Tag: Federal Reserve

Is There an Inflation-Unemployment Trade-off?

Much of what drives the policy choices of Ben Bernanke and the Federal Reserve is a belief in the ability to trade higher inflation for lower unemployment, known within the economics profession as the “Phillips curve.”   But does this trade-off actually exist? 

While its true that many have found a negative correlation between inflation and unemployment prior to 1960, looking at U.S. data, this relationship appears to have broken down in the mid-1960s, just about the time policy-makers thought they could exploit it (Lucas critique anyone?).

It is hard, looking at the graph, which displays the annual change in consumer prices over the previous year and unemployment, to see much of a relationship.  In fact, since 1960, the correlation between changes in CPI and unemployment has been positive.  We have generally seen rising unemployment along with rising inflation.  Of course, one might be concerned that the stagflation of the 1970s is driving this result. But looking at the data since 1980, there still remains a positive correlation between inflation and unemployment.  While I am not arguing that inflation causes unemployment (after all, correlation is not causation), it should be clear from the data that there is not some exploitable trade-off that policymakers get to choose.

The Richmond Fed also has a great history of the Phillips curve that is well worth the read.  Perhaps Fed President Jeff Lacker should bring copies to the next FOMC meeting.

Boehner to Protect the Fed?

With Republicans taking control of the House in January, long-time Federal Reserve critic Rep. Ron Paul is in line to take over chairmanship of the House Financial Service Committee’s Subcommittee on Domestic Monetary Policy and Technology.  This is the subcommittee with direct oversight of the Federal Reserve.

The thought of having some actual oversight of the Fed is apparently making Wall Street and the rest of the banking industry nervous.  Recent disclosures of Fed lending to foreign banks and Wall Street did not help the public image of either Wall Street or the Fed.  With Congressman Paul pushing for a full audit of the Fed, it is likely even dirtier secrets of the Fed may come to light.

So where have the Fed and Wall Street turned for protection?  According to Bloomberg, the Fed’s new protector might be incoming House Speaker John Boehner.   Next week, House Republicans meet to select their committee and subcommittee chairs.  Bloomberg sources report that, at the request of the major banks, Boehner is looking for avenues to either deny Paul that subcommittee chair or to restrict his ability to oversee the Fed. 

While I always expected the House Republicans to eventually revert back to their old ways, I did think they’d at least wait until 2011.  I believe this will be a real test of Boehner:  Does he choose to rein in Ron Paul or rein in the Federal Reserve?

Fed Can’t Serve Two Masters

Last week Congressman Pence and Senator Corker announced a bill to end the Federal Reserve’s dual mandate of price stability and maximum employment.  Before getting into why this is a good start, what exactly is the dual mandate?  Section 2a of the Federal Reserve Act, which sets the Fed’s monetary policy objectives, directs the Fed to:

maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Building upon the notion of the Phillips curve, which suggests an historical relation between inflation and unemployment, some have read 2a as implying that the Fed should pick an inflation-unemployment trade-off that improves social welfare.  It is this perceived “trade-off” that dominates the current actions of the Federal Reserve. Quite simply, Fed leaders, such as Bernanke, believe with a little extra inflation we can get more employment.

The problem is that this isn’t so.  As soon as policymakers tried to exploit this trade-off, in the 1960s and 1970s, it disappeared.  From about 1961 to 1966, it did indeed appear that one could choose a mix of inflation and unemployment.  But from 1966 until 1980, when Volcker moved to bring down inflation, inflation and unemployment were positively correlated.  It appeared that all we got was more inflation and more unemployment.

Despite the painful experiences of the 1970s, Bernanke seems intent on repeating those mistakes.  Which gets to me to the point of removing the dual mandate.  It forces the Fed to focus on the only thing it really has any influence over: inflation.  It also removes the temptation to exploit an inflation-unemployment trade-off that never existed in the first place. 

Now given Bernanke’s views on price stability, eliminating the dual mandate can only be a first step.  We ultimately need to remove the discretion of the government to indulge in the Phillips curve fantasy.

Will the Federal Reserve’s Easy-Money Policy Turn the United States into a Global Laughingstock?

Early in the Obama Administration, there was an amusing/embarrassing incident when Chinese students laughed at Treasury Secretary Geithner when he claimed the United States had a strong-dollar policy.

I suspect that even Geithner would be smart enough to avoid such a claim today, not after the Fed’s announcement (with the full support of the White House and Treasury) that it would flood the economy with $600 billion of hot money. Here’s what my colleague Alan Reynolds wrote in the Wall Street Journal about Bernanke’s policy.

Mr. Bernanke…believes (contrary to our past experience with stagflation) that inflation is no danger thanks to economic slack (high unemployment). He reasons that if people can nonetheless be persuaded to expect higher inflation, regardless of the slack, that means interest rates will appear even lower in real terms. If that worked as planned, lower real interest rates would supposedly fix our hangover from the last Fed-financed borrowing binge by encouraging more borrowing. This whole scheme raises nagging questions. Why would domestic investors accept a lower yield on bonds if they expect higher inflation? And why would foreign investors accept a lower yield on U.S. bonds if they expect exchange rate losses on dollar-denominated securities? Why wouldn’t intelligent people shift their investments toward commodities or related stocks (such as mining and related machinery) and either shun, or sell short, long-term Treasurys? And if they did that, how could it possibly help the economy?

The rest of the world seems to share these concerns. The Germans are not big fans of America’s binge of borrowing and easy money. Here’s what Finance Minister Wolfgang Schäuble had to say in a recent interview.

The American growth model, on the other hand, is in a deep crisis. The United States lived on borrowed money for too long, inflating its financial sector unnecessarily and neglecting its small and mid-sized industrial companies. …I seriously doubt that it makes sense to pump unlimited amounts of money into the markets. There is no lack of liquidity in the US economy, which is why I don’t recognize the economic argument behind this measure. …The Fed’s decisions bring more uncertainty to the global economy. …It’s inconsistent for the Americans to accuse the Chinese of manipulating exchange rates and then to artificially depress the dollar exchange rate by printing money.

The comment about borrowed money has a bit of hypocrisy since German government debt is not much lower than it is in the United States, but the Finance Minister surely is correct about monetary policy. And speaking of China, we now have the odd situation of a Chinese rating agency downgrading U.S. government debt.

The United States has lost its double-A credit rating with Dagong Global Credit Rating Co., Ltd., the first domestic rating agency in China, due to its new round of quantitative easing policy. Dagong Global on Tuesday downgraded the local and foreign currency long-term sovereign credit rating of the US by one level to A+ from previous AA with “negative” outlook.

This development shold be taken with a giant grain of salt, as explained by a Wall Street Journal blogger. Nonetheless, the fact that the China-based agency thought this was a smart tactic must say something about how the rest of the world is beginning to perceive America.

Simply stated, Obama is following Jimmy Carter-style economic policy, so nobody should be surprised if the result is 1970s-style stagflation.

Bernanke’s Twist on Price Stability

While it’s been obvious for years, Bernanke showed his rationale for more easing in today’s Washington Post.  He believes we are in danger of too little inflation.  While common sense might imply that price stability means neither inflation nor deflation, in Bernanke’s book, anything below the Fed’s target of 2 percent is bad.

First of all, there really needs to be a public debate over the Fed’s 2% target.  After all, a 2% rate of inflation over, say, 30 years erodes almost half of one’s wealth.  How that can seriously be viewed as “price stability” is beyond me.  While a 2% rate of inflation is not going to bring the economy to a halt, it is still a massive theft of wealth over the long haul.

Bernanke has also expressed the fear that “low and falling” inflation could lead to deflation, which would raise the real value of debt, which could lead to additional defaults.  But what Bernanke doesn’t seem to get is that inflation isn’t falling. Let’s go to the data.

The graph below is simply the consumer price index (CPI) over the last year.  Does it appear to be falling?  Of course not.  In fact, the trend is one that is rising.

Now CPI includes lots of things, some of which are temporary trends.  The Fed has a nasty habit of excluding those items it doesn’t like.  But let’s take a look at something that matter to the typical family:  food.

In the next chart, we can see that the trend in food costs over the last year has been upward, not down.  Contrary to Mr. Bernanke’s worries, most families worry about putting food on the table, which has been getting more expensive, not less.

Another trend worth examining is the cost to producers, best measured via the producer price index (PPI).  As one can see from the next chart, that has been heading up as well.

The point to all of this is that we aren’t seeing this deflation that Bernanke constantly worries about and we aren’t headed in that direction either.  And the worse part is that we’ve been here before.  In the earlier part of the decade, then–Fed Governor Bernanke urged Greenspan to fight any chance of deflation by cutting rates to what were then all-time lows.  The result was a housing bubble.  Thanks again Ben. 

Now this might all be worth the cost if it reduced unemployment.  But it won’t.  The traditional way Fed policy brings down unemployment is by increasing bank lending, but banks are already sitting on a trillion in reserves.  Inflation, in and of itself, does not create jobs.