Monday, August 12, 2019

Whither the Fed?

Steve Williamson has an excellent long essay, "Is the Fed Doing Anything Right?" on the current state of monetary policy.

Why is the Fed lowering rates?

(If you're impatient, skip to the ** of the most interesting and provocative points)

Steve starts with an Ode to Rules. It would be nice if the Fed acted more stably and predictably, leaving less room for the interpretation that they're just changing their minds, or panicking, or giving in to Trump tweets.

So Steve phrases the question nicely: what has changed since last September, when the Fed seemed fully on a "normalization" path? What is the "data" in a "data-dependent" policy?
They decided (with a couple of dissents) to reduce the target range for the fed funds rate by 0.25% to 2.00-2.25%. That seems to represent a change of plan, since in September 2018, the median FOMC member was thinking that the fed funds rate by the end of 2019 would be 3%. So, something important must have changed since last September. What was it?
From the FOMC statement and Powell's presser after the meeting, it seems there were 5 things bothering the committee: 
1. Weak global growth.
2. Trade policy uncertainty.
3. Muted inflation.
4. The neutral rate of interest is down.
5. The natural rate of unemployment is down.
Go see Steve's graphs. There really is not much case that the US economy is slowing down.
Typically central banks lower interest rates in the face of observed decreases in aggregate economic activity - somewhere. But we haven't seen any such thing. Must be some very weird policy rule at work here.
That's a bit overstated. Central banks do react too forecasts. But most central banks, including ours, react cautiously knowing just how unreliable forecasts are.
 I can certainly understand that there's "trade policy uncertainty." More like "Trump uncertainty," I think. But that's been with us since January 2017. And for North America, which we could argue is more relevant for the US, the trade uncertainty is actually lower than it was in September. The USMCA was signed by Mexico, Canada, and the US on November 30, 2018, though it is as yet not ratified. Brexit anxiety is with us of course, but again that's nothing new. So, I think you have to be more specific if you want to make a general case about policy uncertainty. And what's the hurry? You can't wait for resolution?
The uncertainty work is interesting (a great recent example). But if uncertainty really is an economic problem, it should be reflected in today's investment, investment plans (a great measure) hiring, durables purchases stock prices, and other forward-looking measures. Moreover, it's not clear that the Fed should offset uncertainty as trade. They are "supply" shocks. (Previous post)

The one thing that has changed a bit is inflation.
.."muted" is as a good a word as any for that, relative to the 2% inflation target. The Fed's chosen measure - headline PCE - is at 1.4%, and stripping out food and energy gives us 1.6%. Not low, certainly, and well within what you might think is reasonable tolerance, but definitely below target.
But, putting Steve's point in stronger voice, , 0.4% variation in inflation over nearly a year is tiny in historical context, certainly not the sort of things that usually reverse a steady tightening project.


Here though, Steve's most interesting and provocative points start.
"But, suppose we thought that the only problem here is a slightly-below-target inflation rate. What would the corrective action be?"
The traditional answer, of course, is, lower interest rates.
and assuming there is a stable Phillips curve, everyone knows that lower nominal interest rates imply lower real interest rates in the short run. And lower real interest rates, as everyone knows, makes "aggregate demand" go up. Further, as everyone knows, output is demand-determined, so output therefore goes up. Then, by Phillips curve logic, inflation goes up.
But, as everyone knows, I think, there are issues with the Phillips curve. AOC knows it, and Jay Powell knows it, as we can see in this exchange
The exchange  is really good on both sides. Don't underestimate AOC. She rather brilliantly and knowledgeably led Powell down the road to admit the Phillips curve has died, so unemployment doesn't cause inflation any more. Then she smoothly went right to the (false) implication that any policy previously criticized as being inflationary will not cause inflation. She mentioned minimum wages, but green new deal, free college, medicare for all and a  fiscal blowout cannot be far behind. Powell didn't take the bait, but it's wiggling on the hook.

What about the Phillips curve? Inflation seems to have nothing to do with unemployment (or is it vice versa??) Japan and Europe, as well as our own 10 years of slow growth, seem testament to the falsity of the proposition that lower interest rates spark inflation.

Powell seems to be telling AOC what his staff told him, which is that the Phillips curve is currently very flat. The Phillips curve is still there though, or so Powell seems to think, though he seems a little confused about how the whole thing works. ... 
you can see that in the presser with Powell. The reporters are trying hard to understand what the Fed is up to, Powell is struggling to explain it, and everything is coming out muddled. For example, this exchange: [JC: I edited for clarity] 
MICHAEL MCKEE. ...How does cutting interest rates lower, or how does cutting interest rates keep that going since the cost of capital doesn’t seem to the issue here.= 
CHAIR POWELL. You know, I really think it does, and I think the evidence of my eyes tells me that our policy ... supports confidence, it supports economic activity, household and business confidence, and through channels that we understand. So, it will lower borrowing costs. ... since we noted our vigilance about the situation in June, you saw financial conditions move up...You see confidence, which had troughed in June....You see economic activity on a healthy basis. It just, it seems to work through confidence channels as well as the mechanical channels that you are talking about.
Steve comments scathingly:
Well, there's no confidence channel running from Powell to me, that's for sure.... Powell started off well when he was appointed. He opted for press conferences after every FOMC meeting, reduced the wordiness of FOMC statements, and generally seemed to be communicating well. But this decision makes clear what his limitations are. Powell is an attorney whose experience with monetary policy comes from sitting on the FOMC since 2011. You may think that puts you at the center of things. Sorry, it doesn't. There's a lot Powell doesn't know, and it shows.
True, a "confidence channel'' is something of a new idea, though quite common in central banking circles. We just need to give more and better speeches. All we have to fear is fear itself. But if one accepts an "uncertainty channel" certainly "confidence" can be interpreted as "belief in the Fed put," or other beliefs about future Fed policy.

I think Steve's personal attack on Powell is unwarranted.  Here and in other speeches I see someone who does a darn good job  of digesting fancy macroeconomics, and distinguishing the nuggets of wisdom from the craziness. Many (most) trained PhD economists are no better at steering the ship. You don't necessarily want a PhD hydrodynamicist at the wheel in a storm.

Most of all "There is a lot Powell doesn't know, and it shows" seems to me totally unwarranted. Just what is there to "know" about the Phillips curve? I would much rather have Powell's healthily acknowledged uncertainty than a PhD economist who thinks he or she "knows" how the Phillips curve really works.

(As a reminder, the Phillips curve is not standard economics. It is an empirical correlation that gained causal status by its repetition. Tight labor markets should coincide with higher real wages, wages higher than prices. But there is no natural logic that tight labor markets should coincide with higher wages and prices overall.)

Steve himself goes on to prove just how little anyone "knows" about the Phillips curve and the proper direction of policy right now:
So what's going on here? The Fed announced a normalization plan.. What's that mean? Normal means that short-term nominal interest rates are high enough to be consistent with 2% inflation over the long term. ... That's just the logic of Irving Fisher, which we all learned as undergrads. But, if the nominal interest rate is too low on average, then inflation will be too low, on average. That's abundantly obvious given the post-1995 Japanese experiment. Late last year, the FOMC was thinking that a normal fed funds rate is about 2.5-3.0%. I think that's about right. Basically, they aborted normalization. And, if the FOMC thinks an important goal is hitting 2% inflation, it should have kept its target fed funds rate range constant, or moved it up. [My emphasis]
Steve acknowledges here participation in the great neo-Fisherian heresy, which I flirt with as well. The equations of our best models scream it. Japan and Europe scream it, and their comparison with the US.

Maybe yes, maybe no. But Neo-Fisherians have no business criticizing the Fed chair for uncertainty and a bit of muddiness about how the Phillips curve works, or how interest rates affect inflation!

Steve goes on to discuss the end of QE and IOER, with interesting facts. The "floor system" does seem to be falling apart. I think the answer is simple: if you want to peg rates, peg rates: offer anyone to deposit at 2.00%, and offer anyone to borrow (with treasury collateral) at 2.25%. The Fed wants only the former, to limit quantities, and to offer different rates to different institutions according to their favor with the Fed. All a topic for another day.


  1. If the Federal Reserve does not perceive an inflation problem, then why not stimulate more economic growth? Every new job created is important to the person who takes it. Tight labor markets are a boon to social fabric, far better than any government programs.

    BTW, the level of new job openings have been flat for the last year.

    Perhaps rhere is a more important question that is not being asked by Western orthodox macroeconomists. Is the market signaling that central banks do not have the ammo needed to stimulate the economy? That is, the central banks are armed with popguns.

    Ray Dalio, the world's largest hedge fund manager, and Pimco, the world's largest Bond manager, have both recently stated that central banks lack the tools necessary to accomplish much. Dalio suggests we will inevitably see some version of money-financed fiscal programs.

    If markets conclude that central banks are weaklings, then it may become necessary to arm central banks with helicopters. Interest rates hit zero bound and quantitative easing is weak tea.

    Add on: given touchy politics, maybe the Fed didn't want to say so, but the dollar is too strong.

  2. Add on (sorry). Perhaps like other amateur macroeconomic policy buffs, I find MMT plausible but certainly debatable. I am a bit taken aback by AOC's strong convictions regarding MMT.

    That said, it is a little dispiriting to see people condemn MMT in combination with green programs and predict certain catastrophe.

    Truly, has not MMT in combination with extensive military outlays been the policy of the land at least since 9/11?

    In the last 10 years the US has spent about $12 trillion of borrowed money on military outlays (DoD, VA, black budget, appropriations for foreign wars). This has hardly raised an eyebrow, let alone a published concern, from the anti-MMT crowd.

    As far as I can tell, MMT has effectively been federal policy for a long long time.

  3. Yes, the Phillips Curve is a bunch of data. It needs theory.

    Those who believe that [unexplained] nominal wage growth drive inflation must be misguided. Why would nominal wages jump 10% in any one year, just for the hell of it? That theory must be wrong.

    Now, if monetary policy made demand rise, prices and wages would rise. Wages could rise more than prices when productivity rises and employment rises, perhaps also caused by deregulation.

    The Fed-AOC exchange is not just based on 1970's models, it's based on incorrect 1970's models. In fact, regressing U against dP/P yields a vertical, at ca. 5.5 p.c. Regressing the opposite, which makes no sense, yields the horizontal.

    Getting the natural rate of unemployment down can only be done with real changes. Increases in the minimum wage make it all worse. One can't do real things with money magic. When will they ever learn?

  4. I thought the Phillips curve died in the stagflation of the 1970s. At least that is my memory of the situation.

    I still think 1979 was worse than 2008. The stink of fear was thicker on the street. Basically, Wall Street pulled off a coup d'etat against the Carter Administration. The Fed Chairman and the Sec Treasury were replaced and a full anti-inflation campaign was launched. A measure of the chaos in the markets at the time was the price of Gold which went over $800/oz bu Jan 1980. Interest rates shot up into the 20s.

  5. The justification for cutting the fed funds target is based not primarily on US economic conditions, but on the likelihood of a lower 'natural rate of interest' stemming from slower growth in the rest of the world.One can protest that there is no news since the last meeting, but it is plausible that there is less uncertainty about slow growth abroad, and zero or even negative interest rates. And so what if it suggests the last increase was a mistake? Rates should be set on the best available information at the time, not on some vague notion that the central bank should never even hint that in hindsight a mistake was made.

    For me the bizarre thing was for Powell to go along with the idea that the Fed might need to take aggressive action with large cuts, as means of avoiding a deflationary spiral. We are very far from that, and to suggest otherwise sends a strange signal.

  6. The Fed's target is the one year treasury, look at the chart. The Fed lends to government, it must equilibriate to the government rate, it has no other path.

    The Fed is a central bank, not a normal currency banker like we might find in something like Libra. The Fed has a monopoly, as seen by Zuck withdrawing his idea for a normal currency banker.

    Recessions happen at time and place of regime change, give or take two years. Thus recessions are regular, if thing continue as they are then the Fed can predict recessions every eight years for an eternity, but things to not remain the same.

    The Fed has to worry the Nixon shocks, when they come, and they come at least once a generation.

    None of these facts would, in any way, implicate the Fed in doing the actions of a normal currency banker and most of your equations like Phillips fail.

  7. Why is the Fed lowering rates?
    "A passive Fed might let market rates drive TF and use daily open
    market operations to ensure that FF, the rate it can control, does not get out of line."

  8. What the fed does may be well intended, but it is not all powerful, and cannot control decisions by other relevant actors, or natural occurrences. It may actually be playing a game of chance at a high level. What follows still depends on the roll of the dice. An alternative, however, isn't apparent.

  9. 'They are "supply" shocks.' Maybe, but why is the ten year at 1.85% ? Uncertainty...that which is more difficult against which to hedge than "risk", forces capital to seek safety. 1.85% tells me investors are anticipating more uncertainty rather than less. The Fed is being schooled by the capital markets.

  10. What is interesting is that it seems the Eye of Sauron (aka the media, with some help from politicians) is focused too heavily on the monetary side when the fiscal side is just as important in steering the economic ship. Rearranging deck chairs on the Titanic? Let us hope not. Ha.


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