WSJ Factual Error

From the top story in today’s Wall Street Journal:

At one point during the day, investors were willing to pay more for one-month Treasurys than they could expect to get back when the bonds matured....That’s never happened before.

Actually it has happened before, not in the easily available data, but it has happened – in 1938 (and apparently several other times between 1935 and 1941).

My only source is a talk by Paul Samuelson, for which I cannot even point to a transcript, but I’m confident that primary sources will bear me out. I’m too lazy to go check old copies of The Wall Street Journal on microfilm, but take my word for it.

It’s actually pretty obvious if you look at the monthly data from the Fed. For example, in February 1941, the average yield on 3-month T-bills was 0.03 percent. Considering how the yield fluctuates from day to day and from hour to hour, it’s impossible to believe that it was not negative at certain points during that month. (Technically the Journal was referring to one-month bills, but it’s a safe assumption that, if 3-month bills were selling above maturity value, so were one-month bills for at least part of the time.)


UPDATE: Paul Krugman makes the same claim (hat tip: anonymous commenter)....and I continue to believe it is wrong. I'm not sure his claim is independent: he may have gotten his information from the Journal, or they may have gotten it from the same source, which I hope they will cite so we can follow it up and judge its reliability.

UPDATE2: Reuters and the AP, both citing Los Angeles-based Global Financial Data, report that the last time the 3-month T-bill was at or below zero was January 1940. (Could it merely have been "at" zero? It seems unlikely that the bid would have stopped at exactly zero.) Another AP report says that demand sent "the yield on the 3-month Treasury bill briefly into negative territory for the first time since 1940." Friedman and Jacobson, in A Monetary History of the United States, 1867-1960, say in a footnote that "yields on Treasury bills were occasionally negative in 1940." (Apparently my "obvious" conclusion about 1941 was not correct, buy my main point stands.)

Not a Bubble

Alex Tabarrok of Marginal Revolution has gotten a lot of (mostly dissenting) attention for his argument that there was no housing bubble (hat tip: hmm, I don't even remember, but I'll cite Paul Krugman, Jane Galt Megan McArdle, and Battlepanda, among the many who have pointed to the post). Alex Tabarrok reproduces Shiller's now-famous chart of housing prices over the past 100 years and comments:

The clear implication of the chart is that normal prices are around an index value of 110, the value that reigned for nearly fifty years (circa 1950-1997). So if the massive run-up in house prices since 1997 [culminating at an index value around 200] was a bubble and if the bubble has now been popped we should see a massive drop in prices.

But what has actually happened? House prices have certainly stopped increasing and they have dropped but they have not dropped to anywhere near the historic average. Since the peak in the second quarter of 2006 prices have dropped by about 5% at the national level (third quarter 2007). Prices have fallen more in the hottest markets but the run-up was much larger in those markets as well.

Prices will probably drop some more but personally I don't expect to ever again see index values around 110. Do you?

As Battlepanda points out, "Do you?" is not a very convincing argument unless you already agree with him. But I think I can make it a little bit more convincing:

Prices will probably drop some more, but personally, given the likely effect that an additional 40% drop in home prices would have on the already weak economy, I don't expect that the Fed will allow index values to fall to anywhere near 110 in the foreseeable future. Do you?

Some people will respond with something like, "OK, I don't either, but that doesn't mean it wasn't a bubble; that just means there's a Bernanke put on home prices: there was a bubble, and the Fed is now going to ratify the results of the bubble." But that's not right. The Fed is not actively causing inflation in order to bail out homeowners and their creditors. The vast majority of professional forecasts call for the inflation rate to fall over the next few years. The Fed is just doing its job -- trying to keep inflation at a low but positive rate while maximizing employment subject to that constraint. The ultimate concern of the Fed is to avoid deflation, which becomes a serious risk if the US housing market has a total meltdown. It's very much as if the Fed were passively defending a commodity standard, with the core CPI basket as the commodity.

The ultimate source of the housing boom is the global surplus of savings over investment. That surplus is what pushed global interest rates down and thereby made buying a house more attractive than renting. And that surplus is still with us. If anything, it appears to be getting worse, as US households begin to reject the role of "borrower of last resort." And it is that now aggravated surplus that threatens us with weak aggregate demand and the risk of economic depression in the immediate future -- a risk to which the Fed and other central banks will respond appropriately. Until the world finds something else in which to invest besides American houses, the fundamentals for house prices are strong -- not strong enough, probably, to keep house prices from falling further, but strong enough to keep them well above historically typical levels.

When does monetary policy become ineffective?

Mark Thoma* leaves a succinct comment on my previous post:

Where we differ is the point at which monetary policy loses its effectiveness - I think that happens way before i-rates hit zero.

It’s an interesting point, because it is a position that many economists (including Keynes himself) seem to have held over the years, but one which, as far as I can tell, has never made much sense.**

I should be more specific: It may make sense if you measure monetary policy in certain ways, but not if you measure monetary policy in the way that is reasonable given how today’s central banks set policy. One might be (but in my opinion shouldn’t be) inclined to measure monetary policy in terms of the volume of open market operations, or some similar measure. In that case, it is quite true that a volume of operations that was effective when the interest rate was 5% is no longer likely to be effective when the interest rate is 1%. And certainly the people responsible for conducting those operations do need to be concerned with the volume. But for us, as economists and such, who can and should view monetary policy with some degree of abstraction, it makes little sense to concern ourselves with the volume of such operations. The transaction costs associated with open market operations are tiny (and not proportional to volume anyhow); the market for Treasury bills to be purchased is vast and quite liquid; the absolute size of an open market operation is of little importance, except inasmuch as it affects other variables, such as interest rates. Moreover, the same argument applies to other “quantitative” measures of monetary policy, such as changes in bank reserves and changes in monetary aggregates.

Since today’s central banks (and the Fed in particular) generally define their policy stance in terms of an interest rate, the reasonable way to measure that stance is in terms of an interest rate. Now one might argue (but again, I don’t think one should) that a proportional change in the interest rate that was effective when the interest rate was high will no longer be effective when the interest rate is low. For example, if the interest rate is 8% and you lop off one fourth of it, making the interest rate 6%, that could be quite an effective policy move; but if the interest rate is 1% and you lop off one fourth of that, making the interest rate 0.75%, that is not likely to be very effective at all by comparison. But central banks don’t measure interest rates proportionally, they measure them in…usually 25 basis point increments. And a 75 basis point cut by the Fed, for example, is considered a big move whether the interest rate starts at 8% or at 3%. The sensible question, it seems to me, is whether the effect of a given cut – defined in basis points – will be diminished when interest rates are already low.

If anything, I would argue, the exact opposite should be true. Monetary policy works largely by affecting the discounted value of expected returns on capital assets. When the Fed cuts interest rates, all other things being equal, stocks are worth more, houses are worth more, factories are worth more, machines are worth more, contemplated investment projects are worth more, and so on. The more the value of an asset rises relative to the cost of producing it, the more it becomes profitable to employ people in producing that asset. And theory says this effect should get stronger the lower are interest rates to begin with.

To see the point, consider a world where the risk premium is not an issue and where the Fed sets long-term interest rates. And just to make it clear, consider the extreme case where “long-term” means perpetual. In that case, the value of an asset that produces a fixed stream of returns equals the value of the periodic return divided by the interest rate. Thus if the Fed were to reduce the interest rate from 5% to 4%, it would increase the value of such an asset by 20%. But if the Fed were to reduce the interest rate from 1% to 0%, it would increase the value of the asset by…well, you do the math. In the enterprise of producing an infinitely valuable asset, it is of course profitable to employ as many people as you possibly can, at whatever wage they might require. In the real world, where the Fed controls only short-term rates, and where there is a risk premium associated with most assets, the effect is not so dramatic, but the difference in the effectiveness of policy when interest rates are low vs. high should certainly be in the same direction.

If, therefore, we may define “monetary policy” as the manipulation of an interest rate by a central bank, then we should expect that monetary policy gains more effectiveness the closer the interest rate comes to zero. And indeed, technically, there is no point at which monetary policy, thus defined, “loses its effectiveness.” There is, of course, a point at which additional stimulative monetary policy becomes impossible to practice, namely, the precise point when the interest rate reaches zero.***



* As far as I know, this is the real Mark Thoma – by which I mean the one that writes Economist’s View – not someone else of the same name. As an aside, though, it occurs to me that there is no shared authentication between Blogger and Typepad, so one doesn’t really know such things for sure. If I wanted to, I could probably post comments on other people’s blogs while pretending to be Brad DeLong or Barry Ritholtz. Or one of them could pretend to be me – though it's hard to think of any reason why they might want to.

** Please do not fear, Gentle Reader, that I have entertained for even a brief moment the abominable heresy that St. Maynard may have held a view that was in any way unreasonable. (Indeed, at the very thought, I must ask you to excuse me while I make the sign of the Keynesian cross over my chest.) Rather, I merely posit that there are certain inherent difficulties in communication between the Truly Awakened and ordinary sentient beings such as we. Interpreting the words of our lord**** in accordance with the mere shadows that form our limited experience, it is we who may have fallen into error. I’m personally intrigued by an alternative exegesis preached to me once by radical political economist Stephen Marglin, who suggests that Keynes was referring not to a lack of effectiveness per se but to the political difficulties in implementing a very low interest rate policy in an economy where the rentier class is loath to give up the income it receives in the form of interest.

***Strictly speaking, this is not quite true. Interest rates on some Treasury bills went below zero in 1938. Apparently, there are some people out there who like their Treasury bills so much that they won’t give them up even if you offer a premium to redemption value.

****I trust that the lower case L keeps me safe from the charge of blasphemy. Surely the lord I have in mind was indeed ours. To whom, after all, could Keynes belong***** if not to the Keynesians.

*****Actually, I have nothing to say down here, but I got so fascinated with the idea of nested footnotes that I decided to push the concept one level further.

What is the purpose of a fiscal stimulus?

In the course of thinking about my last post, I have come to a striking realization: the (primary) purpose of a fiscal stimulus is not, as commonly believed, to stimulate aggregate demand and thereby increase economic activity; the purpose is to prevent interest rates from going down.

If the purpose of a fiscal stimulus were to stimulate aggregate demand and thereby increase economic activity, then a fiscal stimulus would almost never be a good idea. Typically, when a fiscal stimulus is proposed, one will hear arguments against it from various economists, typically of the more conservative-leaning variety (as, for example, Andrew Samwick here). These arguments rest on the premise that the conventional reason for a fiscal stimulus is the true reason. They argue (in my opinion) convincingly that that reason is not a good one, and they conclude that a fiscal stimulus is a bad idea. Essentially, anything that fiscal policy can do, monetary policy can do better. And monetary policy will do it, because that’s the job of central bankers. And if you disagree with the central bank about whether we need a stimulus, it will do you no good to try to use fiscal policy unilaterally, because the central bank will act to offset the effect with higher interest rates.

There is one exception – one case where monetary policy (maybe) just doesn’t work: that is the case where the interest rate is zero. In that case, there is no opportunity for the central bank to stimulate the economy by reducing interest rates. And if the central bank tries to stimulate the economy just by increasing bank reserves, this may be ineffective, because banks, having obtained the funds at zero cost, will feel little pressure to make loans; they may simply hold all the extra reserves as free insurance against the prospect of unexpected cash needs. And moreover, their creditworthy customers may not be willing to borrow, even at extremely low interest rates, if they can’t think of anything good to do with the money. This may or may not have happened in Japan; it’s still controversial whether the Bank of Japan’s policy of “quantitative easing” had a major impact. Anyhow, it’s something to worry about.

But in the US, for example, the interest rate has not been zero since 1938. So this one exception does not apply. If you’re worried (like Paul Krugman) that the exception might apply at some point in the not too distant future, then your argument about today is not that the exception does apply, but that we need to take action to avoid the situation in which the exception would apply. In other words, you don’t want interest rates to go too far down. You want a fiscal stimulus to prevent interest rates from going down.

Alternatively, let’s say that you were calling for a fiscal stimulus (or perhaps a larger or better directed one than what we actually got) in 2001 and 2002 and that you had the foresight to see that a monetary stimulus would affect the economy by producing an excessive and ultimately destructive housing boom. If your foresight were that good, you would probably have seen also that the monetary stimulus would succeed in getting the economy going and getting the unemployment rate down. So you couldn’t advocate a fiscal stimulus for that purpose, which would already be served. Rather, you would advocate a fiscal stimulus to avoid an excessive housing boom – by preventing interest rates from going down.

Today it would be hard to argue that a monetary stimulus could spark another excessive housing boom. (It might, I think, spark some kind of a boom, but the boom will be more orderly and rational, given the “once bitten” status of the housing market, as well as the elimination of many of the prospects for creative financing.) But a monetary stimulus could have another bad effect – rising import prices due to sudden drop in the dollar. The way to avoid that effect is to keep US interest rates high enough to attract capital from abroad, which will prop up the dollar. And the way to do that is with fiscal policy – a policy to produce a demand for that capital, so that someone in the US will be willing to pay those interest rates. Again, the purpose of a fiscal stimulus is to prevent interest rates from going down.


[Update: pgl's response at Angry Bear makes me realize that my reference to "another bad effect – rising import prices" was misleading. Rising import prices are a good thing, in my opinion, in that they would help reduce the international imbalance (the large net inflow of goods to the US from Asia), but on balance, only a good thing if the prices rise slowly enough to avoid a dramatic deterioration of the output-inflation tradeoff (i.e. stagflation, or something like it). The argument for using a fiscal stimulus, and therefore having relatively higher interest rates, today is that higher rates would let the dollar fall gradually, thereby avoiding the shock from a sudden deterioration in the terms of trade. It would also avoid a sudden contractionary shock to the rest of the world's economy.]

Paradoxical Responses to Fedspeak

Throughout November, the US Treasury bond market seems to have been responding to Fedspeak by going in the opposite direction from what Fed statements would suggest about interest rates. Early in the month, when Fed officials were sounding (to my ears, anyhow) hawkish, interest rates fell. Over the past few days, with Fed officials sounding more dovish, interest rates have risen.

With respect to long-term bonds, this behavior is consistent with a view in which statements by Fed officials give clues about the Fed’s degree of commitment to keeping inflation low. Hawkish statements mean less inflation, which means lower long-term interest rates. Dovish statements mean more inflation, which means higher long-term interest rates.

It’s a bit harder to rationalize the response of short-term bonds (by which I mean 2-year Treasury notes, Treasury bills, and seasoned securities nearing maturity). The Fed’s commitment to keeping inflation low shouldn’t be much of an issue here, because there isn’t enough time for the inflation to develop before the bond matures.

Another explanation is flight to quality: when the Fed is more hawkish, bondholders worry more about the creditworthiness of other borrowers and shift their assets into Treasury securities, causing the interest rates on those securities to fall. But even the Eurodollar market, which is considered more risky than the Treasury market, has been responding in the same direction.

A variation on the flight to quality explanation is that the flight is from stocks: hawkish statements by the Fed cause investors to sell stocks and replace them with bonds, thus causing bond yields to fall. But presumably the reason investors sell stocks is that they think higher interest rates are bad for the stock market. Why would this cause them to bid down interest rates to an even lower level? Once interest rates fall, wouldn’t they immediately go back into stocks?

My best guess about what’s going on is that the bond market thinks it understands Fed policy better than the Fed does. The bond market is convinced that interest rates will eventually have to come down to prevent, or to recover from, a recession. The sooner the Fed starts cutting – the sooner it sets into motion the recovery process – the less cutting it will eventually have to do. In particular, if the Fed cuts sufficiently at the next two meetings, it may be able to avoid a recession. If not, a recession is nearly certain, and more dramatic (and longer lasting) cuts will be necessary to recover from the recession. This is how I imagine that the bond market reasons, but I’m not convinced that the bond market is right.

Exchange Rate Expectations and Interest Rates

Since I’m (unhappily) short US Treasury bonds at the moment, I should be glad so many people think that uncovered interest parity means US bond yields have to rise when investors lose confidence in the dollar. (See the comments section of this post from Brad DeLong.) But it just ain’t so! Unquestionably, there are reasons to expect interest rates (bond yields) to rise when the dollar weakens, but those reasons are more subtle, and have different economic implications, than a brute force application of uncovered interest parity would suggest.

The theory seems simple enough: if investors expect the value of the dollar to decline, they will require higher yields on their dollar-denominated bonds, to compensate for the lower exchange value of the dollars in which they expect to be paid. The problem is that people take the clause “investors expect the value of the dollar to decline” to refer to a condition independent of how investors respond to that condition. In most models, what actually happens when “investors expect the value of the dollar to decline” is that the value of the dollar immediately declines, and then investors no longer expect the value of the dollar to decline. And most of those models include uncovered interest parity.

Suppose international investors, holding US bonds, suddenly come to believe that the value of the dollar will decline. What do they do? First they sell their bonds, which does cause yields to rise temporarily, but… What do they do with the proceeds? Do they sit on those dollars and wait for yields to rise enough to entice them to buy bonds again? I would think not, if they expect the value of the dollar to decline: instead, investors convert those dollars into (for example) euros and sit on those euros (or invest them in European bonds) until some combination of interest rate and exchange rate movements entices them back to the US bond market. But they don’t have to wait very long, because, in the process of converting those dollars to euros, they have pushed down the value of the dollar sufficiently that it no longer needs to decline. Suddenly, with the dollar no longer expected to decline, US bond yields become very attractive. They become so attractive that investors bid yields back down to their old levels.

In the paragraph above, I’ve snuck in some elasticity assumptions to assure that the value of the dollar doesn’t rise again when investors convert their euros back into dollars to buy back the US bonds. In principle, interest rates and exchange rates should be determined simultaneously. But if we believe in the expectation-based world of uncovered interest parity, then we must also believe in a similar expectational parity between short-term and long-term interest rates. Short-term interest rates are set by monetary policy, and long-term interest rates depend on expectations of future short-term interest rates. So if we hold expected monetary policy constant, all interest rates will be constant. If long-term interest rates rose, investors would try to exchange all their short-term bonds for long-term bonds, but since monetary policy assures a perfectly elastic supply of short-term bonds, this process would not stop until long-term rates came back down. Under these circumstances, the only way the market can adjust to a loss of confidence in the dollar is by bidding down the exchange value of the dollar immediately, until it is no longer expected to fall.

Now, you might point out that expected monetary policy will likely respond to the declining value of the dollar by raising interest rates. That’s true, since the cheaper dollar makes US goods more attractive and thereby produces a stimulus that monetary policy needs to offset. But that is a consequence of the monetary policy reaction function and the goods market equilibrium, not a consequence of uncovered interest parity. And it doesn’t allow one to make the argument, “When investors lose confidence in the dollar, US interest rates will rise, causing the economy to weaken,” because the Fed is only expected to raise interest rates enough to prevent the economy from strengthening, not to weaken it relative to its original condition. There are other, more subtle arguments you could make about why interest rates might rise further (the inflationary impact of the J-curve, behavior of foreign central banks, etc.), and the economy might actually weaken, but we have already wandered far afield from uncovered interest parity. If you want to argue that a loss of confidence in the dollar will weaken the US economy, you’ve got a lot of explaining to do.

Stay Away from the Fan

If we lived in my fantasy world where the Fed targets unit labor costs and everybody knows it, we’d be fine – and due for some more substantial rate cuts. Not that I would have the Fed react dramatically to the latest dip in unit labor costs – which is only one quarter out of many and, after all, could be revised away. My fantasy Fed might take the latest labor cost report as a minor reason to congratulate itself on past policy actions, what with earlier seeming evidence of an acceleration in labor costs turning out to have been falsely alarming. But as for cutting rates, the Fed has plenty of other reasons: a deepening financial crisis that threatens to affect the real economy; a deepening housing recession (depression?) that threatens to spill over to the rest of the economy; a substantial decline in labor demand that has finally begun to show up in the unemployment rate. If labor costs were the target, the Fed could respond to all these concerns and shrug off the other news: the fastest increase in commodity prices since the 1970s. If everyone knew the Fed were targeting labor costs, then workers wouldn’t expect pay increases to compensate for rising energy costs and the like, and the Fed could ease without risking losing credibility or creating an inflationary spiral.

If we lived in my other fantasy world where the Fed follows a backward-looking Taylor rule, we’d be doing OK too – and still (in my opinion) due for some more rate cuts. Although there is inflation on the horizon, the Fed could use (and could already have used) the low reported trailing inflation rates as an excuse to cut rates. By the time the commodity price increases found their way into core inflation, hopefully the financial crisis would be over, and, with any luck, the Fed would re-tighten at just in time to prevent a boom.

But in the real world, Fed policy is judged not by unit labor costs or by its adherence to a backward-looking rule but by outcomes in the core inflation rate. (I’m thankful at least that I live in the USA, where we know that smoking cigarettes causes cancer and targeting headline inflation causes unnecessary recessions and booms.) If the Fed lets the core inflation rate rise for any reason, that will lead people to question the resolve of its still relatively new chairman. And workers, facing a reasonably healthy economy, will feel entitled to wage increases to offset their rising cost of living. And businesses, facing that same reasonably healthy economy and a seemingly friendly Fed chairman, will see no reason not to raise prices enough to preserve their record profits and compensate both for increased energy and materials costs and for increased wages. Unfortunately, the only way for the real Fed to maintain its credibility today is by keeping the economy weak and risking recession, so as to damp any economic optimism, which, in combination with rising non-labor costs, would result in a higher core inflation rate.

So here we are, people. Just over a month ago, I insisted that the s___ was not yet hitting the fan, but it looks like I spoke too soon. The fan is running. The s___ is flying. Just get out of the way.

125 Basis Points

Is it time for another Fed meeting already? How time flies when you’re watching CDO tranches get downgraded from top quality to junk!

I just want to point out that the Taylor rule is still calling for a federal funds rate of 3.5%, and there are 125 basis points left to get there, so by this measure, the FOMC’s job has barely begun. Since the last meeting, the (12-month market-based core PCE) inflation rate has fallen (from 1.7% to 1.6%, rounded) and the unemployment rate has risen (from 4.6% to 4.7%, rounded, but mostly due to rounding), so if anything, the target would be even lower. But with quarter-point rounding in the funds rate target, the combined effect of these changes is not enough to change the result.

As to what the FOMC will actually do this week, I’ll go with the consensus of 25 basis points. As Mark Shivers suggests, there are persuasive arguments to be made for either 0 or 50, and the arguments are sufficiently persuasive that neither of these options can be chosen, because either one would imply a strong rejection of the other. Although the financial crisis has clearly diminished, it may not have diminished as much or as quickly as the Fed had hoped, and part of the reason for its diminishing is the expectation of another rate cut. Depending on how you read the beige book, there either are or aren’t indications that the crisis is affecting the real economy, so the appropriate rate cut is either 50 basis points (to nip this trend in the bud) or 0. An individual might make the choice by flipping a coin, but a committee makes it by splitting the difference.

As for my serious opinion of what the FOMC should do, I think I would go with 50. A 75 basis point cut would risk too much financial market (and foreign exchange market) instability, but even a more conservative Taylor rule would call for at least 50. (Say, for example, we reduced the target inflation rate from 2% to 1.5% and increased the natural real federal funds rate from 2% to 2.5%. That would increase the target funds rate by 75 basis points, leaving 50 still to go. Personally, I’d rather stick with the original rule if we’re going to use Taylor rules at all, but I’m open to choosing a higher inflation reading than my 1.6%.) Some of the arguments I made in September no longer apply (e.g. the temporarily robust dollar, falling employment), but most of them still do, and the bottom line is that even 4.5% qualifies as a slightly restrictive policy, not appropriate when the core inflation rate is still low and 65% of Americans expect a recession (hat tip: Barry Ritholtz).

I could also point out that, while the financial crisis has diminished, the underlying housing problem has gotten worse (and by worse I mean worse relative to expectations). Here in eastern Massachusetts (home of the world champion Boston Red Sox!), where a year ago it was difficult to find anecdotal evidence to support the statistical finding that house prices were declining, it is now difficult to avoid the anecdotal evidence. At dinner Saturday evening, for example, the waitress told my wife about how she and her husband were planning to move but underwater on their mortgage and hoping the bank would accept a short sale. With the personal savings rate still near zero, declining house prices are likely to be a drag on consumer spending for quite a while, and the risk that the we could discover a nonlinearity in the response sometime soon – particularly with oil prices making new record highs and credit conditions fairly tight – is palpable. When and if we hit that nonlinearity, it will be too late to prevent a recession.

Fiscal Policy and Changing Times

To anyone who is familiar with opinions I expressed (in real life) about fiscal policy during the 1980s and 1990s, it may appear that my opinions have changed dramatically, or indeed, that I have completely reversed myself. In particular, anyone who knows what I thought of the Reagan tax cuts (and how harshly a coauthor and I expressed it even 15 years later) will probably be surprised to hear me defending the Bush tax cuts even as Alan Greenspan tries to disown them (not to mention that I spent six posts last year on why I'm not convinced by various arguments for cutting the deficit and one on why the one convincing argument doesn't apply for the immediate future). But I don’t believe my opinions have changed much; what have changed are the economic conditions.

In particular, nominal interest rates have generally been much lower during the new millennium than they were during either of last two decades of the old millennium. (I have a vivid memory of walking through Kenmore Square in Boston in 1992 reading in the Wall Street Journal that traders weren’t willing to buy 10-year treasury notes at a yield below 7%. Today the notes yield 4.6%, and people are surprised how the yield has risen since the Fed meeting.) As I argued in two posts in July, nominal interest rates determine both the harm and the good that can potentially be done by budget deficits. When nominal interest rates are high, deficits are unambiguously harmful. When nominal interest rates are low, deficits may still be mildly harmful, but they can also be helpful and can even become critically necessary when rates fall to near zero.

This all seems to me a fairly straightforward application of textbook macroeconomics: when interest rates are high, budget deficits push them higher and crowd out private investment; when interest rates are low, budget deficits can provide a useful stimulus to keep employment high and avoid deflationary conditions, since monetary policy may not be able to provide a sufficient stimulus. Of course it’s more complicated for an open economy, but the same argument applies to the world as a whole, and the US is a big part of the world economy.

Holy S___, Batman, Look at the Foreign Exchange Market!

In reaction to my last post about the s___ that may soon hit the fan and why labor cost targeting would help, Gabriel M. suggests that I discuss the nature of the s___ in question and how it came about. In a nutshell, the issue is that most economists (not all, but I would say the vast majority) think the dollar is significantly overvalued. For the moment, the market seems to disagree, inasmuch as interest rates on dollar-denominated bonds are not much higher than those on bonds denominated in, for example, euros. In theory, if people believed the consensus of economists, it would be a no-brainer for anyone with an international bond portfolio to dump their dollar assets and replace them with other assets such as euro bonds. (It’s implausible to me that the slight difference in nominal creditworthiness between the US treasury and, say, the German treasury, is enough to make this less of a no-brainer.) If everyone were doing that, dollar interest rates would already be significantly higher than non-dollar interest rates.

I don’t think I’m going too far out on a limb to say that, historically, when economists and the market disagree, the economists usually eventually turn out to be right (though the economists are usually wrong about how long it takes to get to “eventually”). A case in point is the last time the dollar was regarded as severely overvalued, in 1984. It may have taken an international agreement (the 1985 Plaza Accord) to get the dollar on a downward path, but once the decline started, it was beyond what international policymakers seemed able to control. Anyone who listened to economists in 1984 about the dollar, and then changed his mind when they turned out at first to be wrong, would have been extremely unhappy by late 1987.

I should note in passing that there were factors present in the mid-1980s that mitigated, and even reversed, the supply shock from the falling dollar. In 1985, when the dollar began to decline, the US was still recovering from worst recession since the 1930s, so there was considerable slack in the economy. (There may be considerable slack today, too, but that’s not the consensus.) Also, as a consequence of having shown itself willing to induce and prolong the worst recession since the 1930s, the Fed had a surplus of inflation-fighting credibility. And since the dollar had been continuing to rise until early 1985, there was something of a favorable import price shock already in the pipeline to offset the subsequent unfavorable one. Then in 1986, OPEC members were unable to reach agreement on new quotas, and the price of oil dropped dramatically, providing a favorable supply shock to (probably more than) offset the unfavorable shock from the falling dollar. Another factor was that many goods sold to Americans were (either explicitly or implicitly) priced in dollars, so the import price shock from the weak dollar was not as strong as it otherwise would have been. The same is true today, but less so.

Part of the reason that the dollar remains overvalued is that much of the investment in fixed income dollar assets comes from sovereign entities, such as the People’s Bank of China (PBoC) or the Saudi Arabian Monetary Authority (SAMA), that are less concerned about profit and loss than private investors. But even such entities are not entirely oblivious to profit and loss, and lately there are increasing signs of their desire to diversify away from the dollar. In doing so, they would also probably have to give up the currency pegs that have kept the dollar overvalued relative to their own currencies. SAMA gave the world a bit of a shock recently, when it uncharacteristically failed to echo the Fed’s interest rate cut. From China there are vague noises about the “nuclear option” of divesting of US bonds, which would entail dropping the dollar peg entirely. And China’s rising inflation rate is, one may presume, making it clearer to the Chinese authorities that continuing the peg in its current form is not in their national interest. So there are obvious cracks developing in the structure that has supported the overvalued dollar.

Another factor is the low national savings rate in the US, evident in both the negative personal savings rate and the federal fiscal deficit. With Americans not saving, the nation as a whole needs to attract capital from abroad, and that demand tends to keep interest rates high enough (relative to foreign rates) to keep the dollar from weakening too much. (My Keynesian self is telling me that is a big oversimplification, but I don’t want this post to get too long.) The risks here are (1) that (because of liquidity constraints due to falling home prices, or because of demographics, or just because of an attack of prudence) the savings rate could rise, taking away this support for the dollar, and (2) that, if the savings rate does not rise, foreign investors will lose confidence in the creditworthiness of the US and dump dollar assets until the dollar weakens or US interest rates rise.

The low savings rate in the US is necessarily offset by an excess of savings over investment abroad – the so-called “savings glut.” There’s a bit of a chicken-egg debate about which of these is the first cause, but from the point of view of the exchange rate, it doesn’t much matter. If the savings glut is the primary cause (a view to which I’m sympathetic), then the glut itself is arguably what has supported the dollar. However, the scenarios described in the previous paragraph still apply: (1) if Americans become no longer willing to absorb the excess savings, then the dollar will drop; (2) if international savers begin to think that the US is not a good place for their savings, then the dollar will drop. (The first of these scenarios – which I will call the “ice” scenario – is particularly troubling because, while it could be an inflationary shock for the US, it could at the same time be a particularly strong deflationary/recessionary shock for the rest of the world.)

So, whether or not it happens immediately, chances are there will be downward pressure on the dollar in near future, and we cannot assume that the market’s response will be orderly. If the dollar drops quickly, the price of imports would likely rise much faster than the US economy can adjust by shifting demand and production to domestic producers. That’s a classic example of an import price shock, and it would likely cause a rise in aggregate US consumer prices out of proportion with its relatively mild stimulative initial effect on US output (though the latter should increase over time). The shock will likely be exacerbated by rising commodity prices (including oil), as demand by stronger-currency countries pushes up the dollar price of commodities. (It’s debatable whether the last point has any real substance: most commodities are priced in dollars by convention, and their price in terms of some hypothetical “average” currency should not be affected by exchange rates. In theory, rising dollar commodity prices are just part of the original exchange rate shock, but when oil goes to $100, it will certainly get separate coverage in the media.)


Unfortunately, the prospects for anything even vaguely resembling explicit labor cost targeting are dismal at best. So I have left two great hopes for avoiding an unpleasant outcome for the US. First, that the rise in import prices will continue to be slow enough to avoid having much inflationary impact. Second, that there is more slack in the US labor market than the consensus recognizes, and this slack will absorb much of the price shock. Even if my hopes are realized, the outcome will be less than optimal, but then, when do we ever get an optimal outcome?

Unanimous

The Fed didn't quite give me the 175 basis point cut that I was calling for, but depending on how you look at things, it kind of almost did. You can divide the conceivable Fed actions into those that I thought might actually happen and those that were merely my fantasies. If you had asked me before the meeting about the possibility of a unanimous vote for a 50 basis points cut, I would have assigned it to the latter category. So at least things came out on the right side of the reality/fantasy divide.

The disappointing part, though, is that, now that the meeting is over, I won't get a chance to do a post on why the cut should be 200 basis points.

175 Basis Points

At the Open Market Committee meeting tomorrow (today if not yesterday or a month ago, by the time anyone is likely to read this), I recommend that the Fed cut its federal funds rate target to 3.5%. This recommendation is based on a direct application of the rule presented in John Taylor’s 1993 paper:

   r = p + .5y + .5(p – 2) + 2

where p is the inflation rate
and y is the deviation of output from potential

Today, the unemployment rate (if you divide the number of unemployed by the number in the labor force instead of using the one-decimal-place figure reported by the BLS) is within 0.01% of the Phili Fed SPF median NAIRU estimate of 4.65%, so y is zero.

The best price index we have is the market-based core personal consumption deflator, which gives an inflation rate of 1.7% (the very last number in this report) over the most recent 12-month period.

Plug in 1.7 for p and zero for y.

   r  =  1.7 + .5(0) + .5(1.7-2) + 2  =  3.55

which rounds down to 3.5



How on earth is Allan Meltzer (hat tip: Greg Mankiw) able to reach the conclusion that the target should remain at 5.25%?

100 Basis Points

Even I won't call for a 100 basis point cut in the federal funds rate target this month. But Greg Mankiw has unwittingly made me realize that a quick adjustment to his rule-of-thumb Taylor equation would argue for just so large a cut.

To start with, Eddy Elfenbein of Crossing Wall Street does the calculation (hat tip: Greg Mankiw) using Greg's original rule of thumb

    Federal funds rate = 8.5 + 1.4(Core inflation-Unemployment)

and gets 5.088. Rounded to the nearest 25 basis points, that's 5.00, exactly what the current consensus expects from the Fed this month.

But in the original Taylor rule, it's not the unemployment rate, but the difference between actual and potential output, that shows up in the equation. Okun's law would justify using the unemployment rate instead of output, but the implicit assumption of Greg's equation is that "potential unemployment" -- which is to say, the NAIRU -- is constant over time.

In practice, the consensus estimate for the NAIRU has fallen dramatically over the past 15 years. In the early 1990s, 6% was a sort of canonical magic number (and, as I recall, Greg himself argued in December 1994 that the NAIRU was significantly higher than that). According to the Philadelphia Fed's latest Survey of Professional Forecasters, the median estimate today is 4.7% -- a difference of 1.3 percentage points from the early 90s. (Note on the chart on Crossing Wall Street that the Greg's rule tends to come out below the actual funds rate in the early years and above in the later years -- which suggests that the Fed was in fact doing something similar but with changing NAIRU estimates.)

So let's make the assumption that Greg's rule applies in the very middle of that transition -- when the consensus NAIRU estimate was half way between 6.0% and 4.7%, or 5.35%. Now write the more general rule:

    FFR = C + 1.4(Core inflation-(Unemployment-NAIRU))

plug in 5.35 for the NAIRU, and solve for the constant C:

    8.5 + 1.4*(I-U) = C + 1.4*(I-(U-5.35))

Rounding to the nearest tenth, we get

     C=1.0

(That value sounds divinely ordained; doesn't it?) Plug in today's 4.7% consensus NAIRU estimate, and you get

     FFR=1.0+1.4*(I-(U-4.7))

or

    Federal funds rate = 7.6 + 1.4(Core inflation-Unemployment)

Plugging in 4.647 for unemployment and 2.210 for core inflation, as per Crossing Wall Street, gives

     Federal funds rate = 4.188

which I'm happy to round up to 4.25


UPDATE: I just checked the Survey of Professional Forecasters, and I now realize my mind was rounding up the median NAIRU estimate from 4.65 to 4.7. Using the accurate median of 4.65, and making the same "middle of the transition" assumption about Greg's rule, would reduce the calculated target federal funds rate by 3.5 bps, to 4.15, so it still rounds to 4.25.

All for the Want of a Nail

I’m going to pick on Jeff Miron again, and in this case my only source is a couple of paragraphs in Monday’s Harvard Crimson (hat tip: Mark Thoma), so I won’t pretend that I’m really being fair to him, but I think these paragraphs are representative of a point of view that is in need of attack:

Miron...expressed less sympathy than others for the subprime lenders and borrowers, who he suggested are playing the roles of both perpetrator and victim in the current crisis.

"The subprime event is not that big a deal. It’s a small part of the economy. There will be some foreclosures, banks will lose money. That’s life. That’s capitalism. They took risks, and they lost. Policy should not bail out people for greed and stupidity, or their risk taking."

As it happens, I do think that we should have some compassion for subprime borrowers and lenders, not necessarily out of general compassion but for the reasons I discussed here. But I see that compassion as a minor issue. The fact that interest rate cuts (for example) would help these people, is one additional pebble in the balance that weighs toward my advocacy of interest rate cuts, but by itself this factor is not enough to make 25 basis points worth of difference in my opinion on the federal funds rate target. Is it possible that this factor – and the associated “moral hazard” issue – weighs 25 basis points worth (or more) against interest rate cuts for some people? It seems like it does, and that seems foolish to me, but let’s get to the main issue:

The subprime event is not that big a deal. It’s a small part of the economy.

Quantitatively speaking, it’s certainly true that the volume of subprime loans is small compared to the size of the economy. But does that observation justify the conclusion that “the subprime event is not that big a deal”? To me, it seems that the question should be rhetorical, because the obvious answer is “no,” but apparently others don’t find that answer to be obvious. And (assuming that the Crimson quoted him correctly and that he intended those two propositions to be logically connected) I’d have to say that, from my point of view, Jeff Miron doesn’t seem to understand what’s going on.

I’ll allow that Mr. Miron was quoted out of context (by both the Crimson and me); that the reporter probably surprised him when he was thinking about something else, and he didn’t get a chance to think through his answer; that he probably didn’t feel he needed to be too careful about his words when he was talking to the college paper. But when we take into account indirect effects, the subprime event is a very big deal. Subprime may be “a small part of the economy,” but LIBOR – which rose about 35 basis points because of the subprime fallout (in spite of a large drop in T-bill yields at similar maturities) – is not small: as far as short-term lending is concerned, LIBOR is most of the economy.

If it were just a matter of a few institutions that made subprime loans and had to recognize some losses because defaults were higher than they had planned, that would have been a virtual non-event in the grand scheme of things. But the subprime risk is not concentrated in a few institutions – or, to be more precise, maybe it is; we just don’t know where the hell it is, and that’s the problem. Can one say that walking across a minefield is “not that big a deal” because the actual mines underlie only a small fraction of the total area? When you suddenly find that institutions in France and Germany are close to toppling because of a small problem in the US, you’ve got a big problem, because people start to lose confidence in the whole global financial system.

And that’s just the beginning. Another effect of the subprime crisis has been diminished confidence in the bond rating agencies. When investors don’t know which bonds are safe and which aren’t, it becomes hard to borrow money by selling bonds. This has not been a big problem for traditional investment-grade corporate bonds outside the financial sector, but it has been a big problem for lower-rated bonds, and it has been a huge problem for just about any kind of asset-backed security that doesn’t seem to have a government guarantee. One of the results is that it has now become difficult and expensive – even for prime borrowers – to get a mortgage for any property that doesn’t conform to the requirements of government agencies or government-sponsored enterprises. (A particular case in point is the oversized “jumbo” loans that are now required to purchase even many mid-level houses in the post-boom coastal areas.)

And then there is the liquidity crisis. With all the uncertainty about the quality of loans and institutions, the institutions themselves face increased withdrawals of capital and increased uncertainty about withdrawals. At the same time, with all the uncertainty about the quality of bonds and other assets, these assets become more difficult to sell. Leverage is forcibly unwound. Failures cascade. Many of the failures occur outside the banking system and therefore outside the direct influence of central banks. Assets deflate. Otherwise solvent institutions become insolvent. Disintermediation further weakens the financial system.

Job losses in construction, finance, and home furnishings also have multiplier effects. In the financial chaos, with even prime borrowers facing difficulties in purchasing new houses, house prices could fall below fundamental value, and households will be bound by more stringent liquidity constraints and forced to curtail consumption. Financial problems abroad can be expected to dampen improvements in the US trade balance. Damn, I’m really talking myself into forecasting a recession now. Anyhow, to reiterate my original point, even though the subprime problem is a small part of the economy, it is a big deal.

Inflation Worries?

Tim Duy is worried about inflation:

Note also that gold broke out above $700, copper bounced today, oil is poised to make a run for $80, the Baltic Dry Index is off the charts, productivity growth is falling, and the Dollar is set to make another drop. Moreover, I suspect China will be revisiting their currency/foreign exchange reserve policies after the 2008 Olympics, adding to additional downward pressure on the Dollar.

In short, I think the Fed is rightfully cautious about the inflation outlook, but policymakers are likely to cut rates anyway. Historians should take note; I have a sick feeling that this is the moment the tide turned on the 25+ year battle against inflation.

Considering Professor Duy’s apparently high inflation expectations and my low expectations (see point 3 from yesterday), this might be a good occasion for a wager. Unfortunately, pseudonymous persona that I am, I don’t think I’m permitted to make wagers. But if Professor Duy is a betting man, he can get plenty of action from my friend Mr. Market. I see the 10-year T-note quoted at a yield of 4.31%, while the 10-year TIPS is quoted at 2.12% -- a spread of 2.19%, even slightly narrower than the 2.20% where it closed at the end of August. I’ve been keeping track of the month-end closes of this spread, and August 2007 was the narrowest close since October 2003. So if anyone wants to bet on higher inflation, Mr. Market is offering rather attractive terms.

Realistically, one has to recognize that the TIPS-to-nominals spread is narrow in part because of a liquidity premium in the TIPS yield, given today’s thirsty market conditions. So I’m not entitled to say with confidence that the bond market anticipates a CPI inflation rate of 2.19% over the next 10 years or that its anticipated inflation rate is lower than it has been since 2003. Nonetheless, since the yield on nominal T-notes should include a premium for purchasing power risk, and since, by now, TIPS are not all that much less liquid than nominal T-notes, I think it’s fair to say that the bond market doesn’t share Professor Duy’s sick feeling.

75 Basis Points

As long as we’re talking about what I think the Fed should do rather than what I think it will do, why stop at 50 basis points? What I think the Fed should do is move – in one dramatic step – from an officially “restrictive” interest rate policy to an officially “neutral” one. As I argued in the last post, 4.75% is not yet neutral. 4.50% is still not my idea of neutral, but many people will accept it as neutral, and if the Fed describes it as “neutral”, the market will accept that description. With a financial crisis and declining employment, it makes no sense to continue with a “restrictive” policy.

I realize there is a theoretical advantage to small steps in monetary policy, but this past cycle has made me question whether that advantage exists in reality. The idea is to take a small step, observe the results, and then decide whether to take another small step. The problem, though, is that you don’t really get to observe many results until it’s too late. After the Fed started its “measured pace” tightening phase in 2004, there were almost no macroeconomic results to observe until 2006. The big result, ultimately, was that houses (at any given price) became harder to buy – and harder to hold on to if you had an ARM. That result is fairly obvious today – more than 3 years after the tightening phase began – but it was almost imperceptible as recently as the winter of 2006. Moreover it wasn’t until late summer of 2006 that we saw any indication of the effect that result is now clearly having on economic growth. So the idea of doing something and observing the results appears not to be very useful when it comes to the relevant time frames for monetary policy.

When it comes to financial results, as opposed to macroeconomic results, it’s not clear that gradualism even has a theoretical advantage, at least in an environment like today’s. To stop panicking, a market needs to see dramatic action. The Fed has made valiant attempts to undertake dramatic actions that don’t involve its interest rate target, but so far those actions apparently have not been dramatic enough. Apparently, you just can’t have a tight money policy and an easy money policy at the same time.

I think there is a more general theoretical case to be made against gradualism, at least when it comes to “first moves,” in which the direction of movement in the policy variable changes. It’s kind of like menu costs and Ss pricing. After the central bank has maintained a certain policy for a significant period of time, there is a cost to changing it. Indications that might, under other circumstances, argue for a small change in policy, are outweighed by the disruption that a “first move” in policy would cause, and by whatever other “menu costs” are associated with monetary policy. But at some point, the argument for change becomes so strong that it clearly outweighs these “menu costs”. At that point, the optimal policy change is necessarily a large one – because, if the optimal policy change were a small one, then the optimal policy (given the menu costs) would be no change at all.

To put it another way, under normal circumstances, the choice is either do something, do nothing, or sort of do something. Under those circumstances, sort of doing something (e.g., changing the funds rate target by such a small amount that the change can’t be expected to have much real impact) is often the best choice. But when the action being contemplated is a reversal in the direction of policy change, the option of sort of doing something doesn’t exist, because anything you do will be noteworthy. So if nothing is clearly the wrong thing to do – and that is surely the case for the US today – then for Heaven’s sake do something!

50 Basis Points

I don’t expect that the Fed will cut the federal funds rate target by 50 basis points at its next meeting, but I do think that would be a good idea. (This conversation started on William Polley’s blog, but it’s going to get too long for a comment.) I see every reason to prefer erring on the side of too much stimulus rather than too little:

1. With the release of the payroll employment figures for August, as well as the revisions for June and July, not to mention the widely expected prospect of additional downward revisions when the real data on births and deaths come in, we face the serious possibility that the US was already in a recession when August’s financial crisis hit. (That’s in addition to the possibility that we went into a recession in August, and the possibility that the effects of the financial crisis will tip us into recession over the coming months.) If it turns out that the recession began before the financial crisis, we will be experiencing a deepening recession over the coming months, and
   
   
2. that recession could get really ugly. Although I made optimistic noises last year about the tractability of any possible recession, I am becoming increasingly worried about the possibility of a policy-resistant recession. Consider that
   
   
   • the international savings glut is still with us, and, if anything, it’s about time for the US to join the glut rather than playing the hero, as
     
     
     • American households have had a negative personal savings rate for two years, and this is unlikely to continue given the now more limited prospects for capital gains on assets and more restricted access to low-priced credit.
       
       
     • America’s children are about to graduate from college, which puts Mr. and Mrs. America at the point where it’s time to stop worrying about the kids and start panicking about inadequate retirement savings.
       
       
     • tax cuts are going to expire soon, and the Democratic congress is unlikely to extend them.
     
     
   • If the international savings glut should disappear, then we face the prospect of a potentially stagflationary fall in the dollar, which would inhibit the use of policy to end the recession.
     
     
   • A conventional monetary stimulus may in any case prove ineffective, given the “once bitten” status of the housing market and the unresponsiveness of capital spending. I don’t think Ben Bernanke wants to be in the position of having to use his helicopter.
   
   
3. By the standards of the last 50 years, the inflation rate is damn low. The 12-month growth rate of the core consumption deflator is within the target range. Inflation expectations are well-contained by almost any reasonable measure – with median expected 10-year CPI inflation (according to the Philadelphia Fed’s Survey of Professional Forecasters) recently falling below the 2.5 percent level where it has spent almost all of the past 10 years. The weight of risks is overwhelmingly on the side of too little growth rather than too much inflation.
   
   
4. From an economic point of view, monetary policy will still be tight, even after a 50 basis point cut. If you take the rule of thumb that the neutral real overnight interest rate is 2%, and add that 2% to the core PCE inflation rate, you get 3.9%. OK, maybe you don’t buy that – so make it 4.2%, or even 4.5%. But 4.75%? No way is that a stimulus policy.
   
   
5. The longer-term prospects for the dollar are dismal, but at this moment, everyone wants dollars – probably because so many foreigners are trying (or being forced) to unwind levered positions in dollar-denominated assets. Instead of saying, “Let them eat euros!” why not give them the dollars now, and you can take them away later if necessary. If the stimulus turns out to be ”too much” from a business cycle point of view, so much the better from an “orderly foreign exchange markets” point of view. When the world has had its fill of dollars and the thought of the dismal US international investment position starts to cause indigestion, it will be just in time for the Fed to prevent a free fall by raising interest rates in the face of an overheating economy. I’m not advocating exchange-rate targeting, and under normal circumstances, I would say that the Fed should ignore the value of the dollar (except to the extent that it alters the picture for expected employment and inflation). But after so many years of huge and growing current account deficits, these are not normal circumstances; the Fed needs to worry about how potential exchange market instability might constrain its future actions.
   
   
6. History will forgive a recently appointed central banker for overreacting to a financial crisis. (It surely forgave the former Chairman when he overreacted to the stock market crash.) History will not deal so kindly with a central banker who allows the economy to fall into an intractable recession. When the Emperor smells smoke, even if the odor is rather faint at first, he had best put down his fiddle.
   
   
7. One of the mistakes of the last easing cycle was not to cut aggressively enough in the beginning. Ultimately (we can say with hindsight) the easing cycle went too far, but it definitely started too slowly. The Fed was also too slow to ease in 1990-91. The Fed has a lot of inflation-fighting credibility today, and should the economy seem to move in the direction of overheating, the Fed can take back any easing moves without having lost much ground. But you don’t get a second chance to prevent a recession.
   
   
8. All the reasons that I have given already are things the financial markets can figure out for themselves. If the Fed only cuts by 25 basis points this month, markets will have good reason to expect another cut in October. If the Fed cuts by 50 basis points, it can credibly avow a reasonable hope that no further cuts will be necessary.

Monetary Policy Targets

Pondering my last post, I got to thinking: Why stop with LIBOR? Why not target commercial paper yields? Or even maturing junk bond yields? In practice, there are a couple of reasons I wouldn’t suggest such things. First, I don’t trust the rating agencies enough to make them partners in monetary policy. (The definition of what is being targeted would have to be standardized on the basis of ratings, which means that any upgrade or downgrade would change the de facto target.) Second, market-specific problems could distort the economic meaning of the policy. (The latter is already an issue, though, because problems specific to the banking system can distort the economic impact of a federal funds rate target.) But I still think that, in theory, targeting risky interest rates is a good idea.

Here’s my argument: The Fed sets its policy based on an economic forecast, which contains some implicit or explicit assumption about the price of risk. If the price of risk changes, there ought to be some automatic mechanism for altering policy so as to offset the change in the forecast. Targeting risky interest rates would be such a mechanism. (This is essentially the argument I made last month about why a cut in September would make sense.) In fact, the Fed already does this to some extent by targeting the federal funds rate: if the price of risk rises, so does the spread of the funds rate over the risk-free T-bill rate, and the Fed acts to push down the risk-free rate so as to keep the funds rate constant.

But if automatic policy adjustment is a good idea, why stop with risky interest rates? Why not, instead of targeting a single interest rate or reserve aggregate, target some linear (or nonlinear) combination of economic and financial data. (I’ve always thought, for example, that while targeting a single monetary aggregate makes little sense, the aggregates do contain information about how Fed policy is affecting the economy. I’d like to see them be part of such a composite target.) Seems to me that, with today’s technology, it is quite feasible to put monetary policy on autopilot between meetings instead of fixing some particular interest rate (which is kind of like just a primitive version of autopilot). And the formula could be announced and followed by the markets, as any competent quant could program her spreadsheet to mimic the Fed’s spreadsheet. And the decision at a meeting would be, not whether to change an interest rate target, but whether to adjust the autopilot parameters. OK, I’m dreaming, but…

The Fed Funds Puzzle

Greg Mankiw has a post today about “the LIBOR puzzle” – the observation that LIBOR has recently moved up even while other interest rates (such as the 3-month T-bill rate and the expected federal funds rate) have moved down. (In fact, a lot of interest rates that businesses and consumers actually pay have moved up, but these typically are too idiosyncratic to produce the nice statistical series that economists like.)

As I said in Greg’s comments section, I don’t find this to be much of a puzzle: there is the T-bill rate, which is risk-free, and then there is the LIBOR spread – the price of LIBOR counterparty risk – which typically moves in the opposite direction except in response to unexpected news about inflation or Fed policy. The spread (typically <1%, though it is higher at the moment) is normally smaller than the T-bill rate (typically >3%), so the movements in the T-bill rate are usually larger in absolute terms; thus the sum of the two – namely LIBOR – usually moves in the same direction as the T-bill rate. The only difference now is that the spread has moved more than the T-bill rate in absolute terms; thus the sum – LIBOR – has moved contrary to the T-bill rate. It just happens that we’ve experienced a shock which has had more effect on credit spreads than on the level of risk-free interest rates. That’s actually what you might expect from a large shock to the financial sector: since it has only a small expected effect the real economy, it produces a relatively small change in the risk-free interest rate; since it has a large effect on financial conditions, it produces a large change in the risk spread.

You can read more of my ideas about this in the comments section of Greg’s post, but I want to bring up something that has puzzled me for a while. It’s an institutional puzzle. Since the Humphrey-Hawkins Act, the Fed’s primary responsibility has been the management of the US macroeconomy. That being the case, why does the Fed choose to target an interest rate which

1. has little direct relevance to the US macroeconomy and
2. is not under the Fed’s direct control?

Wouldn’t it make more sense to target, say, LIBOR, off of which many interest rates in the US are priced, and which in any case reflects the general cost of the type of risky credit available to private sector agents in the US? Or, alternatively, wouldn’t it make more sense to target, say, the 3-month Treasury bill rate, which the Fed could (if it chose to do so) control with great precision by making a market in T-bills at a temporarily fixed bid and offer.

I presume the Fed has its reasons for targeting the federal funds rate, but if I, in my ignorance, were asked (and I’m just as glad I won’t be) to design a monetary policy, I think I would start by coming up with a LIBOR target and then estimating the expected spread between LIBOR and T-bills, and then I would fix the T-bill rate such that the expected LIBOR would equal the target. Then I would monitor the spread and adjust the T-bill target as the spread changed over time.

In extreme circumstances (like right now, perhaps), it might be necessary to free up the T-bill rate to deal with issues in the banking system. Perhaps under today’s circumstances I would maintain the bid for T-bills but temporarily stop offering them, thus placing a ceiling on the T-bill rate. That’s actually roughly what the Fed has done with the federal funds rate, except that it can’t enforce the ceiling precisely, and it is making a vague pretense to putting a floor on the funds rate, even though the data seem to show zero as the only floor.

Time to Do the Wrong Thing

Something is wrong here. Even though the Fed and its chairman (not to mention anyone who has studied the evidence rigorously) believe that there was never a Greenspan put, the Fed seems to feel that it has to be very careful not to create the impression that the Greenspan put exists. In other words, to some (hopefully not very large, but I'm not sure) extent, the appearance of bailing out Wall Street is now an argument to the Fed's objective function. Which means that, under some circumstances, the Fed will deliberately follow bad policy -- bad meaning suboptimal with respect to the balance of growth and inflation risks -- because the better policy would have the appearance of being too Wall Street friendly.

In fact, since the history of the Greenspan era suggests that following an ex ante optimal policy for growth and inflation does create the impression that there is a Greenspan put, the Fed can expect that it will occasionally have to make a deliberate mistake. Something is wrong.

If the Fed doesn't cut the federal funds rate target in September -- barring a truly dramatic improvement in credit conditions or a series of economic reports that are either stronger or more inflationary than expected -- I will, as I said a few days ago, be puzzled, but perhaps not all that puzzled after all. By such inaction in the face of widening spreads and credit rationing, I argued then, the Fed would be "either making a mistake or acknowledging that they made a mistake earlier by not having raised the rate higher in the first place." But I hadn't considered the possibility of a deliberate mistake. Does one need to sacrifice a virgin on the altar of Moral Hazard Avoidance, not because it will in fact result in a better harvest, but because the people think so, and they won't bother planting unless you do?