The Quick Evolution of FedSpeak

Here's a brief summary of FedSpeak since my last post on Nov 11th. Hawkish comments in black, dovish in green, and labor market concerns in red. Notice the trend?

Fisher (11/14/07): My soundings find no appreciable, let alone debilitating, signs of spillover into the rest of the economy as yet. ...before each FOMC meeting, I consult 35 CEOs from a broad range of businesses, and with the exception of homebuilders, not a single one of them feels the economy is at risk of falling off the table. ...[T]here appears to be some uncertainty about whether we will continue to see inflation slowing... we foresee a risk of a more pernicious pass-through effect than we saw in the recent price increases of underlying commodities.

Hoenig (11/15/07): I think the effects of the financial market disruptions are unlikely to spread very far....
Despite these recent favorable trends, though, upside risks to inflation remain. In addition, we have seen a gradual up-creep in some measures of longer-term inflation expectations.

Kroszner (11/16/07): [T]he economy seems poised to grow for a while at a noticeably slower pace than it did during the summer.... A sequence of data releases consistent with the rough patch for economic activity that I expect in coming months would not, by themselves, suggest to me that the current stance of monetary policy is inappropriate.

Oct 31 Minutes (11/20/07): Participants were concerned about the possibility for adverse feedbacks in which economic weakness could lead to further tightening in credit conditions, which could in turn slow the economy further. ... But participants also noted that in recent decades, the U.S. economy had proved quite resilient to episodes of financial distress, suggesting that the adverse effects of financial developments on economic activity outside of the housing sector could prove to be more modest than anticipated.

Evans (11/27/07): Over the past four months, job growth has averaged about 115,000 per month, ... in line with demographic trends and an economy growing at potential. This is a key fundamental supporting the forecast because gains in employment lead to gains in income, which in turn support gains in consumer spending going forward. [...] With no appreciable slack in resource markets, cost pressures from higher unit labor costs, energy, or import prices could show through to the top-line inflation numbers.

Plosser (11/27/07): Arbitrarily lowering interest rates or providing liquidity to the market does not provide the answers the market seeks. Indeed, in some circumstances, lowering interest rates may prolong the painful process of price discovery. Moreover, a lower funds rate creates a risk that inflation may be exacerbated and inflationary expectations may begin to rise. ... The rise in oil prices and the simultaneous increases in a broader basket of commodity prices suggest that significant inflationary pressures exist....

Kohn (11/28/07): Some broader repricing of risk is not surprising or unwelcome in the wake of unusually thin rewards for risk taking in several types of credit over recent years. And such a repricing in the form of wider spreads and tighter credit standards at banks and other lenders would make some types of credit more expensive and discourage some spending, developments that would require offsetting policy actions, other things being equal....
[T]he increased turbulence of recent weeks partly reversed some of the improvement in market functioning over the late part of September and in October. Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses. Heightened concerns about larger losses at financial institutions now reflected in various markets have depressed equity prices and could induce more intermediaries to adopt a more defensive posture in granting credit, not only for house purchases, but for other uses a well.

Bernanke (11/29/07): We will have the labor market report for November next week, and in the coming days we will continue to draw on anecdotal reports, surveys, and other sources of information about employment and wages. Continued good performance by the labor market is important for maintaining the economic expansion, as growth in earnings helps to underpin household spending.
[T]he outlook has also been importantly affected over the past month by renewed turbulence in financial markets, which has partially reversed the improvement that occurred in September and October. ... These developments have resulted in a further tightening in financial conditions, which has the potential to impose additional restraint on activity in housing markets and in other credit-sensitive sectors.

Mishkin (11/29/07): The near-term path of interest rates is highly uncertain and depends on the implications of the incoming data, which in some cases are evolving right up to the time of the meeting. What is more certain--and far more important--is the commitment of the FOMC to move interest rates as needed to foster outcomes consistent with our dual mandate of maximum sustainable employment and price stability.

Yellen (12/03/07): I expected ... that by now there would have been a noticeable improvement in financial conditions.... [S]ince the October meeting market conditions have deteriorated again, and indications of heightened risk-aversion continue to abound both here and abroad.
Moreover, we face a risk that the problems in the housing market could spill over to personal consumption expenditures in a bigger way than has thus far been evident in the data. This is a significant risk since personal consumption accounts for about 70 percent of real GDP.
Moreover, there are significant downside risks to this projection. Recent data on personal consumption expenditures and retail sales ... have begun to show a significant deceleration—more than was expected—and consumer confidence has plummeted.
There are some significant areas of strength. In particular, labor markets have been fairly robust in recent months. As I mentioned before, the growth of jobs is an important element in generating the expansion of personal income needed to support consumption spending, which is a key factor for the overall health of the economy.

Fittingly, over the last month we've gone from the black of Halloween to the red and green of Christmas. That means we should be getting a Christmas present from the FOMC in the form of a rate cut. How big? The November non-farm payroll report on Friday should tell us. Stay tuned.

Market Stability vs Inflation Expectations

Ever since the Fed officially moved to neutral on Oct 31st, there have been renewed fears that the Fed will allow financial markets to deteriorate rather than cut rates and risk higher inflation.

This trade-off is particularly relevant now, because year-over-year headline CPI is expected to rise over the next several months. Take a look at the graph below. The grey bars are the historical year-over-year CPI rates. The little red bars are the monthly rates. The blue bars are what YoY CPI will be over the next several months if the new monthly CPI numbers come out at a well-contained 2% annualized rate (or 17bps/month). Notice that the YoY rate will trend higher over the next few months, even if the incoming monthly CPI number are low. The actual CPI numbers are likely to be even higher, since the rise in oil prices makes the assumed 2% annualized monthly CPI unreasonably low.


So what should the Fed's immediate focus be: Financial stability or headline inflation risks?

Bill Poole, in a speech last week, came down on the side of market stability:

Concerns that the [Oct 1987] stock market crash might spread to the economy more generally and affect economic growth prompted the FOMC to reduce its target for the federal funds rate by 50 basis points on Nov. 4, 1987. The FOMC cut the target fed funds rate despite the fact that inflation was running at an unacceptably high rate of over 4 percent. The FOMC reduced the target by an additional 30 basis points by Feb. 11, 1988. Once the crisis had passed, the FOMC began raising the target fed funds rate. I have emphasized that the willingness of market participants to take risks is essential to the healing process that restores normal trading in risky assets. When the Fed cuts its target for the federal funds rate, market participants know that the FOMC’s decision at its next meeting will be either to leave the rate unchanged or to cut further. Barring unusual circumstances, the FOMC would not consider a rate increase just after cutting its fed funds rate target. This approach to policy is appropriate when market conditions are fragile because market participants must be confident that they can take positions without the risk that the Fed might raise rates, which would reduce asset values, in the near term. Investors can then concentrate on determining the fundamental value of risky assets and can work on deals to buy such assets from holders forced to sell by their own impaired liquidity and capital positions. As investors accumulate profits from these trades, others are attracted and normal market functioning resumes.

So, according to Poole, the goal of rate cuts during times of market turmoil is to restore confidence sufficiently so that investors are again willing to hold riskier assets. That's problematic for Fed members who don't want to cut rates at the Dec 11th meeting, since markets are expecting a 25bp cut. If they don't cut, the level of risk aversion in the markets will increase, probably significantly. Kevin Warsh, nevertheless, took a more hawkish tone in his speech last week:

There are also important reasons to be concerned about the outlook for inflation. Although recent readings on core inflation have been favorable, prices of crude oil and other commodities have increased. These changes most likely will put upward pressure on overall inflation in the short run. Moreover, the decline in the foreign exchange value of the dollar could lead to higher prices for imported goods. If these same forces cause inflation expectations to become less reliably anchored, then inflation could increase in the longer run as well.

If the Fed could convince market participants of the rationale for focusing on core measures of inflation, they wouldn't have to face this kind of short-term trade-off.  Core PCE inflation is well-known to be a better predictor of future inflation than headline CPI is. This is not even remotely controversial among professional economists. The graph below shows past YoY core PCE inflation plus what the numbers will likely look like in the near future if the annualized monthly rate stays near 1.5%. Clearly there's no imminent inflation problem.


The problem the Fed has is with inflation expectations. Expectations of future inflation can be self-fulfilling and are a very good predictor of future inflation. So if people are going to look at the high upcoming headline CPI prints and decide that inflation is getting out of control, the Fed will be boxed in. They'll have little choice but to raise rates, which would throw lots of people out of work until inflation expectations come back down again. The irony is that core inflation is telling us (reliably) that there isn't an inflation problem; it's only the potential for inflation expectations to get out of hand that's creating the problem. That's why I think it's irresponsible of commentators like Barry Ritholtz to encourage people to focus on headline inflation, and why Mishkin and other Fed speakers need to continue focusing on a communication strategy to break the imaginary connection between non-core inflation and expectations for future inflation.

Mishkin Says He Really Is Neutral...

Governor Mishkin gave a surprisingly hawkish speech yesterday on "Financial Instability and Monetary Policy."

Mishkin has been the most vocal advocate on the FOMC for significant preemtive rate cuts. He's been arguing that financial market instability has the potential to significantly harm real economic growth and, if this were to happen while financial markets were still not functioning properly, that slowdown could spiral into a deep recession that would be difficult to reverse once it took hold. He therefore advocated aggressive rate cuts in advance of any evidence of a growth slowdown. That argument has gotten the FOMC to cut by 75 bps, even though many members sounded reluctant to cut preemptively prior to the Sept 18th meeting.

In the FOMC statement after the Oct 31st meeting, the Fed sounded like they were done cutting rates preemptively, saying that growth risks were now balanced with inflation concerns. But was this a message that everyone on the FOMC really believed, or was it a compromise that was required to convinced some of the more hawkish members to go along with the 25bp cut? I had guessed the later, given how vocal some members had been about downside risks to growth prior to the meeting. Now we have Mishkin, one of the FOMC's chief doves, saying they really are neutral:

In circumstances when the risk of particularly bad economic outcomes is very real, a central bank may want to buy some insurance and, so to speak, "get ahead of the curve"--that is, ease policy more than it otherwise would have simply on the basis of its modal economic outlook. However, because monetary policy makers can never be certain of the amount of policy easing that is needed to forestall the adverse effects of disruptions in financial markets, decisive policy actions may, from time to time, go too far and thus produce unwelcome inflationary pressures. .... If, in their quest to reduce macroeconomic risk, policymakers overshoot and ease policy too much, they need to be willing to expeditiously remove at least part of that ease before inflationary pressures become a threat.

What I just said should serve as a framework for understanding the recent decisions of the Federal Reserve to ease policy, first by 50 basis points on September 18 and then by another 25 basis points last week. The first action was larger than markets expected at the time--indeed, quotes from the federal funds futures market as well as survey data indicated that most investors had anticipated a cut of only 25 basis points in the target federal funds rate ahead of that meeting. As reported in the minutes, the Federal Open Market Committee (FOMC) judged that a policy easing of 50 basis points was appropriate to help offset the effects of tighter financial conditions on the economic outlook. Had the FOMC not eased policy, it would have faced a risk that the tightening of credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment. In addition, it would have faced the possibility that the impaired functioning of financial markets would persist for some time or worsen, which would create an adverse feedback loop not dissimilar to what I earlier called macroeconomic risk. The cut of 50 basis points at that meeting was the most prudent action from a macroeconomic standpoint, even given the Federal Reserve's objective of price stability. Indeed, with economic growth likely to run below its potential for a while and with incoming inflation data to the favorable side, the easing of policy, even if substantial, seemed unlikely to affect adversely the outlook for inflation.

At the FOMC meeting last week, the federal funds rate target was lowered by another 25 basis points. Our economy grew at a solid pace in the third quarter and was boosted importantly by personal consumption and business expenditures, an indication of considerable underlying strength in spending before the recent financial turbulence. However, the pace of economic expansion is expected to slow in the near term, largely because of the intensification of the housing correction. The combined 75 basis points of policy easing put in place at the past two meetings should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and should help promote moderate growth over time.

Going into the meeting, I was comforted by the lack of direct evidence to date of serious spillovers of the housing weakness and of tighter credit conditions on the broader economy. But with an unchanged policy interest rate, I saw downside risks to the outlook for growth. I was mindful, in particular, of the risk that still-fragile financial markets could be particularly exposed to potential adverse news on the housing situation, or on the macroeconomy more generally, and that renewed strains in financial markets could feed back adversely on economic performance. My vote to ease policy at the meeting was motivated by my wish to reduce those risks. The FOMC perhaps could have waited for more clarity and left policy unchanged last week, but I believe that the potential costs of inaction outweighed the benefits, especially because, should the easing eventually appear to have been unnecessary, it could be removed.

Overall, I think that the cumulative policy easing the FOMC put in place at its past two meetings reduced significantly the downside risks to growth so that those risks are now balanced by the upside risks to inflation. In these circumstances, I will want to carefully assess incoming data and gauge the effects of financial and other developments on economic prospects before considering further policy action.

That's about as hawkish as I've heard Mishkin be since the credit turmoil began. This new hawkishness from one of the Fed's main doves makes it significantly less likely that they'll cut again on December 11. Clearly this neutral stance means they won't cut if growth doesn't slow. But both the Fed and most outside observers expect growth to decelerate significantly in Q4. So here's the big question: What will the Fed do if growth slows as expected? Are they neutral relative to current growth, or relative to their outlook for growth? That is, will they cut if growth slows at all, or only if growth slows more than expected. I bet it's more the former, which isn't really a neutral stance at all.

FOMC Cuts 25bps...

... and they say they're done.

Or to be more precise, now that they've cut a total of 75bps, they've got a neutral bias with upside risks to inflation balancing downside risks to growth. So going forward rates are as likely to go up as down.

Here's the statement:

The Federal Open Market Committee decided today to lower its target for the federal funds rate 25 basis points to 4-1/2 percent.

Economic growth was solid in the third quarter, and strains in financial markets have eased somewhat on balance. However, the pace of economic expansion will likely slow in the near term, partly reflecting the intensification of the housing correction. Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time.

Readings on core inflation have improved modestly this year, but recent increases in energy and commodity prices, among other factors, may put renewed upward pressure on inflation. In this context, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully.

The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth. The Committee will continue to assess the effects of financial and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.

Voting for the FOMC monetary policy action were: Ben S. Bernanke, Chairman; Timothy F. Geithner, Vice Chairman; Charles L. Evans; Donald L. Kohn; Randall S. Kroszner; Frederic S. Mishkin; William Poole; Eric S. Rosengren; and Kevin M. Warsh. Voting against was Thomas M. Hoenig, who preferred no change in the federal funds rate at this meeting.

The problem I have with this statement is that it doesn't conform to what most members have said. There was clearly a very wide range of opinions going into this meeting, with Hoenig on the hawkish side and Mishkin on the dovish side, and everyone else scattered between. But unlike most meetings, the difference in preferred policy options between the hawks and the doves was a wide 50bps. That made it fairly easy to predict a 25 bp cut as a compromise, but it makes the interpretation of the statement a bit more complicated.

Why, for example, does the statement say the risks to inflation are roughly in balance with the downside risks to growth? Besides Hoenig, and maybe Plosser and Fisher, who believes that? Certainly not a majority on the FOMC. In late July, right before the mortgage meltdown, in his Humphrey Hawkins testimony, Bernanke forecasted real GDP growth in 2008 of 2.5% - 2.75%, and core PCE inflation of 1.75% - 2%. That's growth just barely at potential, and inflation within their comfort zone. Since then, every Fed speaker who's mentioned it has said the outlook for growth in 2008 has declined, downside risks have increased, and the outlook for inflation has moderated. So the consensus view of the FOMC is growth below potential in 2008 and inflation falling (Yellen, for example, has said this explicitly). That's not a scenario with balanced risks.

So how did we get this statement? It looks to me like the committee compromised by giving the moderates the rate cut, but giving the hawks the statement. The hawks are hoping the statement is tough enough to tie the FOMC's hands at the next meeting. But that's only going to happen if there's no bad news between now and then, and that isn't what's in the forecast...

Counting Votes: What Will The Fed Do?

What's the Fed going to do on October 31st? To get an idea, I've gone back over everything they've said since the last meeting to try and figure out how each FOMC member is likely to vote. Below I've listed the three options the FOMC is likely to consider, along with arguments for each outcome, all culled from recent Fed speeches:

No Change:
We have yet to see convincing evidence that the housing recession is spilling over into the broader economy. While mortgage-related credit markets continue to be tight, prime corporate borrowers have seen little net change in their borrowing costs and their access to credit remains largely unaffected; labor markets remain tight, especially for skilled labor, and real income continues to grow at a healthy pace; exports have been strong due to a strong global economy, and inflation remains a risk partly due to higher oil prices and a weak dollar.

25 Basis Point Cut:
Residential investment has weakened more than expected, and inventories of unsold homes continue to grow. Home prices are falling in many areas of the country. Growth in consumer spending shows signs of slowing; higher credit costs for non-prime borrowers and reduced availability of credit have the potential to further weaken consumer spending growth; Uncertainty remains high and risks remain skewed to the downside. Additionally, core inflation has continued to trend down, implying the stance of policy has grown slightly more restrictive.

50 Basis Point Cut:
Given the large and growing inventory of unsold homes, further home price declines are likely. With mortgage-related credit markets remaining dysfunctional, a precipitous decline in housing prices cannot be ruled out. Should this occur in the face of a possible decline in employment, the downside risks would be significant, since job losses would further weaken demand for housing creating additional negative feedback effects. Given the long lags between policy actions and their impact on the economy, and the possibility that economic downturns can be difficult to reverse once they take hold, additional preemptive rate cuts are needed to insure against this outcome.


Counting Votes
With those set of options, let's turn to the members of the FOMC, whom I've listed below, plus the participants without votes. Links are to all the tagged posts here. Next to each name I've listed my best guess, if I have one, for what option or range they'd accept, along with their main concerns based on their public statements since the last FOMC meeting.

Board of Governors
Ben Bernanke: 25 bps, Insurance against downside risks; Taylor adjustment
Donald Kohn: 25 bps, Downside Risks.
Randall Kroszner: ?
Frederic Mishkin: 50 bps; Financial instability; Insurance against downside risks.
Kevin Warsh: ?

Regional Fed Presidents with votes:
Timothy Geithner, New York: ?
Eric Rosengren, Boston: 25 bps, Insurance against downside risks.
Charles Evans, Chicago: 25 bps, Insurance against downside risks.
Thomas Hoenig, Kansas City: 0-25bps
William Poole, St. Louis: 25 bps, Potential for housing spillover; Downside risks.

Regional Fed Presidents without votes:
Sandra Pianalto, Cleveland*: ?
Charles Plosser, Philadelphia*: 0-25 bps; No housing spillover; Taylor adjustment.
Richard Fisher, Dallas*: 0-25 bps; No housing spillover; Inflation risks remain.
Gary Stern, Minneapolis*: ?
Jeffrey Lacker, Richmond: ?
Dennis Lockhart, Atlanta: ?
Janet Yellen, San Francisco: 50 bps; Financial instability; Insurance against downside risks; Taylor adjustment

*voter in 2008

That leaves quite a dispersion of opinion. So how might this play out? The inflation hawks (Hoenig, Lacker, Plosser, Poole) might argue for no rate cut, but with core PCE falling, expected to continue falling, and well inside the Fed's comfort zone, those arguments won't get very far. Plus only two of the hawks have votes. Mishkin and Yellen will likely make the case for a 50bp cut, but without more evidence of weakness outside of housing, that will be a tough sell, unless Fed staff has significantly downgraded its Greenbook economic forecast. That leaves a 25bp cut as the easy compromise outcome, which is my prediction.

The Fed Funds options market is also expecting a 25bp cut;
Karl Smith at Modeled Behavior expects the Fed to stand pat;
Tim Duy at Economists' View also expects no cut, but is worried;
William Polley expects a 25bp cut, but hopes to see a few hawks dissent;
knzn also expects 25bps, but thinks they should cut more;
Greg Ip, at the WSJ Blog, provides his summary of possible outcomes.

Recommended Reading on the Recent History of Economic Thought

Interest and Prices: Foundations of a Theory of Monetary Policy, Chapter One
by Michael Woodford
Columbia University

A Quick Refresher Course in Macroeconomics
by Gregory Mankiw
Harvard University

Successes and Failures of Monetary Policy since the 1950s
by David Laidler
University of Western Ontario

Mishkin on Financial Instability (10/26/07)

Governor Mishkin gave a speech today on "Financial Instability and the Federal Reserve as a Liquidity Provider." In it, he reviews the history of financial panics with only passing reference to current credit market problems. He makes no mention of current economic conditions or monetary policy.

He does, however, refers for a second time to a paper he wrote ten years ago on "The Causes and Propagation of Financial Instability: Lessons for Policymakers" (pdf). He last referred to this paper in a speech on Sept 10th, eight days before the Fed surprised the market with a 50bp cut.

The paper concludes with a review of how the Fed should respond to financial instability:

One problem in deciding whether to engage in the lender-of-last resort role is to recognize that for it to be effective, it has to be implemented quickly. Less intervention is required the faster the lender-of-last-resort role is implemented....

However, the need for the lender-of-last-resort action to be quick does mean that central banks may not be able to wait until all the information is in that tells them a financial crisis is about to occur or is occurring. To wait too long to implement a lender-of last resort policy could be disastrous.

Given that credit markets have not returned to normal since the 50bp cut on Sept 18, my guess is that Mishkin will be arguing for another 50bp cut on Oct 31. I doubt, though, that the rest of the FOMC will go along with him.

Recommended Reading on General Economics

The Macroeconomist as Scientist and Engineer (pdf)
by Greg Mankiw, May 2006
(Thanks to Tim Kane for the link)

A Review of Thomas L Friedman, The World is Flat (pdf)
by Ed Leamer, UCLA, April 16, 2006

New Chicago Fed President Charles Evans on the Economic Outlook

Charles Evans, the new President of the Chicago Fed and current FOMC voter, gave his first speech yesterday on the Current Economic Outlook. After reading through it a couple times, I get the impression that his thinking on monetary policy is very much aligned with Bernanke, Kohn and Mishkin.

The speech covers a lot of ground in a very clear way, so I'd encourage you to read the entire thing. I want to focus here just on his discussion about "acknowledging uncertainties" when deciding on monetary policy. Just about every recent Fed speaker has mentioned significant downside risks to the economic outlook. Evans tells us how these tail risks to the outlook effect policymaking:

Some risks relate to possible events or extreme macroeconomic outcomes that are not very likely to occur, but whose cost in terms of output or inflation could be quite large. In such cases, it is prudent to adjust policy to be more or less accommodative than we otherwise would as insurance against the highly adverse outcome. These are the risk management or pre-emptive views of policy I mentioned earlier, and they are a common component in central bankers' strategies. But if the extreme event does not occur or its influence subsides quickly, then it is incumbent upon policymakers to recalibrate policy — and to do so from a baseline that accounts for how the additional insurance put into the system affects the outlook for growth and inflation.

He then describes the particular downside scenario that he's thinking about:

To me, the uncertainties about how financial conditions might evolve and affect the real economy mean that risk management considerations have an important role in the current policy environment. The cutback in nonconforming mortgage originations and the continued high level of inventories of unsold homes will result in further weakness in housing markets. ... Housing demand and prices could weaken a good deal more than we expect. ... A more pronounced downturn could weigh more heavily on consumer spending. In addition, further delinquencies and foreclosures could add to the problems with mortgage-backed securities. This, in turn, could generate further adverse effects on financial conditions that support economic activity. Together, such events would pose a more serious downside risk to growth.

I want to emphasize that I do not see this extreme outcome as likely. But it is one of those high cost outcomes that we should guard against. The challenge is to calibrate the insurance in light of the lower probability of the spillover event occurring. Furthermore, if in fact the more likely scenario unfolds in which conditions improve and risks recede, then policy should be prepared to respond to any developments that threaten the inflation outlook.

I read that as saying they will continue to cut rates until Fed funds is below neutral. The only real question is: "Where's neutral?" Evans estimates potential real GDP growth at "somewhat above 2.5%." Adding that to current core PCE inflation of 1.75% YoY, that implies neutral is about 4.25%. If they're only thinking of 25bps of insurance, that gets us to a target fed funds rate of 4%, or three more 25 bps cuts. It's important to note that getting to a 4% rate does not require any of the growth risks to materialize, just for them to be out there. If housing starts to spill-over as the Beige Book has hinted, we should expect to see much lower rates.

Mishkin on Core vs Headline Inflation

Fed Governor Frederic Mishkin gave a speech yesterday on "Headline versus Core Inflation in the Conduct of Monetary Policy." In it, he laid out the best sound-bite argument I've yet heard for focusing on core inflation rather than headline: "Responding to headline inflation is inappropriate because it generates extensive variability in the unemployment rate." He runs through a detailed example to make the point:

Because the point about headline inflation is so important, I would like to illustrate it further with simulations of FRB/US, the model of the U.S. economy created and maintained by the staff at the Federal Reserve Board. To keep the experiments as clean as possible, I assume that the economy begins at full employment and with both headline and core inflation at desired levels. The economy is then assumed to experience a shock that raises the world price of oil about $30 per barrel over two years; the shock is assumed to slowly dissipate thereafter. In each of two scenarios, a Taylor rule is assumed to govern the response of the federal funds rate; the only difference between the two is that in one scenario the funds rate responds to core PCE inflation, while in the other it responds to headline PCE inflation. Figure 2 illustrates the results of these two scenarios:

The federal funds rate jumps higher and faster when the central bank responds to headline inflation rather than to core inflation, as would be expected (top-left panel). Likewise, responding to headline inflation pushes the unemployment rate markedly higher than otherwise in the early going (top-right panel), and produces an inflation rate that is slightly lower than otherwise, whether measured by core or headline indexes (bottom panels). More important, even for a shock as persistent as this one, the policy response under headline inflation has to be unwound in the sense that the federal funds rate must drop substantially below baseline once the first-round effects of the shock drop out of the inflation data. Responding to headline inflation is therefore inappropriate because it generates extensive variability in the unemployment rate--variability that is much more subdued when policy responds to core inflation.

This is a much more effectively way of communicating to the public why the Fed should focus on core inflation. I hope going forward they work on refining this line of line of reasoning. Maybe then mentions of core inflation won't be associated with ignorant jokes about economists who neither eat nor drive.

Bernanke Say They'll Cut Aggressively, If...

Ben Bernanke gave a speech today covering academic developments in the area of Monetary Policy under Uncertainty. He didn't explicitly discuss current monetary policy issues, but he did give us a big clue when he talked about how economists' thinking about the structure of the economy has changed over the last 40 years:

...in his elegant 1967 paper, Bill Brainard showed that uncertainty about the effect of policy on the economy may imply that policy should respond more cautiously to shocks than would be the case if this uncertainty did not exist. Brainard's analysis has often been cited as providing a theoretical basis for the gradual adjustment of policy rates of most central banks. Alan Blinder has written that the Brainard result was "never far from my mind when I occupied the Vice Chairman's office at the Federal Reserve. In my view, . . . a little stodginess at the central bank is entirely appropriate"

This has created the expectation in the markets that the Fed will adjust monetary policy gradually. Bernanke seems to want to dispel this belief:

An important practical implication of all this recent literature [on optimal and robust control] is that Brainard's attenuation principle may not always hold. For example, when the degree of structural inertia in the inflation process is uncertain, the optimal Bayesian policy tends to involve a more pronounced response to shocks than would be the case in the absence of uncertainty. The concern about worst-case scenarios emphasized by the robust-control approach may likewise lead to amplification rather than attenuation in the response of the optimal policy to shocks. Indeed, intuition suggests that stronger action by the central bank may be warranted to prevent particularly costly outcomes.

In introducing these topics, Bernanke made an explicit parenthetical reference to research on the "transmission mechanism of monetary policy." He gave an entire speech on the topic seven weeks ago, so that fact that he's bringing it up again should tell us how much he's thinking about it. This passage, from his Jackson Hole speech on Housing, Housing Finance, and Monetary Policy on Aug 31, 2007, summarizes that thinking:

The dramatic changes in mortgage finance that I have described appear to have significantly affected the role of housing in the monetary transmission mechanism. Importantly, ...housing is no longer so central to monetary transmission as it was. In particular, ...the availability of mortgage credit today is generally less dependent on conditions in short-term money markets, where the central bank operates most directly.... Most estimates suggest that, because of the reduced sensitivity of housing to short-term interest rates, the response of the economy to a given change in the federal funds rate is modestly smaller and more balanced across sectors than in the past.

So if we apply those messages to the current economic situation, what I'm hearing Bernanke say is:

1. Monetary policy can't stop the current housing recession,
   
2. Interest rate cuts will be slower and less effective that they used to be,
3. So if we see the housing recession spillover into the broader economy, we will cut rates very aggressively.

With this in mind, your homework is to re-read the Beige Book, then go look at the Fed Funds probabilities for the Oct 31st meeting outcome. Then decide whether you agree with the market's assessment that no rate cut is more likely than a 50 bp cut (putting aside the fact that a 25 bp cut is most likely).

Recommended Reading on Inflation Measures

The Inflation Update, by Stephen G. Cecchetti
October 16, 2007

A Reconciliation between the Consumer Price Index and the Personal Consumption Expenditures Price Index (pdf),
by Clinton P. McCully, Brian C. Moyer, and Kenneth J. Stewart
Bureau of Economic Analysis Working Papers
September 2007

Pianalto Provides No Clues

Sandra Pianalto, President of the Cleveland Fed, gave a brief speech today on "National and Regional Economic Conditions." Pianalto is not currently a FOMC voter, and she tends to stick to local issues rather than broad macro themes, so she doesn't usually provide much insight into FOMC thinking. She made only one brief mention of policy:

Since our September 18 meeting, the housing sector has remained very weak, but output and employment in other sectors appear to be holding up. Inflation and inflation expectations continue to be moderate and anchored. The strains in financial markets that were so evident and worrisome in mid-September appear to have lessened somewhat. During the past few weeks, as market participants have gained a better understanding of their financial positions and the positions of others, financial markets have become more stable. The Federal Open Market Committee meets again on October 30th and 31st, and we will once more assess developments and act as needed to foster price stability and maximum sustainable economic growth.

That unfortunately tells us exactly nothing about the likely course of monetary policy.

Pianalto will have an FOMC vote starting in January 2008. In the two previous years when she had an FOMC vote (2004 and 2006), she did give more policy-focused speeches, so hopefully we'll get more policy insight from her next year.

The Beige Book Hints at a Housing Spillover

The Fed's Beige Book painted a picture of benign inflation and mild growth. Housing remains very weak, but no wide-spread housing spillover are yet obvious:

"Residential real estate markets continued to weaken, and most Districts reported additional declines in home sales, prices and construction."

"At firms without direct ties to real estate and construction, contacts are still wary that credit tightening and slowing construction might slow activity in their industry, but there is cautious optimism because few see much evidence of such spillovers at this time."

"Consumer spending expanded, but reports were uneven and suggest growth was slower in September and early October than in August."

"Labor markets remain tight across much of the country, and there continues to be moderate upward pressure on wages and benefits. Job growth eased in some regions, however, and wage pressures softened."

"Competitive pressures are restraining retail price increases in many instances."

However, when we look at some of the regional reports, the signs become a little more worrying. If you look at the Case-Shiller home price indices, you'll find that the hardest hit areas are in Florida. Prices in Miami and Tampa are down an average of 6.85% YTD. If we take a closer look at the report from the Atlanta District, which is the district that includes Florida, we find the first hint of a spillover from housing:

"In Florida, several contacts noted that the pace of hiring has slowed, with workers laid off from the homebuilding sector finding it more difficult to find alternative employment."

You get a similar picture on the West Coast. California, Las Vegas and Phoenix have also seen significant recent declines in house prices, with their respective Case-Shiller price indices down an average of 3.77% YTD. If we look in detail at the San Francisco District report, which covers all the western states, we again start to see the first signs of spillover from housing to broader weakness in consumer and business spending:

"Reports on retail sales suggested growth on balance but at a slower pace than in the last few survey periods. ... Demand for home furnishings fell further as the slowdown in housing markets intensified."

"Sales decelerated for advertising agencies and providers of media services, as weak demand for ... home furnishings held down advertising expenditures...."

Now contrast that with the details of the Dallas district, where home prices are still firm (up 2.1% YTD in Dallas):

"The [Dallas Fed District] economy is still digesting ... a slow down in homebuilding and residential real estate, but there continues to be little evidence that this is significantly affecting the broader District economy."

Housing is beginning to spill over. The question is whether there will be enough evidence that the spillover effect is big enough to convince the hawks on the FOMC to vote for a cut on Oct 31, rather than waiting until the Dec 11th meeting for more evidence to appear. Any way you cut it, though, the odds of an additional rate cut have gone up.

Bernanke Drops No Hints (Again)

Ben Bernanke, as has been his habit, dropped very few hints in his speech today on "The Recent Financial Turmoil and its Economic and Policy Consequences."

The majority of the speech was a review of financial market events, mostly repeating the points made by other recent Fed speakers, plus a review of FOMC deliberations, which he paraphrased from the FOMC minutes that were released last week.

The only new information we get is his assessment of events since the Sept 18 meeting, along with the data he'll be watching most closely:

Since the September meeting, the incoming data have borne out the Committee's expectations of further weakening in the housing market, as sales have fallen further and new residential construction has continued to decline rapidly. The further contraction in housing is likely to be a significant drag on growth in the current quarter and through early next year. However, it remains too early to assess the extent to which household and business spending will be affected by the weakness in housing and the tightening in credit conditions. We will be following indicators of household and business spending closely as we update our outlook for near-term growth. The evolution of employment and labor income also will bear watching, as gains in real income support consumer spending even if the weakness in house prices adversely affects homeowners' equity.

In short, I don't think this speech is going to change anyone's mind about the outcome of the Oct 31st FOMC meeting. It sounds to me like Bernanke is still largely undecided himself.

The Fed Hasn't Cut Real Rates, Yet...

Do you want a hint as to what the Fed will do at the next FOMC meeting? You're in luck because Ben Bernanke just gave us a big one in his opening remarks at the conference on John Taylor's Contributions to Monetary Theory and Policy:

The Taylor rule also embeds a basic principle of sound monetary policy that has subsequently been referred to as the Taylor principle. According to this principle, when a shock causes a shift in the inflation rate, the central bank must adjust the nominal interest rate by more than one-for-one. This ensures that the real interest rate moves in the right direction to restore price stability.

That doesn't sound like much of a hint, I know, but read on.

The Taylor principle says that when inflation rises, the Fed should raise nominal rates by more than the increase in inflation, so that real rates go up too. Conversely, when inflation falls, the Fed should cut rates by more than the fall in inflation, so that real rates decline. Bernanke, above, calls the Taylor Principle "a basic principle of sound monetary policy." Frederic Mishkin called it a "key principle" in a recent paper. Don Kohn, in a 2005 speech, called it a "basic precept, embraced by central bankers everywhere."

So with that in mind, let's revisit a passage from Janet Yellen's speech earlier this week:

Over the past twelve months, the price index for personal consumption expenditures excluding food and energy, or the core PCE price index, has increased by 1.8 percent. Just several months ago, the twelve-month change was quite a bit higher, at nearly 2½ percent. It wouldn’t surprise me if core PCE price inflation edged down a little bit more over the next few years.

[I] considered the larger-than-usual cut in the funds rate prudent because... the stance of monetary policy... was growing more restrictive as core inflation gradually trended down.

Well that's quite interesting. Let's take a look at the data. The graph below (click to enlarge) shows several key interest rates, all deflated by the year-over-year change in core PCE. The top two lines are real mortgage rates for conforming and jumbo mortgages. Those rates are significantly higher than they were at the start of the year, adding to downward pressure on real-estate prices. The lower two lines are overnight LIBOR and the Fed funds rate, again both significantly higher than at the start of the year, and still firmly in restrictive territory.


The reason is that core YoY PCE has fallen by about 65 bps since the Fed stopped raising rates last July. The recent trend is even steeper. The 6-month annualized PCE deflator has fallen by 130 bps over that same period, implying the YoY rate will continue to fall:

That puts the Fed, according to their own Taylor Principle that's "embraced by central bankers everywhere", pretty far behind the curve. So can someone explain to me again why the market isn't expecting another rate cut on October 31st?

Yellen on the Economic Outlook (Oct 9, 2007)

Earlier this week, Janet Yellen, President of the San Francisco Fed, gave a speech on "Recent Financial Developments and the U.S. Economic Outlook." Yellen is one of the most informative and articulate Fed speakers; I'd highly recommend putting all her speeches on your reading list. This speech covers lots of ground, but there are three points I want to highlight.

On recent economic performance:

Recent data on personal consumption expenditures have been robust. Manufacturing output and orders for core capital goods have been upbeat, and business investment in equipment and software promises to be a bright spot. Despite the hike in borrowing costs for higher-risk corporate borrowers and the illiquidity in markets for collateralized loan obligations, it appears that financing for capital spending for most firms remains readily available on terms that have been little affected by the recent financial turmoil.... That said, most of these data are too early to reflect the effects of the financial turmoil, and those effects are more likely to show up in data for the current quarter.

Translation: We're not paying too much attention to Q3 indicators; you shouldn't either.

On housing and employment:

"The downturn in house prices would likely be intensified by a simultaneous decline in employment, should that occur, since significant job loss would weaken demand for housing and raise foreclosures."

"Should the decline in house prices occur in the context of rising unemployment, the risks could be significant."

Translation: The Fed will act very aggressively to counter any signs of increasing unemployment.


On inflation and the Fed funds rate:

Turning to inflation, signs of improvement in underlying inflationary pressures are evident in recent data. Over the past twelve months...the core PCE price index, has increased by 1.8 percent. Just several months ago, the twelve-month change was quite a bit higher, at nearly 2½ percent. It wouldn’t surprise me if core PCE price inflation edged down a little bit more over the next few years.

...the stance of monetary policy before the September meeting was probably a bit on the restrictive side.... In fact, the stance of policy was growing more restrictive as core inflation gradually trended down.

Translation: Pay attention to real interest rates. Even after the 50bp cut, the real fed funds rate is still higher than it was at the beginning of the year.

This last point by itself argues pretty strongly for another 25bp cut on Oct 31.

Recommended Reading on Housing

Recent Developments in Real Estate, Financial Markets, and the Economy by Eric Rosengren
President, Federal Reserve Bank of Boston
October 10, 2007

Real Estate in the U.S. Economy, by William Poole
President, Federal Reserve Bank of St. Louis
October 9, 2007

Proceedings of the 2007 Jackson Hole Symposium on Housing, Housing Finance and Monetary Policy, especially the papers by Leamer, Shiller and Mishkin.
September 1, 2007

Poole on Housing and Recessions

Bill Poole, the outgoing President of the St Louis Fed, gave a speech yesterday on housing that essentially endorsed Ed Leamer's view from his Jackson Hole talk that housing recessions are almost always the proximate cause of full-blown recessions:

Consider Figure 6 ... Each line shows the average contribution to real GDP growth (in percentage points) eight quarters before and after each cycle peak from 1953 to 2001. There are three lines representing the contribution to real GDP growth from residential fixed investment (housing), nonresidential structures (commercial and industrial), and business equipment and software investment. These are the major components of private fixed investment.

Residential investment typically turns down ... well before the other two investment components. The figure shows that, on average, housing peaks about three quarters before a recession starts....

Figure 6 makes clear that housing... leads the economy into recession and out of recession.

Here's the graph of year-over-year changes in residential investment:

So if past is prologue then we've got a problem, because it means we're already in a recession.

FOMC Minutes for Sept 18, 2007

The Fed released the minutes of their Sept 18th FOMC meeting, detailing their decision to lower the Fed funds rate by 50bps. Let's start at the end:

"Members judged that a lowering of the target funds rate was appropriate to help offset the effects of tighter financial conditions on the economic outlook. Without such policy action, members saw a risk that tightening credit conditions and an intensifying housing correction would lead to significant broader weakness in output and employment. ... In order to help forestall some of the adverse effects on the economy that might otherwise arise, all members agreed that a rate cut of 50 basis points at this meeting was the most prudent course of action."

Three thing to make note of: First, all members favored cutting 50 bps, including the non-voters. That matters because four regional Fed voters will rotate in January. Second, their main worry is that weakness in housing will be intensified by tighter mortgage market conditions, and that will feed into broader economic weakness. That's important at least as much for what they're not saying, namely that they're not primarily concerned with current growth, employment, inflation etc. Third, they don't expect the 50 bp cut to fully counter the deterioration in the economic outlook.

Now on to the details. Here's how they described the economic environment immediately prior to cutting 50bps:

"...to date, initial claims for unemployment insurance did not indicate a substantial and widespread weakening in labor demand, and labor markets across the country generally remained fairly tight"

"...some recent data and anecdotal information pointed to a possible nascent slowdown in the pace of expansion."

"...financial conditions confronting most nonfinancial businesses did not appear to have tightened appreciably"

"Participants reported that recent financial market developments generally appeared to have had limited effects to date on business capital spending plans and expected that business investment was likely to remain healthy in coming quarters."

"...participants noted that foreign demand remained robust and net exports appeared strong."

That couldn't be clearer: current growth isn't really a problem, certainly not enough to justify their 50 bp cut.

The Fed really does mean it when they say they respond to changes in the outlook for growth and inflation. On the inflation outlook:

"Incoming data on consumer price inflation ...in combination with the easing of pressures on resource utilization in the current forecast, led the staff to trim slightly its forecast for core PCE inflation."

"Headline PCE inflation ... was expected to slow in 2008 and 2009."

"...they generally were a little more confident that the decline in inflation earlier this year would be sustained."

"They also agreed that the inflation situation seemed to have improved slightly and judged that it was no longer appropriate to indicate that a sustained moderation in inflation pressures had yet to be shown."

Again, the message is pretty clear: inflation isn't the central concern. Now on to the growth outlook:

"...the staff marked down the fourth-quarter forecast ... [and] also trimmed its forecast of real GDP growth in 2008"

"...participants judged that credit markets were likely to restrain economic growth in the period ahead."

"...meeting participants focused on the potential for recent credit market developments to restrain aggregate demand in coming quarters."

"...participants judged that some further slowing of employment growth was likely."

"...a further tightening of terms for home equity lines of credit and second mortgages seemed possible, which could weigh on consumer spending, especially for consumer durables."

Ok, now we're getting somewhere. Growth is expected to be below potential through 2008, largely due to problems in credit markets.

So the forecast is for lower inflation and below potential growth through 2008. The only missing piece is the balance of risks for that forecast:

"...participants regarded the outlook for economic activity as characterized by particularly high uncertainty, with the risks to growth skewed to the downside."

"Some participants cited concerns that a weaker economy could lead to a further tightening of financial conditions, which in turn could reinforce the economic slowdown."

"The disruptions to the market for nonconforming mortgages were likely to reduce further the demand for housing"

"...subprime mortgages remained essentially unavailable, little activity was evident in the markets for other nonprime mortgages, and prime jumbo mortgage borrowers faced higher rates and tighter lending standards."

"...if declines in house prices were to damp consumption, that could feed back on employment and income, exerting additional restraint on the demand for housing."

Ouch. Not only do they see downside risks to their growth forecast, but they see the potential for those downside risks to snowball into even greater downside risks. No wonder the 50bp cut was unanimous.

In response, the Fed funds futures markets priced in significantly lower odds of a rate cute this year. Here are the odds for the Oct 31 meeting outcome, before and after the release of the minutes:

I think the market has got it wrong; more cuts are coming.

Recommended Reading on the Taylor Rule

Discretion versus Policy Rules in Practice (pdf) by John Taylor
Carnegie-Rochester Conference Series on Public Policy, 1993

The Fed’s Monetary Policy Rule (pdf) by William Poole
The Federal Reserve Bank of St. Louis Review, 2006

Kohn on the Economic Outlook

Don Kohn, the Vice Chairman of the Federal Reserve Board of Governors, gave a speech today on the Economic Outlook. Kohn is, in my opinion, one of the three most influential members of the FOMC (along with Bernanke and Mishkin), in terms of his ability to frame the debate, so his speeches are worth studying in detail.

When reading through this speech there are a couple important things to keep in mind, especially in light of Friday's better-than-expected employment situation report (pdf), which revised August payroll growth to +89,000 from -4,000.

The recent tightening in the credit markets affects the real economy with a significant lag, the same way an increase in the Fed funds rate would. This credit tightening is happening concurrently with a very deep housing recession, but one that so far has stayed within the housing sector and not spread to the rest of the economy. However, downturns in housing have historically almost alway spread to other sectors of the economy (read Ed Leamer's paper for the gory details). The easiest way, by far, to accelerate the housing downturn and guarantee that it leads to a full-blown recession is to cut off access to mortgage credit. That's precisely what's happened in the jumbo mortgage market (see Felix Salmon for a review). These credit-channel effects are very powerful and very predictable, but they play out in slow motion, over several quarters at least. 1990 is the right analog, not 1998. In such a situation, if the Fed sees significant downside risks to growth, one would expect the Fed to cut rates preemptively, even if current growth and inflation numbers wouldn't seem to otherwise justify a rate cut.

Now, with that in mind, on to the speech. I've quoted the meaty section of Kohn's speech in full below, with his comments on major risks to growth in black, and risks to inflation in red:

I expect that the financial market turmoil of the past few months will leave an imprint on the cost and availability of credit to many household and business borrowers. The greatest effects have been on credit related to residential real estate; in addition to the problems with nonprime and jumbo first mortgages, second mortgages and home equity lines of credit that many households have been using to finance purchases of household durables and other consumer goods and services probably will become more expensive and less available as well. Banks are likely to be especially cautious about making new loans and financing commitments while substantial uncertainty about the quality of loans and the extent of demands from previous commitments persists. So it would not be surprising to see less-generous credit for a wide variety of loans to business and households. And, the rates for some loans are tied directly to elevated libor or other rates in term funding markets.

More generally, credit will probably not be as easily available and as inexpensive for many borrowers as it was a few months ago, even after market functioning improves. In several segments of the financial markets, compensation for taking on risk had for some time seemed too low to be sustainable. In addition, more credit is likely to flow through banks, and leverage in the nonbank sectors of the financial markets will be lower. The higher levels of capital relative to assets should form the basis for a more stable system, but the spread of lending rates over the cost of funds will need to rise so that capital can earn a competitive rate of return.

Many people had expected the Federal Reserve to follow a gradual path of rate reductions in response to financial market developments--say, 25 basis points in September and another 25 basis points in October. Such a path would be in keeping with how we have often approached our policy choices, as it has the advantage of allowing us to calibrate our policy as we see how the economic situation is evolving and responding to earlier policy moves. However, given the circumstances at the time of the September FOMC meeting, there were strong arguments in favor of the larger action of a 50 basis point decrease in the federal funds rate. For one thing, it seemed that a decrease of that size could well be necessary to promote moderate growth. We had been holding the federal funds rate at 5-1/4 percent, well above the expected rate of inflation, in part to compensate for what had been very narrow yield spreads and readily available credit. We did not know how quickly markets would recover, the extent to which credit terms and standards would be tightened, or precisely how households and businesses would respond to recent or forthcoming financial developments. But, pending further evidence, a 50 basis point easing was not an unreasonable first approximation of what might be required to keep the economy on a sustainable growth path.

In addition, I thought that economic performance would be better served by the Federal Reserve taking its chances on responding too much, or too rapidly, to the turmoil in financial markets rather than acting too little, or too slowly. Sluggish or inadequate easing risked a weaker real economy that might cause lenders to pull back even more, leading to a deteriorating situation that could prove difficult to reverse. With the news on inflation relatively favorable of late and with inflation expectations seemingly well anchored, I believed that we would be able to offset the cut in the federal funds rate--if it turned out to be larger than needed--in time to preserve price stability.

Since the September FOMC meeting, we have seen some signs of improvement in some markets that were severely disrupted. For example, investors appear to be differentiating more among risk characteristics of asset-backed commercial paper programs; term funding has become a little more readily available to banks and commercial paper issuers; and the run-off in commercial paper outstandings has slowed. But spreads in these markets are still quite high by historical standards and funding maturities are very short, leaving many markets vulnerable to unpleasant surprises. In mortgage markets, spreads for rates on jumbo prime mortgage loans over those on conforming, agency eligible, loans have come down a bit, but are still elevated. Indeed, it may be a while before market participants regain enough confidence to price and trade certain types of assets and more normal liquidity conditions are restored.

Our policy action will not be able to avert all of the weakness in the economy that may be in train for the next several months. Monetary policy works with a lag, and the effects of our easing action will have their maximum effect only after several quarters. In particular, housing markets are likely to remain depressed in coming months as housing demand is restrained by the difficulty in obtaining mortgages and perhaps also by spreading expectations on the part of buyers that house prices will fall, as they already have in a number of markets. And, although builders have reduced housing starts sharply, they have made very little progress in reducing the number of unsold new homes on the market. As a result, even absent a further deterioration in sales, residential construction would probably decline further in the months ahead, imparting a significant drag on overall growth in real gross domestic product.

Beyond housing, it is too early to tell what effect financial market turmoil is having on household and business spending, though very preliminary and partial information suggest that thus far the effects seem to be limited. Moreover, the available data indicate that the economy entered this period still expanding at a moderate pace. For example, consumption held up well this summer supported by solid growth in real incomes. And, the recent data on orders and shipments of capital goods and on nonresidential construction indicated further growth in capital outlays in August. That said, credit availability is likely to be tighter than before, consumer confidence is down, and businesses will probably be a little more cautious for a while, suggesting that these components of aggregate demand could become more subdued in coming months.

Over time, however, I anticipate that the economy will move back onto a moderate growth track. The housing market should gradually recover as the cutback in production and lower prices help reduce the inventory overhang. And, as it does, the drag on growth from the declines in residential construction will abate, providing a boost to overall economic activity. To be sure, households are likely to start to save more out of their current incomes as they come to realize that they cannot count on a rise in the value of their real estate to build their retirement nest eggs. However, households have been surprisingly resilient to recent economic shocks, and any rise in the saving rate probably would be gradual. More generally, consumer spending should continue to be supported by ongoing growth in employment and income. In the business sector, balance sheets are in good shape, and most firms are not likely to face an appreciable tightening of credit availability. As a result, I anticipate that they will expand their investment spending to keep pace with rising household demands and with strength in export markets. In sum, once we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment.

But you should view these forecasts even more skeptically than usual. The FOMC emphasized the considerable uncertainty in the outlook. As I noted earlier, we do not know how financial markets will evolve, and we do not know how households and businesses will respond to financial developments. Naturally, these types of uncertainties are greatest when markets are behaving abnormally. The recovery from the problems of the early 1990s was prolonged because banks had to rebuild capital; the rebound from the market crisis of 1998 was swifter, helped along by higher productivity growth and the rise in the stock market that accompanied the optimism about high-tech profits. We will need to be nimble in adjusting policy to promote growth and price stability.

Of course, we would not have eased policy if the outlook for inflation had not been favorable. The recent data on consumer price inflation have been encouraging. Movements in energy prices have created volatility in overall inflation, but over the past twelve months both core and total prices for personal consumption expenditures rose 1.8 percent. Moreover, the near-term weakness in the economy should intensify competitive conditions in markets and reduce potential pressures on costs and prices. And, it will be critical for inflation expectations to remain well contained.

Two things to notice about his inflation comments: First, both current inflation readings and the inflation outlook are benign; Second, upside risks to inflation are not his main concern, and will not be a major consideration unless and until he sees a significant inflation uptick, which he clearly doesn't expect.

On the outlook for growth, all of the risks he cites are to the downside, and he expects those risks to persist for many months.

The Fed funds options market is now predicting no cut on Oct 31:

I think that's unlikely.

Fisher on Inflation

Dallas Fed President Richard Fisher came to the defense of core inflation in a speech today on "Inflation Measurement and Price Volatility." In doing so, he comes down firmly on the (correct) side of Brad DeLong and knzn in their slap-down of Barry Ritholtz and Dan Gross, who seem convinced that core inflation is some kind of conspiracy.

It is, of course, no such thing. The real reason that food and energy are ignored in core inflation is that, according to Fisher:

It boils down to what engineers call a "signal extraction" problem; struggling to eliminate "noise" in our monthly inflation measures and trying to maximize the amount of "signal." ... By ignoring items whose price movements display significant short-run volatility, statisticians and policymakers can get a better sense of underlying trends in consumer price inflation. Because the trends change only gradually, measures that give us a better sense of what they are today provide a better sense of where overall inflation will be tomorrow. To make inflation forecasts over the next 12, 18 or 24 months, we are much better off looking at the recent behavior of a core measure ... than we are looking at the recent behavior of headline inflation.

It really is just that simple. If you're interested in the debate, or if you have any sympathy for the Ritholtz/Gross view, do read the entire speech. It's a deeply informed, yet highly readable summary, and it's only 4 pages long. Plus you'll be treated to the rare event of a Fed speaker making a (kind of funny) joke.

For a deeper treatment of how to construct inflation measures that are better at predicting future headline inflation, read Measures of Core Inflation (pdf), by Julie Smith.

Finally, if knzn is reading this, Fisher must have read your proposal to target labor costs, rather than core inflation. Looks like that's not going to happen any time soon:

[T]here are macroeconomic models suggesting that if wages are stickier than prices, a central bank would do well to focus on an index of wages rather than prices. I just can't imagine central bankers lasting very long in their jobs if they continually announced to the public their desire to hold down wage growth.

Recommended Reading

Interview with Frederic Mishkin
The Region - Banking and Policy Issues Magazine
September 2007

In the Lap of the Gods
Speech by Richard Fisher, President of the Dallas Fed
Greater Dallas Chamber Annual State of Technology Luncheon
October 2, 2007

Lockhart in Q&A on Dollar Markets

I just listened to the Q&A from Lockhart's speech on Friday. This was quite interesting, especially in light of Mishkin's last speech on globalization:

"I should repeat the question, a very good question. What's my response to the view that the fed funds as a monetary tool and future fed funds cuts might not be so effective given the intertwined nature of our economy and our financial markets with the global markets. Well it's a very good question and I am confident that the management of the federal funds rate given its effect on dollar markets and global markets remains a very powerful instrument. So I am not, let's say, a believer in the argument that we have been emasculated in our powers to influence the overall economy by virtue of globalization."

It seems increasingly clear that the FOMC views significant dollar depreciation, induced by fed funds cuts, as the most likely monetary transmission mechanism in the event of U.S. economic weakness.

You should be able to predict how imminent this scenario is by counting the frequency of denials like this (again from Lockhart's Q&A):

"The question is what do I see happening regarding the value of the dollar and this is another one of those questions and topics that we at the fed leave to another agency, in this case it's the treasury. So I have to duck that question. It's not our brief to predict the direction of the dollar."

For future reference, as of 10/1/2007: EURUSD = $1.423, USDJPY= ¥115.78

Recommended Reading on the Phillips Curve

Inflation and Unemployment: A Layperson's Guide to the Phillips Curve (pdf)
by Jeffrey Lacker and John Weinberg,
FRB-Richmond Economic Quarterly,
Summer 2007

Implications of Behavioral Economics for Monetary Policy
Speech by Janet Yellen,
FRB- San Francisco,
Sept 28, 2007

Mishkin on Globalization and Rebalancing via Exchange Rates

Frederic Mishkin's gave a speech last Thursday on "Globalization, Macroeconomic Performance, and Monetary Policy," in which he talks in turn about how globalization effects inflation, output, and the "monetary transmission mechanism" (MTM; i.e. how the fed speeds up or slows down the economy). While his views on the first two topics are straightforward and unsurprising, what he says about the MTM is very very interesting.

On Inflation:

We should never forget Milton Friedman's adage that "inflation is always and everywhere a monetary phenomenon." In the long run, as long as a central bank has an independent monetary policy--that is, it is not locked into a fixed-exchange-rate regime in which its hands are tied--the rate of inflation is determined by monetary policy. ... many of the exaggerated claims that globalization has been an important factor in lowering inflation in recent years just do not hold up.

On Output:

[E]conomic globalization has the potential to be stabilizing ... The bottom line, however, is that it is not at all clear whether globalization increases or reduces output volatility.

On the Monetary Transmission Mechanism (MTM):

One of the key transmission channels of monetary policy is the exchange rate. A tightening of monetary policy, for example, raises U.S. interest rates relative to those abroad, thereby inducing upward pressure on the foreign exchange value of the dollar. An appreciation of the dollar, in turn, restrains exports (because the price of U.S. goods rises when measured in foreign currencies) and stimulates imports (because imports become cheaper in dollar terms). The resulting decrease in net exports implies a reduction in aggregate demand. In addition, an appreciation of the dollar that leads to a decline in import prices also helps restrain overall U.S. inflation.

By expanding the share of tradable goods and services in the economy, globalization might increase the role of the exchange rate as a transmission channel of monetary policy and could reduce the role of the interest rate channel. The larger the share of imports and exports in the economy, the greater the change in net exports--and, hence, in the contribution of net exports to gross domestic product (GDP) growth--for a given change in the exchange rate. In addition, the larger the share of imports in the economy, the larger should be the effect on overall CPI inflation of a given change in import prices when the exchange rate changes. (This effect is explicitly incorporated in Federal Reserve staff models of U.S. inflation, which weight import prices by the share of imports in the consumption basket.)

By the same token, the effect of the interest rate channel on overall economic activity may be diminished by greater trade integration as changes in domestic demand are offset by induced changes in imports. Guerrieri, Gust, and López-Salido (2007), for example, find that shocks to domestic demand move output less in more-open economies because they lead to larger offsetting movements in the trade balance. Supporting this result, Ihrig and others (2007) conclude that correlations between real GDP growth and real domestic demand growth have declined in recent decades in the United States and several other industrial economies.

In addition to increasing the sensitivity of the economy to changes in exchange rates, globalization may have increased the sensitivity of exchange rates to monetary policy. Over the past few decades, as capital controls have been eliminated in most major economies and the levels of home bias in portfolio investment have declined, financial markets around the world have become more tightly integrated. An implication of this financial globalization is that demand for domestic and foreign assets is likely to have become more sensitive to international differences in perceived rates of return. Accordingly, monetary policy actions may now exert more influence on exchange rates than was the case when markets were less tightly integrated and assets of different countries were perceived to be less substitutable for each other. This linkage between globalization and the effect of monetary policy on exchange rates is somewhat speculative but represents a worthwhile avenue for further research.

Now why is this so interesting? It is, after all, a fairly text-book treatment of how interest rates effect exchange rates. First, Fed speakers don't usually talk much about exchange rates, and when they do it's usually in the context of import price inflation. This speech is different. Mishkin downplays the potential for increases in import prices to be an independent source of inflation, distinct from monetary stimulus. Instead he emphasizes how exchange rate changes can affect economic growth.

This sounds like an acknowledgement and tacit endorsement that significant dollar depreciation is likely to be one of the main channels through which interest rate cuts, if needed, can effectively stimulate the economy.

Here's the thinking. Suppose the housing recession deepens, and housing prices continue to fall. Suppose also that this leads to a decline in consumer spending (which is 70% of GDP), as households respond by saving more and spending less. This is the standard scenario of the "recession is imminent" crowd. To keep the economy at full employment, the Fed has to get someone to pick up the slack. They do this by cutting interest rates until a sufficient number of people and businesses, either in the U.S. or abroad, decide they want to buy more American goods and services. The only question is, of the many ways that lower interest rates can stimulate that spending, which will be the path of least resistance. The usual housing mechanism (extra mortgage lending leading to extra housing construction) is clearly not going work this time. But getting foreigners to buy more via dollar depreciation will work, as long as that depreciation is allowed to happen. Perhaps this speech is a signal that the Fed is laying the groundwork for that possibility. It's perhaps no coincidence that Mishkin's next speech is on Systemic Risk, which would help to lay even more of that groundwork.


This is going to be an interesting one to watch play out.