Topic: Finance, Banking & Monetary Policy

David Wessel’s Curious Defense of the Fed’s Ambiguous Mandate

David Wessel, the Wall Street Journal’s economics editor, appears displeased that Republican Congressmen Bob Corker, Paul Ryan and Mike Pence want to clarify the Federal Reserve’s mandate – instructing the Fed to focus on preserving the value of its Federal Reserve notes, rather than continuing the 1946 Employment Act’s instruction to also “maximize employment” and minimize long-term interest rates (he mistakenly refers to this as “reopening the Federal Reserve Act,” which included no mandate).    Wessel imagines this must be a political stunt, citing some seemingly sensible comments by Sarah Palin as evidence.  He cannot imagine any valid reason for a prudent backlash against Chairman Bernanke’s repeated references to the dual mandate as an excuse for trying to nudge inflation higher. 

Instead of looking ahead, Wessel looks back – selectively.   He writes, “prices rose at only a 1% annual rate in the third quarter, the Commerce Department said Tuesday.”   However, that figure refers only to personal consumption expenditures (PCE), not to inflation in the overall economy, including producer prices.  The implicit price deflator for GDP rose by less than 1% in 2009, then at a 1.1% rate in the first quarter, 1.9% in the second and 2.3% in the third.  That is insufficient evidence of a worrisome trend, but it is also insufficient evidence to justify a massive program of monetizing long-term Treasury bonds.

Since QE2, Wessel notes, “markets have confounded the Fed by pushing yields on 10-year Treasuries up lately” [to about 2.9% from 2.5%].   I hate say “I told you so,” but I told you so.  

Wessel counters that, “No measure of inflation expectations foresees anything like the 8%-plus inflation of the ’70s.”  Of course not.  If markets expected inflation above 8% then bond yields would already be above 8%.   But expected inflation never makes a sudden leap from 3% to 8% overnight, and expectations are often slow to catch up to reality.  

In 1972, no measure of inflation expectations provided advance warning of the 7.9% rise in the core PCE deflator in 2004 (10.4% including food and energy).  In 1978, no measure of inflation expectations provided advance warning of the 9.2% rise in the core PCE deflator in 1980 (10.7% including food and energy).    Inflation creeps before it gallops.  Yet inflation surprises commonly result in falling bond prices and falling real wages, which means expectations proved overly optimistic.

Mr. Wessel’s new book is called, “In Fed We Trust.”   Such ardent faith has often been misplaced.

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.

Diamond Not Qualified for Fed Board

Tuesday the Senate Banking Committee meets for the second time to consider the nomination of Peter Diamond to a seat on the Federal Reserve’s Board of Governors. Since Professor Diamond was first nominated, he has been awarded the Nobel prize in economics.

Putting aside his academic qualifications, and his misguided views on Social Security, Professor Diamond is not qualified to be a Fed governor for one very simple reason: he is from a Federal Reserve district that already has representation on the Fed.  Paragraph 10-1 of the Federal Reserve Act requires that:

In selecting the members of the Board, not more than one of whom shall be selected from any one Federal Reserve district, the President shall have due regard to a fair representation of the financial, agricultural, industrial, and commercial interests, and geographical divisions of the country.

Mr. Diamond’s Senate paperwork states he is from Massachusetts, which is also the case for sitting Fed governor Dan Tarullo.  In fairness this provision of the law has been ignored and violated in the past.  In fact, both current Fed Governors Duke and Raskin are both from the Richmond district.  As Duke was there first, it would seem clear from a reading of the law and Raskin’s bio that Raskin is serving in violation of the statute.  But then given the actions of the Fed over the last few years, the Fed has certainly shown that it doesn’t feel constrained by statutes.

Bloomberg reports that despite what Diamond’s paperwork says, the White House claims he’s from Chicago.  Not that he’s ever lived there, but because he once gave a lecture at Northwestern.  Next I suspect the White House will claim an extended lay-over at O’Hare is sufficient for residency.

For perhaps the first time in history, all the Federal Reserve governors are from coastal states.  Also every single Fed governor is from a state that Obama won.  Only one governor is from west of the Mississippi river.  How anyone can believe the current make-up of the Board is a “fair representation” is beyond me.  Perhaps this is one explanation for the currently low public opinion of the Fed; it has become more a Cambridge-Wall Street-Washington echo chamber than anything else.

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.

Currency Wars Also Have Unintended Consequences and Collateral Damage

The Fed’s planned purchases of $600 billion of long-term Treasury bonds were targeted for domestic problems, but are having international consequences. The expansion of the Fed’s balance sheet drives down the foreign-exchange value of the U.S. dollar, and (same thing) forces other currencies to appreciate in value.

Emerging markets with high short-term interest rates will attract “hot money” flows. These flows are not stable sources of funding, and disrupt the small capital markets in these countries. Long-term, the appreciation of their currencies harms their competitiveness in global goods’ markets.

Brazil has already imposed capital controls and other emerging markets may follow. The Chinese in particular have reacted sharply.  According to a Reuters dispatch, Xia Bin, adviser to China’s central bank, said another financial crisis is “inevitable.” He added that China will act in its own interests.

In short, the Fed’s actions have undone whatever good came out of the G20 meetings. Any hope for cooperation on currency values and financial stability is out the window. There are potential spillovers in other areas of global cooperation.

Currency wars, like other wars, have unintended consequences and collateral damage.  Some countries will predictably react by imposing capital controls.  Moves to curb imports can follow. Monetary protectionism leads to trade protectionism.

However it might like matters to be, the Fed cannot simply act domestically.  It has reached the useful limits of further easing.