Wednesday, February 22, 2017

With friends like this....

FOMC minutes from the January meeting are out.  They include this:
In discussing the outlook for monetary policy over the period ahead, many participants expressed the view that it might be appropriate to raise the federal funds rate again fairly soon if incoming information on the labor market and inflation was in line with or stronger than their current expectations or if the risks of overshooting the Committee's maximum-employment and inflation objectives increased. A few participants noted that continuing to remove policy accommodation in a timely manner, potentially at an upcoming meeting, would allow the Committee greater flexibility in responding to subsequent changes in economic conditions.
When the Fed began paying interest on reserves in October 2008, this was their stated reason.  They had disastrously left their target rate at 2% when they could have probably already pegged it at zero.  Markets went haywire, and they refused to lower the rate.  They were afraid of hitting the zero lower bound, so they....moved the lower bound up.
We needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which has the side effect of increasing bank reserves, would lead short-term interest rates to fall below our federal funds target and thereby cause us to lose control of monetary policy.  When banks have lost of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing-the federal funds setting the interest rate we paid on reserves high enough, we could prevent the federal funds rate from falling too low, no matter how much lending we did. (The Courage to Act, pg. 325-326)
My shorthand for this is that the Fed normally creates currency by lending cash from their magic vault to the government.  After August 2007, when they started making emergency loans to banks, they would sell treasuries back to the market so that those loans didn't lead to currency creation.  In October 2008, they were running out of treasuries, so they started borrowing that cash back from the banks, in the form of interest bearing excess reserves, in order to prevent that cash from entering the economy.  In other words, from August 2007 to October 2008, the Fed was pulling cash out of the economy in order to sterilize emergency loans.  After October 2008, they were pulling credit out of the economy in order to sterilize emergency loans.

The idea that maintaining an interest rate that is above the neutral rate while Rome burns around them is a strange way to think of being "in control" of monetary policy.  It is so odd how Congress was being asked to basically sign a blank check and to give the Fed an entirely new tool, yet it seems that nobody seriously considered lowering the rate as everything collapsed following that September 2008 meeting.

This is sort of like an anorexic person being in control of their body size.  What exactly is the point?

Anyway, apparently the results of 2008-2009 were not enough to defeat this way of thinking.  That comment from the January meeting is a decent piece of the puzzle that leads me to shade toward pessimism in the short term.

I like to think of it like a Monte Carlo simulation.  Imagine a model that has some random movement, some uncertainty, and some independent variable (here, the neutral Fed Funds Rate) that can maintain some sort of mean reversion in a dependent variable (here, GDP growth, or inflation, or unemployment - economic growth, by one measure or another).  Simulation after simulation should produce some different version of growth moving through time, within some range of a target.  Now, add the implication of that first quote to the specification.  The system is bound to break below the mean.  Every simulation will be growth shifting through time for a little while and then falling.  Eventually, some noise will trigger a premature rise based on this reasoning, and the Fed will be chasing the rate down.  The only question is how long does it take for this to happen and how bad does it get while the FOMC attempts to save face.

Current political uncertainties mean that in our real-life simulation, variance in the random movement and noise has gone way up, which could actually help us avoid this problem if real improvements in the economy move faster than Fed attempts to "control" the interest rate.  Maybe the neutral rate in some of those simulations rises enough to escape this destiny.  So, ironically, I think a sane administration would have led to a more certain near-term contraction.  But, it still seems prudent for the mean expected economic activity, say, one year out, to be shading lower.


  1. Many Fed officials even yet want lower inflation; of course such past Fed officials as Charles Plosser and Richard Fisher publicly rhapsodized about zero inflation or even deflation (during the worst recession since the Great Depression, no less). Many central bankers, of course, yearn for a single mandate, that of zero inflation. Let Rome burn to the ground and into cinders---we central bankers hit our price targets, see!

    The Fed mentions "inflation" 88 times in the just-released minutes. "Prices" 42 times, though some of those mentions were in connection with a technical issue. The Fed reiterates it is below the 2% IT. Why not a 2.5% target? Who knows? A 2% to 3% IT band? No one knows, except Fed officials like 2%, or lower.

    I still ponder IOER. Yes, it sterilized reserves---but how much chance the reserves would be lent out anyway? Was IOER really a subsidy (perhaps needed at the time) for the banking industry, which is the client of the Fed much the way ag is the client of the USDA?

    And egads, what anymore is the justification for keeping unemployed one of 20 people who want to work?

  2. OMG, I read Courage to Act 1 or 2 years ago and noted 5 or 6 paragraphs and that one was one of them! It's horrifying. The result of the Fed's actions in 2008 as they sterilized all their special lending was to this: every dollar they lent to failures like AIG, they pulled from the general market. What a bizarre way to "bail out" the economy.