Wednesday, September 20, 2017

Fed Policy Updates

I happened upon this great line from George Selgin:

In recent Congressional testimony,I likened the Fed's gain in flexibility in a floor system* — its being able to set its policy rate however it likes, while altering the supply of bank reserves however it likes — to the gain an automobile owner might secure, in being able to turn the wheel as much as she likes, while also stepping on the gas pedal however much she likes, by shifting from Drive to Neutral. The problem, of course, is that, while the driver seems to have more options, the car no longer gets her where she wants to go.

This reminds me of two extraordinary paragraphs from Bernanke's "The Courage to Act" (pg. 325-326):
(I)n 2008, we needed the authority to solve an increasingly serious problem: the risk that our emergency lending, which had 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 lots of reserves, they have less need to borrow from each other, which pushes down the interest rate on that borrowing—the federal funds rate.
Until this point we had been selling Treasury securities we owned to offset the effect of our lending on reserves (the process called sterilization). But as our lending increased, that stopgap response would at some point no longer be possible because we would run out of Treasuries to sell. At that point, without legislative action, we would be forced to either limit the size of our interventions, which could lead to further loss of confidence in the financial system, or lose the ability to control the federal funds rate, the main instrument of monetary policy. The ability to pay interest on reserves (an authority that other major central banks already had), would help solve this problem. Banks would have no incentive to lend to each other at an interest rate much below the rate they could earn, risk-free, on their reserves at the Fed. So, by 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.
Instead of lowering its target rate from 2% so it wouldn't run out of assets in the process of trying to suck cash out of the economy, the Fed found a new way to suck cash out of the economy to keep its target rate at 2%.  Three months of chaos ensued, and at the end of those three months, the target rate was lowered to near zero anyway.

During TARP, AIG, and all the rest of the chaos in September 2008, the Fed Funds Rate sat at 2%.  It has confounded me that every headline during that time didn't read, "Wait, why aren't they just lowering the rate?"  But, it's worse than that.  Part of the TARP legislation was the interest on reserves policy, implemented specifically to find a way to maintain a 2% policy without selling off every last liquid security the Fed had, which is what they would have had to do.

All of the drama of September 2008.  All the emergency programs, rule bending, arm twisting, etc. - it was all done so that the Fed didn't have to lower the Fed Funds Rate to a rate which it ended up targeting 3 months later anyway.  It's astounding that the Fed barely gets any criticism for that.  In fact, they would have received much more criticism if they had actually lowered rates and avoided all that drama.  As it was they were already being criticized sharply for trying to salvage the mess that arose.


In current news, this was today's press release from the FOMC:
Higher prices for gasoline and some other items in the aftermath of the hurricanes will likely boost inflation temporarily; apart from that effect, inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near term but to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.In view of realized and expected labor market conditions and inflation, the Committee decided to maintain the target range for the federal funds rate at 1 to 1-1/4 percent. The stance of monetary policy remains accommodative, thereby supporting some further strengthening in labor market conditions and a sustained return to 2 percent inflation.
They are "monitoring inflation developments closely". Now, there is no chance that they will lower rates because of low inflation over the next few months, so this statement is actually a statement of bias.  What this statement actually means is that they will raise rates at the slightest hint of an excuse.  They have an itchy trigger finger.

Likewise, the hurricane comments sound reasonable, but in practice what this means is that we are likely to get some positive noise in inflation.  I suspect that at some point, there will be a measured statement that basically says, "while the recent slight rise in inflation is partially due to recent hurricanes, we believe this is also a sign that inflation is beginning to rise back to our 2% target."  And rates will be hiked.

Today, the FOMC updated its forecasts, which included reducing their forward inflation forecasts.  Upon the news, the odds of a December rate hike shot up.  Now they are at about 70%.  Their 2017 core PCE inflation forecast is 1.5% - down from 1.7% in June.  (Keep in mind, even the FOMC expects some extra inflation from weather events, so this decline is after taking that into account.)  Core PCE inflation over the first 7 months of the year has amounted to about 1.3%, annualized.

I don't really blame the Fed.  They would face opposition if they did anything else.  From what I see in the financial sector, sentiment seems to strongly favor rate hikes.  If financial analysts come to that conclusion, there is no reason to expect other people to object.

Coincidentally, Hurricane Katrina hit in August 2005, in the middle of the Fed's rate hikes at that time.  Inflation spiked in September 2005.  By the end of the year, the yield curve had completely flattened.  Because of the asymmetrical potential value embedded in long term rates near the zero lower bound, the yield curve will probably still have a positive slope when we enter a contractionary context at this level.  I'm not sure we aren't close to that now, with 10 year treasuries at about 2-1/4%.

* Referring to the large balance sheet and paying interest on reserves


  1. Great post.

    I do wonder about the proposition that Fed is under pressure to raise rates (or not cut them back in 2008).

    Yes, there is the chronic tighter money crowd, and their relentless op-eds. But do right-wingers really want tighter money when the GOP runs DC?

    Moreover, we could argue that political actors---such as President Trump---routinely want "easier" money, certainly before any election. And Trump can replace Yellen and Fisher within a few months, at this point.

    So there could be pressure on the Fed to not raise rates.

    I think the problem with central banks is not about pressure, but internal make-up.

    The obsession with inflation is seen in every central banker organization in the Western world, from the BIS, to the ECB, to the Fed. Many central bankers, such as Charles Plosser, have stated the "right" inflation rate is zero (as measured), while others have contended central banks have only one obligation, to keep inflation at zero.

    Real economic growth is a problem only for those in fiscal and regulatory policy making, many central bankers contend.

    My take is the that Fed is mostly independent, and has a large staff that is devoted to tight money, and the ideal of no inflation. It has become a bias inside the Fed, as seen in their staff reports. Remember, these are career civil servants who (likely) never operated a business, or risked capital to start a business or invest in real estate, and perhaps never sought work in the private sector. I hate to say it, but the obsession of central bankers with inflation is nearly cult-like.

    The US economy prospered from 1982 to 2007 with an average CPI of 3%. So why a 2% ceiling (granted on the PCE)? Why not a 2% to 4% inflation target band?

    Weak public organizations, unlike weak private-sector organizations, have staying power. Run a weak business, you will go under. The Fed never goes under. Indeed, they can solidify, ossify, lapidify, petrify.

    I grant much of the financial media seems to accept the idea that tighter money is better, and that periodic cleansings of weak businesses through recessions is a positive. Undercutting labor with higher unemployment rates has merits too.

    But I think the Fed has been drinking the no-inflation absinthe for a long long time, and cannot change.

    A question; If the Fed is bending to politico-economic pressure, who is applying that pressure and why?

    1. Seriously?

      Go to the library. Look at the books on the econ shelf. It's not close.
      In August 2007, the Wall St. Journal explicitly called for the Fed to foment a panic.
      Come on, Ben. You're not new here.

  2. Well….

    The WSJ in the early 1980s told Volcker to ease up, that inflation below 5% was good enough….

    Then in 1992...

    “Too Tight for a Strong Recovery”
    by Milton Friedman
    Wall Street Journal, 23 October 1992
    Reprinted from The Wall Street Journal © 1992 Dow Jones & Company. All rights reserved.

    "The Federal Reserve has reduced the federal funds rate repeatedly from nearly 10% in 1989 to about 3% recently. According to conventional wisdom on Wall Street, that is evidence that monetary policy has been extremely easy, that the Fed has done all it can to stimulate the economy, and that it is pushing on a string, as another ancient cliché has it.
    This wisdom may be conventional, but it is incorrect….."


    But my real point is, "So what?"

    Some op-eds in the WSJ is "pressure"?

    Nixon called Burns into his office for arm-twisting and Reagan did the same with Volcker. That might be "pressure."

    But some chattering heads on TV is "pressure"?

    How about another sermon from James Grant?

    I am not sure central banks are under pressure much. I would happily subscribe to some sort of "regulatory capture" explanations of the Fed, but on pure monetary policy, I do not see it. Well, maybe on IOER. They certainly are more polite to bankers than manufacturers or home builders.

    I think the Fed is a bit of cult. Sometimes, when people want to do something, they cite outside influences. "You know, authority figure Bill said it was a good idea, so I did it."

    Then there is genuflections to higher callings.

    But hey, I am open to ideas. I really do not know why the Fed pursues a too-tight monetary policy.

    How is the pressure applied?

    1. Sure, there seems to be a tendency for tight policy. But, it seems that Greenspan, Bernanke, and Yellen all have been good choices who pulled the Fed and the public to more accommodative policy. The idea of a perpetually tight FOMC is plausible, but it isn't necessary as an explanation. In all the memoirs (Bernanke, Paulson, Geithner), the pressure is palpable. All three are desperate to be forgiven by the public for every small gesture of accommodation that might have accidentally benefited Wall Street. Each has pages and pages of it.

  3. Just for fun:

    "Japan’s central bank opted to hold interest rates steady on Thursday as a new board member dissented in favour of further monetary easing.

    The Bank of Japan said overnight interest rates will remain steady at 0.1 per cent, that 10-year bond yields will be capped at around zero percent and central bank will continue to buy assets at around ¥80tn a year. The decision was forecast by all economists polled by Bloomberg.

    New board member Goshi Kataoko voted for more stimulus as the current policy was not loose enough to meet the BoJ’s 2 per cent inflation target.

    The central bank said the consumer price index is “likely to continue on an uptrend and increase toward 2 per cent.” The CPI currently sits at around 0.5 per cent."


    Interesting that the Bank of Japan is willing to be more aggressive than the Fed.

  4. worth reading

  5. Well, as for Bernanke, Greenspan and Geithner, we might be mixing apples with oranges with steaks in our argument.

    Yes, "bailing out financiers" or "bailing out poor people who bought houses with liar loans" was disliked by polemics in both parties and by some ideologues. Call that Q1.

    I happened to think Q1 was a good idea, and would have gone further with all stages of QE.

    But general monetary easing or tightening---I suspect when Fed officials say there is "pressure" for a tighter monetary policy, they are listening to internal demons. Sure, somebody somewhere is always saying monetary policy should be easier or tighter. The Fed seems to feel the pressure only from the tighter crowd. Maybe the tighter-crowd is aligned with the financial media.

    Fed staff reports, prepared by career civil servants probably free of political pressure, lean heavily towards the tighter end of the spectrum.

    Western central bank literature is redolent with anti-inflationism. The Fed Beige Books have been ringing the klaxons, as the PCE is at 1.5% which could get to 2% someday.

    The BIS is hopeless.

    Well it is a fascinating topic, why this central bank leaning to a tighter monetary policy. There is an idea the Fed is just doing what every public agency does, and that is fight the last war.

    Or that central banks were granted their independence into the teeth of double-digit inflation days. So the hallowed agency mission becomes fighting inflation, not fomenting growth.

    There are class-based analyses of central banks, roughly that bankers and rich people like tight money and workers do not. The Fed hysteria about "tight" labor markets, in every recent Beige Book, certainly fits this framework.

    Also fascinating to watch will be Don Trump. and whether he moves to have pro-growth Fed Chair. As you know, the FOMC is wide-open, with Fisher leaving too, and other empty seats. Trump is such a lulu that anything could happen.

  6. That section of Courage to Act is one of about 5 that I marked when I read it. Whenever I re-read it, it reminds me of a crime show where the killer confesses without even realizing it.

    Here's why I do blame the Fed right now. The focus is on "normalization" but they are ignoring the most abnormal part of their actions. IOR was at 0% for 95 years. The first tightenings this cycle should have been to start letting the balance sheet shrink. And ending IOR would have let them do that faster. Instead they've increased IOR and they no longer even know what size balance sheet is the end game.

    1. Yeah. He confesses and it doesn't matter. The rest of the country is even crazier.

      The other big head scratcher for me is on pages 204 and 205, where panic is hitting various types of securities, and the Fed lets firms fail instead of invoking 13(3). Bernanke's reasoning is that those firms weren't systemically important. Then in the very next paragraph he explains that the precedent for 13(3) in the Great Depression was specifically for small loans to non-systemically important firms.

    2. Ugh. Reading that makes me sick. Now I have to track down those pages and re-read them. The weirdest part for me is that, based on his pre-2005 writings, he should have been the best guy to have there. I guess I'm a terrible judge of those things. :-(

    3. Maybe he was just about the best guy. He and Geithner both were pulling policy in a more accommodative direction, generally. So, it's this weird thing where I think they would have had much better policy if they were truly independent, but public sentiment ends up having an effect if it is strong enough. So, these weird explanations end up being a strange compromise where they have to defend positions that are between where they would have pushed policy, but they would have been pilloried, and the policies they ended up supporting, which were worse, but which were more popular (but still not particularly popular). I can imagine it's an awkward position to be in, and I suspect that there is a lot of motivated reasoning required to save face, because there really is no comfortable, defensible place they could have ended up in. I mean, if Bernanke would have successfully pushed through policies that would have avoided the entire crisis, he would probably be the most hated person in the country now - the academic that ended up bailing out evil Wall Street and feeding the supposed housing bubble that by now would look like Canada if we hadn't engineered the bust.