There isn’t any inflation (or growth) fear there. In fact, using the Fed’s preferred measure of the Taylor Rule the “right” level for Fed policy remains negative (I’m assuming a NAIRU of 5%):

We don’t exactly know the effective impact of QE, but everything except the price of gold points to it being less than the -5% needed to bridge this gap.

Abstract:
The paper uses real-time data to show that inflation and output gap, the variables that typically enter Taylor rules for interest rate setting, can provide evidence of out-of-sample predictability for stock returns from 1969 to 2008. In addition to out-of-sample tests that are based on mean squared prediction error comparisons, we test for the dependence of stock returns on Taylor rule predictors using the information about the whole distribution. The evidence is robust to using various measures of output gap and window sizes. Investor can time the market using Taylor rule fundamentals and generate higher utility.

Link al Paper

Inflationistas versus Deflationistas

I am aware that there is presently a vibrant inflation-deflation debate, as there was one year ago (see the beginning of this post on FT Alphaville) – Wall Street people manage to fret about one thing and its opposite at the same time. I am among them. But, to be precise, I think that we are in a deflationary environment (caused by the continuing deleveraging) that will be followed, when resolved, by inflation (caused by governments printing money). I am, with John Mauldin, in the “deflation-first, then-inflation camp” he referred to in his July 24 letter (Some Thoughts on Deflation). Mauldin has been warning about deflation for quite a while now (see his prescient, if somewhat premature, Forecast 2009: Deflation and Recession). Well, since Bullard has officially joined the deflation camp (note that he is considered an inflation hawk) I’m going to unilaterally decree that we shall worry about deflation, for the time being.

Besides, various inflation indicators tell us that we are uncomfortably close to deflation. “Inflation in the US is now just below 1%, whether you look at the CPI, the Cleveland Fed’s measure, or the Dallas Trimmed Mean CPI. The Fed’s favorite, the PCE, is also approaching 1%. The Dallas numbers are a little behind, but they are at all-time lows.” (Mauldin).

What are the main causes of deflation?

Pay attention: this is going to be on the exam.

First of all, let’s note that there is a type of deflation that is benign. Gains in productivity (such as those brought about by efficient uses of technology) can cause a reduction in production prices that is passed on to consumers. This is benign deflation (we could call it “cost-push deflation”). Unfortunately, this is not the deflation we are talking about at this juncture. The deflation we are starting to experience stems from weak demand (call it “demand-pull deflation”). We worry that the economy might degenerate into a deflationary recession.

What are the main deflationary pressures that are threatening the US economy? They are summarized in the slide below (don’t forget to review it before the test).

What does Bullard say? It’s all about expectations

There is another reason why the US economy is uncomfortably close to deflation, and this one will surprise you. Quoting from the concluding section in Bullard’s paper (page 21 again):

“The US is closer to a Japanese-style outcome today than at any time in recent history.

In part, this uncomfortably close circumstance is due to the interest rate policy being pursued by the FOMC. That policy is to keep the current policy rate close to zero, but in addition to promise to maintain the near-zero interest rate policy for an ‘extended period’.”

How so? – you should ask. An expansionary monetary policy (with the Fed funds “policy” rate close to zero) should increase the money supply and therefore cause (more) inflation. How can a low policy rate be one of the causes of deflation, as Bullard says?

If you’ve read about inflation you know that there is something even more important than the current inflation level to pay attention to, and that is future inflation expectations. This is what Bullard has in mind. Announcing that the Fed will maintain its interest rate target near zero for an extended period convinces people that they should not expect inflation for an even-more extended period – otherwise the Fed would start to hike rates. In other words, the “extended period” language referred to very low interest rates causes people to anchor their inflation expectations to very low levels. Low as in the green circles you see in Bullard’s Figure 1 above (which refer to Japan). Look for the full green circle in that picture marked May 2010. That’s were Japan is right now in terms of CPI-inflation (x-axis) and central bank policy rate (at 0.01%). That’s where you don’t want to see your economy going.

But is the US like Japan?

No, or, more precisely, not for the moment. Observe in Figure 1 above how the US, in the past 9 years, has been in the right-hand side of the picture, in terms of inflation and interest rates: that’s where you see those blue squares. But find the full square marked May 2010. That’s where the US was in May. As Bullard said: “The US is closer to a Japanese-style outcome today than at any time in recent history.

Now look at the intersections of the dashed red line and the curved, upward sloping black line in Figure 1. These lines represent some theoretical relationship (respectively the Fisher equation and a Taylor rule – but to understand what they mean you will have to read the paper and probably a lot of economics before you tackle the paper). What is important now is the meaning of the two intersection points. These are two “equilibrium” or “steady state” points to which economies naturally tend to converge. The one on the right is the “good” steady state, with an inflation rate in the “comfort zone” of 2% to 3% (2.3% in the picture). The other intersection point is the “bad” or “unintended” steady state, and as you see from the picture Japan has been gravitating around that point for most of the decade.

So, simplifying a little bit, the theory predicts that once an economy falls into the gravitational pull of the unintended steady state (and the US is feeling that pull more and more – spot again the May 2010 blue square) it will remain stuck there, maybe for a decade or two (Japan’s lost decade refers to the 1990s – so we can now talk about two lost decades for Japan). That’s what we should fear even more than fear itself – or so we’re told.

How can the US avoid a deflation trap?

Let’s pause for a moment. Remember that long list of deflationary pressures the US economy is contending with? OK: Bullard’s paper says nothing about them. The recipe he proposes is not meant to address those forces, at least not directly. And if it does address them indirectly this is not said in the paper. So you will need to look for another paper if you want to see those deflationary forces addressed. Rather, Bullard is only concerned about the deflationary effect of a protracted zero-rate policy, due to the anchoring of inflation expectation around a very low (deflationary) level. You might hope that once this problem is taken care of, deflation will disappear, but unfortunately this is not in the paper. The paper is really about the deflationary effects that can be addressed through monetary policy – remember that Bullard is a Federal Reserve Bank president. You will also note that these deflationary effects are also caused by the monetary policy itself (rates at zero for an extended period). So, it looks like our Fed officials have (finally) discovered the Hippocratic “first, do no harm” (a lesson Alan Greenspan missed …).

Bullard’s paper, titled Seven Faces of “The Peril” (the Peril being deflation – you knew that, didn’t you?) presents seven ways of analyzing the conundrum I described in the previous section: the possibility that the Fed’s policy and language might inadvertently cause a Japanese-style deflationary spiral. These seven faces are summarized in the slide below.

Two alternative models to the Japan experience

Is Quantitative Easing the magic bullet?

I know you are getting all excited at the prospect of hearing all the virtues of quantitative easing extolled with great elegance by James Bullard. Sorry to disappoint you. The seventh face, the one advocated by Bullard to cure the US’ deflation problem, is a real whimper. All he manages to say in defense of QE is:

“The quantitative easing policy undertaken by the FOMC in 2009 has generally been regarded as successful in the sense that longer-term interest rates fell following the announcement and implementation of the program.”

Yes, but it hasn’t helped in staving off “the peril”, if Bullard is writing such a paper now, after last year’s $1.5 trillion QE 1 program, right? And QE hasn’t helped Japan very much either, has it? Ah, but as Bullard points out in his paper (page 20):

“In the Japanese quantitative easing program, beginning in 2001, the BOJ was unable to gain credibility for the idea that they were prepared to leave the balance sheet expansion in place until policy objectives were met. And in the end, the BOJ in fact did withdraw the program without having successfully pushed inflation and inflation expectations higher, validating the private sector expectation.”

Did it? How different from the US approach, where the Fed withdrew its “credit easing” program at the end of March 2010, only to freak out about deflation a few months later, during which period the economy has slid further toward deflation!

And note the inconsistency of Bullard’s conclusion with the main point of his analysis. He is concerned that the Fed’s zero-rate policy coupled with its “extended period” rhetoric might anchor inflation expectations to deflationary levels. And what does he propose? To leave rates at zero, to leave the “extended period” language intact, and on top of it all to add a second quantitative easing program. What does he hope to achieve? At best, he can hope to anchor inflation expectations even further out in time!

Furthermore, he fails to acknowledge that if inflation expectations have moved down during the QE program (by 50 basis points over 5 and 10 years, as many have pointed out), this might be due to t reasons other than the Fed’s purchases. Since the Fed stopped its purchases of agency paper in March of this year, the yield of Fannie Mae 30-year bonds has dropped 70 basis points, from 5.2% to 4.3%. If the Fed has money to spend, they might as well try to drop dollar bills from airplanes over major cities.

I’m having second thoughts about this case: if this is all the Fed can think of to combat deflation (the entire section of Bullard’s paper on his quantitative easing proposal is reproduced in the slide below), then those traders were right after all in being spooked by Bullard’s paper.

Recent less than favorable economic data has cut the legs out from an extraordinary rally in the equity markets. The weak data started raising eyebrows in early May with feeble ISM numbers, followed by fragile employment numbers. These facts have caused the major indices to correct a little less than 20% and also put the 10-year under 3%. The Federal Reserve acknowledged the “slowing” of the economy and the “soft” data has also put Republicans in the driver’s seat to win key elections come November. The main takeaway is that the recent data has caused many changes in expectations.

The language used by The Federal Reserve regarding target interest rates has been “extended period.” This has been alluded to by Chairman Ben Bernanke as he attempts to use language as a tool in the Quantitative Easing kit. The idea of low interest rates is to essentially lower the cost of capital, thereby raising demand; it has also been used to recapitalize the banks and strengthen their capital position. My argument is that The Fed’s low interest policy may be having a counterintuitive effect and also can become a self-fulfilling prophecy.

The idea of keeping interest rates excessively low is stimulating in nature; there really is no debate for that. The argument arises when the expectation the market has on interest rates has been altered. After the tech bubble, Alan Greenspan kept interest rates unusually low for an extended period of time to stimulate the economy. This led to the “Greenspan Conundrum” where long-term interest rates remained low and even fell despite the Fed’s year-long campaign to raise short-term rates. This related to the current predicament for Bernanke as he has rates unusually low couples with a Fed balance sheet full of recently bought assets, yet there is still talk of a Japanese style deflationary environment.

The “extended period of time” language for low interest rates inadvertently lowers inflation expectations. If the Central Bank is the expert on interest rates and it is expressing those rates will be low for an extended period of time, no traders or economists will be raising their inflation expectations for the future. This bleak outlook also stunts corporation’s investment and hiring plans. The top companies in America are currently sitting on a tremendous amount of cash and see no reason to deploy that cash because the returns on capital will be low according to The Fed’s assessment of the future. The argument is that the Fed’s attempt at being transparent has led to a decrease in inflation expectations, which has led to a decrease in spending, and an ultimately flat economy.

The Fed needs to bring rates higher and possibly consistent with the Taylor Rule. Americans are saving a larger percentage of their income to account for the lower rates in investments. The raising of interest rates will lower the savings rate and increase consumption which will allow for the cycle to churn again. Rates should not be raised to extraordinarily high levels, but to an average rate that is consistent with the past 30 years of growth. The raising of rates will also reduce moral hazard and bubble-like scenarios from occurring. While the raising of interest rates seems like the worst idea for saving “The New Normal Economy,” I believe it is the only action to return the economy to normalcy.

Luigi D’Onorio DeMeo

Federal Reserve Board Chairman Ben Bernanke spent most of his speech to the American Economic Association on Jan. 3 responding to the critique that easy monetary policy during 2002-2005 contributed to the housing boom, to excessive risk taking, and thereby to the financial crisis.

Many have expressed the view that monetary policy was too easy during this period. They include editorial writers in this newspaper, former Fed policy makers such as Timothy Geithner (now the secretary of the Treasury), and academics such as business-cycle analyst Robert J. Gordon of Northwestern. But Mr. Bernanke focused most of his time on my research, especially on a well-known policy benchmark commonly known as the Taylor rule.

This rule calls for central banks to increase interest rates by a certain amount when price inflation rises and to decrease interest rates by a certain amount when the economy goes into a recession. My critique, which I presented at the annual Jackson Hole conference for central bankers in the summer of 2007, is based on the simple observation that the Fed’s target for the federal-funds interest rate was well below what the Taylor rule would call for in 2002-2005. By this measure the interest rate was too low for too long, reducing borrowing costs and accelerating the housing boom. The deviation from the Taylor rule, which had characterized good monetary policy during the previous two decades, was the largest since the turbulent 1970s.

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In his speech, Mr. Bernanke’s main response to this critique was to propose alternatives to the standard Taylor rule—and then to use the alternatives to rationalize the Fed’s policy in 2002-2005.

In one alternative, which addresses what he describes as his “most significant concern regarding the use of the standard Taylor rule,” he put the Fed’s forecasts of future inflation into the Taylor rule rather than actual measured inflation. Because the Fed’s inflation forecasts were lower than current inflation during this period, this alternative obviously gives a lower target interest rate and seems to justify the Fed’s decisions at the time.

There are several problems with this procedure. First, the Fed’s forecasts of inflation were too low. Inflation increased rather than decreased in 2002-2005. Second, as shown by economists Athanasios Orphanides and Volker Wieland, who previously served on the Federal Reserve Board staff, if one uses the average of private sector inflation forecasts rather than the Fed’s forecasts, the interest rate would still have been judged as too low for too long.

Third, Mr. Bernanke cites no empirical evidence that his alternative to the Taylor rule improves central-bank performance. He mentions that forecasts avoid overreacting to temporary movements in inflation—but so does the simple averaging of broad price indices as in the Taylor rule. Indeed, his alternative is not well defined because one does not know whose forecasts to use. Moreover, the appropriate response to an increase in actual inflation would be different from the appropriate response to an increase in forecast inflation.

There are other questionable points. Mr. Bernanke’s speech raises doubts about the Taylor rule by showing that another version of the rule would have called for very high interest rates in the first few months of 2008. But using the standard Taylor rule, with the GDP price index as the measure of inflation, interest rates would not be so high, as I testified at the House Financial Services Committee in February 2008.

Mr. Bernanke also said that international evidence does not show a statistically significant relationship between policy deviations from the Taylor rule and housing booms. But his speech does not mention that research at the Organization for Economic Cooperation and Development in March 2008 did find a statistically significant relationship.

Mr. Bernanke claimed that “Economists who have investigated the issue have generally found that, based on historical relationships, only a small portion of the increase in house prices earlier this decade can be attributed to the stance of U.S. monetary policy.” But two of the economists he cites—Frank Smets, director of research at the European Central Bank, and his colleague Marek Jarocinski—reported in the July/August issue of the St. Louis Fed Review that “evidence that monetary policy has significant effects on housing investment and house prices and that easy monetary policy designed to stave off perceived risks of deflation in 2002-04 has contributed to the boom in the housing market in 2004 and 2005.”

These technical arguments are important, but one should not lose sight of the forest through the trees. You do not have to rely on the Taylor rule to see that monetary policy was too loose. The real interest rate during this period was persistently less than zero, thereby subsidizing borrowers. Thomas Hoenig, president of the Federal Reserve Bank of Kansas City, reported in a speech on Jan. 7 that during the past decade “real interest rates—the nominal interest rate adjusted for inflation—remained at negative levels for approximately 40 percent of the time. The last time this occurred was during the 1970s, preceding a time of turbulence.”

Inflation was increasing, even excluding skyrocketing housing prices. Yet even when inflation is low, the damage of boom-bust monetary policy can be severe as Milton Friedman stressed in his strong criticism of the Fed in the 1950s and 1960s. Stepping back from the fray, an objective observer of all this evidence would have to at least admit the possibility that monetary policy was too easy and a possible contributor to the crisis.

Not admitting the possibility raises concerns. One is that if such a large deviation from standard policy is rationalized away, it might happen again. Indeed, some analysts are worried now about the Fed holding interest rates too low for too long, causing another boom-bust and a shorter expansion.

Another concern is that, rather than trying to be vigilant and avoid causing bubbles, the Fed will try to burst them with interest rates. Indeed, one of the lines from Mr. Bernanke’s speech most picked up by Fed watchers is that “we must remain open to using monetary policy as a supplementary tool for addressing those risks.” We have very limited ability to fine tune monetary policy in such an interventionist way.

Finally, there is a concern that the line of analysis in Mr. Bernanke’s speech puts the full burden of preventing future bubbles on new regulation. Clearly the Fed missed excessive risks on and off the balance sheets of the banks that it supervises and regulates. That policy needs to be corrected. However, it is wishful thinking that some new and untried macro-prudential systemic risk regulation will prevent bubbles.

While I disagree with Mr. Bernanke’s analysis, it is good news that the Federal Reserve Board has begun to examine its policies and publish its findings. This will help inform the Financial Crisis Inquiry Commission, which will soon begin holding public hearings on the causes of the financial and economic crisis. In the meantime I hope the Federal Reserve Board will continue with this new self-examination policy and transparently evaluate all its recent crisis-related actions, from the AIG bailout to the Mortgage Backed Security purchase program.

Mr. Taylor is professor of economics at Stanford University and a senior fellow at the Hoover Institution.

“Experience both in the US and internationally tells us that maintaining large amounts of stimulus over an extended period risks creating conditions that lead to financial excess, economic volatility and even higher unemployment at some point in the future,” he said. Mr Hoenig rejected Mr Bernanke’s argument that the Fed decision to keep rates low after the dotcom crash did not contribute meaningfully to the housing and credit bubble. “Low interest rates contributed to excesses,” he said.

Arguing that economic data are always mixed during the early stages of a recovery, he called on the Fed to “more evenly weigh our short-run concerns against the longer run costs”.

Separately, the FT can reveal that the optimal interest rate in the US has moved above zero, according to a rule of thumb for monetary policy cited by Federal Reserve chairman Ben Bernanke last weekend. The rule of thumb is a version of the so-called Taylor rule, which relates interest rates to unemployment and inflation. It was shown on a chart included in Mr Bernanke’s presentation to the American Economic Association, in which he defended the Fed’s decision to keep rates low after the dotcom bust.

The chart suggested the optimal rate moved above zero around the middle of 2009. On the same basis, the optimal rate is almost certainly above zero today – even though the Fed has kept US rates steady at zero to 0.25 per cent.

The fact that this rule of thumb suggests rates should be above zero highlights the turnround in the situation confronting the Fed since early 2009. At that time, a similar Fed staff analysis suggested the optimal interest rate was minus 5 per cent. The difference reflects the impact of the Fed’s gigantic asset purchase programme and other factors that boosted the outlook for the economy, unemployment and inflation.

The finding is notable because the version cited by Mr Bernanke is forward-looking, uses the Fed’s own forecasts and uses the central bank’s preferred measure of inflation, the personal consumption expenditure deflator. In his speech, Mr Bernanke said such a version was “a more useful benchmark” and “guide to appropriate policy” than the versions of the Taylor rule that used current unemployment and consumer price inflation.

The recommendation of a single rule of thumb does not mean that rate increases are imminent. Fed policy is based on judgment and puts weight on risks as well as the possibility that the neutral interest rate that neither stimulates nor slows the economy can change over time.

The Federal Open Market Committee reiterated in December that it expects to keep rates at “exceptionally low” levels for an “extended period” – commonly interpreted as at least six months. But the rule of thumb suggestion that the optimal rate has risen above zero does underscore the fact that it is no longer unambiguously clear that rates should stay near zero for a very long time

Jan. 5 (Bloomberg) — John Taylor, creator of the so-called Taylor Rule for guiding monetary policy, disputed Federal Reserve Chairman Ben S. Bernanke’s argument that low interest rates didn’t cause the U.S. housing bubble.

“The evidence is overwhelming that those low interest rates were not only unusually low but they logically were a factor in the housing boom and therefore ultimately the bust,” Taylor, a Stanford University economist, said in an interview today in Atlanta.

Taylor, a former Treasury undersecretary, was responding to a speech by Bernanke two days ago, when he said the Fed’s monetary policy after the 2001 recession “appears to have been reasonably appropriate” and that better regulation would have been more effective than higher rates in curbing the boom.

Under former Chairman Alan Greenspan, the Fed lowered its benchmark rate to 1.75 percent from 6.5 percent in 2001 and cut it to 1 percent in June 2003. The central bank left the federal funds rate for overnight interbank lending at 1 percent for a year before raising it in quarter-point increments from 2004 to 2006.

“It had an effect on the housing boom and increased a lot of risk taking,” said Taylor, 63, who was attending the American Economic Association’s annual meeting.

Taylor echoed criticism of scholars including Dean Baker, co-director of the Center for Economic and Policy Research in Washington, who say the Fed helped inflate U.S. housing prices by keeping rates too low for too long. The collapse in housing prices led to the worst recession since the Great Depression and the loss of more than 7 million U.S. jobs.

Almost Zero

Bernanke and his fellow policy makers cut the benchmark interest rate almost to zero in December 2008 and have created unprecedented emergency credit programs to revive lending and spur a recovery.

The Fed chief, speaking at the same conference on Jan. 3, said increased use of variable-rate and interest-only mortgages, and the “associated decline of underwriting standards,” were more to blame for the price bubble than low interest rates.

Bernanke, 56, served as a Fed governor from 2002 until 2005 and backed all the interest-rate decisions under his predecessor, Alan Greenspan. Bernanke took over as Fed chairman in 2006 after serving for half a year as chairman of the White House Council of Economic Advisers.

“Low rates certainly contributed to the crisis,” Baker said in an interview on Jan. 3. “I don’t know how he can deny culpability. You brought the economy to the brink of a Great Depression.”

In his Jan. 3 speech, Bernanke used a modified form of the Taylor rule to support his argument that interest rates weren’t too low following the 2001 recession.

Inflation, Growth

The formula suggests how a central bank should set rates if inflation or growth veers from goals. While the standard rule uses existing data, Bernanke argued that policy makers instead should employ forecasts of prices and output.

Robert Hall, who heads the National Bureau of Economic Research’s panel that dates the beginning and end of recessions, said he found Bernanke’s argument convincing.

“I think Bernanke is completely correct,” Hall said.

Taylor said he didn’t agree with Bernanke’s “alternative interpretation” of his rule. Still, he said the rule supports the Fed’s current policy of keeping interest rates near zero.

“If we are fortunate to get a stronger recovery or if we are unfortunate and inflation picks up, the rate will have to rise,” he said.

–With assistance of Vivien Lou Chen in Atlanta. Editors: James Tyson, Christopher Wellisz

To contact the reporters on this story: Steve Matthews in Atlanta at +1-404-507-1310 or smatthews@bloomberg.net;

“I think we need to take a very careful look at monetary policy and central bankers who do not believe that interest rates played a role in this crisis,” he said. “I think that view is dead wrong.”

A lot of people are discussing Bernanke’s defense of “monetary ease” in 2002, but everyone seems to be missing the much bigger story.  Bernanke’s explanation for the Fed’s actions in 2002 show exactly how monetary policy failed in 2008.  In particular, Bernanke made the following three observations regarding 2002:

1.  Monetary policy needs to focus on the macroeconomy, not specific sectors.

2.  Monetary policy must be forward-looking, must target the forecast.

3.  Monetary policy must be especially aggressive when there is risk of liquidity trap (which would render conventional policy ineffective.)

In 2008 the Fed did exactly the opposite.  Between September and December 2008 the Fed focused on banking, not the macroeconomy, they adopted a backward-looking Taylor Rule, and they were extremely passive when the threat of a liquidity trap was already obvious.

In the 1920s Governor Strong argued that if the Fed were to try to stop the stock market boom, it would be like spanking all one’s children just because one had misbehaved.  Bernanke seems to feel the same way:

Monetary policy is also a blunt tool, and interest rate increases in 2003 or 2004 sufficient to constrain the bubble could have seriously weakened the economy at just the time when the recovery from the previous recession was becoming established.

So the Fed should focus on the macroeconomy, not a specific sector.  I agree. Unfortunately, they did exactly the opposite in the last 4 months of 2008.

The second quotation shows that Bernanke does not accept the policy implications of backward-looking Taylor Rules, he strongly believes that monetary policy must be forward-looking; policy must respond to looming inflation or deflation threats, not the previous year’s inflation rate:

Slide 4 shows that the version of the Taylor rule based on forecast inflation (in green dots) explains both the course of monetary policy earlier in the past decade as well as the decision not to respond aggressively to what did in fact turn out to be a temporary surge in inflation in 2008. This comparison suggests that the Taylor rule using forecast inflation is a more useful benchmark, both as a description of recent FOMC behavior and as a guide to appropriate policy.

There might be no better example of the distinction between forward and backward-looking Taylor Rules than economic situation on September 16, 2008, when the FOMC made its most momentous error.  To set the scene, recall that we had been in recession for nine months.  But the early stages of the recession were extremely mild, and the last unemployment reading had been about 6.2%.  The last CPI data that was available was for July, and due to the extremely high oil prices the headline inflation numbers were over 5%, far above the Fed’s implicit target.  Core inflation, however, was still well-behaved.  And most importantly, the precipitous fall in commodity prices between mid-July and mid-September had greatly reduced inflation expectations.  Two days before the FOMC meeting Lehman failed, and this further reduced inflation expectations in the TIPS markets.  By the time of the September 16th meeting, 5 year TIPS spreads had fallen to only 1.23%.  Now let’s compare the policy implications in September 2008 of a backward looking Taylor Rule, to the forward-looking policy that Bernanke says that he favors:

Backward-looking rule:  There is both a risk of recession and high inflation.  No policy action called for.

Forward-looking rule:  There is risk of recession, and risk that inflation will sharply undershoot the implicit 2% target.  Cut rates.

The FOMC statement said the risks of recession and inflation were roughly balanced.  The Fed took no action.  John Taylor won and I lost.

At this point you might wonder why I put so much emphasis on one meeting, after all the Fed did eventually get around to cutting rates almost to zero, so what’s the rush?  How much harm can be done from one botched meeting?  Normally a single error can be easily corrected, but let’s see what Bernanke says about policy where the economy is teetering on the edge of a liquidity trap:

The aggressive monetary policy response in 2002 and 2003 was motivated by two principal factors. First, although the recession technically ended in late 2001, the recovery remained quite weak and “jobless” into the latter part of 2003. Real gross domestic product (GDP), which normally grows above trend in the early stages of an economic expansion, rose at an average pace just above 2 percent in 2002 and the first half of 2003, a rate insufficient to halt continued increases in the unemployment rate, which peaked above 6 percent in the first half of 2003.  Second, the FOMC’s policy response also reflected concerns about a possible unwelcome decline in inflation. Taking note of the painful experience of Japan, policymakers worried that the United States might sink into deflation and that, as one consequence, the FOMC’s target interest rate might hit its zero lower bound, limiting the scope for further monetary accommodation. FOMC decisions during this period were informed by a strong consensus among researchers that, when faced with the risk of hitting the zero lower bound, policymakers should lower rates preemptively, thereby reducing the probability of ultimately being constrained by the lower bound on the policy interest rate.  (emphasis added.)

Of course this is precisely the mistake the Fed made in late 2008.  In mid-September they saw no need for a rate cut, even though rates were only 2%, and even though T-bill rates had briefly dipped close to zero in the financial crisis of early 2008, and even though Lehman had just failed, and even though TIPS showed a dangerous plunge in 5 year inflation expectations, and even though we had been in recession for 9 months.  In other words, things were already far more scary than in 2002.  By mid-October many observers argued that we were already in a liquidity trap and there was nothing more that the Fed could do.  Time for fiscal stimulus.  That sure didn’t take long!  I have to give credit to Bernanke, he is a superb at diagnosing problems.  To use a medical analogy, Bernanke is the guy you want diagnosing the patient and Krugman is the guy you’d send into the operating room.  In a crisis, you need someone with a sense of urgency and decisiveness, and as well as an understanding of what could happen if you don’t act in time.

I was lulled by all those academic articles (some by Bernanke) into thinking that the Fed had a backup plan if we went into a liquidity trap.  Krugman kept saying “it’s harder than it looks.”  I still don’t think it is that hard, but as a practical matter Krugman was right.  There was no backup plan.  The Fed acted as if there was little they could do once rates hit zero.  That makes Bernanke’s pre-emption doctrine all the more essential.

When I was young, I recall some teenagers who played a dare-devil game on top of those white mushroom shaped water towers that dot the Midwest.  They would start at the top, and see who dared slide the furthest down.  Of course if you make a mistake it is all over.  Once you start sliding, the slope keeps getting steeper.  (Kids, don’t play this game without a parachute.  And if you must play, wear sneakers!)  It turns out that the Fed was playing a similar game, seeing how far down they could let T-bill yields fall without enacting an aggressive policy of monetary ease.  In the first 10 days of October the stock market crashed by 23%.  I’m guessing that by October 10th Bernanke had the sickening feeling in his stomach that one of those kids would have had if they went “over the horizon” on a water tower.   There must have been some point when the Fed realized it was too late for monetary policy.  Why not go immediately from 2% to zero once the mistake was realized?  I’m guessing that they thought that would look too desperate, and admission that they had blown it in the September meeting.

The Fed had already suffered a similar embarrassment in December 2007, when they cut rates 1/4 at a meeting where many were looking for a 1/2 point cut.  The stock and bond markets panicked after the 2:15 pm announcement.  Stocks are easy to explain, but you might be surprised to hear that 3 month T-bill prices actually rose, i.e. yields fell.  How could yields have fallen on a tighter than expected Fed announcement that sharply depressed the stock market?  Easy, the markets knew the Fed blew it, and that this would push us into recession.  They also knew that the recession would force the Fed to make an embarrassing make-up call in the near future.  And they were right, we went into recession and the Fed panicked and cut rates an additional 75 basis points just a month later, and another 50 at the next scheduled meeting—a total cut of 125 basis points in 10 days.  In the fall of 2008 they needed an even more aggressive move.  They needed to cut rates so sharply that 3 month T-bill yields rose.  And they blinked.

Arnold Kling likes to make my belief that tight money was to blame seem very mysterious:

Like Scott Sumner, Krugman views the main problem as deflationary expectations. I am not sure where these expectations come from. In Sumner’s story, people just decide that the monetary authority is willing to see the price level drop.

If you think that low interest rates are easy money and high interest rates are tight money, then it does seem very mysterious.  But it is not mysterious to the stock market.  Unlike Kling, the stock market does believe monetary policy has a near-term impact on the economy.  It isn’t just coincidence that the Dow soared hundreds of points right after 2:15pm on September 18, 2007, or that it crashed hundreds of points right after 2:15pm on December 11th, 2007.  And it’s not just coincidence that 3 month T-bill yields fell on a tighter than expected Fed announcement that plunged us into recession.  Those market responses are sending us powerful signals about how Fed policy shocks (or even Fed errors of omission in the face of an increase in money demand during financial crises), can have a powerful effect on AD.  And the markets also understand how deflationary policies can dramatically worsen a financial crisis.

Most economists ignore these signals because they don’t fit in to their “low interest rates = easy money” worldview.  The markets were warning us all along, it’s just that we weren’t paying any attention.

Here’s how I read the recent AEA meeting speech.  Bernanke is in a box.  He feels he must defend the Fed from the neo-Austrian charge that monetary ease in 2002-04 blew up the housing bubble and led to the sub-prime fiasco.  But if he does so it leaves him open to criticism from people like me who point out that his explanation implies money was much too tight in late 2008.  Bernanke knows that for every Sumner, Woolsey or Hetzel, there are 1000 neo-Austrians.  In purely political terms he probably made the right move at the AEA.  History may not judge him so kindly.

FOUR YEARS AGO WHEN YOU CAME BEFORE the Senate for confirmation to be Chairman of the Federal Reserve, I was the only Senator to vote against you. In fact, I was the only Senator to even raise serious concerns about you. I opposed you because I knew you would continue the legacy of Alan Greenspan, and I was right. But I did not know how right I would be and could not begin to imagine how wrong you would be in the following four years.

The Greenspan legacy on monetary policy was breaking from the Taylor Rule to provide easy money, and thus inflate bubbles. Not only did you continue that policy when you took control of the Fed, but you supported every Greenspan rate decision when you were on the Fed earlier this decade. Sometimes you even wanted to go further and provide even more easy money than Chairman Greenspan. As recently as a letter you sent me two weeks ago, you still refuse to admit Fed actions played any role in inflating the housing bubble despite overwhelming evidence and the consensus of economists to the contrary. And in your efforts to keep filling the punch bowl, you cranked up the printing press to buy mortgage securities, Treasury securities, commercial paper, and other assets from Wall Street. Those purchases, by the way, led to some nice profits for the Wall Street banks and dealers who sold them to you, and the G.S.E. purchases seem to be illegal since the Federal Reserve Act only allows the purchase of securities backed by the government.

On consumer protection, the Greenspan policy was don’t do it. You went along with his policy before you were Chairman, and continued it after you were promoted. The most glaring example is it took you two years to finally regulate subprime mortgages after Chairman Greenspan did nothing for 12 years. Even then, you only acted after pressure from Congress and after it was clear subprime mortgages were at the heart of the economic meltdown. On other consumer protection issues you only acted as the time approached for your re-nomination to be Fed Chairman.

Alan Greenspan refused to look for bubbles or try to do anything other than create them. Likewise, it is clear from your statements over the last four years that you failed to spot the housing bubble despite many warnings.

Chairman Greenspan’s attitude toward regulating banks was much like his attitude toward consumer protection. Instead of close supervision of the biggest and most dangerous banks, he ignored the growing balance sheets and increasing risk. You did no better. In fact, under your watch every one of the major banks failed or would have failed if you did not bail them out.

On derivatives, Chairman Greenspan and other Clinton Administration officials attacked Brooksley Born when she dared to raise concerns about the growing risks. They succeeded in changing the law to prevent her or anyone else from effectively regulating derivatives. After taking over the Fed, you did not see any need for more substantial regulation of derivatives until it was clear that we were headed to a financial meltdown thanks in part to those products.

The Greenspan policy on transparency was talk a lot, use plenty of numbers, but say nothing. Things were so bad one TV network even tried to guess his thoughts by looking at the briefcase he carried to work. You promised Congress more transparency when you came to the job, and you promised us more transparency when you came begging for TARP. To be fair, you have published some more information than before, but those efforts are inadequate and you still refuse to provide details on the Fed’s bailouts last year and on all the toxic waste you have bought.

And Chairman Greenspan sold the Fed’s independence to Wall Street through the so-called “Greenspan Put”. Whenever Wall Street needed a boost, Alan was there. But you went far beyond that when you bowed to the political pressures of the Bush and Obama administrations and turned the Fed into an arm of the Treasury. Under your watch, the Bernanke Put became a bailout for all large financial institutions, including many foreign banks. And you put the printing presses into overdrive to fund the government’s spending and hand out cheap money to your masters on Wall Street, which they use to rake in record profits while ordinary Americans and small businesses can’t even get loans for their everyday needs.

Now, I want to read you a quote:  “I believe that the tools available to the banking agencies, including the ability to require adequate capital and an effective bank receivership process are sufficient to allow the agencies to minimize the systemic risks associated with large banks. Moreover, the agencies have made clear that no bank is too-big-too-fail, so that bank management, shareholders, and un-insured debt holders understand that they will not escape the consequences of excessive risk-taking. In short, although vigilance is necessary, I believe the systemic risk inherent in the banking system is well-managed and well-controlled.”

That should sound familiar, since it was part of your response to a question I asked about the systemic risk of large financial institutions at your last confirmation hearing. I’m going to ask that the full question and answer be included in today’s hearing record.

Now, if that statement was true and you had acted according to it, I might be supporting your nomination today. But since then, you have decided that just about every large bank, investment bank, insurance company, and even some industrial companies are too big to fail. Rather than making management, shareholders, and debt holders feel the consequences of their risk-taking, you bailed them out. In short, you are the definition of moral hazard.

Instead of taking that money and lending to consumers and cleaning up their balance sheets, the banks started to pocket record profits and pay out billions of dollars in bonuses. Because you bowed to pressure from the banks and refused to resolve them or force them to clean up their balance sheets and clean out the management, you have created zombie banks that are only enriching their traders and executives. You are repeating the mistakes of Japan in the 1990s on a much larger scale, while sowing the seeds for the next bubble. In the same letter where you refused to admit any responsibility for inflating the housing bubble, you also admitted that you do not have an exit strategy for all the money you have printed and securities you have bought. That sounds to me like you intend to keep propping up the banks for as long as they want.

Even if all that were not true, the A.I.G. bailout alone is reason enough to send you back to Princeton. First you told us A.I.G. and its creditors had to be bailed out because they posed a systemic risk, largely because of the credit default swaps portfolio. Those credit default swaps, by the way, are over the counter derivatives that the Fed did not want regulated. Well, according to the TARP Inspector General, it turns out the Fed was not concerned about the financial condition of the credit default swaps partners when you decided to pay them off at par. In fact, the Inspector General makes it clear that no serious efforts were made to get the partners to take haircuts, and one bank’s offer to take a haircut was declined. I can only think of two possible reasons you would not make then-New York Fed President Geithner try to save the taxpayers some money by seriously negotiating or at least take up U.B.S. on their offer of a haircut. Sadly, those two reasons are incompetence or a desire to secretly funnel more money to a few select firms, most notably Goldman Sachs, Merrill Lynch, and a handful of large European banks.  I also cannot understand why you did not seek European government contributions to this bailout of their banking system.

From monetary policy to regulation, consumer protection, transparency, and independence, your time as Fed Chairman has been a failure.  You stated time and again during the housing bubble that there was no bubble. After the bubble burst, you repeatedly claimed the fallout would be small. And you clearly did not spot the systemic risks that you claim the Fed was supposed to be looking out for. Where I come from we punish failure, not reward it. That is certainly the way it was when I played baseball, and the way it is all across America. Judging by the current Treasury Secretary, some may think Washington does reward failure, but that should not be the case. I will do everything I can to stop your nomination and drag out the process as long as possible. We must put an end to your and the Fed’s failures, and there is no better time than now.

Welcome to my new blog on my thoughts and observations on the economy (mostly the US but I will dip my fingers in other spaces as well) and markets. I will also occasionally dip my hand into another arena which I have a passion for and that is running. Any comments or feedback will be welcome. Here we go!

Over the past few days we have been enduring the consumption of leftover turkey from last week’s Thanksgiving extravaganza and while we are almost done the low rate feast the Federal Reserve started serving late last year is still being consumed today and looks like there is plenty left to feed the economy. On the other hand, the gravy and other fixings provided from the Fed’s alternative programs continue to fade or at least have some sort of forseeable horizon, although there has been some chatter that some cooks at the Fed are keeping options open to serve more of the sides.

In my modified Taylor rule, which takes into account a few factors which I think are relevant to policy maker’s decisions, when the Fed says that it will keep rates low for an extended period of time given its central tendency foercasts it could mean that rates could stay low until at least Q1 2012 and even then by the end of 2012 the model implies a rate barely above 0.50%. Extended could mean an enternity for some trading perspectives.

The latest Bloomberg survey has he first rate hike pegged in for Q3 2010 with rates rising to 1.50% by the end of Q1 2011. Pretty big difference if you ask me. The problem with raising rates in Q3 2010 is that slack in the economy should remain still very high with the unemployment rate according to the Fed still above 9%. The funny thing is that the Fed’s unemployment forecast looks to be below that of the market’s over the same period, in other words the consensus view may be too optimistic on the rate front particularly given its baseline uenmployment scenario. But on the inflation front the market is forecasting a more hakwish trajectory, although I’m not sure where inflationary pressures could come from with slack still high.

There is also the arguement that the Fed will raise rates sooner than historically, a concept that I buy into. Historically policy makers start raising rates when the unemployment gap is a hair from closing. Given the outlook for unemployment the gap is as expected to be as wide as the talent gap between the New Jersey Nets and the Boston Celtics. If it was the Knicks instead of the Celtics then maybe the arguement for mid 2010 rate hikes may hold. Even if the Fed does wait until 2011 to raise rates it will be much sooner than it has in the past, by about 4 quarters, which is inline with what Fed’s Bullard recently said about the potential for raising rates before 2012 keeping asset bubbles in mind.

Efecto Contango en el UNG:  La opinion de H.T. Love

Taylor Rule: Critica a la justificación de miembros de la FED sobre su rol en los 2000s.

Paul Krugman recently pointed out that Reagan did it. Deregulation in the financial sector opened the gates for financial innovation that benefited a few while harming the rest. The financial sector was enabled to play a huge Ponzi scheme, where banks and companies had to increase their debt in order to sustain their profits. Those that did not increase their debt were bought up with the extra credit that was inserted into the economy by the Fed.

So, I would argue that Taylor is wrong in saying that low interest rates caused the housing boom, but would point out that the loose monetary policy caused an increase in overall company debt. This opens the gate for debt-deflation, which has been the main worry of Hyman Minsky. On the other hand, the US financial system got an extra boost from China. The Chinese government – via their central bank – invested heavily into treasury bonds, crowding out private investors. These had to look for alternative investments. After scrambling to find a place to “dump” the foreign capital, Wall Street firms came up with asset-backed securities. Mortgages were one of those assets. This invention changed the rules of the game.

Above you find a graph taken from M.A. Akhtar’s Understanding Open Market Operation, published by the St. Louis Fed. It shows how monetary policy affects the economy. This is the so-called transmission mechanism. Housing is affected by cost and availability of credit, which, according to the graph, are determined by interest rates, among other things. It is this connection that John Taylor highlights. Economists have been saying that for decades, so basically it is nothing new. Low interest rates, especially the long-term one, create incentives to build and buy houses. This is a major transmission channel of monetary policy. Hence, low interest rates lead to more investment via an increase of economic activity in housing.

How does the securitization of mortgage-backed loans fit into the picture? A comparison with the old transmission mechanism should provide some insights. Before securitization, banks gave a loan to somebody and waited until the loan plus interest was paid back in full. The amount of credit available for the bank was reduced by the amount of the loan. The bank had the loan on its own books, and it waited to get the money back and then give another loan. If the loan would not perform – the house owner defaults for some reason – the bank would have to take a loss. The amount of loans taken out depended on the US interest rate, because this is how the banks refinanced.

Asset-backed securities (ABS) changed this. Formerly, banks held on to the loan until it was fully paid back, securitization means that the loan will be sold on. This means that the bank gives away the loan, and then sells the expected income stream to a 3rd party. Often, diverse loans were sliced and mixed to reduce the risk of default. This created a very opaque product. Rating agencies rated the resulting ABSes according to the rating of the origin – the emitting bank. They simply did not have the resources to go through thousands of single loans for each single ABS. Also, conflict of interest might have been an issue.

Through ABSes, banks were able to unload mortgages to 3rd parties. The foundations of this were laid in the 1980s, hence Krugman blaming Reagan. It took until the early 2000s that mortgages would transform themselves into a licence to print money. The Wall Street bank would give the loan (and gain a fee), bundle existing loans and sell them off (and gain a fee). After collecting the fees, no risk was left for the bank. Loans were no in the books anymore since they belong to a 3rd party now. Also, the whole monetary value of the loan was back at the bank. Time to repeat the whole circle. As long as house prices are on the rise, people will take out loans to get their free lunch – buy a house, sell it for a profit, repay the loan, pocket the rest. Teaser rates increased the appetite for loans, and banks and debtors collaborated to get around the lending standards, leading to warnings from the FBI as early as in September 2004.

So, who would buy the resulting financial product, which was opaque and risky, and hence carried a high interest rate? Here we have to take a broader perspective. The US attracted a lot of capital from countries like China, Japan and Germany. All these countries are net exporters versus the US, which means that the US has not enough foreign currency to pay for all their imports. Hence, trade partners have to accept financial assets as payments for part of their exports (the part that exports were higher than imports). This could be anything: dollars, t-bonds, stocks and corporate bonds.

China invested heavily in t-bonds and drove the risk-less interest rate down. Other investors were looking for some other asset to invest in, since the yield from t-bonds was low, eventually even below the level of inflation. Savers did not want to lose purchasing power. They were craving for something with a higher interest rate. A higher interest rate means higher risk. In the early 2000s, Wall Street firms came up with the product to establish a supply of what was demanded – a high-yield but seemingly secure investment. This lead to an explosion of the housing bubble, first with rising prices, and then the second with a steep fall.

Of course, there are other factors that play a role. Fannie Mae and Freddie Mac were involved in the mortgage frenzy, bankers were greedy, regulators sleeping – but all of this was nothing new. Also, the failure of Basel II or the rating agencies were not coming out of the blue. These problems existed for a long time or were known by experts beforehand. However, the consensus of society was let the market work. Politics were pro-business, allowing hedge funds to work without oversight and without significant taxation of their windfall gains. Education was pro-business, with the new neo-classical synthesis ruling and mathematical modelling taking over a more historical and institutional approach.

So, how did we get off the track? It seems that global economic imbalances together with an unregulated financial sector in the US has caused all the trouble. The main international imbalance is that of China and the US, caused by an implicit understanding between a Chinese Communist president and the US administration of George W Bush that China would provide finance for all the fiscal excesses of the US government. Is the purchase of US t-bonds by the People’s Bank of China, which belongs to the Chinese Communist Party, an outcome of free markets?

So I agree with John Taylor saying: ‘Government actions and interventions caused, prolonged, and worsened the financial crisis’ – but for different reasons. Also, I ask myself who determines government actions and interventions.

UPDATE 11/06/2009: According to Martin Wolf from the FT, Goldman Sachs has written (but not published) a paper which takes the same point of view – that the Chinese appetite for t-bonds drove their yields so low that investors were looking for new opportunities with high yields.

Figure 1 shows that the actual interest-rate decisions fell
well below what historical experience would suggest policy
should be. It thus provides an empirical measure that mone-
tary policy was too easy during this period, or too “loose fit-
ting,” as The Economist puts it. This deviation of monetary
policy from the Taylor rule was unusually large; no greater or
more persistent deviation of actual Fed policy had been seen
since the turbulent days of the 1970s. This is clear evidence
of monetary excesses during the period leading up to the hous-
ing boom.

The Federal Reserve does not agree with the graph from The Economist and (in 2007 already) had developed its own graph (Figure 1B). The Fed’s Vice Chairman Donald Kohn points out:

As John pointed out, a notable deviation happened beginning in 2002, and I would like to discuss that period to illustrate the limitations I noted earlier.

You can read more about the Fed’s view here. Let me explain how the Taylor rule works. Based on Knut Wicksell‘s work and updated as the New Neo-classical Synthesis, there is a supposed relation between inflation and the interest rate. Hence, if an economy overheats due to too much demand, the resulting inflation can be fought by increasing interest rates. This makes credit more expansive and will harm investment. Inflation should move downwards.

In a weak economy with low inflation, lowering the interest rate will lead to more investment, since credit has gotten cheaper. More investment means more demand, prices will rise in response. It is then the choice of the policy maker which inflation rate is optimal. Using the Taylor rule, the interest rate can be used to get the optimal inflation rate. So much for theory.

Now, Taylor claims that after 09/11 the Fed set the interest rate too low, ignoring the Taylor rule. However, the result was not higher inflation, as predicted by the theory around the Taylor rule. This was surprising. A lower interest rate was supposed to generate higher investment and finally higher inflation. But that never materialized. So there must have been multiple equilibria. Two interest rates generate the same inflation rate. If this is so, the Taylor rule makes no sense, since you cannot know which is the better optimal interest rate and how many of them exist anyway.

I would like to ask John Taylor: Why was there missing inflation when interest rates where brought down after 9/11? Did maybe the cheap credit go into financial markets to fuel a bubble, while consumption was left unchanged? Since your theory ignores financial markets (while others have shown that adding financial markets to it destroys the Taylor rule), isn’t it then your own rule based on faulty theory that has lead to Fed policy that fuelled a fire?

UPDATE 29/05/2009: I suppose that the book is based on this paper by John Taylor from November 2008. It starts, just like the book, with a graph from The Economist.

Bubble, bubble, toil and trouble—that’s an apt metaphor for the Federal Reserve policies meticulously dissected by Stanford professor John Taylor, in the Wall Street Journal and other places.  He shows that the Fed set the financial crisis in motion and then made it worse.

Relative to the pattern that held since 1987 – a standard that has come to be known as the Taylor Rule – the Fed kept interest rates exceptionally low in 2002-2006.  Easy credit got real estate prices bubbling, which convinced folks that property prices go only one way and concealed the risk of price declines. Hence homeowners, developers and banks over-extended themselves.

Once the credit bubble collapsed in 2007, the excessive debt became rancid. Taylor argues that the Fed mis-diagnosed the problem as a lack of liquidity. Once again opening the spigot and cutting US rates, it brought down the US dollar. The price of oil, being denominated in dollars, consequently went through the roof. That wrecked household budgets and people responded by curtailing consumption. Thus economic conditions worsened.

Funny, the Fed did something similar in the1920s and 30s. Back then, Hayek argued that monetary policy distorted interest rates and Mises observed that political pressure for cheap money caused unwarranted credit expansion, according to a study presented by Lawrence White to the Colloquium last week.

That early-20th century policy debacle led to a massive expansion of government spending, programs and regulation. The current witches’ brew concocted by the Feds looks to have the same result. In both of these eras, the government messed up the economy big time and then come to the rescue by fattening itself.

The first time was definitely tragedy; the second time should be farce, going by Marx’s quip—but no, most likely what we’re seeing is the making of another tragedy. In any case, Taylor’s National Bureau of Economic Research paper detailing Fed actions and their effects is well worth a careful read—unless you prefer to get his book.

The recent financial turmoil and its economic consequences have led the Federal Reserve to aggressively cut the federal funds rate, a key benchmark for all interest rates. In a previous blog post, I explained how the Fed could keep the federal funds rate constant while money demand increases. Now I want to focus on how and why the Federal Reserve reduces the federal funds rate.

The “how” question is easily answered in most economics textbooks. Once the Federal Open Market Committee (FOMC) decides to cut the federal funds rate by 50 basis points, the Open Market Trading Desk purchases the quantity of government securities necessary to reach the new federal funds rate. The graph on the right shows how open-market purchases could lower the federal funds rate from 5.25% to 4.75%.

So far, I have stuck to the facts without building a model of the Fed’s behavior. Economists sometimes find it convenient to model the behavior of the Fed in terms of a monetary policy reaction function (MPRF). The following is an example of an MPRF from Ben Bernanke and Robert Frank’s Principles of Economics:

Of course, the MPRF above is just one example, and there are other examples (such as the Taylor Rule) that are more complex. For teaching purposes, let’s just use the simple MPRF.

In addition to equations, economists often use graphs to depict models. The following graph shows the simple MPRF with the real interest rate on the Y-axis and the inflation rate on the X-axis. Assume a 3% actual and long-run target inflation rate.

The graph shows that a downward shift in the MPRF reduces the actual real interest rate from 2.25% to 1.75% when the actual inflation rate is equal to the initial target inflation rate of 3%. Assuming that the actual inflation rate remains constant in the short run, the shift in the MPRF causes a reduction in the real interest rate, and consequently stimulates investment and consumption. The ultimate goal is to stimulate aggregate demand and prevent the recent financial turmoil from drastically affecting the broader economy.

Discussion Questions

1. Refer to the simple MPRF equation. A downward shift of the MPRF could be accomplished by a reduction in the long-run target real interest rate (r*). The Fed typically sets r* in line with the equilibrium real interest rate that prevails in the market for loanable funds. Is there reason to believe that the recent financial turbulence has disrupted investment, private saving, public saving, or net capital inflows?

2. A downward shift of the MPRF could also be accomplished by an increase in the long-run target inflation rate. Is there reason to believe that the Fed has increased the long-run target inflation rate?

3. Are there other factors that the Fed should consider in its MPRF?

Some of the arguments are, (like this one by William Buiter of the FT) to put it mildly, very technical.

Basically, though, there are two schools of though:

1. We should set interest rates based on what we know about the present
2. We should set interest rates based on what we believe about the future

There is something called the Taylor Rule (see here) which is broadly accepted by economists as “what you should do if you want to base your decisions on the present”.

Now for the bad news – if we apply the Rule to the UK, we see that Base Rates should go up to about 7% – which would imply that investors were paying about 8.5% for their mortgages, and home-owners a little less.
However, the Bank of England clearly don’t want to do this – because (among other things) of the knock-on effect it would have on the cash-flow of most of the UK’s working population. Instead, they are basing their interest rates on the Treasury’s predictions of the future…

… which is to say that 2008 will be a ghastly year for, well, everyone… but that 2009 will be a lot better, with rates being a bit LOWER than they are now.

Here’s hoping!

I find it interesting that the fact that you have to pay a LOT more than the base rate to get a mortgage actually suggests that the “markets” believe that rates should be higher than they are now (and the jump to fixed rates suggests that the markets believe that rates will go higher.)

Photo copyright Katie Tegtmeyer – used under a Creative Commons licence.