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).

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?

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.

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...