suggested (as the third option) that the FOMC might make it clear that rates will remain low for an even longer period than markets are currently expecting. Within the Committee, there have been calls for caution and to remove the “extended period” language from the statement. These have been led by Thomas Hoenig, president of the KC Fed and host of the conference. By suggesting the only option was lengthening the period of low interest rates, Bernanke delivered the back of his hand to his host and the other inflation hawks on the FOMC.
Bernanke then mused about suggestions by some economists that perhaps the Fed should set an inflation target — that is, promise to deliver higher inflation rates to stimulate the economy. Fed chairmen do not engage in abstract speculation about policy, and to raise the inflationary option gave it place above all other possibilities. Bernanke hastened to add that there was at present no support for such a policy within the FOMC, and it “is inappropriate for the United States in current circumstances.”
In other words, the Fed chairman is thinking about an inflationary policy and, if circumstances change and he can build support within the FOMC, he is willing to implement it. When central bankers speculate in public about the possibility of an inflationary monetary policy, the currency is in jeopardy and the country in peril.
By Pulling His Punches, Bernanke Shatters ObamaCare’s Credibility
Federal Reserve Chairman Ben Bernanke gave a speech in Dallas yesterday where he inadvertently discredited claims that ObamaCare would reduce health care costs and the federal deficit. According to The Washington Post:
Federal Reserve Chairman Ben S. Bernanke warned Wednesday that Americans may have to accept higher taxes or changes in cherished entitlements such as Medicare and Social Security if the nation is to avoid staggering budget deficits that threaten to choke off economic growth…
While the immediate audience for the speech was the Dallas Regional Chamber, his message was intended for Congress and the Obama administration…
Bernanke has urged Congress to address long-term fiscal imbalances in congressional testimony before, but usually only when he is asked about them by lawmakers. His speech Wednesday aimed to reach a broader audience, steering away from technical economic speak and using plain, sometimes wry, language — a rare thing for a Fed chairman.
The non-partisan Congressional Budget Office projects the annual federal deficit will be at least $700 billion in each of the next 10 years. Deficit spending is a form of taxation without representation, because it increases the tax burden of generations who cannot yet vote (often because they are as yet unborn). Bernanke wants us to end deficit spending. Kudos to him.
But consider the timing of his speech. Why wait until April 7, 2010, to deliver that message directly to the public? Why not give that speech in January? Or February? Or any time before March 21?
The reason is obvious: Bernanke held back to appease his political masters.
Wednesday Links
- Cato experts will live-blog Obama’s State of the Union Address tonight. Join in, submit questions, and watch the speech right here on Cato@Liberty at 9:00 PM EST.
- A quick, ten-point libertarian State of the Union Address.
- One “Great Canard”: Federal Reserve Chairman Ben Bernanke argues that the Fed’s monetary policy was not responsible for the U.S. housing bubble.
- Podcast: “Obama’s Fiscal Right Fake” featuring Chris Edwards.
Popping Bubbles
David Leonhardt’s column today in the New York Times, in reaction to Ben Bernanke’s recent speech at the American Economic Association meetings, asks an important question:
If the Federal Reserve failed to detect the housing bubble when it occurred, why should we entrust it with that role in the future?
But he doesn’t follow the logic of his question far enough and instead embraces a financial equivalent of the National Transportation Safety Board, as if technical solutions exist and could be implemented if politics got out of the way.
In our recent Policy Analysis, Jagadeesh Gokhale and I examine a more complete list of technical and political problems that stand in the way of asset bubble management. Can bubbles be detected using scientific techniques (econometric models) with little controversy? We argue no.
Would stopping bubbles involve the simple implementation of a technical solution such as raising interest rates, or would they instead involve trade-offs with other policy goals? We argue the latter.
Even if bubbles could be detected easily with no controversy and policy solutions involved no tradeoffs, could the Fed maintain political support by stopping booms if the benefits of such a policy (preventing busts after financial bubbles burst) were never observed? We argue no.
And finally, even if all the previous problems were solved, how would raising interest rates reduce the supply of capital to housing markets given that a rate increase would increase the supply of capital to the United States and interest rates for both long-term and short-term housing loans have become decoupled from federal funds rates?
Our reasoning, like Bernanke’s, suggests that the events of 2008 were not the result of “bad” monetary policy. However, we believe that granting additional regulatory authority to the Fed will not prevent similar episodes because of the technical and political difficulties we describe in our paper.
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