Tag Archives: Fed

Mishkin speech

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Not a quick read, but telling – inflation risks seem to be overtaking concerns with the economy:

Does Stabilizing Inflation Contribute to Stabilizing Economic Activity?

(Interesting that this is a question)

The ultimate purpose of a central bank should be to promote the public good through policies that foster economic prosperity. Research in monetary economics describes this purpose by specifying monetary policy objectives in terms of stabilizing both inflation and economic activity. Indeed, this specification of monetary policy objectives is exactly what is suggested by the dual mandate that the Congress has given to the Federal Reserve to promote both price stability and maximum employment.1

Yes, just as the mainstream says, and FOMC voting member Fisher restate recently: price stability is a necessary condition for optimal long-term employment and growth.

We might worry that, under some circumstances, the objectives of stabilizing inflation and economic activity could conflict, particularly in the short run. However, economic research over the past three decades suggests that such conflicts may not, in fact, be that serious. Indeed, stabilizing inflation and stabilizing economic activity are mutually reinforcing not only in the long run, but in the short run as well. In my remarks today, I would like to outline how economic researchers came to that conclusion, and in so doing, explain why it is so important to achieve and maintain price stability.2

Seems the emphasis is now on price stability. The question remains whether talk will translate to action.

The Long Run
Both economic theory and empirical evidence indicate that the stabilization of inflation promotes stronger economic activity in the long run.3

(I don’t agree, but that’s another story. Congressmen do, however, need low inflation to stay in office, hence the dual mandate.)

Two principles underlie that conclusion. The first principle is that low inflation is beneficial for economic welfare. Rates of inflation significantly above the low levels of recent years can have serious adverse effects on economic efficiency and hence on output in the long run. The distortions from a moderate to high level of long-run inflation are many. High inflation can cause confusion among households and firms, thereby distorting savings and investment decisions (Lucas, 1972; Briault, 1995; Shafir, Diamond, and Tversky, 1997).

(I don’t agree that these ‘distortions’, if any, are qualitatively less supportive of public purpose.)

The interaction of inflation and the tax code, which is often applied to nominal income, can have adverse effects, especially on the incentive of firms to invest in productive capital (Feldstein, 1997).

(If so, that’s a reason to adjust the tax code, rather than a ‘problem’ with inflation per se?)

Infrequent nominal price adjustment implies that high inflation results in distorted relative prices, thereby leading to an inefficient allocation of resources (Woodford, 2003).

(Versus our current allocation of real resources??? But yes, these are the mainstream pillars.)

And high inflation distorts the financial sector as firms and households demand greater protection from inflation’s erosion of the value of cash holdings (English, 1999).

As above. It’s already hard to pin down any real value added to most, if not all our financial sector…

The second principle is the lack of a long-run tradeoff between unemployment and the inflation rate. Rather, the long-run Phillips curve is vertical, implying that the economy gravitates to some natural rate of unemployment in the long run no matter what the rate of inflation is (Friedman, 1968; Phelps, 1968).4

And the mainstream also adds ‘no matter what the fiscal balance’.

The natural rate, in turn, is determined by the structure of labor and product markets, including elements such as the ease with which people who lose their jobs can find new employment and the pace at which technological progress creates new industries and occupations while shrinking or eliminating others. Importantly, those structural features of the economy are outside the control of monetary policy. As a result, any attempt by a central bank to keep unemployment below the natural rate would prove fruitless. Such a strategy would only lead to higher inflation that, as the first principle suggests, would lower economic activity and household welfare in the long run.

Yes, the mainstream believes this, and the general assumption is that 4.75% is currently the natural rate of unemployment. January unemployment was reported at 4.9%; so, this implies we are already very near full employment, and therefore lowering rates to help the economy may only generate more inflation, and not more output.

Empirical evidence has starkly demonstrated the adverse effects of high inflation (e.g., see the surveys in Fischer, 1993, and Anderson and Gruen, 1995). In most industrialized countries, the late 1960s to early 1980s was a period during which inflation rose to high levels while economic activity stagnated. While many factors contributed to the improved economic performance of recent decades, policymakers’ focus on low and stable inflation was likely an important factor.5

Correct, only ‘likely’. I attribute other factors to the real performance, but, again, that’s another story.

The Short Run
Although there is no long-run tradeoff between unemployment and inflation, in the short run, expansionary monetary policy that raises inflation can lower unemployment and raise employment. That is, the short-run Phillips curve is not vertical.

(This is also theoretically and empirically subject to much recent debate.)

That fact would seem to suggest that achieving the dual goals of price stability and maximum sustainable employment might at times conflict. However, several lines of research provide support for the view that stabilization of inflation and economic activity can be complementary rather than in conflict.

Economists have long recognized that some sources of economic fluctuations imply that output stability and inflation stability are mutually reinforcing. Consider a negative shock to aggregate demand (such as a decline in consumer confidence) that causes households to cut spending. The drop in demand leads, in turn, to a decline in actual output relative to its potential–that is, the level of output that the economy can produce at the maximum sustainable level of employment. As a result of increased slack in the economy, future inflation will fall below levels consistent with price stability, and the central bank will pursue an expansionary policy to keep inflation from falling.

Yes, the FOMC has believed increased slack would bring down the level of inflation. And, they further believed that there was some risk of a total financial collapse, which would result in a massive 1930s style deflation. Not sure if they still do.

The expansionary policy will then result in an increase in demand that boosts output toward its potential to return inflation to a level consistent with price stability. Stabilizing output thus stabilizes inflation and vice versa under these conditions.

For example, the Federal Reserve reduced its target for the federal funds rate a total of 5-1/2 percentage points during the 2001 recession; that stimulus not only contributed to economic recovery but also helped to avoid an unwelcome decline in inflation below its already low level.

The international context was deflationary, as import prices were falling and putting downward pressure on domestic prices. (Also, the Fed economists trace the recovery to the ‘fiscal impulses’ rather than the lower interest rates.)

At other times, a tightening of the stance of monetary policy has prevented the economy from overheating and generating a boom-bust cycle in the level of employment as well as an undesirable upward spurt of inflation.

This is also difficult to separate from the fiscal cycle, but, again, it is the mainstream view.

One critical precondition for effective central-bank easing in response to adverse demand shocks is anchored long-run inflation expectations. Otherwise, lowering short-term interest rates could raise inflation expectations, which might lead to higher, rather than lower, long-term interest rates, thereby depriving monetary policy of one of its key transmission channels for stimulating the economy.

Yes, the mainstream considers inflation expectations as the critical determinant of the price level.

The role of expectations illustrates two additional basic principles of monetary policy that help explain why stabilizing inflation helps stabilize economic activity: First, expectations of future policy actions and accompanying economic conditions play a crucial role in determining the effects of current policy actions on the economy. Second, monetary policy is most effective when the central bank is firmly committed, through its actions and statements, to a “nominal anchor”–such as to keeping inflation low and stable. A strong commitment to stabilizing inflation helps anchor inflation expectations so that a central bank will not have to worry that expansionary policy to counter a negative demand shock will lead to a sharp rise in expected inflation–a so-called inflation scare (Goodfriend, 1993, 2005). Such a scare would not only blunt the effects of lower short-term interest rates on real activity but would also push up actual inflation in the future. Thus, a strong commitment to a nominal anchor enables a central bank to react more aggressively to negative demand shocks and, therefore, to prevent rapid declines in employment or output.

The last few weeks have seen an elevated use of this kind of definitive, hawkish language, even from some of the Fed doves.

Unlike demand shocks, which drive inflation and economic activity in the same direction and thus present policymakers with a clear signal for how to adjust policy, supply shocks, such as the increases in the price of energy that we have been experiencing lately, drive inflation and output in opposite directions. In this case, because tightening monetary policy to reduce inflation can lead to lower output, the goal of stabilizing inflation might conflict with the goal of stabilizing economic activity.

Yes, that is what they see developing as the current set of options.

Here again, a strong, previously established commitment to stabilizing inflation can help stabilize economic activity, because supply shocks, such as a rise in relative energy prices, are likely to have only a temporary effect on inflation in such circumstances. When inflation expectations are well anchored, the central bank does not necessarily need to raise interest rates aggressively to keep inflation under control following an aggregate supply shock. Hence, the commitment to price stability can help avoid imposing unnecessary hardship on workers and the economy more broadly.

The Fed has to manage expectations at all times.

The experience of recent decades supports the view that a substantial conflict between stabilizing inflation and stabilizing output in response to supply shocks does not arise if inflation expectations are well anchored. The oil shocks in the 1970s caused large increases in inflation not only through their direct effects on household energy prices but also through their “second round” effects on the prices of other goods that reflected, in part, expectations of higher future inflation.

Yes, that’s the mainstream theory.

Sharp economic downturns followed, driven partly by restrictive monetary policy actions taken in response to the inflation outbreaks. In contrast, the run-up in energy prices since 2003 has had only modest effects on inflation for other goods;

(Seems to me it took about three years this time, about the same as back then?)

as a result, monetary policy has been able to avoid responding precipitously to higher oil prices. More generally, the period from the mid-1960s to the early 1980s was one of relatively high and volatile inflation; at the same time, real activity was very volatile. Since the early 1980s, central banks have put greater weight on achieving low and stable inflation, while during the same period, real activity stabilized appreciably.

(Energy and commodity prices also fell with excess supply and then stabilized for almost two decades, bringing down and stabilizing core inflation and stabilizing real activity.)

Many factors were likely at work, but this experience suggests that inflation stabilization does not have to come at the cost of greater volatility of real activity; in fact, it suggests that, by anchoring inflation expectations, low and stable inflation is an important precondition for macroeconomic stability.

Research over the past decade using so-called New Keynesian models has added further support to the proposition that inflation stabilization may contribute to stabilizing employment and output at their maximum sustainable levels. This research has also led to a deeper understanding of the benefits of price stability and the setting of monetary policy in response to changes in economic activity and inflation.

Repeating the need for price stability as a necessary condition for optimal employment and growth.

In particular, research has emphasized the interaction between stabilizing inflation and economic activity and has found that price stability can contribute to overall economic stability in a range of circumstances. The intuition

Okay.

that leads to the conclusion that stabilizing inflation promotes maximum sustainable output and employment is simple, and it holds in a range of economic models whose policy prescriptions have been dubbed the New Neoclassical Synthesis. To begin, the prices of many goods and services adjust infrequently. Accordingly, under general price inflation, the prices of some goods and services are changing while other prices do not, thus distorting relative prices between different goods and services. As a consequence, the profitability of producing the various goods and services no longer reflects the relative social costs of producing them, which in turn yields an inefficient allocation of resources.

(Only if there was efficiency in the first place, where many if not most prices are ‘cost plus’ and institutional structure determines many others, such as health care prices, tax laws, corporate law, etc.)

A policy of price stability minimizes those inefficiencies (Goodfriend and King, 1997; Rotemberg and Woodford, 1997; Woodford, 2003).

There are several subtleties here. First, in some circumstance, relative prices should change. For example, the rapid technological advances in the production of information-technology goods witnessed over the past decades mean that the prices of these goods relative to other goods and services should decline, because fewer economic resources are required for their production. Conversely, shifts in the balance between global demand for, and supply of, oil require that relative prices change to achieve an appropriate reallocation of resources–in this case, the reduced use of expensive energy.

(Makes me wonder how does a financial package designed to help people pay their energy and food bills fits in?)

Thus, the policy prescription refers to stability of the price level as a whole, not to the stability of each individual price.

Second, the New Neoclassical Synthesis suggests that only those prices that move sluggishly, referred to as sticky prices, should be stabilized. Indeed, these models indicate that monetary policy should try to get the economy to operate at the same level that would prevail if all prices were flexible–that is, at the so-called natural rate of output or employment. Stabilizing sticky prices helps the economy get close to the theoretical flexible-price equilibrium because it keeps sticky prices from moving away from their appropriate relative level while flexible prices are adjusting to their own appropriate relative level. The New Neoclassical Synthesis, therefore, does not suggest that headline inflation, in which the weight on flexible prices is larger, should be stabilized. For example, to the extent that households directly consume energy goods with flexible prices, such as gasoline, headline inflation should be allowed to increase in response to an oil price shock. At the same time, insofar as energy enters as an input in the production of goods whose prices are sticky, stabilizing the level of sticky prices would require that the increase in energy-intensive goods prices be offset by declines in the prices of other goods.

Yes – AKA, ‘Don’t let a relative value story turn into an inflation story.’

That reasoning suggests that monetary policy should focus on stabilizing a measure of “core” inflation, which is made up mostly of sticky prices. Simulations with FRB/US, the model of the U.S. economy created and maintained by the staff of the Federal Reserve Board (Mishkin, 2007b), illustrate this point. To keep the simulations as simple as possible, I have assumed that the economy begins at full employment with both headline and core inflation at desired levels. The economy is then assumed to experience a shock that raises the world price of oil about $30 per barrel over two years;

(It actually went up more than that.)

the shock is assumed to slowly dissipate thereafter.

(It hasn’t yet, hence the problem of core converging to headline when headline trends.)

In each of two scenarios, a Taylor rule is assumed to govern the response of the federal funds rate; the only difference between the two scenarios is that in one, the federal funds rate responds to core personal consumption expenditures (PCE) inflation, whereas in the other, it responds to headline PCE inflation.6 Figure 1 illustrates the results of those two scenarios. The federal funds rate jumps higher and faster when the central bank responds to headline inflation rather than to core inflation, as would be expected (top-left panel). Likewise, responding to headline inflation pushes the unemployment rate markedly higher than otherwise in the early going (top-right panel),

Maybe. This function has not held true in recent history.

and produces an inflation rate that is slightly lower than otherwise,

As above.

whether measured by core or headline indexes (bottom panels). More important, even for a shock as persistent as this one, the policy response under headline inflation has to be unwound in the sense that the federal funds rate must drop substantially below baseline once the first-round effects of the shock drop out of the inflation data.7

The basic point from these simulations is that monetary policy that responds to headline inflation rather than to core inflation in response to an oil price shock pushes unemployment markedly higher than monetary policy that responds to core inflation. In addition, because this policy has larger swings in the federal funds rate that must be reversed, it leads to more pronounced swings in unemployment. On the other hand, monetary policy that responds to core inflation does not lead to appreciably worse performance on stabilizing inflation than does monetary policy that responds to headline inflation. Stabilizing core inflation, therefore, leads to better economic outcomes than stabilizing headline inflation.

Yes, they firmly believe that.

Although the simplest sticky-price models imply that stabilizing sticky-price inflation and economic activity are two sides of the same coin, the presence of other frictions besides sticky prices can lead to instances in which completely stabilizing sticky-price inflation would not imply stabilizing employment (or output) around their natural rates. For example, in response to an increase in productivity (a positive technology shock), the real wage has to rise to reflect the higher marginal product of labor inputs, which requires either prices to fall or nominal wages to rise for employment to reach its natural rate. If both nominal wages and prices are sticky, a policy of completely stabilizing prices will force the necessary real wage adjustment to occur entirely through nominal wage adjustment, thereby impeding the adjustment of employment to its efficient level (Blanchard, 1997; Erceg, Henderson, and Levin, 2000). Indeed, if wages are much stickier than prices, the best strategy is to stabilize nominal wage inflation rather than price inflation, thereby allowing price inflation to decline to achieve the required increase in real wages.

Makes sense under mainstream assumptions.

Fluctuations in inflation and economic activity induced by variation over time in sources of economic inefficiency, such as changes in the markups in goods and labor markets or inefficiencies in labor market search, could also drive a wedge between the goals of stabilizing inflation and economic activity (Blanchard and Galí, 2006; Galí, Gertler, and López-Salido, 2007). For example, in sectors of the economy subject to little competitive pressure, prices that firms set tend to be higher and output lower than would prevail under greater competition. Monetary policy is, of course, unable to offset permanently high markups because of the principle, mentioned earlier, that the long-run Phillips curve is vertical. However, a temporary increase in monopoly power that raises markups would exert upward pressure on prices without, at the same time, reducing the productive potential of the economy. That would, indeed, be a case of a tradeoff between stabilizing inflation and stabilizing output.

How about a non-resident monopolist at the margin, like the Saudis?

These examples narrow the degree to which the recent findings of congruence between stabilizing inflation and economic activity apply in all cases, but they do not necessarily overturn the findings. The example of sticky wages would not invalidate the view that stabilizing inflation stabilizes economic activity if wages are sticky, for example, because they are held constant in order to operate as an “insurance” contract between employers and workers (Goodfriend and King, 2001). And for many of the inefficient shocks that drive a wedge between the sustainable level of output and the level of output associated with price stability, monetary policy may be the wrong tool to offset their effects (Blanchard, 2005).

Of course, central banks at times will still face difficult decisions regarding the short-run tradeoff between stabilizing inflation and output. For example, judging from the fit of New Keynesian Phillips curves, a substantial fraction of overall inflation variability seems related to supply-type shocks

(Rather than a ‘monetary phenomena’ as they say, inflation can be a supply shock phenomena?)

that create a tradeoff between inflation and output-gap stabilization (Kiley, 2007b). But the key insight from recent research–that the interaction between inflation fluctuations and relative price distortions should lead to a focus on the stability of nominal prices that adjust sluggishly–will likely prove to have important practical implications that can help contribute to inflation and employment stabilization.

Stabilizing Inflation as a Robust Policy in the Presence of Uncertainty
The discussion so far has been based on the premise that the central bank knows the efficient, or natural, rate of output or employment. However, the natural rates of employment and output cannot be directly observed and are subject to considerable uncertainty–particularly in real time. Indeed, economists do not even agree on the economic theory or econometric methods that should be used to measure those rates.

(And I can give you some good reasons there is no natural rate of unemployment as well.)

These concerns are perhaps even more severe in the most recent models, where fluctuations in natural rates of output or employment can be very substantial (for example, Rotemberg and Woodford, 1997; Edge, Kiley, and Laforte, forthcoming). Furthermore, because the natural rates in the most recent models are defined as the counterfactual levels of output and employment that would be obtained if prices and wages were completely flexible, the estimated fluctuations in natural rates generated by the research are very sensitive to model specification.

If a central bank errs in measuring the natural rates of output and employment, its attempts to stabilize economic activity at those mismeasured natural rates can lead to very poor outcomes. For example, most economists now agree that the natural unemployment rate shifted up for many years starting in the late 1960s and that the growth of potential output shifted down for a considerable time after 1970. However, perhaps because those shifts were not generally recognized until much later (Orphanides and van Norden, 2002; Orphanides, 2003), monetary policy in the 1970s seems to have been aimed at achieving unsustainable levels of output and employment. Hence, policymakers may have unwittingly contributed to accelerating inflation that reached double digits by the end of the decade as well as undesirable swings in unemployment. And although subsequent monetary policy tightening was successful in regaining control of inflation, the toll was a severe recession in 1981-82, which pushed up the unemployment rate to around 10 percent.

How about the tight fiscal policy from the interaction of inflation and the tax structure (described by Governor Mishkin above) that drove the budget to a small surplus in 1979, along with oil gapping from $20 to $40 as the Saudis hiked price and accumulated $US financial assets rather than spending their income, which drained aggregate demand from the US economy.

Uncertainty about the natural rates of economic activity implies that less weight may need to be put on stabilizing output or employment around what is likely to be a mismeasured natural rate (Orphanides and Williams, 2002). Furthermore, research with New Keynesian models has found that overall economic performance may be most efficiently achieved by policies with a heavy focus on stabilizing inflation (for example, Schmitt-Grohé and Uribe, 2007).

Back to stabilizing inflation, the main theme of the speech.

Conclusion
Because monetary policy has not one but two objectives, stabilizing inflation and stabilizing economic activity, it might seem obvious that those objectives would usually, if not always, conflict. As so often occurs with the “obvious,” however, the impression turns out to be incorrect. The economic research that I have discussed today demonstrates, rather, that the objectives of price stability and stabilizing economic activity are often likely to be mutually reinforcing. Thus, the answer to the title of this speech–“Does stabilizing inflation contribute to stabilizing economic activity?”–is, for the most part, yes.

Price stability is a necessary condition for optimal employment and growth.

A key policy recommendation from the past three decades of research in monetary economics is that monetary policy makers must always keep their eye on inflation and emphasize the importance of price stability in their actions and communications.

First time I’ve seen the word ‘action’ regarding inflation, and it’s placed first.

Doing so does not mean that monetary policy makers are less concerned about stabilizing economic activity. Rather, by appropriately focusing on stabilizing inflation along the lines I have outlined here, monetary policy is more likely to better stabilize economic activity.

A speech can’t get any more hawkish than that.

Lots of data between now and March 18th.

I still expect weakness and rising inflation.

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Bloomberg: Fed Sees Rate Low `for a Time’ Then Possible Reversal

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Fed Sees Rate Low `for a Time’ Then Possible Reversal (Update1)

by Scott Lanman

Enlarge Image/Details

(Bloomberg) Federal Reserve officials signaled they are prepared to quickly reverse last month’s interest-rate cuts after concluding that borrowing costs need to be kept low for now.

Policy makers cut their 2008 growth forecasts and said that rates should be held down “for a time,” minutes of their Jan. 29-30 meeting showed yesterday. They also called inflation “disappointing,” and some foresaw raising rates, possibly at a “rapid” pace once the economy recovers.

The threat goes beyond remarks by Chairman Ben S. Bernanke, who last week warned that policy will have to be “calibrated” over the next year to meet both inflation and growth objectives.

Yes, the issue is they believe an output gap greater than ‘zero’ is required to bring down inflation over time; so, they can’t afford to let the economy fully recover and grow at an inflationary pace.

So while they don’t want to allow a massive collapse, they also don’t want the output gap to be too narrow to bring down inflation.

This could mean, for example, a GDP growth rate speed limit of between 1% and 2% given current data points of GDP growth and coincident inflation.

That would mean achieving ‘stability’ at current GDP and employment levels rather than a ‘recovery’ to lower unemployment and 2.5%+ GDP.

With inflation expectations considered to be on the verge of elevating, the FOMC now faces elevating risks of both inflation and recession.

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More on ‘now vs the 70’s’

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Comments people emailed me and my responses:

Bob Hart wrote:

http://www.wtrg.com/prices.htm

This graph supports your statement below:
Prices fell from a high of maybe $40 per barrel to the $10-15 range for the next two decades

2008-02-21 Crude Oil Production OPEC Countries

Thanks!

“So, there is nothing the US can do to keep core inflation in check? Only the Saudis (and other oil producers) control US inflation?”

In this case, yes. If the Saudis keep hiking cpi goes up and an inflation begins via the various channels that connect energy with other prices. And in this case exacerbated by our pension funds.

Randall Wray wrote:

right: previous high inflations have always been: energy, food, and shelter costs. I haven’t looked at shelter costs this time around.

Haynes wrote:

Great piece. I’ve been thinking along the same lines over the last few weeks. I wish I had been a lot shorter the long end but think that trade still makes sense, especially given future deficits over the next 3-5 years. Having been born in the 1980s and not lived through oil embargos, stock market stagnation and hyper inflation, I am not exactly sure what the play is over the near-term and longer term. If you were to set up a portfolio that couldn’t be changed over the next 3 yrs / 5yrs / 10yrs what do you think the mix should be?

I like AVM’s current mortgage construction: buy FN 5’s versus tailored swap at LIBOR plus 25 basis points with a ‘free’ embedded put. Put it on and sit tight for Fed hikes. Worst case you get LIBOR plus 25.

Call your AVM salesman ASAP before the spread vanishes!!!

Do you buy TIPS / Broad based commodities indices (DJP) / Gold / Stocks / short end / long end?

‘Raw’ TIPS imply a low real rate. If the Fed decides to rais the real rate, you lose.

You could do a 10 year break even bit, especially in Japan, but I like the mortgage trade better.

Think that you could get killed owning bonds but input prices have already run so much its hard to buy commodities in a potentially declining demand environment. Do you buy stocks hoping they simply stay inline with inflation or do you just hold cash?

In the medium- and long-term the S&P will probably more than keep up with inflation, but help to get the right one and to get the right entry point.

Thanks for the help. I know you are busy but any insight would be much appreciated. thanks.

Philip wrote:

I agree entirely with the view that the 1970s was a question of energy prices, a supply-side phenomenon rather than anything else. The implications for policy are important; we might produce a problem where it does not exist if policy is predicated on the wrong interpretation of the problem.

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Now versus the 1970s

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Looks very much like the 1970’s to me.

Yes, the labor situation was different then – strong unions due to strong businesses with imperfect competition, umbrella pricing power and the like.

But it was my take then that inflation was due to energy prices, and not wage pressures. Inflation went up with oil leading throughout the 1970’s and the rate of inflation came down only when oil broke in the early 1980’s, due to a sufficiently large supply response. It was cost push all the way, and even the -2% growth of 1980 didn’t do the trick. Nor did 20%+ interest rates. Inflation came down only after Saudi Arabia, acting then as now as swing producer, watched its output fall to levels where it couldn’t cut production any more without capping wells, and was forced to hit bids in the crude spot market. Prices fell from a high of maybe $40 per barrel to the $10-15 range for the next two decades, and inflation followed oil down. And when demand for Saudi production recovered a few years ago they quickly re-assumed the role of swing producer and quietly began moving prices higher even as they denied and continue to deny they are acting as ‘price setter’ with inflation again following.

And both then and now everything is ultimately ‘made out of food and energy’ and hikes in those costs work through to everything else over time.

There are differences between then and now. A new contributor to inflation this time around are our own pension funds, who have been allocating funds to a passive commodity strategies as an ‘asset class.’ This both drives up costs and inflation directly, and adds to aggregate demand (also previously discussed at length).

Also different is that today we’ve outsourced a lot of the labor content of our gdp, so I suggest looking to import prices of high labor content goods and services as a proxy for real wages. And even prices from China, for example, have gone from falling to rising, indicating an inflation bias that corresponds to the wage increases of the 70’s.

Costs of production have been going up as indicated anecdotally by corporate data and by indicators such as the PPI and its components. These costs at first may have resulted in some margin compression, but recent earnings releases seem to confirm pricing power is back and costs are pushing up final prices, even as the US GDP growth slows.

US policies (discussed in previous posts) have contributed to a reduced desire for non residents to accumulate $US financial assets. This plays out via market forces with a $US weak enough to entice foreigners to buy US goods and services, as evidenced by double digit growth in US exports and a falling trade gap. This ‘external demand’ is providing the incremental demand that helps support US gdp, and corporate margins via rapidly rising export prices.

World demand is high enough today to support $100 crude, and push US cpi towards 5%, even with US GDP running near zero.
As long as this persists the cost push price pressures will continue.

Meanwhile, markets are pricing continued ff rate cuts as they assume the Fed will continue to put inflation on the back burner until the economy turns. While this is not a precise parallel with the 1970’s, the era’s were somewhat similar, with Chairman Miller ultimately considered too soft on inflation during economic weakness. He was replaced by Chairman Volcker who immediately hiked rates to attack the inflation issue, even as GDP went negative.

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Bank of France says Fed overreacted to market decline

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Interesting they would take a shot like that at the Fed. Probably concerned about Euro strength and the US gaining export share.

Bank of France Says Fed Overreacted to Market Decline

By Francois de Beaupuy

(Bloomberg) The Bank of France said the U.S. Federal Reserve may have cut interest rates too much and too quickly in response to financial-market declines.

An unsigned article in the Paris-based bank’s monthly bulletin, published today, said new financial products have amplified asset price swings.

That may lead to “stronger monetary reactions than what would otherwise be necessary, as shown by the recent decision of the Federal Reserve,” the article said.

The unusual criticism by one central bank of another may reflect the European Central Bank’s reluctance to follow its U.S. and U.K. counterparts in cutting rates to cushion against an economic slowdown. The ECB left its benchmark rate at 4 percent this month even as growth prospects deteriorate.

“The Bank of France is simply going along the ECB line, trying to manage expectations away from any response similar to the Fed,” said Gareth Claase, an economist at Royal Bank of Scotland Plc in London. “The Fed moved quickly and far. The ECB is likely to move slowly and little.”

The Fed has lowered its benchmark rate by 2.25 percentage points since September to 3 percent — including a three-quarter point emergency cut on Jan 22 — and traders expect another reduction next month.

‘Unusually High’
German Finance Minister Peer Steinbrueck said Feb. 12 he didn’t see ECB Bank President Jean-Claude Trichet shifting to a neutral stance, which might be a prelude to cutting rates. At a press conference last week, Trichet said uncertainty about growth prospects is “unusually high,” prompting traders to raise bets on a rate cut.

“Pressure on the ECB increased after the massive Fed rate cuts,” said Michael Schubert, an economist at Commerzbank AG in Frankfurt. “The ECB has said that it won’t act anytime soon. It doesn’t want to be driven by the Fed.”

German investor confidence unexpectedly increased this month, a sign the European economy can weather the U.S. slowdown.

“It’s unusual for central banks to criticize the actions of others,” said Dominic Bryant, an economist at BNP Paribas in London. “The U.S. is in recession, so it’s somewhat difficult to say the Fed overreacted.”

♥

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February 19 recap

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Might be a revealing day coming up.

I’m watching for markets to begin to link higher oil prices to the potential for higher interest rates, rather than the reverse as has been the case since August.

With oil up to the mid 97 range this am, the question is whether short term interest rates move higher due to possible Fed concerns about inflation, even with weak growth and continuing financial sector issues. Even Yellen recently voiced concerns about energy prices now feeding into core inflation measures which are now above her ‘comfort zone.’ And Friday Mishkin said more than once in a short speech that the Fed had to be prepared to reverse course if inflation expectations elevate.

Yes, credit spreads are a lot wider, but when, for example, I ask the desk if any of the wider AAA’s are ultimately money good, I get a lot of uncertainty. So it seems to me in many cases markets are functioning to price risk at perceived potential default levels? So some of the current spreads may be wider than they ‘should be’ but maybe not all that much?

Yes, the financial sector has been damaged (and damnaged).

Yes, housing is weak without the bid for subprime housing of 18 months ago.

And yes, the consumer has slowed down some.

However, exports are booming like a third world country- growing around 13% per year, also do to financial market shifts, this time away from $US financial assets.

This is offsetting weakening domestic demand and keeping gdp positive, at least so far.

Meanwhile, it looks like a full blow 1970’s inflation in the making if food, fuel, and import/export prices keep doing what they are doing.

And with Saudi production continuing to creep up at current pricing, seems demand is more than strong enough for them to keep hiking prices.

And suddenly Yellen and Mishkin, both doves, substantially elevate their anti inflation rhetoric, as core levels have gone just beyond even their comfort zones.

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Mishkin’s speech

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From today’s speech:

A central bank must always be concerned with inflation as well as growth. As I have emphasized in an earlier speech about inflation dynamics, the behavior of inflation is significantly influenced by the public’s expectations about where inflation is likely to head in the long run (Mishkin, 2007a). Therefore, preemptive actions of the sort I have described here would be counterproductive if these actions caused an increase in inflation expectations and in the underlying rate of inflation; in other words, the flexibility to act preemptively against a financial disruption presumes that inflation expectations are firmly anchored and unlikely to rise during a period of temporary monetary easing.

There have been recent signs of inflation expectations rising, including today’s jump in the one year Michigan expectation to 3.7%.

Indeed, as I have argued elsewhere, a commitment to a strong nominal anchor is crucial for both aspects of the dual mandate, that is, for achieving maximum employment as well as for keeping inflation low and stable (Mishkin, 2007b). Policymakers therefore need to closely monitor information about underlying inflation and longer-run inflation expectations, and the central bank must be ready to hold steady or even raise the policy rate if the evidence clearly indicates a significant rise in inflation expectations.

Says here he will vote to hike if expectations elevate.

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Preliminary February Michigan survey

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Survey shows people are watching TV and reading the newspapers.

For the third consecutive month, more households reported that their financial situation had worsened rather than improved over the past year.

But due to inflation, not falling nominal income:

Moreover, due to a higher expected inflation rate and smaller expected wage gains, 46% of all households anticipated declines in their inflation adjusted incomes during the year ahead, the worst reading since the 1990 recession.
Overall, consumers expected a year-ahead inflation rate of 3.7% in early February, up from 3.4% in the prior three months.

The Fed uses this as one of their inflation expectation indicators. It has gone from too high to even higher.

In contrast, long term inflation expectations, a proxy for core inflation, was unchanged and well anchored at 3.0% in February.

Yes, but still too high.

Eighty-six percent of all consumers thought that the national economy was in decline, the highest level recorded since 1982. Year-ahead prospects for the national economy were just as bleak as 72% expected bad times, a level comparable to the worst levels in the recessions of the early 1990’s and 1980’s. The anticipated downturn is expected to result in more joblessness in the year ahead, a prime concern of consumers. A rising unemployment rate was expected by 52% of all consumers in early February, up from 33% a year ago, and comparable to the peak levels recorded in the months surrounding prior recessions.

The rest is more of the same and shows influence of the media.

Personal Finances—Current went from 98 to 96

Not bad.

Personal Finances—Expected 116 to 108

As above.

The survey clearly shows expectations have deteriorated for both the economy and inflation.

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Bernanke written testimony

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As you know, financial markets in the United States and in a number of other industrialized countries have been under considerable strain since late last summer. Heightened investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates, triggered the financial turmoil. However, other factors, including a broader retrenchment in the willingness of investors to bear risk, difficulties in valuing complex or illiquid financial products, uncertainties about the exposures of major financial institutions to credit losses, and concerns about the weaker outlook for the economy, have also roiled the financial markets in recent months.

As the concerns of investors increased, money center banks and other large financial institutions have come under significant pressure to take onto their own balance sheets the assets of some of the off-balance-sheet investment vehicles that they had sponsored. Bank balance sheets have swollen further as a consequence of the sharp reduction in investor willingness to buy securitized credits, which has forced banks to retain a substantially higher share of previously committed and new loans in their own portfolios. Banks have also reported large losses, reflecting marked declines in the market prices of mortgages and other assets that they hold. Recently, deterioration in the financial condition of some bond insurers has led some commercial and investment banks to take further markdowns and has added to strains in the financial markets.

This had been expected to cause banks to not be able to lend as before. So far that hasn’t happened. Funds are there for credit-worthy borrowers.

The banking system has been highly profitable in recent years and entered this episode with strong capital positions. Some institutions have responded to their recent losses by raising additional capital. Notwithstanding these positive factors, the unexpected losses and the increased pressure on their balance sheets have prompted banks to become protective of their liquidity and balance sheet capacity and, thus, to become less willing to provide funding to other market participants, including other banks. Banks have also become more restrictive in their lending to firms and households. For example, in the latest Senior Loan Officer Opinion Survey conducted by the Federal Reserve, banks reported having further tightened their lending standards and terms for a broad range of loan types over the past three months. More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth.

Bernanke sees the above as stemming from the supply side – bank’s becoming ‘protective’ of their balance sheets and rationing credit.

I see it, at the macro level, as banks being prudent in trying to lend only to people who can pay it back at spreads that compensate them for perceived risks.

In part as the result of the developments in financial markets, the outlook for the economy has worsened in recent months, and the downside risks to growth have increased.

Not sure if this means things have gotten worse since the last meeting – probably not.

To date, the largest economic effects of the financial turmoil appear to have been on the housing market, which, as you know, has deteriorated significantly over the past two years or so. The virtual shutdown of the subprime mortgage market and a widening of spreads on jumbo mortgage loans have further reduced the demand for housing, while foreclosures are adding to the already-elevated inventory of unsold homes. Further cuts in homebuilding and in related activities are likely.

Not much spillover yet.

Conditions in the labor market have also softened. Payroll employment, after increasing about 95,000 per month on average in the fourth quarter, declined by an estimated 17,000 jobs in January.

He must know January is subject to revision in a couple of weeks.

Employment in the construction and manufacturing sectors has continued to fall, while the pace of job gains in the services industries has slowed. The softer labor market, together with factors including higher energy prices, lower equity prices, and declining home values, seem likely to weigh on consumer spending in the near term.

Forward looking only? Seems he doesn’t think the consumer has already cut back all that much.

On the other hand, growth in U.S. exports should continue to provide some offset to the softening in domestic demand, and the recently approved fiscal package should help to support household and business spending during the second half of this year and into the first part of next year.

This could mean the Fed forecasts are for stronger growth now that the fiscal bill has been signed.

On the inflation front, a key development over the past year has been the steep run-up in the price of oil. Last year, food prices also increased exceptionally rapidly by recent standards, and the foreign exchange value of the dollar weakened.

The three negative supply shocks.

All told, over the four quarters of 2007, the price index for personal consumption expenditures (PCE) increased 3.4 percent, up from 1.9 percent during 2006. Excluding the prices of food and energy, PCE price inflation ran at a 2.1 percent rate in 2007, down a bit from 2006.

Doesn’t mention the recent acceleration of core PCE over the last several months.

To date, inflation expectations appear to have remained reasonably well anchored,

Only ‘reasonably’.

but any tendency of inflation expectations to become unmoored or for the Fed’s inflation-fighting credibility to be eroded could greatly complicate the task of sustaining price stability and reduce the central bank’s policy flexibility to counter shortfalls in growth in the future.

Indicating that if they do elevate, it’s too late. Most of the FOMC agrees with this.

Accordingly, in the months ahead we will be closely monitoring inflation expectations and the inflation situation more generally.

To address these developments, the Federal Reserve has moved in two main areas. To help relieve the pressures in the interbank markets, the Federal Reserve–among other actions–recently introduced a term auction facility (TAF), through which prespecified amounts of discount window credit can be auctioned to eligible borrowers, and we have been working closely and cooperatively with other central banks to address market strains that could hamper the achievement of our broader economic objectives.
In the area of monetary policy, the Federal Open Market Committee (FOMC) has moved aggressively, cutting its target for the federal funds rate by a total of 225 basis points since September, including 125 basis points during January alone. As the FOMC noted in its most recent post-meeting statement, the intent of these actions is to help promote moderate growth over time and to mitigate the risks to economic activity.

Promote moderate growth over time. With inflation where it is, they can’t promote robust growth or full-employment. They need a positive output gap to bring inflation down to their long-term objectives.

A critical task for the Federal Reserve over the course of this year will be to assess whether the stance of monetary policy is properly calibrated to foster our mandated objectives of maximum employment and price stability and, in particular, whether the policy actions taken thus far are having their intended effects.

Doesn’t sound like there’s another cut coming? The ‘stance’ is the real rate, and without inflation coming down, keeping the stance constant doesn’t mean cutting rates.

Monetary policy works with a lag. Therefore, our policy stance must be determined in light of the medium-term forecast for real activity and inflation, as well as the risks to that forecast.

As follows:

At present, my baseline outlook involves a period of sluggish growth,

It would have to get worse for a change in stance.

followed by a somewhat stronger pace of growth starting later this year as the effects of monetary and fiscal stimulus begin to be felt.

Somewhat stronger – can’t get too strong and close the output gap.

At the same time, overall consumer price inflation should moderate from its recent rates, and the public’s longer-term inflation expectations should remain reasonably well anchored.

Headline CPI expected to flatten, but doesn’t mention core, which is probably projected to rise as it catches up to headline.

Although the baseline outlook envisions an improving picture, it is important to recognize that downside risks to growth remain, including the possibilities that the housing market or the labor market may deteriorate to an extent beyond that currently anticipated, or that credit conditions may tighten substantially further. The FOMC will be carefully evaluating incoming information bearing on the economic outlook and will act in a timely manner as needed to support growth and to provide adequate insurance against downside risks.

Barring a major deterioration in the growth outlook from ‘sluggish’ by the next meeting seems rates may be on hold.

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Bernanke preview

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If inflation is now above Bernanke’s comfort zone, as per Yellen who has been more dovish than Bermanke, and above their long-term target of maybe 2%, it can only be brought down by maintaining an output gap greater than zero under the mainstream theory they all subscribe to.

Particularly with the negative supply shocks of food, crude, and import/export prices persisting. And with energy prices (headline CPI) now showing up in core prices, also as per Yellen, inflation expectations are showing signs of coming unglued.

And the fiscal package has likely increased the Fed’s growth forecasts (smaller output gap) for Q2, Q3, and Q4.

The Fed believes a zero output gap means about a 4.75% unemployment rate.

That means the Fed wants to keep the economy from deteriorating and unemployment from rising, but it also doesn’t want unemployment falling to 4.75% which would mean it would have to act (rate hikes) to get it back up to something over 5% to meet long-term inflation targets.

So while Bernanke can say he stands by to do everything necessary to avoid a financial collapse, he also can’t allow the output gap to go to zero.

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