Comments about the FOMC minutes and Fed policy

The release of the minutes of the most recent Fed meeting reveals the sharp disagreement among members of the FOMC, particularly between some Fed presidents and members of the Board of Governors.  What can and should the Fed do given the weakness of the economy?  Let's first look at whether it should implement QE3 (large scale purchases of securities).  The benefits of QE3 would be reducing long-term interest rates further with the hope of stimulating lending and spending.  The extra liquidity may also reduce risk premiums (extra interest paid by those without stellar credit; i.e., those with good credit, but not excellent credit); risk premiums on Baa corporate bonds have risen to 3.25% recently, which is the highest since the financial crisis and higher than any non-recession period.  Arguments against QE3 include the limited effect that it will likely have on the real economy.  The main effects of QE2 were a sizeable increase in bank reserves with little of the new funds making it into the economy.  Many blame QE2 for increases in commodity prices, though there is some debate about this (other factors clearly contributed to increases in oil prices such as the Arab Spring, growth in the global economy, particular China, etc.).  QE3 would likely encourage more speculation and lead to some increase in commodity prices, which is harmful to the economy.  Overall, the potential costs of QE3 exceeds any benefits at this time.  What would need to happen to justify QE3?  There would need to be a serious concern of deflation, as there was in 2008.  As of now, market-based forecasts of inflation are neither high nor low; the break-even inflation rate on 5-year Treasuries are just over 1.6%.  So financial markets don't think inflation is going to be high any time soon, but also don't anticipate deflation.

Much of the weakness in the economy is beyond the control of the Fed, so it should be cautious in implementing any new stimulus.  Options available include reducing interest rates on reserves (currently 0.25%, higher than other short-term interest rates), which may provide some incentive for increased bank lending.  Something similar to operation twist from the 1960s is possible (increasing the Fed's holdings of long-term bonds while reducing holdings of short-term bonds by the same amount), but is likely to have a limited effect.  It should be remembered that without any change, Fed policy is still quite stimulative.  The federal funds rate at about 0.15%, below all measures of inflation (whether core of overall), resulting in negative real interest rates.  Also, the Fed is maintaining a very large balance sheet ($2.65 trillion) and is reinvesting interest earned each month in new bond purchases.

So what should the Fed do?  Barring significant economic decline and deflation, QE3 is not appropriate.  Given current and expected economic weakness, continuing its current, highly stimulative policy seems to be the best course of action.  However, it's unlikely to result in strong economic growth any time soon (factors beyond the control of the Fed will keep the economy from growing much for the foreseeable future).

Bernanke speech at Jackson Hole

As expected, Fed chair Ben Bernanke didn't introduce any new proposals during his speech in Jackson Hole.  Real time economics provides highlights of his speech.  Will the Fed introduce QE3 at some later date as some economists, such as Nouriel Roubini have suggested?  Bernanke has emphasized that the his primary criteria that would lead him to implement another round of QE is fears of deflation (as was the case in late 2008 prior to QE1 and in 2011 prior to QE2).  Given that most measures of inflation are close to the Fed's target, QE3 is unlikely any time soon.  While some have criticized Bernanke, claiming that his policies will lead to high inflation, he continues to express the goal of keeping inflation at about 2% over time (a goal he first proposed in the 1990s).  In fact, some economists have suggested that he raise his target for inflation to 4%; an idea rejected by Bernanke (so he gets criticized for possibly contributing to high inflation and for keeping it too low).  Greg Mankiw provides a defense of Ben Bernanke.  As he expressed today, Ben Bernanke recognizes the limits of monetary policy, that the Fed cannot ensure economic growth on its own, particularly sustained economic growth over time.  At the same time, it plays a critical role in dealing with extreme financial distress or preventing deflation.

What about previous rounds of QE?  Most economists strongly supported the first round of QE, which followed the approach suggested by Milton Friedman when an economy experiences a financial crisis.  It accomplished its goal of stabilizing the financial system and preventing deflation (returning the economy back to normal would have been nice, but was not an expected outcome of the first round of QE).  QE2 was more controversial.  Virtually all of the new reserves introduced by the Fed remained in banks rather than circulating in the economy.  Banks used it to build up excess reserves; the Fed's $600 billion in purchases of treasuries was accompanied by a little more than a $600 billion increase in excess reserves (see change in excess reserves from November to June).  Thus, new money is not flooding the economy, meaning fears of very high inflation are unfounded (unless the Fed allows the reserves to flood the economy at some point in the future).  However, when short-term interest rates are so low, many investors or speculators take on more risk in search of higher returns, leading to potential bubbles in some assets.  Thus, though low interest rates are desirable in trying to stimulate economic growth, there are risks to such a policy if kept in place for too long.

There's been no more difficult time to implement monetary policy than today, given the after effects of the financial crisis, sovereign debt crises, ongoing economic weakness, etc.  In addition, the heated political environment poses an additional challenge to being chair of the Fed, particularly if he has any interest in visiting Texas!

What happened to the recovery?

The recession officially ended in June 2009 and was followed by a modest recovery in late 2009 and 2010 (which is normal when an economy recovers from a financial crisis).  However, the recovery ground to a halt in 2011.  While growth in the second half of 2010 was just below 2.5%, it fell to less than 1% in the first half of 2011.  The economic weakness was across the board, as growth in consumption declined from 3% in the second half of 2010 to 0.1% in the second quarter of 2011, reflecting consumers who were already deleveraging and then were hurt by a spike in gas prices.  Business investment grew more modestly as investment in equipment rose moderately after experiencing double-digit growth in the first 1.5 years of the recovery, suggesting that firms had been making up for the severe decline in equipment investment that took place during the recession.  Similarly, export growth has moderated from the bounceback that took place following the end of the recession.  Nondefense government purchases have experienced declines, particularly at the state and local level as state and local governments reduce spending to balance their budgets.

What happened?  Recoveries following financial crises tend to be weak.  Stimulus from fiscal and monetary policy provided a temporary boost, but did not solve the underlying problems faced by the economy.  As consumers continue to struggle with high debt, underwater mortgages, high unemployment and underemployment, and stagnant wages, consumption will remain weak (or worse when faced by shocks such as spikes in oil prices or significant declines in the stock market).  Government will be a drag on economic growth as we enter the age of austerity (the only question is how much of a drag).  Exports, which are dependent on the state of the global economy, will grow at a slower rate due to the slowdown in the global economy, which is very weak in Europe and moderating in areas that had been experiencing rapid growth (Asia and Latin America).  Given the limited demand for their products, growth in business investment will be modest.

Currently, the debate is whether the US will experience weak economic growth over the next couple of years or have an outright recession.  The signals are mixed as some indicators suggest weak growth (for example unemployment claims) while others indicate that there is an increasing risk of recession (such as significant declines in various regional purchasing manager's indexes).  Whether we have a "growth recession" (anemic economc growth) or a recession (decline in economic activity), the average person may not notice the difference.

Financial Crises vs. Typical Recessions

To understand what's going on in today's economy, you must recognize that we haven't experienced a normal recession, but instead it was caused by a financial crisis.  For those who follow economics, you're probably well aware of the research performed by Ken Rogoff and Carmen Reinhart ("This time is different").  Bascially, people accumulate a lot of debt as their perceived wealth increases (in this case, their primary asset, their house, increases in value).  At some point, the bubble bursts and their wealth declines but their debt remains.  Consumers need to spend years deleveraging to get their finances in order, thus consumer spending remains constrained.  Meanwhile, the financial system is severely damaged as many loans are not repaid, thus lending becomes tight for an extended period of time.  A substantial portion of the economy needs to undergo structural adjustment as it had become too focused on producing goods and services related to the bubble (housing) and needs to shed jobs and production in those areas and find new productive areas.  However, with a damaged financial system, it's difficult to finance new businesses (for example, small businesses who had relied on home equity lines of credit no longer have home equity or lines of credit).  Add it up and you have a deep downturn followed by a weak recovery.

What about government?  Budget deficits and the national debt increase significantly due to the economic downturn (government collects less tax revenue due to declining incomes, etc., and automatically spends more on programs associated with increased unemployment and increased poverty).  Other factors contribute to the rise in the national debt, including stimulus programs (whether tax cuts or spending increases).  Given the extended nature of the economic weakness, the deficit remains high and the national debt soars.  At some point, the government reaches a limit in terms its ability to provide further stimulus.  In the case of the US, add to that the increase in entitlement spending due in part to the retirement of baby boomers (for example, medicare) and the debt becomes a crisis.  The focus shifts from economic stimulus to reigning in excessive debt.

That's a quick overview of where we stand today.  Details will be explored in future posts.