Operation Twist

As expected, the Fed announced that it's going to implement operation twist - selling $400 billion worth of short-term securities and buying $400 billion worth of longer-term securities.  In addition, the Fed plans to reinvest funds from mortgage-backed securities (MBS) into MBS rather than treasuries.  The goal is to reduce long-term interest rates in general and long-term mortgage rates in particular.  How much of a difference will it make?  Perhaps a little, but not too much.  Mortgage rates will probably decline somewhat, but that depends on other factors as well (whether new economic data indicates weakening of the economy, investors seeking safe-haven plays, etc.).  In addition, the Fed stated that there are significant downside risks to the economy, which is the primary reason it thought it needed to provide further stimulus.  The initial reaction of financial markets was a major decline in stocks and record-low yields on ten-year bonds.  In addition, the dollar strengthened against the yen, euro and pound.

Politics and the Fed

Research and practice indicate the it's best for central banks to be independent of the political process.  In fact, since the 1990s, central banks in most economies have become more independent.  Exceptions include Venezuela and Argentina - two countries now experiencing very high inflation.  Recently, the Fed has come under increasing criticism from politicians from both the left and the right.  While Presidents Reagan and Clinton honored Fed independence, the times seem to be changing.

Yesterday, the Republican leaders of Congress, in a move not seen in recent history, sent a letter to the Fed that urged it not to engage in any further stimulus.  It should be noted that they added that if further stimulus is implemented, it should make the case for the stimulus.  Of course anyone who follows the Fed knows that the Fed always makes the case for its policy by releasing a statement explaining its policy decision (you may disagree with its case, but it provides support for its decision).  Why would the Fed want to engage in stimulus?  It expects inflation to be close to its stated goal (close to 2%) while economic growth and unemployment are awful (do I think they should do more stimulus today?  Keep reading).

On the left, Rep. Barney Frank wants to keep Fed district presidents from being voting members since he thinks they tend to focus more on inflation than economic growth.  However, many Fed district presidents are the strongest proponents of more stimulus (president of Boston Fed, Chicago Fed, etc).

Though I may not agree with every decision that the Fed makes, members of the Fed are thoughtful and have a much better understanding of the economy and monetary policy than members of Congress and most politicians.  For example, a presidential candidate explained that he doesn't like Ben Bernanke because he thinks there's too much government spending.  Of course, Ben Bernanke is not involved in government spending.  There are many other examples in which politicians have displayed a lack of understanding of monetary policy (as well as other issues!).  Shouldn't elected officials have a say in what the Fed does?  The President and Congress set the guidelines for Fed policy and have given it two mandates - low inflation and low unemployment.  Congress can change that to a single mandate of low and stable inflation.  One of the early supporters of that approach was Ben Bernanke.  However, he recognized that, since other factors can have temporary effects on inflation and policy takes time to have an effect, low and stable inflation is an intermediate term goal (in other words, a change in Fed policy today would have a significant impact on inflation until 2012, so it need to consider the likely direction of inflation instead of the current rate).  Would a single mandate have kept the Fed from implementing QE2?  Ben Bernanke has emphasized that one of the primary motivations behind QE2 was to prevent deflation, so a single mandate linked to inflation wouldn't have made a difference.

Should the Fed implement more stimulus today?  If I was a voting of the Fed, I  would vote no (I also leaned against QE2).  Monetary policy is very stimulative already and most of the current economic problems today won't be solved by even looser policy.  The Fed may want to save their remaining ammunition in case of another crisis (which may result from sovereign defaults in Europe).  One last point - is inflation out of control and, as Newt Gingrich state in a recent debate, is Ben Bernanke engaging in a highly inflationary policy?  The facts thus far indicate that inflation has been lower under Ben Bernanke than almost any other Fed chair.  In addition, financial markets expect inflation to remain under 2% per year for the next decade (based on the TIPS market).  Also, while some economists have tried to make the case for higher inflation (more than 2%), Bernanke has rejected that approach and emphasized that the Fed still seeks a medium term goal of 2% inflation.  So Bernanke's goal is clearly not higher inflation.

Though I would have made different decisions than Ben Bernanke and the Fed, I think Bernanke is being unfairly maligned as politicians look for easy targets to blame for the state of the economy.

Changes Over the Last Decade

Here is an interesting link from real-time economics showing that only those with advanced degrees saw their incomes rise more quickly than inflation over the last decade (based on census data).

This story is from 9/11 AOL's Daily Finance) and considers how the economy has changed since 2001 including comments from different economists.

The IMF just came out with its latest global forecast.  Within the report is a chart that shows the change in jobs based on pay (lower third, middle third and top third from 1993-2006) for different countries.  All countries show the same trend: significant declines in the middle with most showing increases in the top and bottom.

Inflation and jobs

This morning's inflation report confirmed that inflation is firming, at least for now.  Though people don't like to hear this, when you exclude food and energy, inflation is lower than the headline figure, but core inflation is still 2%, the highest in recent years.  Unlike last year, there are no signs of potential deflation for the foreseeable future.  This should reduce the likelihood of Fed easing at it's next meeting next week.  By the way, why look at core inflation instead of overall inflation?  Gas prices have dropped since the data for the report was collected, which should lead to lower inflation next month.  Fruit and vegetable prices spiked in the 3 months ended in February, declined over the next 3 months and rose significantly again between May and August.  That led to higher inflation early in the year, less inflation in the Spring and more in the summer (even including seasonal adjustments).  Over time, headline inflation is the figure to watch, but it tends to be distorted in the short term by the volatility in the prices of certain products.
Meanwhile, new claims for unemployment rose, signaling continued weakness in the jobs market.  Given the weakness in the job market and higher inflation, real weekly earnings declined by 0.8% in August and is now down by 2.2% since it's recent peak in October 2010.  Clearly, weakness in the job market along with weak earnings will continue to put pressure on consumer spending, contributing to continued economic weakness into 2012.

Interview in Orlando Sentinel

I was interviewed for a blog post in the Orlando Sentinel.   As typically found on blogs, there were several negative comments.  For those who are interested, here is the complete text of what I said:

It’s hard to make the case that major reductions in government spending in the near term will result in more economic growth.  Most who advocate that approach also want the dollar to strengthen in value.  The few countries that are cited as reducing government spending and achieving short-term economic growth benefitted from a weaker country and increased exports to a strong global economy (for example, Canada in the early 1990s).  Given weakness in the global economy, it’s hard to see how a stronger dollar (and thus more expensive exports) combined with major, immediate reductions in government spending will lead to more economic growth in the near term.

Time to criticize the other side.  The first round of stimulus tended to focus on temporary increases in demand (cash for clunkers, short-term tax cuts to encourage spending, etc.).  Thus, when the stimulus ended, so did it’s effect.  Given that it was clear to many economists that this would be an extended recession/period of economic weakness given that it was due to a financial crisis, short-term increases in demand were ineffective (more government debt without much economic benefit).

What about the balance between encouraging growth and containing the national debt?  It’s a tricky balance.  The national debt is a major medium-term problem, but the record-low interest rates on government bonds indicates that global investors are not worried about the credit-worthiness of the US (at least for now).

Given the above, there is room for policies that encourage economic growth accompanied by concrete plans to reduce the deficit over time.  The policies should both encourage demand in the short term while enhancing long-term economic growth and the underlying strength of the US economy.

·         Tax reform, both corporate and individual, that eliminates most deductions/loopholes while reducing tax rates could increase revenue somewhat while encouraging economic growth.  Note: many conservative economists, such as the chair of Reagan’s council of economic advisors, Martin Feldstein, consider many of the loopholes to be a hidden form of spending and thus eliminating them would not be tax increases but eliminating tax expenditures (see WSJ article).

·         Spending on needed infrastructure improvements could lead to construction jobs while making the economy more efficient.  Rather than spreading the money across congressional districts, identifying the top priorities for the nation could be more efficient (electric grid, ports, etc.).  Dare I suggest a commission develop the priorities since most citizens lack faith in the government to choose the right priorities?

·         A temporary reduction in both the employee and employer portion of the payroll tax won’t have much long-term benefit, but could provide workers with extra after-tax income while also temporarily reducing the cost of employing workers.  The self-employed would particularly benefit as they pay both portions of the payroll tax.  Reducing both portions by 2% would result in a 4% reduction in tax rates for the self-employed and help some small businesses.

·         The primary reform for long-term deficit reduction would involve reforming entitlements, since they are the major reason for future increases in the national debt.  It gets complex, but reforms should include means testing of Medicare and making it more market-oriented; also adjusting increases in social security benefits by the inflation method preferred by economists for other purposes (it gets technical, but it’s called a chain-weighted index and has been around for quite a while; not a trick designed recently).  This would reduce the deficit by hundreds of billions of dollars over the next decade while using a more accurate measure of inflation.

Of course there are other things, but this is a start: encourage demand and economic efficiency while also getting the deficit under control over time.  This wouldn’t result in an economic boom, but provide both short-term and long-term help to the economy given the economic environment in which we’re operating.

This morning's job report

Clearly, this morning's report about the job market was not good.  Net job creation was zero, the weakest since September 2010; private sector job creation was the weakest since early 2010.  Of particular concern was the widespread decline in aggregate hours worked across many industries in the private sector.  Thus, even though the number was distorted by the strike by 45,000 Verizon workers, there was weakness throughout the economy.  Aggregate hours worked declined significantly during the month and is on track for a decline of about 0.4% for the third quarter (annualized rate), the first quarterly decline since late 2009.  Another concern for the future of the job market is the decline in productivity thus far in 2011, which suggests that companies face no pressure to add workers to meet current demand (i.e., rapid increases in productivity would suggest that workers are being stretched to meet demand; declining productivity implies workers aren't being pressed to produce at an optimal rate and thus new workers are not needed).  Another concern is that the number of people working part time for economic reasons surged by over 400,000, resulting in an increase in the U6 measure of unemployment to 16.2%.

How about some good news?  The private sector added 17,000 jobs.  If you add the 45,000 striking Verizon workers, that increases to 62,000, indicating weak growth as opposed to outright decline.  At best, it suggests that the job market will continue to struggle into 2012, with unemployment remaining at historically high levels.  In fact, the OMB forecasts that the unemployment rate will average 9% in 2012.

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).