Bear Sterns

I started this post last Monday and then got distracted. Looking at it now, I think the fragment is worth preserving.

I’ve spent the past week being pissed off at all the people who were pissed off about the so-called “bailout” of Bear Stearns. In the light of this morning’s [Monday the 24th] news, I’m starting to half agree with them.

Earlier, I was going to write a post about what a lucky accident it was that the current Fed Chairman is also one of the world’s foremost experts on the problems of the early 1930’s. Now I’m beginning to wonder if it would have been better to have someone with a less well-matched academic background and more poker skills.

In retrospect, it appears that the $2/share price in the original version of the Bear deal was not a real price, just a piece of propaganda, intended to give the impression that it wasn't a bailout. But it's now clear that, whether or not one calls it a bailout, Bernanke offered a lot more in loan guarantees than was really required to get J.P. Morgan to do the deal. (The $1 billion deductible on the new version of the deal is not very convincing as a concession by Morgan, and in any case, it only makes it more obvious that the Fed's original offer was much higher than it needed to be, if Morgan is willing to take a hit both on the special financing and on the purchase price.)

I don't think that's exactly a moral hazard problem, but it's the same general idea. The next time the Fed wants somebody's help to keep the financial system afloat, that somebody will know to charge dearly for that help.


UPDATE: And another thing. What the hell were Ben's priorities? If he wanted to reassure the financial markets, he shouldn't have pushed for a price that made Bear Stearns appear to be in much worse shape than it actually was. (Did that just not occur to him? Did it not occur to Tim Geithner? Did it not occur to anybody at the Fed?) If he wanted to make the Fed look tough, he shouldn't have offered way better financing terms than were really needed to get the deal done. (As noted above, both the price and the financing terms got worse for Morgan subsequently, and they were still willing to play.) Did it not occur to him that being tough with winners was important for the Fed's reputation too, as well as being tough with losers? This was a major screw-up.

What's going on?

In Paul Krugman’s latest column (hat tip: Mark Thoma), he compares the current financial crisis to the bank runs of 1930 and 1931:

The financial crisis currently under way is basically an updated version of the wave of bank runs that swept the nation three generations ago. People aren’t pulling cash out of banks to put it in their mattresses — but they’re doing the modern equivalent, pulling their money out of the shadow banking system and putting into Treasury bills. And the result, now as then, is a vicious circle of financial contraction.

That sounds like a pretty good description of what’s going on, but there’s something missing. Thinking about this as a regular person rather than an economist, I have to ask, “Who are these ‘people’ that are pulling their money out of the shadow banking system and putting it into treasury bills?” Because it sure isn’t me. I have my cash in a prime money market fund; I deliberately passed up the “treasury-only” option, and I see no reason to change my mind now. My fund hasn’t broken the buck. In fact, I haven’t heard of any money market fund that has broken the buck recently. (Possibly something escaped my attention, with all the news that’s come out lately, but even if there have been one or two cases, there haven’t been many, and they haven’t been big ones.)

I don’t know exactly what my fund manager is doing; I imagine they’ve probably increased the proportion of treasuries in their portfolio, and I guess, technically, it was “people” that made that decision, but it wasn’t any people that I know personally. If anything, I’d like my fund to skate closer to the edge. It would not drive me into bankruptcy if the share price went from $1.00 to $0.99. In fact, I probably wouldn’t even notice, except for the fact that I’d read about it in the newspaper, and the fund would probably send me all kinds of stuff in the mail about how something went terribly wrong and the employee has been fired and this will never ever happen again in a million years and they’re completely changing all their control procedures and they’re changing their name just to show that they aren’t really the ones who lost that one cent.

So I guess the point is, it’s not really “people,” in the sense of retail investors, who have lost confidence; it’s institutions. Maybe that’s why so many “people” have a hard time seeing what the big deal is and why the Fed needs to help “bail out” Bear Stearns. As for me, when I see the TED spread approaching 200 basis points and the treasury bill rate approaching zero, I know that something is very wrong and that the Fed has good reason to be taking drastic measures, but I’m still a little confused as to why all this is happening. I understand that the consequences of the failure of a major investment bank under these conditions would be disastrous, but I still have trouble seeing why J.P. Morgan needed $30 billion in non-recourse financing to convince it to buy Bear Stearns for a tiny fraction of what the market seemed to think it was worth.

Capital Flight is Good

Some people (Yves Smith and Tim Duy, to name two, but I’m sure there are many others that I haven’t gotten around to reading yet) are worried that concern about capital flight is going to have to be a constraint on the Fed’s ability to deal with this crisis. I disagree. I don’t think the Fed will or should be concerned about capital flight. In fact, I think capital flight is part of the solution, not part of the problem.

In general, capital flight is a problem if you care about quantities that are not denominated in your own currency. If all the quantities you care about are (or can be) denominated in your own currency, then you can just print as much currency as you need to replace the foreign capital. There are basically 4 situations where capital flight is a problem, which I will call the 4 Fs:

1. Full employment. If all your real domestic resources are being used, then the withdrawal of foreign capital will mean the withdrawal of real resources, which will reduce your growth potential. This was an issue for the US in the late 90s. But today the US is not at full employment. And if you still think it is, just wait a few months.
   
   
2. Fixed exchange rate. If you need to defend an exchange rate, the government will effectively have to supply exiting capital out of limited official reserves. This was a large part of the problem in the early 30s. But today the US does not have an obligation to defend its currency, nor does it have (about which see the rest of this post) and interest in maintaining its currency’s value.
   
   
3. Foreign currency-denominated debts. If you have to pay back foreign currency, you’ll be in trouble if capital flight weakens your own currency and thereby makes foreign currency harder for you to get. This has been a problem in various places, particularly Latin America, in the past, but it’s not an issue for the US today: almost all our debts are denominated in dollars.
   
   
4. (in)Flation. If your country is experiencing, or on the verge of experiencing, an unwelcome inflation, capital flight will exacerbate the problem by weakening your currency and thereby raising import prices. As of 8:29 AM on Friday, I still thought this was an issue for the US today. I no longer do.

For the US today, the real problem would be if foreigners insisted on continuing to purchase US assets. That would support the dollar, making it that much harder to sell US goods and services and contributing to the weakening of the economy, thereby exacerbating the positive feedback between a weak economy and a weak financial system.

As long as inflation was a major issue, there were limits to what the Fed could do to stabilize the domestic financial system. It could only take on mortgage securities, for example, up to the point where it used up all its assets. In that situation, an absence of foreign demand for US securities might be a big problem.

If, as now appears to be the case, the risk of deflation is a bigger issue than the risk of inflation, then there is no limit to what the Fed can do. If it runs out of assets, it just prints more money to buy assets with. If foreigners refuse to buy US assets, the Fed prints money for Americans to buy them. If Americans refuse to buy risky assets, then the Fed can trade its own assets for risky assets through programs like the TSLF. Or lend money directly against risky assets. If foreigners withdraw capital, the Fed can replace it with newly created money. (Actually, it won’t need to, because when the proceeds from the withdrawn capital are converted out of dollars, the counterparty to that conversion will have dollars to invest.)

If the dollar weakens, so much the better. $2/Euro. $3/Euro. In the words of Chico Marx, “I got plenty higher numbers.” It might be a problem for Europe, but not for the US (and for Europe it would be a self-inflicted wound, since there is plenty of room to expand the supply of euros if there were a will to do so).

There is no limit to the potential magnitude of the Fed’s actions, but there could conceivably be limits to the effectiveness of those actions even as the magnitude becomes infinitely large. That situation is exactly one where capital flight would be a good thing. If the Fed can’t manage to stimulate the economy sufficiently by printing money, the stimulus has to come from somewhere else. Increased demand for US exports, due to a weak dollar, due to capital flight, is one of the chief candidates.

TSLF: Is the government taking a risk?

In one of the latest blogospheric analyses of the Fed’s plans to accept private-label mortgage backed securities as collateral, James Hamilton concludes that the government is taking on a definite risk (specifically, although the Fed is the agent, it is really the Treasury’s risk, since the Fed’s profits are received by the Treasury) but that the risk is not a very large one. I wonder, though, if it’s appropriate to view the risk characteristics of the specific transactions in isolation without considering how they influence the Treasury’s other risks.

Modern portfolio theory teaches us that an asset that looks risky in isolation can actually decrease the risk of a portfolio. For example, if you have a portfolio that consists entirely of government bonds, and you take out some of the bonds and replace them with stocks, you have replaced a safer asset with a riskier one, and yet your portfolio overall is now less risky. In that context it is the correlation (or rather, lack thereof) between asset returns that is the issue, but in the case of the government itself, a more important issue is how transactions in one set of assets affect the value of other assets and liabilities.

In particular, the government’s most important asset, in real economic terms, is the expectation of tax revenues. Tax revenues depend mostly on incomes. In particular, revenues depend not on potential incomes but on actual incomes, so any expected gap between the two reduces the value of the government’s most important asset. The government’s most important liabilities are the securities it issues, most of which are denominated in nominal dollars and most of which do not contain a call provision. A worst case scenario for the government is a Japanese-style deflationary depression, in which the value of the government’s liabilities rises in real terms, while the value of its most important asset is eroded by an ongoing output gap.

Deflation might not have seemed like an issue before Friday’s CPI report, but now the risk cannot be so easily dismissed. Most of the positive inflation in recent months appears to be the result of rapidly rising commodity prices, which are volatile and could easily reverse direction. Meanwhile, the US labor market is weak, and the financial system – what’s left of it – is fragile. If, by taking on certain (relatively small, in the grand scheme of things) financial risks, the government is able to materially reduce the risk of a financial collapse and thereby reduce the risk of a deflationary depression, there is probably a net decline in the government’s total risk.

To put it a little differently, as James Hamilton says, “you don’t get something for nothing,” but, it seems to me, if the something that you get is clearly worth more to you than the something that you gave up, you kind of do get something for nothing. Don’t you?

Rising Inflation Expectations: Bad News or Good News?

Suppose that Greg Mankiw and others are correct in suggesting that inflation expectations have risen dramatically. Is this bad news or good news?

By way of full disclosure, I should note that it’s clearly good news for me, since I’m short nominal Treasury notes. If you follow the logic, that means it’s in my interest to convince other investors that conditions are more inflationary than I really think they are, so while the main point of my last post still stands, you should probably take the caveats (“There's little question that the expected inflation rate has risen...”) with a grain of salt. (Rising inflation expectations are clearly good news for me, but if this is what the good news looks like, I’d hate to see what happens to nominal yields when inflation expectations are falling!)

As to the “general interest,” however, the most obvious interpretation is that rising inflation expectations are bad news, because they mean that markets have lost confidence in the Fed’s willingness to keep inflation within its perceived target range. Or, as Greg puts it (quoting the Cleveland Fed’s Web server and adding a double entendre), “the system ‘has experienced an unexpected error.’” If the market loses confidence in the Fed’s inflation target, then, theoretically, the change in the expectations term in the Phillips curve causes it to shift upward, and we can anticipate both higher unemployment rates (in the short run) and higher inflation rates (in both the short run and the long run, unless confidence is eventually restored) than we would otherwise experience at any given level of aggregate demand.

Under that interpretation, the higher unemployment rates in the short run are clearly bad news. As for the higher inflation rates, I’m not so sure. A slightly different, but related, interpretation is that the market correctly perceives that the Fed has finally come to its senses and raised its inflation target from an unreasonably low level. Indeed, the current crisis, in which reasonable people are worried both about inflation becoming unhinged and about a potential deflationary collapse, is a good demonstration of why the target should be higher. It is kind of hard to believe that the Fed has come to its senses, though, since the rest of the world’s major central banks have been even further from their senses than the Fed.

Even if you think the Fed’s perceived* inflation target (between 1.75% and 2% on the personal consumption deflator, which is maybe about 2.25% to 2.5% on the CPI) is reasonable, you might think there are certain situations where the target should be raised. One of those situations might be a “safety trap” – where investors shun all but ultra-safe assets, even when the expected returns become much lower than those on risky assets. Arguably (though the argument becomes much weaker when you look at the stock market instead of the credit markets) the US is experiencing a safety trap now, and one solution is to take away the safety of the supposed safe asset by promising to inflate away the returns to be earned by government bondholders. Another situation where raising the target might be a good idea is when the uncertainty around the expected inflation rate increases, so that pursuing the original target would produce a significant risk of deflation. There might be a fairly strong case (as I suggest in the previous paragraph) that the US is in that situation right now. Obviously if you think that current circumstances call for an increase in the inflation target, then it is good news to learn that (in the judgment of the market) the target has actually increased.

But all these interpretations assume that the general shape of the distribution of inflation possibilities remains roughly the same. Moreover, casual talk of “expected inflation” suggests that we think the mean and the median of the distribution are roughly the same, since “expected inflation” could refer to either one. But perhaps what has happened is that the mean of the distribution has risen but the median has not. I would interpret the Fed’s target more as a median than as a mean. I would certainly hope that it isn’t the mean, and that the Fed would be more willing to tolerate inflation rates 3% above its target (high by recent standards but far from disastrous) than rates 3% below its target (deflation, which could be disastrous). Under this interpretation, the market still has confidence in the Fed’s target as a median, but the market is reassured that extremely low inflation rates will not be tolerated, so that the distribution has become more skewed to the right, and the mean has risen. In that case, the increase in mean (but not median) inflation expectations is good news.

[UPDATE: Paul Krugman, using what seems to be another species of the "in this situation, the inflation target should be raised" argument, makes the case that high inflation expectations are good news.]


*The Fed has actually announced a 3-year-ahead forecast, which can perhaps be reasonably interpreted as a target.

Inflation Expectations

This chart is showing up in too many places. The latest, to which I link, is Greg Mankiw's blog.

The implication is that the expected CPI inflation rate over the next ten years has risen from its typical value of around 2.5% to around 3.4% recently. There's little question that the expected inflation rate has risen over the past couple of months, with commodity prices rallying like never before (literally), and that is certainly an issue that the Fed has to be concerned about, but do we really believe that the expected inflation rate has risen quite so dramatically?

I don't. If you look at the raw breakeven inflation rate from the 10-year tips-to-nominals spread, it has only risen by about 20 basis points in the past couple of months, and it still hasn't taken out the highs that it made in 2005 and 2006. We can reasonably surmise that this understates the increase in expected inflation, since we also know that liquidity has gone to a premium over the past 6 months and that TIPS are less liquid than nominal Treasury notes. We can't quite be sure, though, because inflation uncertainty has also increased, so the increased risk premium for inflation uncertainty (which applies to nominal Treasuries) may be offsetting the increased liquidity premium (which applies to TIPS).

The 3.4 percent figure comes from a very specific way of estimating the liquidity premium. IIRC the Cleveland Fed does a regression on the spread between on-the-run (recently auctioned and therefore highly liquid) and off-the-run (slightly less liquid) Treasury notes. Recently that spread has increased dramatically, so the methodology is adding a large liquidity premium onto the expected inflation rate. But how large, exactly, should it be? Given that liquidity conditions are outside the range of the data prior to August 2007, and given that I think there are omitted variables (specifically, a time trend over the period during which TIPS were becoming more available and gaining more market acceptance, as well as a reverse time trend at the very beginning, when TIPS were new and exciting and therefore didn't need to offer high yields) in the specification, and given that I'm not sure that the on-the-run-to-off-the-run spread is the best measure of the liquidity premium anyhow, and given that there are issues about the inflation risk premium, I'm not at all comfortable accepting the Cleveland Fed's estimate.

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.]

What is a stimulus

At the request of fellow commenter Robert D. Feinman, I’m expanding a comment from Economist’s View into a full blog post. Apropos of Paul Krugman’s column on the fiscal stimulus plan, Robert posted a comment asking:

What is "savings"? I understanding taking the check over to Walmart.

If I take the check and deposit it in my local bank what then? The bank loans out the money or buys notes from the Treasury (lending to the government). The money is then spent by the recipient. The difference is that in one case I determine how the money is "spent", in the other I delegate the spending to some one else. Why is one a stimulus and the other not?

In a later comment, I answered:

When you deposit the money in the bank, it doesn't actually get loaned out; it gets withdrawn by the Fed. That's an oversimplification, but it's roughly what happens. If you deposit money in the bank, it makes more money available in the banking system, which tends to push down the federal funds rate; but the Fed has a policy of controlling the federal funds rate, so it will act to offset your deposit by selling treasury bills (or, more precisely, probably, by buying fewer treasury bills than it otherwise would).

This raises the question of why we would need a fiscal stimulus in the first place, because if it wanted to, the Fed could just put more money in the banking system (causing the federal funds rate to fall), and there would be more loans and more purchases and we'd get the same stimulus. And the reason has to be something bad about low interest rates, but it's not clear exactly what. Maybe we're worried that low interest rates would weaken the dollar too much and cause an import price shock. Or maybe we're worried that interest rates will go down to zero (as they did in Japan), in which case banks might be unwilling to lend out the money that the Fed creates (since they wouldn't be taking any loss by just holding it, and the risks of lending might be too high).

I could add here that I think both of these considerations are things we should be worrying about right now.

Now that I think about it, though, the reason doesn’t have to be something bad about low interest rates; it could be, for example, the lag in effectiveness: one may imagine that tax rebates will be spent (if they are spent at all) more or less immediately, whereas if the money is in the banking system, it takes time to lend out, and it takes time for the borrowers to spend it.

When I actually say it, that argument doesn't sound very convincing, so I'll go back to "something bad about low interest rates," but I'll note that the "something bad" may also relate to policy lags. For example, if the "something bad" is an excessive housing boom, that also has a delayed economic stimulus effect, so that's a reason that the Fed can't do as big an initial stimulus with monetary policy as the government could do with fiscal policy.

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.

A Crude Form of Inflation Targeting

In his latest sermon against core inflation, Barry Ritholtz makes an important point – sort of. At least, he brings up an important issue, but I think his message that the core is evil distracts him from thinking more subtly about the implications. The title of his post, “Rising Crude Oil Pushes Consumer Prices Higher,” says most of it, and when he says, “consumer prices,” he means, “even core prices.” It’s a fact that we can’t escape: energy is a critical input to many goods (and services) that are part of the core. And even if it is only targeting a core price index, the Fed still has to worry about oil prices.

This is, as I said, an important point, but I don’t think it implies that everyone who emphasizes the core is either a liar or an idiot. It just means that anyone who claims to make an optimal forecast of the core without taking oil prices into account is not being careful. It also means that, even if we are confident that the Fed is targeting a core index, we should expect the Fed to take into account the inflationary impact of large oil price increases. At the same time, the Fed may take into account the potential recessionary impact of rising oil prices, if it judges that the price increases are a supply-side effect and not a demand-side effect.

So the monetary policy implications of rising oil prices are ambiguous, but they clearly don’t follow the simple formula that the bond market sometimes seems to expect: tighter oil => weaker economy => easier money. If the change in oil prices is a demand-side effect, then it’s actually a symptom of a stronger economy rather than a cause of a weaker economy, and the formula goes something like this: stronger economy => tighter oil => tighter money. If the change in oil prices is a supply-side effect, it will unambiguously tend to weaken then economy, but the Fed may perhaps prefer an even weaker economy to an unchecked inflationary impulse, and the result may still be tighter money.

If it were up to me, the Fed’s target would not be core consumer prices but something (such as unit labor costs) that excludes the effects of energy shocks altogether. Such a target would allow the US to take an adverse energy shock entirely in the form of a higher price level (rather than going through the painful process of squeezing profit margins, which tends to have unemployment as a side effect) without raising long-term inflation expectations. (An abrupt energy shock could still weaken the economy by James Hamilton’s mechanism of forcing difficult transitions – squeezing profit margins in some areas while raising them in others – but I don’t think there’s much we can do about that.) Since unit labor costs seem to be a politically unacceptable target (and the data are unreliable in the short run), one could perhaps imagine a core price index that is corrected for the indirect effects of food and energy prices. (I guess that would piss Barry Ritholtz off even more.) I’d also like to exclude import prices, so the GDP deflator might be a reasonable first-round candidate, though it brings in another set of problems.

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.

Core Inflation and Price Stability

I’ll begin with a hypothetical question: If half the prices went down by 10%, and the other half went up by 10%, would that be price stability? If you have faith in the General Price Level, you may answer yes, but since the General Price Level has never revealed itself to me, nor did my parents teach me to believe in it, I must ask, “How can it be price stability if none of the prices are stable?” As a price level agnostic, I have to think that “reasonable price stability” (a phrase from the Fed’s mandate in the 1978 Humphrey-Hawkins Act) requires that at least some prices (perhaps as many prices as possible) be stable.

Now, food and energy prices are nearly impossible to stabilize, because they are so volatile, and because it’s extremely difficult, except over very long time horizons, to distinguish temporary fluctuations from longer-term trends. (One could, I suppose, choose a particular food or energy price and stabilize it by intervening directly in the market, but I think most people can agree that would not be a reasonable policy.) Given that food and energy prices cannot reasonably be stabilized, does it make sense to make a half-hearted attempt to stabilize them at the expense of destabilizing most other prices?

Many prices, on the other hand, can be reasonably stabilized, primarily because the people who actually set those prices prefer them to be stable and will be willing partners (up to a point) in any attempt to stabilize them. I would argue that pursuing “reasonable price stability” does not mean sacrificing Isaac or Iphigenia on the altar of the General Price Level. Rather, it means using monetary policy to discourage the aforementioned naturally stable prices from exiting the realm of stability.

You can see (I hope) why I think that the core inflation rate is more relevant to the Fed’s mandate than the overall inflation rate. You may say that I am just playing semantic games here, but I believe the semantics have substantive importance. For one thing, my reference to human sacrifice is not entirely metaphorical: the human cost of attempts to stabilize the general price level can be quite high when volatile commodities face upward price pressures.

More to the point, perhaps, the semantic problems with attempting to stabilize the general price level are indicative of the danger that such attempts will backfire even with respect to their semantically questionable objective. Food and energy commodities are typically traded in speculative markets, and speculative markets have been known to exhibit both excessively persistent trends and very dramatic reversals. I don’t think I need to remind anyone of what NASDAQ stocks did between 1995 and 2003. Suppose the same thing were to happen to oil. (It very well may be happening, though I don’t mean to suggest that I expect a reversal.) Suppose oil prices were to rise persistently for 5 years and then reverse dramatically. A central bank bent on achieving “general price level stability” would be forced to keep the economy weak for those first 5 years so as to drive down other prices and compensate for the rising price of oil. When oil prices began to fall rapidly, the economy would be weak, and the non-energy part of the economy would already be experiencing falling prices. Before the central bank’s reaction to the reversal had a chance to affect most prices, the “general price level” would be dropping dramatically. (The same logic also applies in reverse, if you imagine oil prices falling for 5 years and then suddenly jackknifing upward and consider what the general inflation rate would look like.)

It’s interesting to consider alternative core measures, such as the Cleveland Fed’s median CPI or the Dallas Fed’s trimmed mean measures, in the light of my agnostic semantics of price stability. A literal application of those semantics would suggest that means and medians are the wrong kinds of statistics to use. Rather, it is the mode of the price distribution that should be of concern if the objective is to stabilize as many prices as possible. My last example, though, suggests that the purely statistical month-by-month trimming of a price index is not an adequate approach. The prices that need to be stabilized are not the ones that have recently been most stable but the ones that are most likely to be stable in general. While there may still be a good case for ignoring outliers in the price distribution, there is an even better case for ignoring prices that are generally unreliable.

Core For: More

Barry Ritholtz replies in the comments section of my earlier post about core inflation:

By framing the issue the way you did, you get one answer.

I prefer a different set of questions. These of course generate a different set of answers.

My questions:

1) What is the actual rate of inflation?

2) Why does the BLS model (the official inflation rate) vary so greatly from the real world experience?

3) What are the Fed policy repercussions of the spread between the two?

4) What does this mean to consumers? Investors? Savers?

I am not surprised that traditional economists have circled the wagons around my attack on the credibility of BLS and the Fed. Thats what all Guilds do when they sense a challenge to their authority . . .

He has more on his own blog, but let me try my answers. I first note that these questions, as he stated them originally, mostly relate to the full CPI, not particularly to the core CPI. The core is not “the official inflation rate,” nor should it be. At least in my view, the “official inflation rate” should measure what prices in general have done retrospectively; it gives us information about the past, and the core would be the wrong information. To the questions,

1. What is the actual rate of inflation?
   
   It depends on what you mean, specifically, precisely, operationally, by inflation. It is a mistake to think there is one “true” inflation rate, because different prices are changing by different amounts and in different directions, and because quality is changing in ways that affect different people and different businesses differently, and because the effects of these changes – even on an individual – are often impossible to measure. How can we know, for example, how much it is worth to have a more powerful computer for the same price? In most cases, all we can do is make an educated guess, and depending on how one chooses to educate the guess, many different reasonable answers are possible.
   
   It is also a mistake to go (as Barry Ritholtz seems to do in the post cited) directly from the premise that “inflation is primarily a monetary phenomenon” to the conclusion that inflation should show a consistent quantitative link with a particular measure of the money stock. The relation between inflation and (any particular definition of) money depends on the evolution of payments technology and potential output. In particular the finding that the CPI diverged from M2 and M3 starting in the mid-90s tells us very little: either productivity really did start growing more quickly (in which case we should expect such a divergence) or else it didn’t.
   
   
2. Why does the BLS model (the official inflation rate) vary so greatly from the real world experience?
   
   The question is not very meaningful unless you can specify what you mean by “real world experience” and demonstrate that it differs from the BLS model. If you mean subjective “real world experience,” then I’m inclined to blame psychology rather than measurement for the difference.
   
   
3. What are the Fed policy repercussions of the spread between the two?
   
   OK, never mind. On his own blog, Barry changes the question:

   Why does the Fed Focus on the Core rate, and not the actual rate? What are the Fed policy repercussions of this?

   To the extent that the Fed does focus on the core rate, it does so primarily for two reasons (and more which I may discuss in a later post):
   
   
   • Using short-run (e.g, 1 year or less) measurements, the core rate has generally proven to be a better predictor of future inflation than the full rate.
     
     
   • The core represents items with relatively sticky prices, so price pressures on the core do more damage than price pressures on noncore items. In particular, downward price pressure on the core causes recessions. Because noncore prices are more flexible, the damage is absorbed by prices before it can cause distortions in quantities.
   
   The repercussion, over the past 5 years of rising energy prices, is that we have had 5 years of economic growth when we could have had an ongoing recession.
   
   
4. What does this mean to consumers? Investors? Savers?
   
   To consumers, it means more of them have jobs than otherwise would. It also means that the decline in their real incomes has come in the form of price increases rather than wage cuts, so they can (wrongly) blame it on the Fed rather than the scarcity of oil. (It is always nice to have an institution to blame instead of an abstract concept.)
   
   To investors, it means that, in retrospect, they should have owned TIPS instead of nominal bonds. By the way, the Treasury is still selling TIPS, if you want ’em. Unfortunately, just as in 2002, we lack perfect foresight as to what the noncore component of inflation will do. It may go down, and you may get screwed owning TIPS. But if you want a secure real return, it’s available.
   
   To savers, I’m not sure what it means. Barry has a wee bit of a point that, by focusing on the core without making sufficient qualifications, the Fed may be misleading people into thinking that the core is the actual inflation rate, and savers will be disappointed when it comes time to spend their savings. I don’t see this as a reason to de-emphasize the core for policy purposes but as a reason to be more careful when speaking about it.

If traditional economists are circling the wagons around the core, that’s because it really is a better policy target. (As to BLS methods, that’s another question entirely, about which Barry and I might be able to find some common ground...but this post is already too long.)

What is the core for?

Suddenly I have so much to say about the core CPI, in response to the latest attacks by Barry Ritholtz and Daniel Gross. I've already said most of it in comments to a post by Brad DeLong (also note kharris' insightful comments) and one to the original Barry Ritholtz post. I may reproduce some of them in future posts here, but my last (thus far) comment (from the DeLong post) is probably what needs to be said first:

There are really 3 separate questions here:

(1) What is the best measure of retrospective changes in purchasing power?

(2) What is the best indicator of the general trend in prices (with respect to what can expected in the immediate future)?

(3) What is the best target for monetary policy?

For the first question, obviously the full index is better than the core, and nobody denies that.

For the second question, there is room for debate, but if the only choices are the core and the full index (to measure inflation for a specific period of a year or less), I would still choose the core. (If you let me smooth the inflation rate with, say, an exponential smoother, I might prefer the full index.)

For the third question, I think there is little room for reasonable debate: the core is better. When food and energy prices go up relative to other prices, the optimal policy rule would accommodate those increases so as to allow other prices to remain stable. The increase in the general inflation rate does little harm; the alternative of deflation in the non-core component would do considerable harm.

Messrs. Ritholtz and Gross, and their supporters in this commentary, are finessing the issue by not distinguishing among these three purposes.

The answer to the third question only works if people know roughly what to expect in advance. If people expect the Fed to control the overall inflation rate but the Fed only attempts to control the core, the outcome will not be good when the two start to diverge. People who attack the core index are contributing to the likelihood of such a bad outcome, as well as to the likelihood of the other bad outcome in which the Fed actually does control the full inflation rate even in situations where it shouldn't.

Not Hitting the Fan Yet

The dollar is now at a record low against the Euro, down more than 20 percent from its peak in 2002, down so low it’s about equal to a Canadian dollar.

So begins Robert Reich's blog post to which I referred on Friday. By my arithmetic the situation is even more extreme, with the dollar having lost about 40% of its value in Euros since the 2002 peak. But should the drop in the dollar between January 2002 and September 2007 really be a cause for concern in the US?

I don't see why. Most of the drop happened in 2002 and 2003, and the remainder has happened slowly over the subsequent four years, with a slight acceleration over the past few weeks. That's water under the bridge. If that drop in the dollar were going to cause inflation in the US, or to cause a drop in US real incomes, it would already have happened.

But incomes (on average) have continued to rise, and as for inflation, I think the figures in the August Personal Income and Outlays report (see Tables 9 and 11, along with historical data available here) should put to rest any immediate concern. Looking at my favorite inflation indicator, the market-based personal consumption deflator excluding food and energy, we have the following annualized (logarithmic) growth rates:

1 month    1.15%
2 months   1.34%
3 months   1.39%
6 months   1.18%
9 months   1.67%
12 months  1.61%
18 months  1.89%
2 years    1.87%
3 years    1.80%
4 years    1.70%
5 years    1.57%
6 years    1.56%

None of this suggests that inflation has yet become a problem at all. Given the presumed target of 1.5%, the recent data would even make a better case for worrying about deflation than about inflation. (Remember that food and energy prices can be quite volatile, so one shouldn't ignore the risk that, for example, a reversal in the oil market could send the full deflator quickly into negative territory.)

Though I have worried in some recent posts about the potential for a drop in the dollar to force the Fed into a stagflation regime, it needs to be emphasized that this worry is about the future and not about the present. If the s___ is going to hit the fan, this is actually a pretty good time for it to hit.

It Depends Why You're Using the Word "Why"

Gabriel M. makes a good point about John Stewart's and Greg Mankiw's question, "Why do we have a Fed?" The answer not only depends (as I argued) on what alternative you have in mind; it also depends on what you mean by "why." The question can mean, "Why is it a good idea to have a Fed?" (Gabriel's answer: it's not. Obviously I disagree.) Or it can mean, "How did it come about that we have a Fed?" Only under a very optimistic view of history are the two questions equivalent. I would personally argue that the reasons given at the time for establishing the Fed were (approximately) valid and remain (approximately) valid today. But even with my relatively sanguine view of quasigovernmental institutions, I have to acknowledge both that the Fed's founders may have had ulterior motives and that the rationale they gave proved quite imperfect in many respects.


UPDATE: In a comment, Gabriel indicates that his answer to "Why is it a good idea to have a Fed?" is not as extreme as I stated above.

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?