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.

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.