In Case You Were Wondering...

It's still happening.  Eight months on and counting, expected inflation continues to fall at a steady pace as seen below: (Click on figure to enlarge.)

Several things to note about this remarkable downward trend.   

First, given that productivity is now declining this picture screams out that total current dollar spending is expected to decline.  That is, the market expects weaker aggregate demand (AD) in the future and, as a result, there will be lower inflation.  Even if one is convinced that this downward trend is being driven in part by a heightened liquidity premium the implication is the same.  A heightened liquidity premium indicates increased demand for highly liquid assets like treasuries and money which, in turn, imply less aggregate spending. Recent AD forecasts support this interpretation.

Second, the spread has on averaged declined about 0.55 basis points a day over the January 4, 2010 - September 2, 2010 period.  At this pace and with no policy change, zero inflation expectations will be hit sometime around March 2011. Thereafter, it's a deflation expectation world.

Third, the Fed has done nothing meaningful to arrest this downward trend. The biggest move it made was on August 10 when it announced plans to stabilize the size of its balance sheet. The spread continued to fall after the announcement. The failure of the Fed to stabilize this downward trend amounts to the Fed passively tightening monetary policy.  Lest you think I am being too critical here, Bernanke admitted in his Jackson Hole speech that Fed was passively tightening by not stabilizing the Fed's balances sheet. By his own logic then, the Fed is tightening by allowing inflation expectations to deteriorate. 

Finally, this is the longest-running decline for this spread since the daily TIPS data for this maturity became available in 2003.  Yes, the 2008 decline is larger, but it only lasts from July to November, 5 months.  This decline is going on 8 months now with no end in sight.  If the Fed continues to ignore this downward trend one can only imagine how ingrained these expectations will become.

All I Want for Christmas is...

to have Scott Sumner's modest proposal for more Fed action be implemented.  Please Santa Claus Ben, grant me this one Christmas wish.  And one more thing, could you do it before Christmas?

Payroll Tax Holiday with a Twist

There is a lot of chatter right now about whether a payroll tax holiday would provide an effective stimulus to the slumbering U.S. economy.  The motivation for this chatter is the news that the White House is considering, among other things, some kind of payroll tax cut.  The discussion so far has been mixed with some folks like Scott Sumner, Tyler Cowen, and Arnold Kling endorsing it while others like Megan Mcardle and Mark Thoma expressing uncertainty as to how much stimulus it would actually provide.  Mark Thoma concludes his discussion of this proposed tax cut with the following:

Thus, the overall effect on employment depends upon the net effect of the AD and AS shifts. If the AD shift dominates, as I suspect it would, it's still possible for this policy to have positive effects on output and employment. But the size of the effect depends upon the strength of the demand side shift, and how strong the shift would be is an open question, particularly given the degree of household balance sheet rebuilding we are seeing which causes the tax cuts to be saved rather than spent.

See the rest of Thoma's post as to why a payroll tax could affect both aggregate supply (AS) and aggregate  demand (AD).  One way to make sure the AD effect dominates would be to do the payroll tax holiday in the manner I suggested a few days ago: have the Federal Reserve (Fed) fund the payroll tax holiday with a "monetary gift" to the Treasury department and at the same time commit the Fed to doing so until a certain nominal target (e.g. a price level target) is hit. As discussed in the comments in my previous post, only part of this funding would truly be a "monetary gift" from the Fed. Still, the announcement of a nominal target to complement the payroll tax holiday would go a long ways in stabilizing the nominal expectations.

With all that said,  I am not advocating this approach as my first-best solution. I would rather go with  more aggressive monetary policy along the lines Scott Sumner discusses here.  If, however, there is going to be a payroll tax holiday, why not make it more effective by bringing in the Fed's money helicopter?  The biggest impediment to this proposal is a legal one, it would require Congressional approval.

Update:  I overstated Tyler Cowen support for the payroll tax cut.

What If the Fed Had Tightened Monetary Policy in 2003?

Dean Baker provides a nice follow-up to my last post.  He argues the Fed could and should have done something to stem the housing boom back in 2003-2004. His post reminds me of the interview Alan Greenspan did on the House of Cards documentary.  In it, Greenspan claims that if the Fed had tried to stop the housing boom it would have (1) caused a recession and (2) faced political backlash for stalling the drive for increased home ownership. I am not convinced of (1), but even if it were true surely a recession in 2003 would have been far milder than the Great Recession we are working our way through now. Household balance sheets would not be the wreck they are today and, as a result, neither would government balance sheets be so damaged (i.e. public spending stepped in to replace private spending during the recession and thus created a mess in government's balance sheet). On (2), the whole point of central bank independence is to be able to make the tough, unpopular call sometimes. Anyways, here is Dean Baker: 

[The NYT] notes Bernanke's statement that in 2003-2004 it was not clear that the housing market was in a bubble and that by the time it was clear, it was too late for the Fed to do anything without seriously harming the economy. Of course it was clear as early as 2002 that the housing market was in a bubble, but more importantly, Bernanke's claim that the Fed could not act until it was clear is absurd.

The Fed always acts in an uncertain environment. For example, Alan Greenspan raised interest rates in anticipation of inflation on numerous occasions. The logic of this action was that it was worth slowing the economy and raising the unemployment rate rather than risk an increase in the rate of inflation. In effect, this action assumes that the certainty of higher unemployment from raising interest rates is better than the risk of higher inflation.

Had the Fed acted to burst the bubble in 2003-2004, the risk would have been that it temporarily depressed house prices by scaring people about excessive prices and limiting the exotic mortgages that were boosting demand. By contrast, if it had acted correctly in preventing the growth of a dangerous bubble, it would have prevented the worst downturn in 70 years.

Any serious weighing of the benefits and risks of bursting the bubble in 2003-2004 would have surely come down in favor of bursting the bubble. The Fed's decision not to burst the bubble was one of the most disastrous failures of monetary policy in history.

Nice smackdown Dean!

What Role Did the Fed Play In the Housing Bubble?

I really did not want to revisit this question since  I have already covered  it here many times before.  Folks, however, are talking about it again given its coverage at the Fed's Jackson Hole conference. Mark Thoma, for example, has posted several pieces on it in the past few days. Most of this renewed discussion has taken a less critical view of the Fed's role during the housing boom, specifically the role played  by the Fed's low interest rate policy.  I feel compelled to rebut this Fed love fest since there are compelling reasons to believe the Fed did play an important role in creating the housing boom. To be clear, I do not see the Fed as the only contributor--far from it--but it  does appear  to be one of the more important ones.  Here is my list of reasons why:

(1) The Fed kept its policy interest rate, the federal funds rate, below the natural or neutral interest rate for an extended period.  It is not correct to say the Fed kept interest rates very low and thus monetary policy was very loose. Interest rates can be low because the economy is weak, not just because monetary policy is stimulative.  Interest rates only indicate a loosening of monetary policy if they are low relative to the neutral interest rate, the interest rate level consistent with a closed output gap ( i.e. the economy operating at its full potential).  There is ample evidence that the Fed during the 2002-2004 period pushed the federal funds rate well below the neutral interest rate level. For example, see Laubach and Williams (2003) or this ECB study (2007).  Below is graph that shows the Laubach and Williams natural interest rate minus the real federal funds rate. This spread provides a measure on the stance of monetary policy--the larger it is the looser is monetary policy and vice versa.  This figure shows that monetary policy was unusually accommodative during the 2002-2004 period. This figure also indicates an important development behind the large gap was that the productivity boom at that time kept the neutral interested elevated even as the Fed held down the real federal funds rate.

(2) Given the excessive monetary easing shown above, the Fed helped create a credit boom that found its way--via financial innovation, lax governance (both private and public), and misaligned incentives--into the housing market. Housing market activity was further reinforced by "the search for yield" created by the Fed's low interest rates.  The low interest rates  at the time encouraged investors to take on riskier investments than they otherwise would have.  Some of those riskier investments end up being tied to housing.  Thus, the risk-taking channel of monetary policy added more fuel to the housing boom.

(3) Given the Fed's monetary superpower status, its loose monetary policy got exported across the globe. As a result, the Fed helped create a global liquidity glut that in turn helped fuel a global housing boom.  The Fed is a global monetary hegemon. It holds the world's main reserve currency and many emerging markets are formally or informally pegged to dollar. Thus, its monetary policy was exported to much of the emerging world at this time. This means that the other two monetary powers, the ECB and Japan, had to be mindful of U.S. monetary policy lest their currencies becomes too expensive relative to the dollar and all the other currencies pegged to the dollar. As as result, the Fed's loose monetary policy also got exported to some degree to Japan and the Euro area.  From this perspective it is easy to understand how the Fed could have created a global liquidity glut in the early-to-mid 2000s.  Inevitably, some of this global liquidity glut got recycled back into the U.S. economy and further fueled the housing boom (i.e. the dollar block countries had to buy up more dollars as the Fed loosened policy and these funds got recycled via Treasury purchases back to the U.S. economy). Below is a picture from Sebastian Becker of Deutsche Bank that highlights this surge in global liquidity:

For these reasons I believe the Fed played a major role in the credit and housing boom during the early-to-mid 2000s. Let me close by directing you to Barry Ritholtz who gives more details on how the Fed's policy distorted incentives in financial markets.

Update: An good question was raised in the comments section: if the federal funds rate was below the neutral rate for so long, then why was there disinflation? The answer is that the same productivity boom that kept the neutral interest rate elevated also created deflationary pressures. The Fed saw the disinflation and acted as if it were created by weak aggregate demand (AD). Instead, it should have been less concerned since it was strong aggregate supply (i.e. the productivity gains) creating the disinflation at the time. AD, in fact, was not falling during this time and could not have been the source of the low inflation. The figure below illustrates this point.  It shows the productivity surges at this time coincided with the two sustained drops in inflation while demand growth surged. (Click on figure to enlarge.)

What Can Be Done to Hasten the Recovery?

I believe the Fed can and should be doing more to create a more stable macroeconomic environment.  There is much they can yet do to stabilize aggregate spending and improve economic certainty.  However, even if we were to get this from the Fed it still would not solve all our economic problems. We are in the midst of a massive deleveraging cycle by households and unless something radical happens like swapping  the underwater portion of household mortgages for equity  this process will probably take years to unfold. Ken Rogoff reminds us of this point in a recent article:

What more, if anything, can be done? The honest answer – but one that few voters want to hear – is that there is no magic bullet. It took more than a decade to dig today’s hole, and climbing out of it will take a while, too. As Carmen Reinhart and I warned in our 2009 book on the 800-year history of financial crises (with the ironic title “This Time is Different”), slow, protracted recovery with sustained high unemployment is the norm in the aftermath of a deep financial crisis.

The only palliative he sees is higher inflation:

Given the massive deleveraging of public- and private-sector debt that lies ahead, and my continuing cynicism about the US political and legal system’s capacity to facilitate workouts, two or three years of slightly elevated inflation strikes me as the best of many very bad options, and far preferable to deflation. While the Fed is still reluctant to compromise its long-term independence, I suspect that before this is over it will use most, if not all, of the tools outlined by Bernanke.

I too don't want to comprise the Fed's long-run inflation credibility.  That's why I want a NGDP  level target (my first choice) or price level target (my second choice... I really don't like this one but I will settle for it). It would create some higher (catch-up) inflation until we hit some target level and stabilize thereafter. If this policy were made explicit it would do much to stabilize economic expectations, a big plus in our current mess.  Again, this will not fix our structural problems, but it would create a more stable macroeconomic environment in which to make the needed structural adjustments.  Now if we could get more discussion on  proposals to hasten the restoration of household balance sheets, such as the one to swap underwater mortgage debt for equity, maybe the structural adjustments could  be expedited too.

The Right Kind of Helicopter Drop

Some observers say the Fed is out of ammo, that any further attempts by it to stimulate nominal spending is like pushing on a string--it's futile.  This understanding ignores the fact that the Fed has yet to use all of its big guns and that these guns were found to be highly effective in ending the Great Contraction of 1929-1933.  Moreover, Fed officials including Bernanke believe the Fed could do more if it wanted to do so.  So the "Fed is pushing on a string" folks are simply wrong.  Still, it is always useful to consider exactly how the Fed could stimulate total current dollar spending. Ricardo Caballero does just that in his recent proposal to have the Fed do a helicopter drop via the U.S. Treasury Department. His proposal is very explicit in how it would work and with a few minor tweaks I believe it could be effective in stabilizing aggregate demand. Here is Cabellero:

[T]he Federal Reserve has the resources but not the instruments, while the US Treasury has the policy instruments but not the resources. It stands to reason that what we need is a transfer from the Fed to the Treasury...what we need is a fiscal expansion (e.g. a temporary and large cut of sales taxes) that does not raise public debt in equal amount. This can be done with a “helicopter drop” targeted at the Treasury. That is, a monetary gift from the Fed to the Treasury.

I would tweak this proposal in two ways.  First, I would do fiscal expansion via a payroll tax holiday.  Second, I would announce that this payroll tax holiday would be contingent on hitting an explicit nominal GDP or price level target.  Thus, as long as the target was not being met the payroll tax holiday would be in effect. I really like this proposal for the following reasons:

1. The money is sent directly to the public; it bypasses the credit-clogged banking system and puts into the hand of the spenders.
2. There is no increase in the public debt, thus there is no Ricardian Equivalence problems.  
3. It is politically feasible: the Republicans get a payroll tax cut and the Democrats get fiscal expansion.
4. It is radical enough to work.  To change expectations there has to be some shock-and-awe break from the current policy of allowing declines in inflation expectations, core prices, and nominal spending. This should do it.

The biggest drawback to this proposal is the issue of how the Fed could unwind the monetary expansion at a later date. This program would have the Fed increase its liabilities (i.e. the monetary base) without any offsetting increase in Fed assets (e.g. treasury securities).  Having these assets available would be important for the Fed down the road if, say after the economic recovery, it needed to pull back some of the money created through this program.  Caballero suggest the Fed could use some of its new tools (e.g. Fed term deposits ) or add contingency conditions that would require the Treasury to return money to the Fed. None of these solutions would be painless.  Felix Salmon suggests a way around this problem is simply to front-load the seigniorage (i.e. Fed profit)  returned to the Treasury.  It is unclear, though, how well this would work.   Seigniorage is limited and thus the Fed could not unconditionally commit to an explicit NGDP or price level target with it. It would therefore be difficult shake deflationary expectations. One soultion might be to have the Fed simply buy treasury securities directly from the U.S. Treasury instead of giving it a "monetary gift" via a helicopter drop. As long as the Fed held  securities there would be no increase in the amount of publicly held debt. Some of the debt may ultimately leak bank into the public domain if the Fed used it to reverse some of the monetary expansion.  As long as the leakage was not too much the same benefits outlined above would apply.