Sunday, August 7, 2011

Pre-FOMC: A Guide to What's on the Table This Week

The upcoming FOMC meeting this week is a critical one, and an important test for Ben Bernanke. In terms of something we can agree the Fed should be concerned with - inflation - here is what is going on. The figure shows the cpi, the core cpi (cpix in the figure) the pce deflator, and core pce deflator (pcex in the figure). I've taken January 2005 as a base period here. This is obviously arbitrary, but that choice is instructive in this context. The figure also shows a 2% trend path, which represents the Fed's quasi-explicit target. I'm not defending the 2% inflation target, and I don't think the Fed can defend it either, relative to 0%, 1%, 3%, or 4%, for example.

In June, the headline cpi was 3.1% above the 2% trend, the pce 1.6% above, the core cpi 0.4% below, and the core pce 0.6% below. Now, if the FOMC wanted to be consistent with previous FOMC statments and public minutes, and if it were looking only at that picture, there would be grounds for tightening. While core price indexes are a little below where they should be, an increase in the relative price of food and energy has persisted since 2005, and there is no good reason to expect that relative price shift to go away. As I noted here, the FOMC is on record as being focused on headline inflation, and rightly so.

Of course, the FOMC is not looking just at that picture. Indeed, unless you have been living in an isolation tank for the last several weeks, you know that all hell appears to be breaking loose. The Fed is bound by law to speak to its dual mandate, and I think there is little dispute about the role of a central bank in promoting financial stability.

On the real side, the last quarterly GDP numbers were weak, and there is nothing very promising in the monthly data. Things could be worse, but residential construction is still in the toilet, with no pickup in housing starts; consumption expenditure is weak; employment is growing but at a slow pace; the employment/population ratio is also still in the toilet.

In financial markets real and nominal yields on US government debt have recently dropped significantly. Stock prices are falling. Sovereign debt problems in Europe are going unsolved. Our federal government's inability to develop a coherent fiscal plan has the potential to get us into trouble.

How do we make sense out of this, and what should the Fed be doing about it? First, suppose that the turmoil in financial markets is only temporary, but nevertheless forecasts indicate that real growth (absent Fed action) will continue to be more sluggish than we had expected. Should the Fed be doing something? No, there is nothing it can do. The interest rate on reserves has been at 0.25% since fall 2008, and the "extended period" language could be in the FOMC statement until eternity. The Fed could do QE3, but QE2 was irrelevant, so another round would have no effect either. Even if you thought quantitative easing worked as the Fed claims, long-maturity Treasury yields are already low. The problem is not that safe long bond yields are too high.

On the financial front, the big story is uncertainty. One story you hear is that firms are not investing because they are uncertain about future government behavior. While we appear to have a weak executive branch and a goofy legislative branch, I think the uncertainty people are concerned with is rooted in debt problems - in this case sovereign debt. Europe's sovereign debt problems have the potential to produce calamity on the order of what we saw in fall 2008. Mitigating that is our previous experience, and the fact that policymakers have had more time to figure out where the vulnerabilities lie.

A key problem is that low US Treasury yields reflect a scarcity of safe assets in the world. US debt, in spite of our recent fiscal fracas and S&P downgrade, is still viewed as a safe haven. I mentioned above that inflation, if anything, is currently too high in the US, but a continuation of the current financial conditions, or a worsening of the situation in Europe, would ultimately lead to a downward price level adjustment in the US, due to the increase in demand for the liabilities of our consolidated government. Effectively, there is a liquidity problem, but it is not one that can be solved through standard open market operations - this is not a currency shortage (as for example in the Great Depression) but a shortage of consolidated-government debt (i.e. the net debt of the central bank and federal government combined).

What to do about the liquidity shortage? The Fed can of course use conventional discount window lending, but currently the liquidity problem is mainly in Europe, not in the US. There is another tool, though, which is the Fed's swap facilities with foreign central banks. These played an important role during the financial crisis, were discontinued, and then renewed again in May 2010. As far as I can tell, these swap lines are still open, but are currently not being used, and I don't know why. Maybe someone has information on this.

In any event, I'm very curious to see what comes out of this FOMC meeting. Reassuring words? Something big? There is certainly a lot at stake, including the credibility of the institution.

23 comments:

  1. The swap lines are open, and are not used.

    The swap lines arent't used because the institutions that are eligible to borrow are finding it cheaper to borrow from other market counterparties than from the central banks. The central banks offer the dollars at a significant spread above market rates.

    Unless the US dollar funding market was severely stressed/tiered there would be no logic in any individual market participant borrowing from a participating central bank, as they could get the same dollars, for the same term, cheaper elsewhere.

    ReplyDelete
  2. So, I think we should conclude that the situation is not currently that dire. If there was a severe problem, the swap lines would be used.

    ReplyDelete
  3. "Now, if the FOMC wanted to be consistent with previous FOMC statments and public minutes, and if it were looking only at that picture, there would be grounds for tightening."

    I don't see why this is the case. It would be true IF the Fed followed price-level targeting with growth in target of 2% a year. In that case, it would say the current price level exceeds the target and contractionary policy would be warranted.

    The Fed, however, is not an explicit price-level targeter, although I think this discussion regularly comes up at FOMC meetings. Instead, it appears to have an inflation goal in mind for the next year or two (2% or so) and it adjusts policy to achieve this forward-looking goal, with additional adjustments made to reflect the dual mandate and conditions in the real economy. Because it does not follow PLT, its policies do not depend directly on past inflation rates. I.e. above-average inflation rates over the last few years do not call for more contractionary policy than expected given expectations of future macroeconomic conditions.

    -C

    ReplyDelete
  4. As they're not explicit other than that some of them say "2%," we can only guess. It has to be 2% over some horizon. If it's the horizon I look at here, they should tighten. If you use another base period, or horizon, you can get a different answer. I'm sure that will enter the discussion when they meet.

    ReplyDelete
  5. If you read past minutes of FOMC meetings, or speeches by FOMC members on inflation, it's pretty clear that they're all targeting future inflation rates and trying to get them to some target. I.e., the horizon is purely in the future. You'll never read an FOMC member saying "inflation was 1% two years ago and 3% last year, so we're right on target", which is what you'd expect under PLT. Past inflation rates are, conditional on current expectations of future inflation, pretty much irrelevant to policy decisions. See the vast literature on estimated Taylor rules using real-time expectations.

    The only exception I've seen is Gorodnichenko and Shapiro (JME 2007) who argue that one can detect some element of PLT in policy decisions. But they seem to be the outliers.

    -C

    ReplyDelete
  6. As a "New Monetarist" what do you think of the "quasi-monetarists" like Scott Sumner, Nick Rowe, David Beckworth, Bill Woolsey and Josh Hendrickson? A number of them have advocated that the Fed target nominal GDP (though some have other ideals like aggregate wages or some productivity norm).

    Kurt Schuler has a brief discussion with links to some of the relevant economists here.

    ReplyDelete
  7. 1. "If you read past minutes of FOMC meetings, or speeches by FOMC members on inflation, it's pretty clear that they're all targeting future inflation rates and trying to get them to some target." Yes, I think that's basically correct. There is talk about current conditions, but the discussion about inflation tends to focus on what current actions imply for future inflation, given the forecast, expectational measures including the breakeven rates implied by Tips yields, and notions of "resource slack," i.e. Phillips-curve ideas about what causes inflation. Of course, what is optimal is another question. I have argued elsewhere that if you are worried about the effects of inflation uncertainty over various horizons on credit markets, that history matters, and price level targeting would work well.

    2. On quasi-monetarists: They have some similar ideas about the role of assets in financial trade, though they use a different language. However, it seems to me that nominal GDP targeting has to operationally be a specific class of Taylor rule, i.e. they are not proposing anything fundamentally different from what a New Keynesian would think about.

    ReplyDelete
  8. Effectively, there is a liquidity problem, but it is not one that can be solved through standard open market operations - this is not a currency shortage (as for example in the Great Depression) but a shortage of consolidated-government debt (i.e. the net debt of the central bank and federal government combined).

    A "liquidity problem?" What on earth do you mean? Seems to be a solvency problem to me and I have no idea how a swap line to Europe is supposed to solve this problem. But maybe I am missing something?

    ReplyDelete
  9. If there is a shortage of consolidated-government debt then... perhaps government should issue more debt?

    -RV

    ReplyDelete
  10. David,

    Look at the TIPS yields. They are incredibly low, reflecting a scarcity of safe, liquid assets.

    RV,

    Yes, consider this. Suppose that the central bank had the authority to tax and to issue tradeable interest-bearing debt, i.e. Fed bills. Then, in circumstances like this, the central bank could essentially do a Ricardian-type intervention (except with non-Ricardian results), i.e. issue more debt with the promise to retire it at some specified date in the future through taxation. Of course, we could think of good reasons why we would not want to give unelected officials the power to tax in a democracy.

    ReplyDelete
  11. Steve,

    First, I agree that there is an asset shortage. God, we've been talking about this forever. Not sure how repeating it here answers my question.

    If I understand your position correctly, it is this. An hypothetical temporary swap of U.S. Treasuries for PIGS debt would help alleviate the asset shortage.

    If this is what you are saying, then I disagree. If it is not what what you're saying, then please correct me.

    ReplyDelete
  12. Or are you just suggesting that the Federal Government should run even bigger deficits, pure and simple?

    -RV

    ReplyDelete
  13. David,

    What is PIGS debt?

    RV,

    I described something in my last reply to you that I thought would work. I described it as a central bank operation, but it's fiscal policy. Why was I thinking of this as a job for the central bank? Because, though this would be very simple, our fiscal authority is not currently (or probably ever) capable of doing this.

    ReplyDelete
  14. PIGS: Portugal, Italy, Greece and Spain.
    - C

    ReplyDelete
  15. PIGS. This was somehow familiar, but I couldn't place it. Now I remember. You might be able to tell a story about how swaps for PIGS debt is equivalent to the Fed swap facilities with the ECB, but that's not what I had in mind. The central bank swaps essentially allow the Fed to make discount window loans in Europe, in US dollars, through the ECB, at the ECB's discretion, and the Fed does not bear any risk, provided the ECB is solvent.

    ReplyDelete
  16. Steve, yes, that's right. But what are you suggesting? That the USD is more liquid than the Euro? The ECB can create Euros to lend (which they are de facto doing, by purchasing PIGS debt). How does borrowing USD from the Fed, and then lending USD locally (Europe) help alleviate the global asset shortage? Especially through the swap facility (temporary loans)? I just don't get it.

    ReplyDelete
  17. I don't get it...what "monetarism" do you see in "New Monetarism" when you talk about inflation with out even mentioning money supply growth or velocity?? MV=PT ...

    ReplyDelete
  18. "I don't get it...what "monetarism" do you see in "New Monetarism" when you talk about inflation with out even mentioning money supply growth or velocity?? MV=PT ..."

    We know you don't get it, it is clear from every word you type. Go away.

    ReplyDelete
  19. St. Louis fed drama ITT?

    ReplyDelete
  20. Just a suggestion, David. Not sure I get it entirely either. Go off and think about it.

    On monetarism:

    No, that's actually in there too, but in reality the "moneyness" of assets is much more flexible than what Milton Friedman had in mind. For example, for some types of transactions, T-bills (or T-bonds for that matter) are much more useful in exchange than is currency or even bank liabilities.

    ReplyDelete
  21. David,

    Don't know if you have thought about, but I have anyway. Here is another thought. Central bank lending increases the outstanding debt of the consolidated government (fiscal authority + monetary authority), right? Of course, under some circumstances, an increase in central bank lending might be neutral. Of course, we have some idea that, even if central bank lending were neutral most of the time, that during some kind of crisis, it could matter. Now, if there is some market segmentation between Europe and the US (not sure why), it might make a difference if the Fed could lend in Europe rather than in the US, which would make these swap arrangements matter in a European crisis.

    ReplyDelete
  22. From a few comments back: This is not some unusual drama. This is just how Andolfatto interacts with me. He was like this as a student too. It takes some getting used to.

    ReplyDelete
  23. Anyone out there who believes they were sold a Bank Swaps product should act, by seeking a legal advice to see if they can make a claim for compensation against the bank.

    ReplyDelete