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.

Kohn Endorses Greenspan's "Mopping-Up" Response to Bubbles (9/21/07)

Don Kohn gave a speech in Frankfurt last week at the German Bundesbank on the "Success and Failure of Monetary Policy since the 1950s." Kohn has worked at the Fed for the entirety of Greenspan's tenure, and he seems to have absorbed a lot of Greenspan's views. However, in the first part of his speech (covered in an earlier post), Kohn seems to be distancing himself from Greenspan's opposition to inflation targeting. In the second half though, Kohn returns to the fold and whole-heartedly endorses the Greenspan view of asset price bubbles, which I think of as the "Mopping Up" approach:

1. The Fed can't predict Asset Bubbles,
2. Even if we could identify a bubble, the Fed can't stop it without damaging other parts of the economy,
3. After a bubble bursts the Fed can cut rates aggressively to limit the damage to the broader economy.

The second of David's open issues--whether central banks should lean against possible asset price bubbles--was the key topic in my discussion here eighteen months ago, at Otmar's festschrift. My answer then is my answer now. A central bank should focus on the outlook for the macroeconomy and generally relegate asset prices to the subordinate role of inputs to the forecast process. I view this as the simple application of humility that David and I find so admirable. Although economic theory provides no settled answers to any topic, its predictions are especially imprecise with regard to asset pricing, which has two implications for central bankers. First, little confidence can be attached to the determination that an asset bubble exists except in the most extreme of circumstances. Second, even less confidence can be attached to predictions of the effects of policy on asset prices, and in particular on any speculative element in those prices. Moreover, monetary policy actions addressed at a perceived bubble in one sector may have undesirable effects on other asset prices and the economy more generally.

As a result, my preferred policy framework remains three pronged: First, assign the single instrument of monetary policy to its macroeconomic objective; second, rely on regulation to erect a resilient financial structure; and, third, in the event that market judgments prove to be wrong and financial prices adjust sharply, apply the tool of monetary policy to the macroeconomic task at hand [Shivers: i.e. cut rates]. That task is not always easily captured by simple statistical regularities. Relationships between financial markets and economic results are complex and nonlinear, especially when markets are not behaving normally. When investors are ebullient, their expectations of outsized capital gains can feed on themselves and back on the economy. On the way down, investors' loss of confidence, a reduction in credit availability, and a tightening of terms and conditions for credit have the potential to have pronounced effects on activity and inflation.

Follow Mishkin

Frederic Mishkin has only been on the Board of Governors for about a year now, but in that time he's become an incredibly good barometer of Fed thinking. If you were trying to predict the outcome of the Sept 18th FOMC meeting, and all you had done was read Mishkin, you likely would have nailed it.

I've linked below to Mishkin's most relevant speeches since joining the Fed. The paper he gave at Jackson Hole on Housing and the Monetary Transmission Mechanism is the most important by far. It's long (55 pages) and a bit wonky, but well-worth perusing.

March 23, 2007: Inflation Dynamics, 8 pgs
April 10, 2007: Monetary Policy and the Dual Mandate, 4 pgs
May 24, 2007: Estimating Potential Output, 7 pgs
June 23, 2007: Globalization and Financial Development, 8 pgs
Sept 1, 2007: Housing and the Monetary Transmission Mechanism, 55pgs
Sept 10, 2007: Outlook and Risks for the U.S. Economy, 6 pgs
Sept 21, 2007: Will Monetary Policy Become More of a Science? 46 pgs
Sept 27, 2007: Globalization, Macroeconomic Performance, and Monetary Policy, 10 pgs

Plosser on Productivity and Rate Cuts (9/25/07)

Charles Plosser, President of the Philadelphia Fed, gave a speech today on Invention, Productivity, and the Economy. Plosser has been on the job for about a year now; in terms of FedSpeak, he's been one of the most hawkish members of the FOMC. He doesn't currently have a vote, but he will in 2008, so his views about the how the Fed should respond to recent economic events are of increasing importance.

Productivity is important for two related reasons. First it tells you where the economy's natural speed limit is: potential growth = labor force growth + productivity growth. Second, as a rule-of-thumb, a good estimate of the neutral fed funds rate is potential growth + inflation.

The issue is especially important now, because estimates of recent year-over-year productivity growth by the BLS have been declining:

The question of whether this recent decline is real (the estimates could get revised up), and if so whether it's temporary or permanent is of central importance to the stance of monetary policy.

In Plosser's own words:

In the long run, the economy’s growth rate largely reflects two factors. The first is the growth rate of the labor force, which is determined by demographic factors like the birth rate, age distribution, and immigration. The second is the growth in the productivity of the labor force, which depends on both physical and human capital and incentives for research and innovation. Monetary policy cannot be used to achieve a long-run growth rate that is inconsistent with these economic fundamentals.

[...]

As you know, in recent years, productivity growth has slowed from its very rapid pace in the last half of the 1990s. Although there continues to be much uncertainty about how much of the recent slowdown in productivity growth will prove to be transitory and how much will prove to be persistent, my own view is that trend productivity growth will turn out to be only slightly below 2 percent. And that will mean trend economic growth over the next few years is likely to be close to 2-3/4 percent, slower than the more than 3 percent growth we saw in the late 1990s but not as slow as some economists are forecasting.

So using Plosser's 2.75% trend growth and current core PCE inflation of 1.9% (from table 11 of the BEA's Personal Income and Outlays report), we conclude that Plosser's estimate of a neutral fed funds rate is currently about 4.65%, slightly below the current target of 4.75%.

Now that we have an idea of where neutral is, we can move on to Plosser's take on the economic outlook, which will give us an idea of how much above or below neutral he thinks the funds rate should be.

In early September, the August employment report contained some surprises. It reported an employment decline of 4,000 jobs. My own reaction was to take that number with a grain of salt because August is a tough month to estimate because of back-to-school effects. ... More troubling for the outlook, in my mind, was the downward revision to both June and July employment gains.

While the unemployment rate remains low, the softening of employment gains in the early summer suggests that the labor market may not be quite as tight or as robust as we previously thought. If so, then it may have a dampening effect on income and consumption growth in the months to come. Having said that, I would not be entirely surprised if employment growth rebounded. Nevertheless, a softening labor market is a factor in the revision to my outlook.

Incoming information showing a continuing sharp decline in house prices and weak home sales also contributed to the downward revision to my outlook. The cumulative information on the housing market over the last few months has suggested that the recovery in residential construction is likely to be delayed until later in 2008 than many forecasters originally thought.

Finally, the turbulence in the financial markets has created additional uncertainty. While there is little direct evidence that the financial disruptions have significantly affected the broader economy, that certainly is still a real possibility. One source of that risk is that consumers and businesses may choose to delay or defer spending plans until the future becomes a little clearer. In addition, the general tightening of credit conditions, if persistent, can aggravate and possibly further delay the recovery in housing and further dampen both consumer and business spending.

Well, that's pretty clear. I think it's safe to assume he thinks that monetary policy should be on the stimulative side of neutral.

Now on to the part that's meant for people who weren't paying close enough attention:

Thus the pace of economic activity is likely to be somewhat slower in the next few quarters than I expected earlier. A slower economy means that real interest rates must decline to bring about the appropriate adjustments to restore growth. In recognition of this, I believe last week’s action to lower the fed funds rate target was appropriate.

[...]

It is important to understand that the economy is expected to grow more slowly in the coming months, despite last week’s decision to reduce rates. Therefore, I will not be surprised to see weaker statistics making headlines. But weaker numbers will not lead me to revise my outlook or my view of the appropriate funds rate target, unless they are much weaker than already anticipated and accumulate sufficiently to generate another downward revision in my outlook.

One could quite easily conclude from those two paragraphs that Plosser is in the "one and done" camp. I.e. that the recent 50bp cut is quite sufficient, so don't expect any more cuts.

There are two reason I don't think that's the case. First, we just did the math: Plosser thinks we're at neutral now, and just said the economy is slowing, which requires stimulus. Second, and this is key, when policymakers talk about the "appropriate funds rate target," they are referring both the current rate target, and to an expected path of future rates (which they all have in the back of their minds). It is entirely consistent for a policymaker to say the current rate is appropriate, and to expect to cut rates at the next meeting.

So, if I'm reading this correctly (a big "if"), Plosser has managed to pull off a neat trick. First, he sounds very hawkish to a broad audience, which should help to bring inflation expectations back down a bit. At the same time, he's signaling to the narrow financial market audience, the ones who allocate capital, that it's ok to go ahead and take a bit more risk (which stimulates growth), because the Fed will cut rates again to assure the economy keeps growing near potential.

Very clever.

As alway, views welcome...

Bob McTeer Has a Blog

Bob McTeer, who was President of the Dallas Fed for 14 years, from 1991 to 2005, has started a blog.

He's already quite a few very good posts up:

Some Thoughts on the Credit Crunch
The Fed’s Tool Kit
Moral hazard at the Fed

Fisher = Neutral Bias

Dallas Fed President Richard Fisher gave a speech today on education fittingly entitled "You Earn What You Learn," though he did spend a good part of it on monetary policy.

Fisher's speeches aren't usually subtle. There's usually nothing to read between the lines, so it doesn't really pay to over-analyze them. There are two parts I want to highlight, both basically speak for themselves.

Here's how he described last Tuesday's FOMC deliberations:

As we sat down to the FOMC table on Tuesday, we were faced with a situation that, drawing on my Naval Academy days, I would liken to a ship navigating a narrow passage between two shorelines.

On one shore, we have an otherwise healthy economy weakened to an unknown degree by a correction to excessive speculation in its housing sector and related financial instruments. On the price front, the economy has been experiencing mitigation in inflationary tendencies, thanks, I believe, to prudent monetary policy—albeit against a background of an energetic global economy that continues to create upward price pressures on all sorts of commodities, on transportation costs and even on what was once assumed to be an endless supply of cheap imports from China. If we had maintained the anti-inflationary course we had been following for more than 14 months by holding the fed funds rate at 5.25 percent, I believe we would have risked oversteering our course and potentially run afoul of the shoals of unacceptably slow economic growth. ... Recent trends in inflationary impulses and expectations, however, appeared to me to provide some wiggle room to adjust our tiller and steer a more growth-oriented course.

Looking to the other shoreline, we were confronting the rocky outcropping that economists call moral hazard. ... Overcorrecting our course with too aggressive a shift in the fed funds tiller would have, I believe, undermined the discipline that market forces impose upon wayward financial institutions and investors.

Fisher currently doesn't have a vote on the FOMC, but he will starting with the Jan 30, 2008 meeting.

The remainder of the speech was on education and the knowledge economy. Given that the UAW just went on strike today, this was particularly apt:

At the end of 2005, the U.S. auto and auto parts manufacturing industry employed about 1.1 million workers and added 0.8 percent of the value to our gross domestic product. The legal services sector employed nearly the same number but contributed 1.5 percent of the value added to GDP. In other words, lawyers produce twice as much as automobile workers. ...There is no more vivid demonstration of how services have replaced manufacturing as the engine of our economic prosperity.

It's also a good reminder that recessions in the future are unlikely to play out the way they have in the past.

P.S.: Bernanke also gave a speech on education today (Education and Economic Competitiveness), but, as has been his habit recently, he made no comment on monetary policy.

Kohn on Inflation Targeting (9/21/07)

Don Kohn gave a speech in Frankfurt yesterday at the German Bundesbank's 50th Anniversary conference on the "Success and Failure of Monetary Policy since the 1950s." The speech focuses on inflation targeting and asset price bubbles.

First, inflation targeting. The debate about whether the Fed should have an explicit inflation target reignited when Ben Bernanke became Chairman. Chairman Bernanke has been a strong supporter of inflation targeting. Vice-Chairman Kohn has been opposed to the idea. So it's interesting that in this speech Kohn seems to be warming up to the idea:

In many countries, ... price stability [is] pursued through the formal apparatus of an inflation target.... [T]he spread of such regimes has coincided with sustained low global inflation. In addition, no adopter of an inflation target has subsequently abandoned it....

Evidence has accumulated to suggest that stock prices, interest rates, and measures of inflation expectations seem to vary less in economies in which the central bank has an explicit long-run goal for inflation....

A formal inflation target represents a national embrace of a goal.... An important effect of such public acceptance of price stability is that it erodes the standing of those who would direct central bank action toward other ends. [I wonder who he's talking about.]

In the midst of this inflation-targeting lovefest, he interjects this caveat:

Before anyone jumps to the conclusion that Frankfurt is a stop on my road to Damascus, let this Saul state that for me the case remains open.

Wow... I'm almost giddy at what a great piece of Fedspeak that is. Doesn't it sound like he's at best noncommittal?

Note that he doesn't say "...let me state that the case remains open," instead he says, "let this Saul state..." Saul, or course, was the zealous persecuter of the early Christians in Jerusalem, who, while walking on the road to Damascus, was struck by lightning and received a revelation from God, thereafter becoming one of early Christianity's most fervent missionaries (St. Paul).

Now I may well be reading between lines that aren't there, but Don Kohn's speeches are usually very tightly written; he frequently says things obliquely, but he almost never says things unintentionally.

It sounds to me like Kohn is going do a Nixon-in-China on inflation targeting.



We'll tackle Kohn's thinking on asset bubbles in a subsequent post...

The Twelve Districts

Trivia: Which state is home to two Reserve Banks?

Shorter Bernanke (9/20/07)

Ben Bernanke testified today before Barney Frank's House Committee on Financial Services. Like his last speech, the testimony is mostly recycled.

Here's the short version (paraphrasing just a little):

Subprime's a mess, especially ARMs. Regulators are trying to help to prevent unnecessary foreclosures, but we think raising GSE conforming loan limits is a bad idea.

Oh, btw, financial markets are pretty stressed; we didn't want it to spill over, so we cut interest rates.

That pretty much covers it.

FOMC Statement, Sept 18, 2007

The FOMC cut rates 50 bps.

Here's what I found interesting from their statement:

First, the rationale was preemption: "Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time."

Second, the vote was unanimous. Even William Poole and Thomas Hoenig, who had given the most hawkish speeches prior to the meeting, voted in favor. I had thought that at least one might dissent, which might have helped keep the hit to inflation expectation down.

So it appears the argument over whether this Fed believes preemptive policy easings are justified is now over. The risk managers won.

Counting FOMC Votes (Sept 18, 2007)

OK, got your coffee and a sharpened pencil? It's accounting time.

Below are all the members of the FOMC, starting with the ones who have votes. Links are to the most recent speech they've given after August 10, and to any relevant posts here.

For simplicity, I'll assume they've only got a choice between cutting 25bps and 50bps. Next to each name I've listed my best guess, if I have one, for which policy they'd prefer, along with a recent sound-bite that I think summarizes their main concern.


Board of Governors
Ben Bernanke: 50bps, "deterioration in financial market conditions ... increased the downside risks to growth."
Donald Kohn: 50bps.
Randall Kroszner: 50bps, "financial stress... has spread to other markets"
Frederic Mishkin: 50bps, "potentially adverse implications for real activity"
Kevin Warsh: ?

Regional Fed Presidents with votes:
Timothy Geithner, New York: ?
Eric Rosengren, Boston: ?
Charles Evans, Chicago: ?
Thomas Hoenig, Kansas City: 25 bps, "the economy is doing reasonably well"
William Poole, St. Louis: 25 bps, "There’s no need ...unless there’s some sort of calamity taking place"

Regional Fed Presidents without votes:
Sandra Pianalto, Cleveland: ?
Charles Plosser, Philadelphia: 25 bps, "the economy is remarkably resilient"
Richard Fisher, Dallas: 25bps, "Our economy appears to be weathering the storm"
Gary Stern, Minneapolis: ?
Jeffrey Lacker, Richmond: 25bps, "risks to economic growth appear to be relatively minor"
Dennis Lockhart, Atlanta: 25bps, "I would like to see inflation sustained at a somewhat lower rate"
Janet Yellen, San Francisco: 50bps, "increased downside risks"


That still leaves a lot of question marks, but among the Governors (plus Yellen) concern seems to be centered around the potential for a seize-up in the banking sector to negatively impact the real economy, and the importance of short-circuiting that process.

Most of the hawkish talk has come from the regional Fed presidents, though mostly the non-voters, who have yet to see much actual impact on the real economy.

I'm in the minority, but I expect 50bps.

Expectations for the Sept 18th Fed Meeting

Implied from Fed Funds Options*:

*Note that these probability estimates are from the prices of fed funds options, which pay out based on the effective fed funds rate, not the target rate. To the extent that the effective rate remains under the target rate, they overestimate the probability of a 50bp cut, and underestimate the probability of a 25bp cut.

From the survey of 130 economists on Bloomberg:
77% expect a 25bp cut,
18% expect a 50bp cut, and
5% expect no cut at all.

I expect a 50bp cut.

Kohn Soundbites

From Fed Board Vice-Chairman Don Kohn's last speech, Financial Stability and Policy Issues, May 16, 2007:

"We could face situations in which asset price movements are exacerbated by the actions of market participants, including dynamic hedging strategies or forced liquidations of assets to meet margin calls, and those asset price movements could feed back onto the economy....

In the extreme, price variations and other adverse developments could call into question the viability of these intermediaries, threatening a larger cumulative real effect....

We need to accept that accidents will happen--that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises....

Supplying additional liquidity and reducing borrowing costs can greatly ameliorate the effects of market events on the economy, and those types of macroeconomic interventions will carry less potential for increasing moral hazard than would the discount window lending..."

Interesting.

What The Fed Should Do (Mishkin 1997 & 2007)

Frederic Mishkin, who, along with Don Kohn and Ben Bernanke, is one of the major macroeconomic heavyweights on the Board of Governors, recently gave a speech on the Outlook and Risks for the U.S. Economy in which he highlighted a paper he wrote in 1997, when he was Director of Research for the FRB of New York.

That paper (The Causes and Propagation of Financial Instability: Lessons for Policymakers (pdf)) lays out the circumstances under which asymmetric information problems can magnify and multiply into a full-blown financial crisis. The bad news is that those preconditions describe the current situation disturbingly well. The good news is that Mishkin tells us what the Fed should do in response.

Here's the abridged version of Mishkin's top four causes of financial instability:

Four factors typically help initiate financial instability:

(1) increases in interest rates,
(2) a deterioration in bank balance sheets,
(3) negative shocks to nonbank balance sheets, and
(4) increases in uncertainty.

Countries often begin experiencing major bouts of financial instability when domestic interest rates begin to rise, often with the rise initiated by interest rate increases abroad. For example, most financial crises in the United States in the nineteenth and early twentieth centuries began with a sharp rise in interest rates that followed interest rate increases in the London markets. ... these rises in interest rates increased adverse selection problems in the credit markets. The rise in interest rates also increased moral hazard problems because the resulting decrease in cash flow hurt the balance sheets of nonbank firms. In addition, the increase in interest rates weakened bank balance sheets because of banks’ maturity mismatch....

Figure 1: Propagation of Financial Instability in Industrialized Countries

Also characteristic of the early stages of financial instability is a deterioration in bank balance sheets because of risky loans that have turned sour. In the recent Mexican episode, the source of these weakened balance sheets was financial liberalization that led to a rapid acceleration of bank lending, in which bank credit to the private nonfinancial business sector rose from 10 percent of GDP in 1988 to over 40 percent in 1994. This lending boom, which stressed the screening and monitoring facilities of the Mexican banks, along with the inability of the National Banking Commission in Mexico to adequately supervise these new lending activities, led to growing loan losses in the banking sector. ... The deterioration in bank balance sheets decreased the ability of the banks to lend because efforts to improve their capital ratios required retrenchment on lending.

Stock market crashes are also typically associated with financial instability.... The declining net worth of nonfinancial firms then increased adverse selection and moral hazard problems in financial markets because the effective collateral in the firms had decreased, while the decline in net worth meant that the incentives for borrowers to take on risk at the expense of the lender had increased.

The fourth factor that frequently appears when there is financial instability is an increase in uncertainty, whether because an economy is already in recession, or because a major financial or nonfinancial firm goes bankrupt, or because of increased political instability.... Increases in uncertainty make it harder for financial markets to process information, thereby increasing adverse selection and moral hazard problems and causing a decline in lending and economic activity.

If any of the four factors in the top row of the figure occurs, it can promote financial instability. If all of these factors occur at the same time and are large, the situation is likely to escalate into a full-scale financial crisis, with much greater negative effects on the real economy.

That was what he said ten years ago. Now here's what he said last week:

...an increase in uncertainty and concerns about the quality of information can lead investors to pull back from financial markets and restrict productive lending--with potentially adverse implications for real activity. That is essentially the story I laid out in a paper delivered at the Kansas City Fed’s Jackson Hole conference about ten years ago.⁷ In my view, such an increase in uncertainty is an important part of what we have observed recently.

That takes care of the diagnosis; now for the prescription (again from 1997):

The asymmetric information analysis thus suggests that a lender-of-last-resort role may be necessary to provide liquidity to nonbanking sectors of the financial system in which asymmetric information problems have developed....

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 because once market participants know that liquidity is being injected into the system, uncertainty in the financial markets will decrease. Thus, the Federal Reserve’s actions during the stock market crash of 1987 are a textbook case of how a lender-of-last-resort role can be performed successfully. The Fed’s action was immediate, with an announcement that operated to decrease uncertainty in the marketplace. Reserves were injected into the system, but once the crisis was over, they were withdrawn. Not only was a financial crisis averted, but also the inflationary consequences of this exercise of the lender-of-last resort role were quite small.

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.

Sounds to me like a 50bp cut on Sept 18, with a neutral bias after that, which implies they'll have a hiking bias once the downside risks from the financial market turmoil recede.

The Fisher Smackdown (9/10/07)

Richard Fisher, president of the Dallas Fed and current non-voter, gave a speech on Monday, nominally about The U.S., Mexican and Border Economies, though half the speech was about the U.S. economic outlook.

Before we get into this speech, a few words about his style: Fisher's speeches have this down-to-earth, straight-shooter, vernacular quality to them that I really like. He comes across as the kind of guy you'd want to have a drink with. I don't remember ever reading a dry speech from him. You can think of him as an everyman version of Janet Yellen. He also likes jokes and puns, which brings me to his current speech.

In recent weeks, we have heard much about financial market turbulence. We've been distracted by the noise of the subprime fallout, periodic reports of a "seizing up" in asset-backed commercial paper markets, volatility in the stock market and tremors in other parts of the financial infrastructure. (Apparently it is no longer true that, as Andrew Mellon once famously quipped, "Gentlemen prefer bonds.")

HA! You have to admit, it's not the Tonight Show, but for a Fed speech that's funny!

OK, now in all seriousness, here's Fisher's money quote:

Amidst this clamor and drama, some might have lost sight of our economy's great resiliency. ... Given the financial turmoil that began last month, I am generally encouraged by what I have heard and seen so far: As yet, tighter credit conditions do not appear to have had a major impact on overall economic activity outside of real estate.

So he'll be arguing for a 25bps, rather than 50bps, cut on Sept 18 (not cutting isn't really an option).

And now my favorite part. I may well just be projecting here, and he pulls it off with a completely straight face (at least on paper), but this looks to me like a much needed smackdown of that CNBC madman who accused the Fed of being "out of touch" and "asleep at the wheel."

As we approach the upcoming session of the FOMC, each of the participants, including me, is diving deep into the data and taking soundings from business leaders, bankers and others with operating ears to the ground to ascertain the current pace of the economy and—this is important—the prospective dynamics of growth and inflation. I am particularly active on this front. Before each meeting, I speak with around 30 CEOs and CFOs of a careful selection of large and small companies from around the country in order to get an in-depth understanding of the pace of economic growth and price pressures they see through their businesses. Meanwhile, our staff routinely surveys a broad base of businesses within our district and reports their findings in what is known as the Beige Book, the most recent of which was released last Wednesday. Lately, I have focused on how recent developments in financial markets are impacting the revenues and costs, supplier and customer dynamics, product mix and growth projections of these hands-on operators of our economy.... it is fair to say that I am encouraged by what I have heard against a background of constant negative speculation and the occasional discordant note, such as last week's employment numbers. Our economy appears to be weathering the storm thus far.

Booyah that, J.C.!

A (Not So) Secret Rate Cut?

Felix Salmon, William Polley, David Gaffen and Nouriel Roubini began a discussion last month, now continued at Greg Mankiw's blog, about whether the Fed has already cut the Fed Funds rate target without announcing it. The evidence for an implicit cut is that the Effective Fed Funds rate has averaged only 4.97% since August 10 (data here), versus an official target of 5.25%:

The innocent explanation for this, which most people except Roubini seem to be accepting, is that the increased volatility in the fed funds market has made it harder for the Fed to hit its target, so they're simply erring on the side of caution.

I don't think that's what's happening for two reasons.

First, there have been other periods of volatility in the fed funds market that didn't produce significant under- or over-shooting of the target rate. The picture below shows the scatterplot of absolute deviations of the daily effective fed funds rate from the target versus the intraday fed funds range (high minus low) since July 2000. I've removed the Sept 11, 2001 outliers, though it doesn't change much if you leave them in. The data since Aug 10th is bolded, and the straight line is the regression using pre-Aug 10 data.

The Fed's undershooting clearly is not purely a result of higher intraday volatility.

Second, the Fed can intervene in the fed funds market as often as it wishes. Typically it only does so once a day in the morning, but it can and occasionally has conducted open market operations more frequently intraday. So if the Fed really wanted to hit a 5.25% target, it could.

The conclusion I'm forced to make is that the Fed is hitting its target, but that target is 5%.

Lockhart joins the Hawks

On Monday, Atlanta Fed President Dennis Lockhart gave a repeat of his Sept 6 speech: After The Feast. Lockhart is a bit of an unknown quantity, having only joined the Fed in March. He's only given one previous speech (Competitive Pressures and Workforce Adaptability), which covered local issues in the Atlanta district.

He lays out his views though in this current speech, coming down firmly on the side of the hawks. Here are the money quotes:

In my view current readings of inflation represent progress, but not victory. I would like to see inflation sustained at a somewhat lower rate—with emphasis on "sustained."

If inflation is allowed to accelerate, bringing it back down will be costly and painful. High and unstable inflation can distort economic decision making and—once ratified by public expectations—is difficult to reverse. By contrast, low and stable inflation fosters an economy that's conducive to rational business activity and resistant to exogenous shocks....

Although I believe that Fed intervention is appropriate if markets are clearly not working properly, I am aware of the potential pitfalls of such interventions. Caution may cause some observers to argue that the central bank is insufficiently preemptive in its actions. But I believe the Fed's longer-term objectives are well served by a deliberate and measured response to financial market turbulence. Such a response should distinguish, as much as possible, between liquidity actions aimed at keeping markets orderly and monetary actions aimed at cushioning the economy from the impact of financial market instability.

Lockhart, however, doesn't have a vote on the FOMC until 2009.

Yet another reason to read the Financial Times

Yes, the Financial Times is the best newspaper on the planet. The fact that this article is written almost as an aside says a lot:

Lex: Federal Reserve System

The Federal Reserve System is split into 12 regional banks.... A devolved model certainly guarantees debate: on Monday the presidents of the Dallas and San Francisco Feds gave divergent hints about the likely path of US interest rates. But is it really necessary?

The Fed’s structure is a historical quirk. After two failed attempts to establish US central banks, in 1913 a regional model was enacted, partly to mitigate political concerns about concentration of power. The 12 cities selected look pretty arbitrary today: Minneapolis has under 2 per cent of the system’s assets, while San Francisco, responsible for the whole of the US west of Dallas, has 11 per cent, and New York a third....

Since 1942 New York has had its own seat on the Federal Open Market Committee, which decides interest rates, but the other regional Feds share four of 12 FOMC seats on a rotating basis. Only New York conducts market operations while management of backoffice systems is being consolidated....

If the devolved model of the ... Fed did not exist, no one would invent [it]. But the political and constitutional dimensions of central banks make rapid reform unlikely. Regional Feds are at least quietly streamlining themselves by focusing on specific operating areas (Atlanta is big on money laundering) and intellectual fields (St Louis is known for monetarism, while San Francisco is home to gurus on Asia).

Bernanke's Buba Speech (9/11/07)

Chairman Bernanke gave a highly-anticipated speech today at the Bundesbank (the "Buba"). The topic was Global Imbalances: Recent Developments and Prospects. Given the uncertainty around next week's Fed meeting, the speech was as closely pored over as Paris Hilton's stolen address book. See, for example, here, here, here, here, here, ... (you get the idea). Unfortunately the speech was about as relevant as Paris' address book, and about as old as that story. Bernanke's speech was largely a rehash of his 2005 Savings Glut speech.

Nevertheless, there was one nugget at the end that wasn't in the 2005 speech:

What implications would a gradual rebalancing have for long-term real interest rates? The logic of the global saving glut suggests that, as the glut dissipates over the next few decades and thereby reduces the net supply of financial capital from emerging-market countries, real interest rates should rise

He presumably leaves it as an exercise for the reader to figure out what implications a sudden rebalancing would have on long-term interest rates, like might happen, for example, if U.S. consumers collectively decided tomorrow that they no longer wanted to be the consumers of last resort for the rest of the world. I'm guessing this is what the FOMC was referring to on Aug 17 when they said "the FOMC judges that the downside risks to growth have increased appreciably."

I think it's fair to say that the Fed is now officially in risk-management mode. That means preemptive interest rate cuts. I still think they'll do 25bps to Fed Funds and 50bps to the discount rate, but I wouldn't bet against a 50bp/50bp cut.

As always, views welcome...

Yellen on the Economic Outlook

Janet Yellen, the San Francisco Fed President and current FOMC non-voter, gave a speech today on "Recent Financial Developments and the U.S. Economic Outlook."

Before we get into this particular speech, you should know that I really like Dr. Yellen's speeches. She gives the best general speeches of anyone on the FOMC, hands down. They're deeply informed, highly readable, frequently entertaining (really) and they invariably manage to cut to the heart of even the most complicated situations. In short, they cut through the noise.

And, on top of that, she's a professor at my graduate school alma mater (go Bears!).

Now, on to the speech. Frankly, it's so concise and well-written that excerpting it seems counter-productive. You really should read the whole thing. Nevertheless, I've got a few points I want to highlight.

The first half of the speech reviews recent events in both the credit markets and the broader economy. The gloom and doom have been so widespread, at least on Wall Street, that what struck me first was the silver-lining to her speech:

First, she points out that credit conditions have not tightened for everyone:

On the corporate side, prime borrowers have experienced little change in their borrowing costs....

In mortgage markets ... borrowing rates for low-risk conforming mortgages have actually decreased somewhat....

So what's the problem?

[S]ome markets have become downright illiquid; in other words, the markets themselves are not functioning efficiently, or may not be functioning much at all. This illiquidity has become an enormous problem for companies that specialize in originating mortgages and then bundling them to sell as securities.

What should the Fed be doing?

The Fed has three main responsibilities that pertain to these developments: promoting financial stability to help financial markets function in an orderly way, supervising and regulating banks and bank holding companies to ensure the safety and soundness of the banking system, and conducting monetary policy to achieve its congressionally mandated goals of price stability and maximum sustainable output and employment.

Notice the order? First promote stability, then supervise and regulate banks, and last (last!) conduct monetary policy (i.e. fiddle with the Fed Funds rate).

When should the Fed use monetary policy?

For the conduct of monetary policy, the main question is how recent financial developments and other economic factors affect the outlook for the U.S. economy and the risks to that outlook. The reason this is the main question is that monetary policy’s unswerving focus should be on pursuing the Fed’s mandated goals of price stability and full employment. Monetary policy should not be used to shield investors from losses.

OK, easy enough. So has the economic outlook changed?

Despite the hike in borrowing costs for higher-risk corporate borrowers ... 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.

But it's not all rosy:

That said, financial market turmoil seems likely to intensify the downturn in housing.

Beyond the housing sector’s direct impact on GDP growth, a significant issue is its impact on personal consumption expenditures, which have been the main engine of growth in recent years.... A drop in house prices is likely to restrain consumer spending to some extent....

A big issue is whether developments in the relatively small housing sector will spread to the large consumption sector, perhaps through declines in house prices. Should the decline in house prices occur in the context of rising unemployment, the risks could be significant.

But that's enough gloom... back to the silver lining:

We should remember that conditions can change quickly for better or for worse—especially in financial markets—so it’s hard right now to speak with a great deal of confidence about future economic developments. It’s also important to maintain a sense of perspective: past experience does show that financial turbulence can be resolved more quickly than seems likely when we’re in the middle of it. Moreover, the effects of these disruptions can turn out to be surprisingly small. A good example is the aftermath of the Russian debt default in 1998. Many forecasters predicted a sharp economic slowdown as a result; but instead, growth turned out to be robust.

Then, just when you think you know where she's going with this, we read this:

On the same day [the Fed cut the discount rate, Aug 17], the Fed also issued a new statement on monetary policy, which said, and I quote: “although recent data suggest that the economy has continued to expand at a moderate pace, the Federal Open Market Committee judges that the downside risks to growth have increased appreciably.” This assessment apparently is similar to that of market participants. Investors’ perceptions of increased downside risks have resulted in a notable decline in the rates on federal funds futures contracts and their counterparts abroad. The statement emphasized that the Committee is prepared to act as needed to mitigate the adverse effects on the economy arising from the disruptions in financial markets.

I had to read that three times, because I didn't quite believe it the first two times. Now Janet Yellen isn't an FOMC voter this year, but her opinions are taken seriously and her voice carries a lot of weight. She just said the FOMC agrees with the Fed Funds options market, which is currently pricing in these odds for cuts:


So despite all the talk of using other policy options to deal with the credit market illiquidity, it sounds to me like there's going to be a very lively debate at the FOMC about whether to cut the Fed Funds rate 25bps or 50 bps. I'm guessing Janet Yellen in now in the 50bps camp. I'm also guessing that she thinks those 50bps should be taken away if and when the credit market liquidity problems abate, which, as she says, could happen more quickly than people expect.

Views welcome...

Charles Plosser on Monetary Policy and Financial Stability

Sept 8: Philadelphia Fed President Charles Plosser on Monetary Policy and Financial Stability.This is a really interesting speech. But before I dig into it, some background: Since the beginning of the current credit market turmoil, there have been repeated and vocal calls for a significant reduction in the Fed Funds rate. Fedspeak so far has focused on other policy responses to the credit market liquidity crunch, specifically through aggressive discount window lending. The Fed has acknowledged that there are now greater downside risks to the outlook, but maintained that a Fed Funds rate cut would be contingent on incoming macro data (as opposed to credit market data) showing a deterioration in the real economy. So far the employment report has come in weak, but the ISM index and the Beige Book were neutral. Meanwhile, in his concluding remarks at the Jackson Hole symposium, the head of the NBER, Martin Feldstein, suggested that the Fed should cut rates immediately, possibly by as much as 100 bps. Plosser's speech is a repudiation of that view:

Temporary disturbances that don’t affect the forecast for inflation and growth over the time horizon that monetary policy affects the economy do not necessitate a change in the target funds rate. But shocks that have a more lasting impact and cause the forecast for inflation and growth to deviate significantly from the FOMC’s goals do call for a change in monetary policy.

...

The U.S. economy has proven to be very resilient to all sorts of shocks over the past several decades. In part this reflects the fact that not all sectors of the economy move together, and a decline in one sector does not always imply major problems in the economy as a whole.

...

When information indicates that the outlook for economic growth and inflation has changed, one still has to ask whether it has changed enough to impede the achievement of the Fed’s goals of price stability and maximum sustainable economic growth. As I mentioned, the economy is remarkably resilient. One must also ask how much monetary policy can influence that forecast over the relevant time horizon. Thus the Committee usually does not base its decision to change monetary policy on any one number, but instead assesses the cumulative impact of all incoming data for the outlook in light of its ultimate goals.

...

Policymakers must be careful to allow the marketplace to make necessary corrections in asset prices. To do otherwise would risk misallocating resources and risk-bearing, as well as raise moral hazard problems. This could ultimately increase, rather than reduce, risks to the financial system.

...

Providing liquidity in the face of a financial shock that threatens the orderly functioning of markets is an important function of the central bank. The Fed has taken extraordinary steps at other times in the past two decades to help keep financial markets functioning. It is important to realize that doing so does not necessarily require a change in the target fed funds rate.

...

In those cases when financial shocks lead to substantial and sustained reassessments of the economic outlook in relation to the Fed’s ultimate objectives for price stability and economic growth, the Fed may have to take actions, not only to address the financial shock, but to change monetary policy as well.

...

I believe disruptions in financial markets can be addressed using the tools available to the Federal Reserve without necessarily having to make a shift in the overall direction of monetary policy. A change in monetary policy would be required if the outlook for the economy changes in a way that is inconsistent with the Fed’s goals of price stability and maximum sustainable economic growth.

The remainder of the speech focuses on the tools the Fed has available, other than the Fed Funds rate target, to deal with financial stability issues. It should be clear from that focus that the Fed wants to solve this problem without resorting to the very blunt tool of significant Fed Funds rate cuts.

Yves Smith and Calculated Risk have addition commentary on the speech.

Anatomy of a Recession (Ed Leamer at Jackson Hole)

This year's Jackson Hole Symposium was on Housing, Housing Finance, and Monetary Policy. If you're interested in learning more about the current subprime mess, the symposium proceedings are a good place to start.

Ed Leamer, from UCLA, presented a paper on Housing and the Business Cycle (pdf). It's well worth reading in detail. He gives a very thorough and readable analysis of the last 10 recessions, detailing how recessions start (a downturn in residential housing investment, not housing prices), how they spread (weakness in consumer spending first on durables, then non-durables, then services, but not business spending), how they deepen once they've started (a fall in business investment in equipment, software and inventories), and finally how the end: housing investment recovers, then consumer spending recovers, and lastly business spending recovers. Eight of the last ten recessions fit this mold; 1953 and 2001 were the two exceptions.

The recovery is aided by cuts in the Fed funds rate, which disproportionately stimulate housing demand and which have historically signaled the beginning of the end of a recession. This time, however, the Fed's already used up those bullets during its last round of cuts in 2001-2003. With the huge housing inventory overhang, there's no more housing investment left to stimulate. So if consumer spending starts to fall, interest rate cuts by the Fed might support housing prices by making mortgage finance cheaper, but housing investment isn't going to recover in the way that has typically been required to end a recession. So a consumer recession could be long-lasting.

The paper is long (73 pages), but lots of graphs and his conversational writing style make it easy reading.

Getting up to speed...

Hello! Welcome to The Talking Fed.

My name is Marc; I'm a bit of a Fed addict.

Over the last couple years of following the Fed closely, I've come to the conclusion that there is simply no better way to get a quick but firm grasp of major macro policy issues than to read and digest Fed speeches.

So the goal here is to blog about every speech by every FOMC member, as well as selected other Fed research and data releases (all in my spare time, as this is only tangentially related to my actual job).

To get up to speed, here's a summary of Fed communications from the last few weeks:

Aug 31: Chairman Ben Bernanke on Housing, Housing Finance, and Monetary Policy at Jackson Hole.

Sept 1: Fed Governor Frederic Mishkin on Housing and the Monetary Transmission Mechanism at Jackson Hole.

Sept 5: Beige Book released.

Sept 6: St Louis Fed President Bill Poole on Jobs and Trade.

Sept 6: Fed Governor Randal Kroszner on Analyzing and Assessing Banking Crises.

Sept 6: Dallas Fed President Richard Fisher (text not yet available; Reuters has a summary).

Sept 6: Atlanta Fed President Dennis Lockhart speech entitled After the Feast.

Sept 8: Philadelphia Fed President Charles Plosser on Monetary Policy and Financial Stability.

James Hamilton at Econbrowser provides and excellent summary of the Jackson Hole proceedings; William Polley and Yves Smith offer summaries and analysis of the more recent speeches.

There will be five more speeches in the coming couple days, which I'll cover here, then the usual quiet period until the Sept 18 FOMC meeting (when the real excitement begins!).