In a presentation to this year’s annual meeting of the American Economic Association, Alan Blinder argues that the circumstances—low inflation and low nominal interest rates, persistent excess capacity, and fiscal policy paralyzed by large debts—that have forced central banks to operate through unconventional policy will be a recurring feature of the economic landscape. “We can’t stuff the crazy aunt back in the closet”.
According to Economist Magazine, of the rich world’s four major central banks, Britain’s and Japan’s already have their policy rates stuck near zero and the fourth, the European Central Bank (ECB), is likely to get there this year. Meanwhile, the balance-sheets of all four institutions have ballooned as they expand the volume and range of assets and loans they hold (see charts below).
Whatever central bankers do, they cannot repair problems best fixed by politicians, such as America’s incoherent fiscal policy or Europe’s fractured institutions. Asked about the ECB’s aggressive new lending to banks, Masaaki Shirakawa, the governor of the Bank of Japan, said it could “buy time”. But he warned it could backfire if politicians fritter away whatever time the central bank has bought. Unfortunately, that risk is never low.
Interview of Chicago Fed’s president Charles Evans, one of the vocal doves on the Fed’s Open Market Committee (or FOMC). Evans advocates the Fed should target on employment growth, and consider raising inflation target to 3%, instead of 2%.
He favors the Fed clearly states its future course of actions and offers clear forward guidance contingent on economic outlook. He cited a piece by Mike Woodford on FT, who made the following forceful argument:
…Mr Bernanke can and should use his speech today to explain how his policy intentions are conditional upon future developments.
A clarification could help the economy in two ways. First, he could signal that a temporary increase in inflation will be allowed, before policy tightening is warranted. This would stimulate spending by lowering real interest rates. Second, specifying the size of any permanent price-level increase would avoid an increase in uncertainty about the long-run price level. This in turn would ward off an increase in inflation risk premiums that might otherwise counteract the desirable effect of the increase in near-term inflation expectations.
Uncertainty about the economic outlook is likely now the most important obstacle to a more robust recovery. The problem is not just uncertainty about Fed policy, but the fact that the Fed has become harder to “read” does not help. Better Fed communication, long on the agenda, would be particularly helpful at this juncture. Jackson Hole provides Mr Bernanke with the ideal opportunity.
My problem with Woodford’s recommendation is, how can the Fed convince people that the raise of inflation target is going to be temporary? What if employment situation won’t get any better after raising inflation target to 3%? Will 4% then be tolerable? Will this generate a positive spiral of inflation (expectations)??
Roach questions the Fed’s monetary policy channel through wealth effect, which is prone to generate asset bubbles one after another. He also thinks the Fed should change its narrow policy objective of price stability, but to ensure broader financial stability.
America’s financial sector is still undergoing the deleveraging process – Big banks are busy in repairing their balance sheets, gradually writing off their losses in housing bubble era.
But with Fed’s super easy monetary policy and easy access to the dirt cheap credit, there seems to be a divergence in terms of attitude toward credit. The main street corporate America now is the one who carries the credit torch forward. With interest rate expected only to rise (not fall), America’s corporations are borrowing like there is no tomorrow. This is being reflected in the junk bond market, where yields again fell close to the 2007-level low.
Is another credit bubble in the making? Are we going to see a flurry of corporate defaults in coming years? Is the Fed just delaying the inevitable?
This FT video may offer you some insights to the issue.
Yield curve is telling a very different story than the stock market. Echoing Meltzer’s earlier piece, “Bernanke’s 70s show“, maybe stagflation is for real…reports WSJ:
Treasurys may be signaling trouble.
The market is behaving in ways that suggest investors are starting to fret over the potential for stagflation in the U.S. …
Consider the Treasury “yield curve.” It refers to the difference between short-term and long-term interest rates on U.S. Treasury debt. Typically, as the economy is expanding, this curve has an upward slope, and is usually at its steepest during the earliest stages of a recovery.
Eventually, investors anticipate the Fed will begin raising interest rates to stave off inflation. That tends to lift short-term rates, compress long-term ones, and generally flatten the curve, or even invert it if investors expect the outcome could be recession.
Lately, with the U.S. growth outlook improving, the slope of the curve hasn’t started flattening, as might be expected at this point in the recovery. Instead, it has gotten steeper.
Earlier this week, the spread between two-year and 30-year Treasury yields hit a record-wide four percentage points, notes RBS Securities. At the same time, the implied annual inflation rate over a five-to-10 year horizon, based on Treasury yields, has moved up above 3% and towards levels last seen before the Fed’s previous rate-rise cycle began in mid-2004.
Investors, in other words, don’t expect the Fed to be as aggressive as in the past in raising rates—even as they see inflation on the rise.
“I think the Fed’s credibility is in question here,” says Priya Misra, head of rates strategy at Bank of America Merrill Lynch.
Or perhaps investors simply realize the Fed has put itself between a rock and a hard place. The U.S. unemployment rate is currently 9.4%, after all. It was at 5.6% in June 2004.
In a twist, the best scenario for the U.S. now is that interest rate increases in China, Brazil and other emerging markets rein in global cost pressures, giving the Fed—and the recovery—some breathing room.
The U.S. needs strong growth more than ever, especially with limited appetite for serious fiscal overhaul, to assuage the market’s other worry: wide deficits and heavy debt.
Interview of Cathy Mann at Brandeis University. She noted there was inconsistency in the Fed’s monetary policy —given the current unemployment rate, the Fed can’t be fighting inflation and unemployment at the same time — Either the Fed will have to give up their target on unemployment rate (6%), or they’ll have to give up their inflation target. And since neither QE1 or QE2 did much to job creation, it’s better to give up the target on unemployment rate, rather than letting the market form expectations that inflation is going to get out of control.
It’s the replay of 1H of 2008, only with more severity. If were not for Lehman’s collapse, the prices of commodities would have shot to the roof more than two years ago. Now the still-the-same super easy monetary policy made commodity prices, especially food prices, come back again, evident everywhere in the world.
(click to enlarge, source: BOE)
China just reported its latest CPI number of close to 5%, but food prices jumped over 10% year over year. The food inflation forced China’s Bureau of Statistics to adjust down the weight of food in the CPI calculation. Isn’t this ridiculous! — The government wanted to you to believe as if inflation does not exist!
At the same time, various signs show that the huge excess reserves are being gradually unleashed from banks’ balance sheets — one indicator is that the yield on junk bonds has almost reached historical lows; another sign is that banks now started to relax their lending standards to both consumers and small businesses.
What we are seeing is exactly the divergence of traditional inflation measure (CPI) and asset inflation. Let’s call it “biflation”.
What do the years 1971, 2003 and 2010 have in common? In each year, low U.S. interest rates and the expectation of dollar depreciation led to massive “hot” money outflows from the U.S. and world-wide inflation. And in all three cases, foreign central banks intervened heavily to buy dollars to prevent their currencies from appreciating.
When central banks issue base money to buy dollars, domestic interest rates are forced down and domestic inflationary pressure is generated. Primary commodity prices go up quickly because speculators can easily bid for long positions in organized commodity futures markets when interest rates are low.
The world saw a surge in the dollar prices of primary commodity prices in 1971-73 following the Nixon shock of 1971 when the U.S. abandoned the gold standard. There was also a commodity price surge during the Greenspan-Bernanke shock of 2003-04, when the federal-funds rate was reduced to an unprecedented low of 1% followed by a falling dollar.
Now we have what one might call the Bernanke shock. The Fed has set U.S. short-term interest rates at essentially zero since September 2008, followed in 2010 by quantitative easing to drive down long-term rates. Predictably, primary commodity prices in 2009-10 surged. In 2010 alone, all items in the Economist’s dollar commodity price index rose 33.5%, while the industrial raw materials component soared a remarkable 37.4.%.
The longer-term inflationary and economic consequences over the next decade of this most recent U.S. loose money shock remain to be seen. But we can glean useful hints by looking at the aftermaths of the two earlier shocks. In the 1970s, “stagflation” (inflation combined with cyclical bouts of unemployment and wide swings in exchange rates) seemed intractable. Productivity growth in mature industrial countries fell sharply.
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The Greenspan-Bernanke interest rate shock of 2003-04, followed by a weakening dollar into the first half of 2008, created the bubble economy. Primary commodity prices began rising significantly in 2003-04, then flattened out before spiking in 2007 into the first half of 2008.
But the biggest bubble was in real estate, both commercial and residential. With low mortgage rates and no restraining regulation on mortgage quality, average U.S. home prices rose more than 50% from the beginning of 2003 to the middle of 2006. This led to an unsustainable building boom—with echoes around the world in countries such as the U.K, Spain and Ireland. The bubbles in primary commodity prices collapsed mainly in the second half of 2008. But the residue of bad debts, particularly ongoing mortgage defaults, led to the banking crisis and global downturn of 2008-09.
So what lessons can we draw from these episodes of U.S. easy money and a weak dollar for the stability of the American economy itself?
First, sharp general price increases in auction-market goods such as primary commodities or foreign exchange (i.e., a weakening dollar) is an early warning sign that the Fed is being too easy—a warning that the Fed is again ignoring as we enter 2011.
Second, beyond the rise in primary commodity prices, general price inflation in the U.S. only comes with long and variable lags. After the U.S. monetary shock, hot money flows into countries on the dollar standard’s periphery cause a loss of monetary control and general inflation to show up there more quickly than in the U.S.
In 2010, consumer price indexes shot up more than 5% in major emerging markets such as China, Brazil and Indonesia, while the consumer price index in the U.S. itself rose only 1.2%. Similarly, after the Nixon shock of 1971, there was much more explosive inflation in Japan in 1972-73 than in the U.S. But by December 1979, inflation in America’s producer and consumer price indexes was more than 13%.
In the following video, Ben Bernanke answers questions from Paul Ryan (R-WI). Paul asked some really sensible questions. Bernanke remains largely too confident. This is generally not a good sign.
Allan Meltzer, a historian specialized in the Federal Reserve system, in the following WSJ piece, shares his historical view on the Fed and inflation outlook. He thinks Bernanke Fed will put us on another “70s show”.
In the 1970s, despite rising inflation, members of the Federal Reserve’s policy committee repeatedly chose to lower interest rates to reduce unemployment. Their Phillips Curve models, which charted an inverse relationship between unemployment and inflation, told them that inflation could wait and be addressed at a more opportune time. They were flummoxed when inflation and unemployment rose together throughout the decade.
In 1979, shortly after becoming Fed chairman, Paul Volcker told a Sunday talk-show audience that reducing inflation was the best way to reduce unemployment. He abandoned the faulty Phillips Curve thinking that unemployment was the enemy of inflation. And he told the Fed’s staff that while he thought highly of their work, he did not find their inflation forecasts useful. Instead of focusing on near-term output and employment, he changed the Fed’s policy to put more emphasis on the longer-term reduction of inflation. That required a persistent policy that President Reagan supported even in the severe 1982 recession.
We know the result: Inflation came down and stayed down. The Volcker disinflation ushered in two decades of low inflation and relatively steady growth, punctuated by a few short, mild recessions. And as Mr. Volcker predicted, the unemployment rate fell after the inflation rate fell. The dollar strengthened.
That was not unprecedented. The Phillips Curve often fails to forecast correctly. Spanish inflation has increased in the last year while the unemployment rate rose above 20%. Britain also has rising inflation and rising unemployment. Brazil lowered inflation and unemployment together. There are many other examples if only the Fed would look at them.
Throughout its modern history, the Fed has made several of the same policy mistakes repeatedly. Two are prominent now. It concentrates on near-term events over which it has little influence, and neglects the longer-term consequences of its operations. And it interprets its dual mandate as requiring it to direct all of its efforts to reducing unemployment when the unemployment rate rises. It does not have a credible long-term plan to reduce both current unemployment and future inflation, so it works on one at a time. This is an inefficient way to achieve a dual mandate. It failed totally during the Great Inflation of the 1970s. I believe it will fail again this time.
Commodity and some materials prices have increased dramatically in the past year. Countries everywhere face higher inflation. Despite the many problems in the euro area, the dollar has depreciated against the euro, a weak currency with many problems, suggesting that holders expect additional dollar weakness. Imports will cost more.
I believe it is foolhardy to expect businesses to absorb all the cost increases by holding prices unchanged. And loan demand has started to pick up, increasing the amount of money in circulation. It is a big mistake to expect that the U.S. will escape the inflation that is now rising throughout the world.
Because the Fed focuses on the near term, it tends to ignore changes in money-supply growth. This, too, is a mistake. Sustained inflation always follows increases in money-supply growth. Sustaining negative real interest rates (i.e., adjusted for inflation), as we have now, will cause this.
The Fed should make three changes. First, it should increase the short-term interest rate it controls to 1%, which would show that it is aware of the inflation risk and will act promptly to counteract it. Current low interest rates are an opportunity for the Fed to start reducing excess reserves.
